Constitutionality of the bankruptcy law: Defaulters’ paradise lost

It is not often that an order of the Supreme Court (SC) contains an epilogue and prologue. But the judgement deciding the constitutionality of the insolvency and Bankruptcy (IBC) does precisely that.

It traces the end of an era replete with feeble enforcement rights and intransigent borrowers to a legal regime which revitalises creditor protection and relegates rights of defaulting promoters. In the prologue the court has analysed various studies, statistics and the magisterial report of the Bankruptcy Law Reform Committee (BLRC) to denote the pitiful state of recoveries for lenders under laws prior to the IBC. The SC then goes on to reject each of the grounds for challenging the IBC.

The first major challenge related to the perceived inferior treatment of operational creditors. In bankruptcy laws globally, the axis of distinction is between secured and unsecured creditors. In a radical departure from all precedents, the BLRC proposed to categorise creditors as financial and operational.

Financial creditors are typically banks and bondholders whereas operational creditors include trade counterparties, employees and tax authorities. On the face of it, under IBC the financial creditors clearly have the upper hand. They constitute the committee of creditors, which takes all key restructuring decisions and may even get a higher payout in liquidation.

The petitioners argued that there was no intelligible basis for this categorisation since the company essentially owes dues to both sets of creditors. The Supreme Court found a clear and rational basis for this differentiation.

First, financial creditors are in the business of providing credit. They are adept at credit analysis and evaluating financial prospects of a business – at the time of sanctioning debt as well as through its life cycle which makes them better equipped to judge the viability and feasibility of a resolution plan. Secondly, financial creditors generally are long term providers of finance and will be more amenable to complex restructuring terms.

Operational creditors, on the other hand, are providers of goods and services and are neither inclined to look beyond their payment cycles nor do they have the financial sophistication to restructure a distressed company. At the same time, the IBC also contains safeguards for operational creditors.

For instance, National Company Law Appellate Tribunal (NCLAT) has held that operational creditors should be roughly treated at par with financial creditors under a resolution plan. Moreover, all dues to operational creditors under a resolution plan must be paid before any lenders are paid.

In any event, the IBC guarantees operational creditors a minimum amount – being the sum they would have recovered on liquidation. On this basis, the SC concluded that though the distinction between creditors is unique it is not devoid of sound reasoning.

In practice, IBC has been a terrific negotiating tool for operational creditors who have been prolific in filing IBC cases with the aim to settle with the borrower prior to the commencement of formal insolvency.

The second challenge was on section 29A – the section which bars defaulting promoters from regaining control of insolvent companies. At its inception, the IBC was meant to offer a respectable restructuring tool to not only creditors but also to the distressed borrowers.

The promoters were expected to play a key role in revival of sick companies by submitting resolution plans just like other bidders. The aim was to remove the stigma attached to bankruptcy and encourage sick companies to file for bankruptcy voluntarily – much like the practice under the US Chapter 11 bankruptcy process.

However, soon it was realised that resolution plans for highly distressed companies entailed large haircuts for lenders and extremely low recoveries for operational creditors. Owners who ran the company into the ground on borrowed funds could win their companies back while whitewashing associated liabilities.

Not only was this a clear moral hazard but could become politically unpalatable at a time of absconding robber barons. Section 29A was introduced to allay fears of abuse of the IBC process.

The section essentially has two parts. The first past sets out eligibility criteria for potential bidders of the company. It contains the broad set of disqualifications applicable across the world on the basis of the past criminal record, SEBI and Companies Act violations, willful defaults etc… – but most contentiously, it disqualifies a bidder if it had a record of being in control of an NPA. While the debarment on the basis of wrongdoing is justifiable, it was contended that a company could turn into a non-performing asset (NPA) for macroeconomic reasons with no ill intent or willful default of the promoters.

It was passionately argued that the NPA ground caught out innocent and industrious promoters suffering from a downturn in the economy. The SC, however, looked at the fine print of this section. The section sets out that only promoters who have been in control of an NPA for more than one year shall be debarred.

The SC observed that by this time, the Reserve Bank of India (RBI) would have classified the account as a ‘substandard account’ requiring higher provisioning by lenders. This means that even if the original default was for extrinsic reasons, the promoter had ample time to restructure the debt but failed to do so. This clearly showed malfeasance at worst and ineptness at best – both being highly undesirable attributes for a bidder of an insolvent entity.

The second part of section 29A was more problematic. In an economy rife with benami transactions, it was felt that if a bidder directly suffered from disqualifications, she could route the bid through group companies or relatives. To plug this gap, section 29A contained a large list of relatives and connected persons whose antecedents would also matter.

If any of the connected persons suffered from the ineligibility under section 29A, such taint would automatically attach to the bidder regardless of whether the connected person was acting in concert with the bidder. To take a bizarre example, if I was bidding for a company but my estranged brother had an NPA for more than a year, it would debar me even if my brother had nothing to do with my business or my bid. It was correctly argued that this provision would unfairly punish Abel for the sins of Cain.

To SC’s credit, instead of striking down the edifice of section 29A, it merely read it down. The SC said that a bidder would be debarred only if the tarnished connected party was actually involved in the business of the bidder. Absence a business connection, section 29A would not unfairly penalise the bidder.

The SC is silent on questions of whether there is a presumption of an existing business nexus between relatives and group companies with the bidder, which entity has the onus of proving the nexus and the applicable standard of proof required. This is likely to spur litigation in the near future. But retention of section 29A in principle is a body blow to defaulting promoters hoping to assume control in a clandestine manner.

The apex court also reiterated a cardinal principle of judicial review. Laws challenged for impinging on personal liberties and human rights are subjected to a heightened judicial scrutiny. But when it comes to commercial laws, the SC reaffirmed that courts must adopt a hands-off approach since such laws are technical in nature and drafted after due consideration of socio-economic conditions.

The courts are unelected guardians of the constitution and must not arrogate to themselves the role of technical experts or policymakers. The SC held that absent patent arbitrariness or grave breach, there must be judicial deference towards upholding complex economic laws. This principle underscores the line beyond which judicial review descends into judicial activism.

Most importantly, it portends which side the SC may be leaning towards later this month when deciding the constitutionality of another crucial economic legislation – the RBI’s Revised Framework for Resolution of Stressed Assets – released on February 12 last year – the outcome of which will be of great significance for the ailing power sector companies.

Thankfully the epilogue of the order is not an obituary of the IBC as many promoters would have hoped, but a toast to its success. To quote the last paragraph of the SC order – defaulters’ paradise has been lost and in its place, the economy’s rightful position has been regained.

Author

Suharsh Sinha, Partner

Published In:CNBC TV18
Date: February 1, 2019