Informal Corporate Rescue Mechanism

Corporate Insolvency

Informal Corporate Rescue Mechanism: Approach and Implementation in India.’

Introduction

Modern corporate and banking practices around the world have, over the years, adopted various measures to deal with distressed companies and distressed debts/loans. Various factors, such as size of company, extent of distress, extent of individual lender exposure, future viability etc. play a part in the final decision and actions therein. The particular insolvency regime involved is a major factor which determines the ease with which one particular option can be exercised as compared to the other. Thus a creditor-oriented regime makes it easier for the lenders to take charge of proceedings and pursue measures to recover their dues, which ultimately may lead to the winding up of the debtor company. In contrast, a debtor-friendly regime leans towards recuing the company.

The present economic recession has resulted in widespread debt-defaults and company distress. Since the present scenario is a result of a systemic failure rather than individual instances, winding-up of companies do not look like the best option to be followed. Rescuing companies and putting life back into them (provided they are viable for the future) is what is being pursued commonly. Rescue mechanisms are of two kinds, formal and informal. The formal rescue process would involve a court-led or supervised procedure which ultimately leads to rescuing of a company, through measures such as change in management and debt restructuring. The best examples would be the Administration process under the Insolvency Act in U.K. and the Chapter 11 bankruptcy procedure in USA (though scholars such as Dan Prentice are of the view that the Administration process does not have as its main focus the restructuring and continuation of business of a company, when compared to the Chapter 11 proceedings in USA, which mainly concentrates on restructuring and rescue. ).

Out-of court rescue procedures through workouts/debt restructurings have seen a gradual but steady growth worldwide. Workouts typically involve a reduction of debt and an extension of payment terms. The main costs associated with debt restructuring are the time and effort to negotiate with bankers, creditors, vendors and tax authorities thus making it a less expensive and preferable alternative to winding up proceedings. Companies facing short-term liquidity problems find such workouts a viable mechanism to get back on track. Creditors would also find that the possibility of getting higher returns would be much greater in case they are able to successfully restructure the debts of the company and keep it as a going concern. This would be more evident in cases of companies having high debt exposures and showing high going concern value.

Though the roots of out-of-court corporate debt restructuring practices can be found in the history of sovereign debt defaults (arguably originating in the medieval period and continuing throughout into the 20th Century, peaking in the 19th Century), the genesis of present day informal restructuring can be credited to the Bank of England guidelines, commonly referred to as the “London Approach” . The London Approach which had its inception in the 1970’s has developed over the years, adapting itself to the various financial innovations and the dynamics of a growing economy. Over the years the degree of direct involvement that the Bank of England has had over restructurings under the London Approach has reduced considerably owing to various reasons. However the principles enunciated remain strong and has been the source of reference and inspiration for similar mechanisms in other jurisdictions. India is a recent additions to this list.

India’s foray into informal debt restructuring has been comparatively recent. Prior to 2001, there was lack of a systematic mechanism to expedite informal debt restructurings and other company rescue processes. The statutory framework in India for recovery of distressed companies, the Sick Industrial Companies Act, 1985 , authorised the Board of Industrial and Financial Reconstruction (BIFR) to supervise the re-organisation process. However the BIFR’s role in the process was and remains very unsatisfactory. This led to institutionalisation of informal rescue through debt restructuring via the Corporate Debt Restructuring (CDR) mechanism established by the Reserve Bank of India (RBI), in 2001. This platform was largely on the lines of the London principles and has been used quite extensively in recent times. Various Circulars have been issued by the Reserve Bank of India with regard to the CDR procedure. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act 2002 was another step in the right direction as far as corporate rescue procedures were concerned. The Act provided for the setting up of Asset Reconstruction Companies (ARC) in India with the main purpose of undertaking the management of non-performing loans acquired from secured creditors.

