Early Warning Signals of Stress in a Corporate

Stress in the world of banking and finance is associated with sign of  incipient sickness in the conduct of business of borrower. To know the concept of  stressed asset in corporate  we need to look back to couple of decades after  bank nationalization. 

In the early ninety’s of last century prudential norms of asset classification and capital adequacy  were introduced in the country under Banking and Financial sector reforms which together with the industrial sector reforms made a paradigm shift from age old banking practice in India. Prior to that in two tranches nationalization of banks took effect leading to fast expansion of banking throughout the length and breadth of the country. The resultant surge of industrial activities in India due to relatively easy access to fund, deregulation in industrial sector and liberal industrial policies and encouragement by way of incentives & subsidy from both the central and  state governments altogether changed the sloth, slow moving underdeveloped  economy to a rapidly growing developing economy.

The resultant economic activities brought sea changes in social sector gradually shifting large chunk of population from agriculture towards micro, medium and large industries. As a natural consequence service sector started growing by leaps and bounds and India freed itself from  dependence of first world country  in matters of food grains, machineries etc.

In the above back drop, banks, more particularly Public Sector Banks which were the only players gradually shifted their preference in urban and metros from trade and small priority sector lending to industrial advances, advances to service sectors and retail lending. 

To regulate the fast growing  banking activity Reserve Bank of India  was focussed towards honest implementation of  income recognition and asset classification, tight provisioning norms and capital adequacy in banks besides the traditional credit management approach. With the formation of separate Tribunal under the prescription of Narasimham Committee for recovery of Non Performing Assets,  the credit discipline from the point of view of lenders and borrowers were satisfactory. The system started wilting with time as there were stiff competition within the banks for sharing chunk of the pie.

In the midst of unhealthy competition among banks inadequate credit appraisals of new industrial and infrastructure advances became a new norm leading to acceptance of small, medium and large advances proposals from dubious entities having little exposure, knowledge and inadequate investible funds with them. The generous approach of banks by way of relaxations in various norms and securities encouraged fly by night operators to encash the opportunity. The unfortunate result of dilution of norms was quick mortality ( means slippage of an advance facility within one year of disbursement). As a result there were unmanageable pile of suits in   Debt  Recovery Tribunal and locking up of bank funds necessitated new enactment SARFAESI Act 2002 to enable bankers to encash their enforceable securities. 

Post Global Financial Crisis in 2008 saw another new development with the introduction of regulatory forbearance by RBI. The asset classification norms were tweaked in restructured accounts to give relief for temporary mismatch in cash flow in the existing economic slow down throughout the world. The bankers, particularly the PSBs allowed all and sundry including insolvents within the facility thus deferring identification of potential NPAs. At withdrawal of the regulatory forbearance there were flood of slippage and the NPA level of all banks and particularly PSBs went to new height not experienced in previous two decades.

Meanwhile, during the last decade RBI felt urgent necessity of implementing stringent credit monitoring mechanism to curb the disproportionate growth of impaired assets and introduced stressed assets concept within the standard asset category based  on period of default in payment of either the principal or interest or for continuous excess of balance outstanding over limit or drawing power or for non renewal of accounts within a definite time frame. Depending upon time period of overdue the stressed assets other than NPA are SMA 0( 1 to 30days default), SMA 1 (31to 60 days default) and SMA 2 (61 to 90 days default). If the default persist on 91^st day accounts turned to NPA. The periodical AQR(Asset Quality Review) of RBI for big advances of Banks to recognise incipient sickness in accounts and prescribe immediate corrective measures is a step towards this direction.

Finally, the Insolvency and Bankruptcy Code 2016 is based on default concept of corporate and has given free hand to bankers to quickly move to the NCLT to save upon time and   value of the impaired assets.   

Insolvency and Bankruptcy Code, 2016 (“IBC”) has been primarily used for Corporate Debtors. 4,593 Corporate Debtors have undergone the Corporate Insolvency Resolution Process (“CIRP”) with initiation of 4,708 CIRPs, closure of 3,068 CIRPs, and ongoing 1,608 CIRPs as on 30.09.2021 as depicted as depicted adjacent.

 

Particularly worrying is the increase in ongoing cases which might soon run to unmanageable levels. This is also because that many cases for which IBC is not an ideal fit get dumped in the IBC process indiscriminately.

 

We see from the adjacent figure that most of the CIRPs discussed above end in liquidation which is not the end of the IBC process nor is it the end of the litigation process. In fact, many cases linger on without end in liquidation offering no exit since unlike CIRP liquidation is not a time-bound process. Only 14% of the closed CIRP cases have seen resolution.

