Bankruptcy Code in the Indian Financial System

Posted in Finance Articles, Total Reads: 1206 , Published on 02 February 2017
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Recently the government has passed a historic bill: Insolvency and Bankruptcy Code (IBC) to amend and consolidate existing law on bankruptcy, and to create a unified legal framework. Before discussing the details of IBC and analysing its impact, first we must examine the current scenario of NPA across banks and the different loan recovery processes, in order to build the ground for the bankruptcy code.

The banking system is a crucial pillar for the economic growth and prosperity of any country. This fact was clearly evident during the Global Financial Crisis when every major world economy and their banking system had collapsed. But the Indian banking system had successfully sailed through the stormy waters of GFC and emerged as a strong entity. However, recently, this robustness has been probed due to the rise in NPAs. Many loan recovery processes like SICA, Lok Adalat, DRT, SARFAESI Act have been implemented by the Indian government and regulators, but none of them have proved to be efficient enough to handle this situation. Consequently, the banks are running in huge losses. 


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Loan Recovery Processes

The Government initiated taking actions towards the increasing problem of NPA in the 1980s. The first major step taken was Sick Industrial Companies Act (SICA) which aimed at timely detection of sick companies and required quick action for either revival or liquidation. However, SICA had several drawbacks. Firstly, any firm was regarded sick only after its net worth had eroded by at least 50%. This worked against the foremost objective of quick detection. All these processes required in the involvement of a legal intermediary such as people’s court, DRT for resolution. The government realized the need for prompt recovery and presented the SARFAESI Act. The SARFAESI Act allowed banks to take possession of the defaulter’s assets and sell them to recover the debt. As the court’s intervention in this process was eliminated, the process could be accelerated. The SARFAESI Act also overcame the issue of debtor fraudulently using SICA as a mode to prevent/ delay repayments to creditors. The Insolvency and Bankruptcy Code(IBC) involves the Insolvency Resolution Process(IRP) which can be initiated by any creditor, that is, a financial firm or an operational creditor like non-financial firm or an employee when an individual or a firm default on their credit contracts. During IRP, creditors asses the viability of defaulter’s business, whether it can be rescued and revived or it should be liquidated immediately. The request for IRP is initiated by the National Company Law Tribunal (NCLT) which appoints Resolution Professionals to administer IRP.


During IRP, Resolution Professionals take over the management of the firm and operate the business as a going concern under the broad direction of a Committee of Creditors. This involves taking decision-related to bringing fresh finance in the business by investing bids for commercial contracts to keep the business running. This is a unique aspect as in the countries like U.S., China, the power remains in the hands of only defaulter’s management while bankruptcy professionals oversee business so as to avoid asset stripping.


Speedy Resolution

The most crucial aspect of IRP is its definite time limit 180 days to make a consensus on the business viability. If in 180 days, 75% majority of Committee of Creditors do not approve a resolution plan, then the debtor is declared bankrupt. Also in certain cases, NCLT could also provide extended 90 days’ period on the request of Committee of Creditors.


This speedy resolution is helpful in two ways. Firstly, it prevents decline in the value of the underlying assets. Secondly, it incentivizes creditors to make a rational decision on whether to revive or liquidate the business, since, on liquidation, creditors usually wouldn’t be able to recover the complete amount. On the case of liquidation, bankruptcy code also gives the lucidity about the priority of claims by different category of creditors over the liquidated assets.


Conclusion

The enactment of Insolvency and Bankruptcy Code (IBC) is one of the major milestones in the Indian financial system. But its effective implementation is the biggest challenge owing to requirement of judicial infrastructure, dearth of qualified Resolutions Professionals, the lack of data privacy and authenticity about the present and past financial situations of the debtors and creditors, and the synchronisation between bankruptcy code and other existing laws such as SICA, Companies Act, SARFAESI act etc.

Currently, India ranks 136 out of 189 countries in the World Bank’s index on the ease of resolving insolvencies. The Bankruptcy Code has its own flaws but it will certainly improve India’s current ranking. The vital point is not to hinder the current economic activity in terms of borrowing like a leveraging firm without a reduction in risk taking, the share of borrowing from NBFC, unsecured borrowing in total debt etc. because the very purpose if the bankruptcy code is to bring efficiency in the system.

Now time will show whether Bankruptcy Code is effective enough or not but we must admit that is far better and robust than the existing bankruptcy laws which are neither effective in time to recovery nor in terms of amount recovered.

 

This article has been authored by Kunal Bhalerao from IIM Raipur

 

References

www.domain-b.com/finance/banks/20161003_shareholders.html

www.thequint.com/business/2015/11/06/new-bankrutpcy-law-ease-of-doing-business-insolvency-resolution-early-detection-of-financial-distress-arun-jaitley

www.livelaw.in/insolvency-bankruptcy-code-2016-successfully-decoded-review-commentary-insolvency-bankruptcy-code-penned-pranav-khatavkar/


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