This project proposes to broadly go through the various facets of informal corporate debt restructuring and rescue in India. As a backdrop, part II of the project looks into the London Approach, its history and development, its features and various issues which have hampered its viable continuance. Part III looks into the Indian position. Firstly it describes the Indian position prior to 2001. Then it goes on to the Corporate Debt Restructuring mechanism, its features and the various issues of concern that continue to plague the CDR system in India. Further, it looks at the work of the Asset Reconstruction Companies (ARCs) in India, its effectiveness and issues of concern. I wish to propose a more flexible system which can imbibe the qualities of both debt restructuring under CDR and non-performing asset reconstruction by the ARCs, whereby some of the issues of concern can be effectively addressed.

Informal Workouts in UK: London Approach

Early development

The 1970s, which witnessed a period of prolonged industrial recession in the UK, represents the Bank of England’s initial foray into restructuring and rescuing companies. While high inflation and unemployment gripped the country, the industrial companies experienced a massive financial crisis. Mass liquidation would have made matters even worse, eroding the very economic structure in the country. The formal procedure under the existent insolvency law was unsuited to ‘constructive survival’. The Bank of England realised that more than a formal set of rules to enable a more structured format to workouts, what was needed was an intermediary who could organise discussions between creditors and debtors, while working on the basis of a set of guiding principles to engage in implementing a viable recovery package. The Bank decided to take on the role itself, since it was best placed as regulator of banks to organise and lead the other commercial banks. One of the main reasons why the Bank was able to engage in such a role was because its functions were not fully described in the Bank’s statute. This meant that there was no regulatory road-block affecting the Bank’s role as an intermediary. Other reasons were that firstly, the Bank was trusted by companies and banks alike; secondly, the help that the Bank provided did not demand any remuneration.

The Bank, in case of a workout for a distressed company, would call upon and organise a meeting of the various participant banks. A lead bank would usually be appointed. The issues would be hammered out and decided by the creditor banks together on a consensus basis, with the Bank facilitating discussions and helping the lead bank with the restructuring package proposal. The solutions within the package would involve various kinds of workouts including interest holidays, additional finance with or without the backing of any special arrangement for security purpose, change in management, fresh investment, debt-equity swaps etc.

Later Developments

Changes in the state of the economy and creditor-debtor relations saw a change in the role of the Bank of England from active participant to a more passive role of an honest broker in negotiations and formation of restructuring packages. Essentially the recession of the early 1990s was different from that of the 1970s in that it was brought about as a result of a decade of sustained economic distress backed by irresponsible banking practices and heavily geared companies. The competition for providing banking services during the 1980s owing to the economic upsurge and banking deregulation in UK, saw a huge inflow of foreign participants in the banking sector. The debt market expanded broadly as a majority of deals and transactions entered into were heavily leveraged. Adding to this, due to the growing complexities of financial arrangement the world over, the emergence of hedging instruments and multi-currency loan facilities etc, ease of transfer of facilities through loan sales, sub-participation, risk-participation etc. confirmed that the creditor-debtor relations were rapidly diminishing from a traditional relationship-based one to a purely transaction-based one.

In many ways, the 1990s recession presented a whole array of different problems to the banks and companies. Thus the traditional methods of restructuring as adopted earlier by the Bank of England needed revision. The Bank decided that this time it should restrict itself to being a passive participant, playing minimal role in review and framing a rescue package and in negotiating issues. Thus the Bank came up with guidelines, which we now refer to as the London Approach. The alternative term “London Rules” seemed inappropriate since it presumed a sort of formality to the general provisions enunciated. A formal structure was in fact deliberately avoided by the Bank after taking the opinion of the banking community; one among the main reasons being that the informal guidelines could avoid legal scrutiny from the domestic supervisors of the foreign creditor banks involved.

