[Siddhant Dubey is a third-year student at Institute of Law, Nirma University, Ahmedabad]
Demand for a separate resolution mechanism for Non-banking Financial Companies (NBFC) has never been off the hook. However, in recent times this perennial debate has become more pertinent and vivacious. The country is witnessing a significant economic and consumption downturn. Many trace this back to when Infrastructure Leasing & Finance Services (IL&FS) defaulted in the payments of its lenders and prompted panic in the market. This default by the IL&FS followed by the Punjab and Maharashtra corporation (PMC) bank catastrophe surfaced the need for an exhaustive resolution mechanism for financial institutions.
The Government introduced the Financial Resolution and Deposit Insurance (FRDI) bill in 2017, which was believed to be the pioneer in the resolution bank and insurance companies. However, it was annulled after some time due to a proposed bail-in clause. Now, the Ministry of Corporate Affairs (MCA) notified under section 227 of the Insolvency and Bankruptcy code (IBC) about the insolvency and liquidation of financial service providers (FSP). The notification directed that the code will now also be applicable to systematically important NBFCs having an asset size of over 500 crores as a class of FSPs. Deliberating upon this, the author will further discuss the hardships that come with this inclusion which cries for outside restructuring mechanisms.
Heavily Clogged-up NCLTs
IBC was legislated to expedite the resolution of Non-performing assets (NPA) which is pivotal in increasing cash flow and recouping the financially damaged companies. However, IBC and National Company Law Tribunal (NCLT) are heavily burdened and not performing as expected. Further adding FSBs to the code will only decelerate the already afflicted process.
As per the recent Insolvency and Bankruptcy Board of India quarterly, a total of 2542 cases have been brought in for corporate resolution. However, only 156 got settled through the resolution, whereas 587 of them went for liquidation. Total assets recovered till now stands at 43%, but this incorporates seven out of 12 huge accounts that make up the most of corporate defaults. Keeping these seven accounts aside, the recovery rate is just 30.4% which is not very much different from the recovery rate of 27% before the enactment of IB code.
It is mandated for IBC to pass the resolution within 330 days. However, cases like Essar steel taking over two years and around 60% of all the cases still awaiting resolution corroborates the need for more NCLT benches and other modus operandi for tackling bankruptcy. At present, there are 16 benches. However, ideally, the number of benches should be similar to the number of high courts i.e. 24. Further, some of these benches only function twice a week and also have an insufficient number of judicial and technical members. These factors all in all severely act as an impediment in timely resolution of a case. Now pouring them with the resolution of FSBs too will hamper their efficiency even more.
Financial Firms and Financial Institution are Structurally different
The resolution of any conventional financial firm is done by letting all the creditors of the company to decide how the realization of assets should take place. This is termed as the collective action process involving all the creditors of the firm. However, owing to certain structural differences in the balance sheet composition of financial firms and Financial Institution, this process does not hold relevance in the resolution of insurance corporations or banks.
Liabilities of any bank usually comprises depositors or institutional lenders. Pertinently, coordinating with this large number of creditors, like people who are the depositors in the bank or have purchased insurance policies is very tiresome and costly. Further, to coordinate with the creditors, their agents are required to represent their will. However, this is not possible in the present case of insurance policyholders or depositors.
In insurance companies, the majority of liabilities bestows from the current or future claims of people holding an insurance policy. These claims generally depend on the happening or not-happening of an event. However, under the IB Code, only customers having actual claims are considered as the creditors of the company. Claims which are yet to fructify are excluded from the list of creditors, and this exclusion is often very high in number. If this happens, the resolution will be based on the decision of a very small group of creditors and this would be unfair for other customers who were excluded from the creditors' list.
Issues Stemming From Asset Monetization
The assets of any bank and insurance company comprise their loans or investments in the form of shares and bonds. These are heavily interconnected and influence the behavior of the financial system and economy of any market. Going by the standard resolution process and monetizing these assets in a very short span of time might adversely affect the functioning of both the financial system and economy. For example, premature recalling of loans is one way for the quick generation of cash. However, consequently, this might upset the borrowers of these loans, specifically households and firms which are in financial constraints. Further, the borrowers in order to meet the pre-payment calls will be re-financing on unfavorable terms which could put them into debt, and might even make them insolvent. A recent happening that illustrates this phenomenon is the abrupt drop in the share price of various finance corporations and non-banking finance corporations, followed by the default of IL&FS.
Besides this, the notification has been applied only to a single case where RBI initiated insolvency resolution against the Dewan Housing Finance Corporation (DHFL) in December 2019. The practical implementation of this notification is still speculated by many. Pertinently, the majority of the stressed assets of either NBFCs or other banking companies, are liquidated through private negotiation, regulatory intervention, or government actions.
Financial Resolution and Deposit Insurance (FRDI) Bill, 2017
By introducing the FDRI bill In 2017, the government made its first step towards establishing a substantial framework for the resolution of financial institutions. This included insurance companies, banks, payments systems, mutual & pension funds, and financial institutions of foreign countries working in India. However, the bill was retracted owing to a proposed bail-in clause. As per this clause, the concerned authority holds the right to either nullify the debts or convert the debts into an instrument of ownership such as equity. This clause attracted public outcry because the application of this would repeal the maximum deposit insurance coverage of Rs. 1 lakh and also, the depositors of the financial institutions will be partly bearing the cost of resolution. Considering that India has one of the lowest deposit insurance coverage among the emerging nations and then came bail-in clause, it is likely for deposit holders to fear and oppose the bill.
The FRDI was pleasantly accepted and implemented by countries like the USA, the UK, Germany, France, etc. owing to their G20 commitments. However, the economic conditions of these countries are much improved and different from India. In simple words, countries like the US and other developed economies of the European Union majorly depend on private financial institutions and banks whereas developing economies like India depend heavily on public sector banks for their market to function. Considering such polarity in economic conditions, implementing the bill ‘as-it-is’ seems irrational. Notably, emerging economies like Argentina, South Korea, Brazil, China, Turkey, and Mexico have only partly accepted the provisions of the bill and struck out the bail-in clause.
However, now the government is planning to re-enact the FRDI bill with some changes in the provision that impeded its implementation in 2017. Authorities assert that the polemical bail-in clause will be excluded and chances are that deposit insurance coverage will be increased from 1 lakh to 5 lakhs.
Presently, NCLT and bank-led resolutions are the principal methods of restructuring stressed assets or NPA. However, judging the current status of overburdened NCLT, the need of the hour is an outside restructuring mechanism for the resolution of these assets. Pertinently, in the year 2018, Sunil Mehta Committee proposed a five-pronged plan for the resolution of NPAs which was called project sashakt. Apart from NCLT, this plan provided the following ways of restructuring:
Small and Medium enterprise (SME) led: Loans with a cap limit of $7 million to be resolved by a template approach with the help of an SME steering committee.
Asset Management Company (AMC) led: The aim here is to rejuvenate all the errant corporations through either merger or acquisitions supported by the funds which would also raise money from Foreign Institute Investors. Even though Sashakt India AMC was established but the company never went into operation.
Asset trading platform: the purpose here was to build a platform for the exchange or trading of distressed companies. Initially, the Indian Banks’ Association was keen on it, but it never took off.
Bank-led resolution: The approach here was to create a consortium of lenders, of which the primary lending bank would have to ensure the resolution within 180 days. Banks were to sign the inter-creditor agreement to make this consortium happen. however, the signing is taking longer than usual.
It’s time for the government to consider the status quo of insolvency in India and enact a full-fledged resolution mechanism dedicated to financial institutions. The authorities should assess the previous version of FRDI objectively and make it viable for an emerging economy like India.