 

Of all the CIRPs admitted, there is wide variation in the admission, settlement, resolution, and liquidation in terms of the sectoral distribution. This is well shown in the adjacent graph.

 

We see that while the manufacturing sector is most likely to get resolved, and the real estate sector is most likely to enter into settlement and withdrawal. The electricity sector is also highly likely to get resolved and undefined sectors are most likely to be liquidated, seeing no resolution. Most of the discussion of the IBC has been centered around big real estate and manufacturing units since they form the bulk of the cases. However, the efficacy of the IBC as a blanket solution for distressed assets is really tested in the face of other sectors. We see that even though the real estate sector is most likely to be settled, accounts which are not settled are highly likely to enter liquidation thus causing distress to many home buyers.

 

Of the 4,708 CIRPs admitted till September 2021, 1,419 have concluded in liquidation with 1,640 still ongoing. Of the 1,419 liquidations, only 164 have been concluded accounting for only 5% of the total CIRP closures. Hence, liquidation is a limbo process not beneficial for every kind of corporate debtor. However, the very kind of corporate debtor which is most likely to enter into liquidation is the same kind which should not have been admitted into CIRP in the first place.

 

The starkest difficulty of IBC is seen in the case of infrastructure companies. Generally these are large corporate houses building infrastructure projects for various government undertakings such as road, railways, bridges etc. The banking facility availed by such companies is a non-fund based facility viz. a “Bank Guarantee”. In case of default, this bank guarantee comes due as a liability providing no relief on the asset side of the corporate debtor. The assets are future receivables from the project which has failed. So the possibility of any receivables are remote. The government generally has a clause inherent to the contract of such companies that in case of insolvency or bankruptcy of such a company, the contract gets automatically terminated. The infrastructure asset being an immovable construction is seized by the government along with its roadways and waterways and the company is left without any recourse. In this scenario, the company enters the IBC with nothing but a myriad of litigation and a bank guarantee liability running at least hundreds of crores in rupees. This is an impossible situation to navigate through and the company inevitably falls into unsolvable litigation and liquidation, with some scrap value getting preserved. Certainly IBC is not the appropriate way to go about resolving such a company.

 

Contrast that with a real estate company without any liquidity to service its bankers. The bankers invoke the IBC which risks this real estate borrower to lose not only the project at hand, but also the control of all lands acquired in the company. The company has value and it has been seen that the management becomes surprisingly resourceful in finding the liquidity in view of incoming insolvency. Where even the threat of a “creditor in control” model results in the resolution of the corporate debtor.

Effectiveness of IBC’s institutional structures – IBBI, IPs, AA, and IUs

As per IBBI Newsletter of June, 2021, IBC had enabled recovery of Rs. 2.5 lakh crore, against admitted financial claims of Rs. 7 lakh crore – translating to a recovery rate of 36% – for the 396 cases resolved out of the total 4,541 admitted. Of the remaining cases, 1,349 were under liquidation; 1,114 were closed under appeal/ review/ settled or withdrawn, and 1,682 were outstanding. A closer look at the data shows, however, the recovery rate and resolution timelines have a lot more room for improvement. This makes a continuous strengthening of the Code and stabilisation of the overall ecosystem imperative. In respect of 396 resolved cases, actual recovery rate was 36%.

Firstly, out of these 396 cases, the recovery rate, excluding the top 15 of the 396 resolved cases, estimated actual recovery rate was 18% in respect of remaining 381 cases. Estimated actual recovery rate for 1349 liquidation cases was 5%. Secondly, average resolution time for the aforementioned resolved cases is 419 days compared with the stipulated maximum of 330 days. About 75% of outstanding cases have already been pending for more than 270 days.

Notwithstanding these challenges, the IBC has played a key role in resolution of stressed assets so far. Its effectiveness will continue to be tested given the elevated level of stressed assets² in the Indian financial system. In this milieu, the government has been proactive in addressing issues being faced by various stakeholders. In August this year, the Standing Committee on Finance made recommendations to reinforce the IBC and the associated ecosystem. The critical recommendations include: 1) developing specialised National Company Law Tribunal (NCLT) benches to hear only IBC matters; 2) establishing professional code of conduct for committee of creditors (CoC); 3) strengthening the role of resolution professionals; and 4) digitalising IBC platforms in order to make the resolution process faster and maximise the realisable value of assets.

 

However, after all said and done, there seems to be a lot to be done at the Code enforcing agencies, which are IBBI, IPA, CoC, IPs, IU and AA.