London Approach- features

The essential features of the London Approach have been emulated in the informal workout mechanisms worldwide, notably by the East Asian countries. The main features of the London Approach are:

i. The creditors must be ready to compromise to a certain extent by not immediately opting for enforcement proceedings such as receivership or liquidation. Thus a concerted effort towards workouts must be evidenced.

ii. The creditors must commission an un-biased group of experts, including insolvency practitioners and accountants to review the financial position of the distressed company and give an impartial account of the various parameters relevant.

iii. The company must be left in a position to trade during the period of independent review, so as to keep intact the confidence of its creditors. For this purpose the creditors must agree upon a temporary stand-still, maintaining the facilities.

iv. The Lead Bank, which is usually the major creditor, must be selected so as to lead the efforts of structuring the package.

v. The discussions need not necessarily come to a conclusion that the company must be restructured. Thus the creditors must come to an initial opinion on whether to rescue or not.

vi. In most cases, the company may not survive purely on interest deductions, or default waivers. Additional infusion of money may be warranted, either by original creditors or fresh investors. Usually such additional financing would enjoy priority during recovery/repayment.

vii. Whether it is with regard to collection of proceeds or sharing the burden of losses, pari passu principle must be followed and seniority of claims recognised.

As mentioned above, the London Approach does not provide any kind of guarantee to reviving a company to its original stature. Attempting to do so at any cost would only undermine the process and affect the viability of the London Approach as a whole. The London Approach merely aims to ensure that any decision taken, whether it be revival, or ultimate winding-up, be taken after considerable thought gone into the matter, and after a proper review is effected. Moreover the Approach does not have the object of reviving any companies or type of companies in particular, unless the macro-economic consequences of deciding in a particular manner are that great.

London Approach- Result and impact

The success of the London Approach was evidenced by the fact that a considerable number of companies were successfully revived due to a concerted action on the part of the creditors and the companies. In most cases where the companies were considered, the creditors have been agreeable to the packages proposed and have worked on those lines; cases of dissent and disagreement have been few.

The view that London Approach provides a pragmatic solution to recovery issues has been shared by creditors, not only the local banks but also the foreign banks which participated in the restructurings of 1990s. This wide-spread opinion is also one of the reasons for the success of the Approach, since its voluntary nature necessitates its acceptance by creditors as a premise for initiating the restructuring procedure.

London Approach- Issues

The London Approach after 1998 may have ceased to have as much effect since it is no longer the regulator of banks in England. Under the terms of Bank of England Act 1998, this mantle has been passed on to the Financial Services Authority (FSA). This has been the main issue which has dampened the viability of the London Approach. Various other issues have been causes of concern for the Bank of England. The powerful banks have (though infrequently) used the Bank of England censure as a weapon to get their way with smaller banks and to force them to agree to sometimes unfavourable terms in the rescue package. The cost of workouts has been another concern. In large cases, the creditors have often opted for independent legal advice and other resources instead of pooling the resources and using them commonly. This has unnecessarily added on to the debt burden of the company being revived. Furthermore, the London Approach as a modern day panacea has not stood as firm as it used to. Owing to the diversification of the creditor base which now includes bond-holders and secondary market investors and different modes of financing including securitisation and credit swaps, creditor co-ordination has become an issue not easily resolvable by the traditional approach. The globalisation of financial markets and the emergence of markets for distressed corporate debt also put strains on the London Approach.

London Approach- Extension to other Jurisdictions

The London Approach’s success and viability is evidenced by the adoption of corporate workout mechanisms around the world modelled on London. These include various jurisdictions including Indonesia, South Korea, Thailand, Argentina etc. Most of these approaches have been adapted as per the requirements of each jurisdiction and the respective insolvency regimes.

Some jurisdictions show an inclination for a partially centralised system, with the Government being an active participant. In the Thailand, for example, the Bangkok Approach provides for Corporate Debt Restructuring Advisory Committee (CDRAC) headed by the Governor, Bank of Thailand, as an intermediary for negotiations. Moreover in case the creditors fail to reach a consensus, or a 75% super-majority, the final decision rests with the court.

The second approach shows a decentralised structure, where the creditors rather than the Government play an active role. In Argentina, for example, the only role of the Government was to enact emergency legislation, if necessary in order to promote standstill periods and encourage out-of-court transactions.

