NBFC resolution under IBC: It’s all about the manner

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NBFC resolution under IBC: It’s all about the manner

A trial and error approach should not be adopted for the shadow banking sector, given the likely adverse effect on the economy

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The Insolvency and Bankruptcy Code (IBC), which was enacted in December 2016, is meant for insolvent distressed companies. Eight months later, then Finance Minister Arun Jaitley introduced the FRDI (Financial Resolution and Deposit Insurance) Bill in the Lok Sabha to tackle insolvency of financial service providers (FSPs).

However, the Bill was shelved as it ran into a controversy over the Rs 1 lakh deposit insurance per bank account. The fear was a depositor would be left with just one lakh of her entire life savings, which usually run into lakhs, in the case of a bank failure.

These were two separate legislations. Clearly, the government wanted to keep FSPs outside the IBC as they are of high public interest and pose risks of systematic failure, requiring specialised treatment.

Recently, the government has changed its thinking to treat troubled FSPs under the IBC. The NBFC crisis involving the collapse of shadow banks such as IL&FS and DHFL has triggered this rethink. Section 227 of the IBC allows the government to notify NBFCs like DHFL for insolvency and liquidation in the ‘manner’ it prescribes.

The manner of such resolution can be two ways. One is to use non-controversial parts of the FRDI Bill and the other is to use the tested insolvency framework.

The less controversial part of the FRDI Bill recommends setting up a ‘resolution corporation’. Apart from government representatives, this corporation will have members from important regulatory bodies, including the RBI (Reserve Bank), Sebi (Securities and Exchange Board of India), IRDAI (Insurance Regulatory and Development Authority of India) and PFRDA (Pension Fund Regulatory and Development Authority).

It will have the mandate of classifying risk into different viability categories for FSPs. In case an FSP falls in the critical risk category, the resolution corporation will act as the administrator. It will also have termination rights over the FSP and is tasked with ensuring its resolution. If the resolution fails, this corporation will also act as liquidator to the FSP in question.

This corporation will come with the power of a civil court. The power can be exercised for: discovery, production and inspection of books of account; summons to key personnel and issuing commissions to examine the witnesses, among others. Pending an investigation, the corporation can also restrain an FSP or its officers from conducting business. It can authorise the agency concerned to conduct search and seizure operations against an FSP at any place.

Under the tested insolvency framework comes pre-packed insolvency procedure or ‘pre-packs’. The system, largely in practice in the UK and the US, allows for financial reorganisation of a company before the commencement of insolvency or bankruptcy. Such reorganisation is reached after cooperation and consultation between corporate debtor and its creditors. Though the concept as a whole is fairly new to India, the RBI’s June 7, 2019, circular contained similar aspects. The circular gave “complete discretion to lenders with regard to design and implementation of resolution plans, subject to the specified timeline and independent credit evaluation”.

Such discretion is available only before commencement of insolvency proceedings. If the resolution plan is to be implemented, all lenders shall enter into an inter-creditor agreement (ICA). When the ICA exceeds 75 percent of the total outstanding credit and 60 percent of total lenders in number, the decision shall be binding upon all the lenders.

Both systems come with their own pros and cons. The FRDI set-up can suggest excessive government intervention, which may discourage creation of new shadow banks. The government in that case will be required to provide deposit insurance. The cap of Rs 1 lakh on deposit insurance had already created panic amid the public. Any new quantum of deposit insurance will be met with fierce opposition and may dent consumer trust in banks.

The pre-packs can subvert the intention of the IBC being a ‘creditor-in-possession’ model. Section 29A specifically debars promoter/management of corporate debtor in which a fraudulent transaction has taken place to take part in the resolution process.

When both the systems are compared, FRDI provides for an early warning system whereas pre-packs may be entered when much of the water has flown under the bridge. On the other hand, pre-packs give lenders independence to craft resolution plan as per their own financial wisdom. The FRDI system may be reminiscent of the licence raj where the state tasks itself with every aspect of economy. However, there is no denying that once adopted, the FRDI system provides a conclusive solution whereas pre-packs offer an additional tier of negotiation before triggering the insolvency code. It is, after all, subject to “meeting of minds” of creditors and debtors.

However, as the government weighs the manner to bring FSPs under the IBC, it must not adopt a “trial and error” approach for this sector. If faulty frameworks get implemented, any spillover effects on the economy may be too large to handle.

Source- Moneycontrol.