Firstly, some words about AA may be stated. IBBI has been a silent spectator of the AA encroaching into its jurisdiction. While IBBI has been stressing the need of observing timeline of the IBC processes, the AA never seems to be bothered about the timeline when it comes to their obligation in the adherence to timeline. AA liberally allows adjournments on flimsy grounds or blank requests by the parties or on its own accord without any reasons. AA liberally allows time for filing pleadings in spite of the non-compliance by delinquent parties to the case. AA entertains arguments by senior counsels for hours together on a particular law point when the IBC is all about the necessity of the business-like attitude of all concerned in resolving the cases. AA frequently takes views beyond the IBC on the pretext of natural justice and even dares to remove the RP on the application of the Suspended BOD, ignoring that RP had filed application under section 66 of the IBC for several hundred crores of rupees  and also ignoring the specific direction of the Supreme Court. It seems that the AA acts more on the wisdom of the judge than on the letter and spirit of the statute. AA even delays the cases where CoC files application for replacement of RP and also when the RP files application for liquidation. Even after the completion of timeline, the AA does not pass the order of liquidation even when the case is fixed for the same for hearing and adjourns abruptly.

Secondly, IBBI, itself adds to agony to effective management of the IBC. IPs are being supervised by IPAs and also by IBBI. For same information, multiple information is to be filed by IP separately to IPA and also to IBBI in different time based and event based forms. IBBI, liberally, amends regulations without any value addition to the IBC system. One such example was the introduction of Form CIRP-8 by inserting Regulation 40A in the CIRP Regulations. The RP, who complied with the requirement of intimation of determination to the IBBI as per CIRP Regulation 35A long back, was also required to file the Form. Instead of requiring to file additional information over the earlier or requiring the updation of earlier information, a whole new Form is asked to be filed by both IPAs and IBBI. IP is forced to keep the IBBI informed every 30 days about the delays in the any event of the IBC, even when the delay had nothing to do with the RP’s action, in Form-8 and is made liable for penalty on lapses. IBBI makes a panel of IPs for providing the same to AAs. These empanelled IPs are rendered eligible for allotment for assignment by the AA for a period of 6 months. Most recent such panel has been released on 31.12.2021 for validity from 01.01.2022 to 30.06.2022. Such panel suffers from some inherent discrepancies since it allows only those IPs to apply for empanelment, who hold the valid AFA for the full period of the stated period. Out of 3500 and odd IPs, only about 900 IPs were empanelled. Similarly for the immediately preceding 6 month period, only 500 IPs were empanelled. Such stipulation for AFA holding was illogical and impractical as it denied the opportunity to even an IP, whose AFA was subject to renewal at the far end of the period and the IP could renew the AFA only within 45 days prior to the expiry date. Further, the guidelines for empanelment stated that the IPs with existing assignments were less eligible for assignment than the IPs with no existing assignments, but such information was not forwarded to the AA by IBBI. The CPE hours earned by IPs, have to be claimed by them in the IBBI website within a week. Such information on the IBBI website has to be approved by the IPA. IPA takes 3-4 months’ time in approval and sometimes rejects the claim without any communication to the IP.

Thirdly, the IPA also contributes its own role in the frustration of the IBC system. The IPA enrols the IPs. IBBI registers the IPs. Thereafter, IPA allows the AFA. IPA requires IPs to file monthly returns and half yearly returns. The IPA requires the IPs to file the disclosures of the relationships with the professionals; CoC members etc. even if there are no related parties or connected parties and require that NIL statement has to be filed. At the time of AFA renewals, it requires the IPs to file Forms with IBBI even if those are not required to be filed. These specific requirements are made by the IPAs when renewal of AFA is being applied, delaying the AFA approval, sometimes, leading to missing the important timelines, like IBBI empanelment etc. Such requirements could be asked by the IPAs in more frequent manner and not to delay on such reasons. CPE hours should be approved more regularly as it expects from the IPs.

Fourthly, the CoC is more concerned on recovery and not resolution. In most of the cases, the CoC consciously drives the CIRP to liquidation. CoC is L1 driven and non-committal of reasonable professional fees for the IPs, forensic audit for quality work, interim finance and extending further credit line to prospective resolution applicants. In many cases, the CoC constituents act through their senior employee officers, who delay the CIRP process by not deciding on the matters in the CoC meetings. In some strange cases, it has been found that such senior officers seem to be more on the sides of the Suspended BOD, who bled the CD in the past. 

Fifthly, IP, who acts as IRP or RP, is not less responsible for the effectiveness of the IBC system. A chain is as strong as its weakest link. The RP is required to interact with the Suspended BOD (SBOD), who was primarily responsible for the stressful condition of the CD. The SBOD was not, prima facie, desired that there should be any CIRP or at least the IP, who was in the driving seat, should be rendered helpless by not providing information, records and encumbering the assets etc. aided by the senior lawyers, who represent them forcefully before AA and prove that the IP was not doing his duty properly and unnecessary harassing the SBOD. If the IP was not strong enough to sustain the pressure of the less supporting CoC and over pressurising SBOD, would not be able to prove the fraud and avoidable transactions conclusively, leading to the delinquent SBOD getting scot free.