Informal Workouts in India

India’s insolvency regime prior to 2001 can be said to have been marred by the absence a viable mechanism for restructuring. Rather than encouraging an in-depth debt restructuring strategy after scrupulous cash-flow analyses and consolidated negotiations, the Indian strategy was more or less one of rehabilitation by way of some kind of relief or concession on a superficial level. There were two connected issues which were the main causes of concern. Firstly the rapid rise in Non-performing Assets (NPAs) in India. Secondly the weak insolvency laws of the country. Following the sudden opening up of the economy through the liberalisation measures of 1991, mushrooming industries in India were commonplace. Unlike in UK, this was not complemented by a rush by banks to provide funding for the same. Banks were still restricted by a strict monetary policy, which meant that the interest rates remained high. However, the companies continued to accumulate a high ratio of gearing. India’s industrial boom was evidenced at a time when global demand diminished. This meant that the assets gradually saw value erosion. The NPAs of the Public Sector Banks as of March 2001 had risen to Rs 548 billion, while those of other financial institutions had reached Rs 240 billion, causing a major concern for the banking sector which had not been used to coping with this degree of financial stress.

Individual settlements were the norm. However such settlements took much more time due to lack of an organised structure, thus resulting in further erosion of the asset base and even less returns to creditors. Further, the fact that most of the major creditors were in fact state-owned banks and financial institutions took its toll since court intervention on account of public interest litigation was an interference. Moreover the compromises and other arrangements as decided by such creditors also required the approval of, among others, the Central Vigilance Commission and the Comptroller and Auditor General.

India’s insolvency regime, in any case was not helping matters. Company winding-ups were a long drawn process, taking on an average 10 years, with instances of some cases taking up to 50 years. The restructuring regime had been initiated by the passing of the Sick Industrial Companies Act (SICA) in 1985. The task of reviving sick companies was handed to a quasi-judicial body called the Board for Industrial Financial Reconstruction (BIFR). Under the Act, it is up to the Board of Directors of a sick company to refer the matter to the BIFR for consideration. The BIFR would look into the matter, and if necessary, appoint an Operating Agency (OA), usually a major creditor of the company to prepare a report on the feasibility after reviewing the financial position of the company. If the BIFR was satisfied that the company was sick and that restructuring would be a viable option, it would direct the OA to prepare a scheme of reconstruction of the assets.

Though the enactment of the SICA received praise since it had initiated a rescue culture in the Indian insolvency regime, the issues at the time of implementation meant that it was creating more harm than help. Under the SICA, a reference could be made to the BIFR only if the company under consideration was ‘sick’. The definition for ‘sick company’ provided that the company’s accumulated losses must equal or exceed its net worth. This meant that only a company which was technically insolvent could be referred to the BIFR for reconstruction. Thus a company with temporary liquidity problems or losses was not eligible for reconstruction and BIFR intervention would only be at a stage when the losses accumulated have made any meaningful reconstruction an impossibility.

Further, during the period that the inquiry is being made and the scheme is being prepared and implemented, the debtor company is in possession of the assets and unless otherwise ordered by the BIFR, the sick industrial company could dispose off its assets. This confers an unmerited advantage on the inefficient management of the sick industrial company.

SICA does not specify any time-frame for the rehabilitation of a company and was to be implemented with the consent of each creditor obtained in respect of any concessions or reliefs required to be granted under the scheme. It has rarely resulted in successful restructuring on account of delays in preparing the scheme or objections raised by the company or the affected creditors. Further the BIFR proceedings increasingly came to be abused by the companies’ promoters. Since the initiation of BIFR proceedings automatically put a freeze on recovery and other civil proceedings by the creditors, company accounts were sometimes deliberately manipulated by the promoters. The defaulting debtors thus found safe haven under the BIFR proceedings. Moreover the law did not provide for any punitive action against this malpractice. The result is that the BIFR procedure under SICA has been a complete failure.

Corporate Debt Restructuring

Having realised the need for a more efficient restructuring mechanism which facilitates out-of-court settlements and quickens the recovery process in a fast moving economic climate, and also having taken note of the success of informal recovery mechanisms around the world, the Reserve Bank of India issued a Circular on August 23 2001 providing for the implementation of a Corporate Debt Mechanism (CDR) system and guidelines regarding the same. The objective as stated by the RBI was to ensure a ‘timely and transparent mechanism’ and involving other stakeholders through an ‘orderly and coordinated restructuring programme for restructuring the corporate debts of viable entities facing problems,’ not coming within the ambit and scope of BIFR or any other legal proceedings. The CDR structure and procedure has undergone various amendments, the latest being in 2008.