Last but not the least, the IU, has been moving at snail’s pace in providing the much needed support system to the IBC system. The IU has not been pro-active in spreading the services, which it could extend at economical cost competing with market forces providing similar services.

Need for Developing a Market for Distressed Assets

With the onset of the Insolvency and Bankruptcy Code, 2016 (“Code”), much focus has shifted to distressed assets and opportunities in the same. As developed economies realize, there is a wealth of opportunity in the markets for distressed assets and have structures to optimize the same. India is still in a protective stage where the market for distressed assets is scattered with neither a coherent information platform, nor a way to inform investors regarding all aspects of the assets.

 

The scattered nature of stressed assets may be seen in several avenues – (i) assignment of distressed loans by lenders to asset reconstruction companies, (ii) sale of physical assets under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI”), (iii) resolution by means of a resolution plan under the provisions of the Code, (iv) sale of assets under liquidation etc. All such avenues use a myriad of marketing and technology platforms including the website of the Insolvency and Bankruptcy Board of India (“Board”), the website of National E-Governance Services Ltd (“NeSL”), MJunction Services Ltd, AuctionTiger.net, newspaper advertisements, local dealerships etc.

 

Over time, the market for distressed assets has grown bigger and more scattered. Every attempt to streamline the process ends up creating a choice for a new process versus an old one, which results in further dispersion of information. For example, in a typical auction for an assignment of a loan account, the bid documents are only distributed to asset reconstruction companies (“ARCs”) having an ‘agreement’ with the assignor lender. Such assignor, being typically a large public sector bank, does not go out to explore the market for more financial institutions but restricts the search to ARCs having an agreement with itself. Given that information inadequacy omnipresent in all stressed asset cases, the ARCs take their time while doing their due-diligence by when the assignors’ auction process may be over. There is no single platform where the list of all such loan accounts may be listed with basic details about them. Most such deals then happen bilaterally rather than exploring the wider market. So while the process may give an illusion of a ‘Swiss Challenge Method’ being followed, in practice it is simply a negotiated deal. Even then, the cooperation of the original management of the borrower is actively sought by the assignee to the debt in order to effectively resolve the company. In most such cases, the assignee is reduced to be a backdoor vehicle for the borrower to enter into a settlement with its lender. And the entire process happens without any transparency or regulation.

 

Similar inadequacies are faced in other processes of sale of distressed assets as well. The reasons being lack of transparency and lack of a coherent market for distressed assets. Time and again the government has tried to implement systems to build such a system. The Board has enabled the listing of all auctions under liquidation on its website and has encourages the use of NeSL to conduct the auctions so that all such activities at least till the fold of the Code may remain organized, and hence measurable. However, the Board made no means available to convert the data into metrics. Further, the technology platforms recommended turned out to be ineffective at the time of their launch losing much confidence in the eyes of the stakeholders, who resorted to using private platforms for their needs. Today, there are over 15 auction service providers marketing themselves and rendering services to insolvency professionals with no means of collating data amongst themselves.

 

Another major distressed asset in the country is in the form of companies looking to be resolved. This happens both within the framework of the Code and outside it. And is met with the highest level of customization possible for distressed assets in the country. The resolution plans may be as simple as refinancing or settlement via equity infusion to revive the corporate debtor. Or may include parts of mergers and acquisition, dissolving parts of the business, tax optimization, and refinancing using long-term debts which themselves may run into stress in due course. In this scenario we realize why stressed assets have customarily been a very disorganized space. Different borrowers may require a variety of different solutions, which may not always be available in the market. Of course the lack of information availability does little to help standardize the process. But fact remains that there’re no “standard solutions” when it comes to stressed assets.

 

The National Company Law Tribunal that acts as an adjudicating authority for insolvency cases in India might be the greatest repository of data for insolvency cases. All insolvency cases at some point need to refer to the Adjudicating Authority for a variety of reasons and if not for anything else, then at least for obtaining final orders on their cases. Further, the Adjudicating Authority requires the insolvency professionals to regularly report the progress of the cases, creating a large repository of regularly updated information. However, all this information is never converted into any knowledge due to the lack of any metrics. The information keeps getting rusted into back alleys of old courtrooms (or in a modern sense, in cloud storages). But no real value is ever derived out of them. It is no surprise that the number of cases pending to be adjudicating before such forums itself is an undefined number with no metrics for that as well. The judicial system works without accountability, or worse – measurability.