Structure and Procedure

The RBI envisages a 3-tier structure to the CDR system:-

1. CDR Standing Forum and Core Group – The CDR Standing Forum is vested with the highest policy making powers. It represents all the banks and financial institutions participating in the CDR system. The main functions of the Standing Forum include laying down of policies and guidelines and monitoring the progress of the CDR process. Other functions include:-

1. Mediating between the Creditors and the Borrowers to resolve any conflicts which arise and reach a consensus upon the CDR package taking into consideration, the interest of all parties concerned.
2. Ensuring the smooth functioning of the CDR Empowered Group and CDR Cell (Tier II and Tier III respectively), by providing guidelines with regard to “critical parameters” for restructuring.
3. Reviewing any cases (on an individual basis) of the CDR Empowered Group and the CDR Cell, if the need arises.

The Core Group does not form a separate tier, but is a part of the Standing Forum. The main function undertaken is that of assisting the Standing Forum in its functions.

2. CDR Empowered Group – The Empowered Group is in charge of dealing with and deciding individual cases that come up before it for debt restructuring. The general standing members of the Group consist of Executive Director level officers representing the Industrial Development Bank of India, ICICI Bank, and State Bank of India. However other members are deputed to the Group on a case-by-case basis.

The procedure is initiated when a case is referred to the Empowered Group by the CDR Cell, along with the preliminary reports of the same. The Group reviews the case and decides upon the feasibility of restructuring the particular borrower. Upon the approval of the Empowered Group, the CDR Cell is empowered to structure the restructuring package along with the Lead Creditor involved, or, any other bank designated by the creditors involved. The Empowered Group is given 90 days to decide upon the viability of restructuring the borrower. This may be extended to 180 days.

The Empowered Group’s decision upon viability for restructuring shall be final, and once such a decision is made in the affirmative, the company immediately moves into a phase of restructuring. If the company is found not suitable for restructuring, the creditors will have to look for other means, which may include either formal recovery mechanisms or filing for winding up of company.

3. CDR Cell – Though the CDR Cell appears to play an assistant role to Empowered Group and Standing Forum, most of the ground-level work is undertaken by the Cell. The initial reference for restructuring, must be made by the creditors to the Cell. It is the Cell that initially scrutinises the proposal. Within thirty days of reference, a primary restructuring plan is made by the Cell along with the creditors. It is this plan which is submitted along with the request to the Empowered Group for approval. Further, subsequent to the approval, the Cell is in charge of preparing the detailed restructuring plan with the help of the creditors. Outside expert help is at times solicited, if the need arises.

Which Cases are Eligible – One of the main features of CDR is that only multi-lender facilities, syndicated loans etc are eligible under the CDR mechanism. Thus a single lender facility or any arrangement involving only one bank or one financial institution does not qualify for the CDR process.

Cases which have already been initiated or are pending under the BIFR proceedings cannot be usually admitted for restructuring under the CDR mechanism. However the Core Group may on a case-by case basis decide to admit large or consequential BIFR cases. This comes purely within the discretionary power of the Core Group. Further the creditors must also seek the consent of the BIFR for the transfer of such cases.

Other eligibility criteria include :-

• • • The net exposure of the borrower company must not be less than Rs.100 million.
    • Companies which have been involved with fraud and malfeasance as against its creditors, even if it be in a single creditor are ineligible to restructure under CDR.
    • Companies which have been classified as wilful defaulters are ineligible (However, if the Core Group is satisfied that the earlier classification of the company as a wilful defaulter was not done in a transparent manner and that the company will be able to rectify its position if given an opportunity under the CDR mechanism, such cases may be admitted for CDR).
    • Cases where creditors have filed recovery suits against the company, the company can be still be eligible for CDR.

DCA and ICA- Providing a Legal Basis for the CDR Mechanism – Since the CDR mechanism is, as is the London Approach, a voluntary informal mechanism for debt restructuring, the question arises as to how the creditors and debtors to the CDR may be held bound by the CDR plan. The London Approach at its inception found success due to the overwhelming support that the Bank of England received from the Banking Community in UK. However the same moral ground would not be relevant due to the minimal role of the Reserve Bank of India in CDR matters. The Debtor-Creditor Agreement (DCA) and Inter-Creditor Agreement (ICA) seek to create a contractual basis for binding the parties to the CDR.

The Debtors are expected to accede to the DCA, so as to be bound by the restructuring package. This can be either by way of a contractual clause within the initial loan documentation whereby the debtor agrees to the CDR process if in case such a reference is made at a future point. In most cases however, it is made at the time reference is made to the CDR Cell for restructuring.

The ICA however is a standard contract which all the participating members of the Standing Forum are part of, with renewable validity period of 3 years. Creditors who are not part of the Standing Forum, may attach themselves to the ICA as and when an exposure arises which leads to a CDR initiation.

Stand-Still Clause – A Stand-Still clause, which is contained usually in the Debtor-Creditor Agreement, is in place so that the CDR system proceeds in a smooth manner. However the stand-still clause is binding only for a period of 90 days which may be extended to 180 days from commencement of CDR process. Essentially the agreement binds all parties from seeking any kind of outside enforcement or remedies, or other legal action. Criminal proceedings may still be allowed to continue during the stand-still period.

Additional Finance – In most debt-restructuring cases, mere interest holidays or debt-equity swaps may not be sufficient to tide over the problem. The CDR, following the London Approach, provides for additional financing to be made, if the need arises. The additional finance among all creditors will be provided on a pro rata basis. Further, the creditors of additional finance will have preferential claim over the others, with respect to the amounts obtained in recoveries.

Exit Option – The creditors who do not wish to provide further financing have the option of exiting the CDR procedure. The RBI tries to discourage this by disincentivising the exit option. Thus the exiting creditors have the obligation of either finding and arranging fresh credit from outside or existing creditors, or forgoing the first instalment of interest payment that is due to it following the CDR package coming into force.

Conversion Option – Debt to Equity swaps are a common method of reducing the debt exposure of the borrower and this is specifically provided for in the RBI guidelines. However it is upto the Empowered Group to decide upon the matter and the extent when framing the restructuring package. Such conversions are usually exempted from the capital adequacy requirements of the banks and financial institutions.

Impact

The CDR system has proved an effective alternative to the formal restructuring mechanism under BIFR. As on December 2008, the total value of cases which have been referred to CDR is Rs. 909 Billion (approx.), out of which cases involving Rs. 845 Billion (approx.) have been succesfully restructured.

One of the main beneficiaries of the CDR system in India has been the steel industry. Essar Steel Ltd, one of the major players in the Steel industry in India, had, in October 2002 landed itself with a debt burden of Rs.28 billion. The company decided to enter into a CDR arrangement with its creditors, led by the IDBI Bank. The CDR package included term loan extensions, waiver of penalty interests and liquidated damages, certain debt-equity swaps, additional financing on a priority basis. Certain minor debts were also resolved in a discounted one-time settlement basis. The CDR package was put into effect, and by 2005, Essar Steel had managed to dramatically improve its financial ratios and declare profits. By 2006, the company’s net worth had gone up to Rs.43 billion. By June 2006 the company had managed to pay back the entire CDR debt. Similar turnarounds were effected in other steel majors such as Jindal Vijayanagar Steel and Ispat Industries.

Various industry majors have undergone CDR process over the years, mostly meeting with success. The most recent case is that pharmaceutical giant Wockhardt India, which is currently undergoing a major restructuring exercise under CDR.

Issues

Corporate Debt Restructuring owes its success mainly to the fact that the Indian economy is still on the path of growth, and in many ways, is nascent, compared to banking dominated economies such as UK and other developed economies of the world. This probably explains the reason why a system which has slowly but surely begun to lose its sheen in UK still finds popular acceptance and success in India.