Will IBC bankrupt banks?

Mrs. Bumble had broken some trinkets but it was her husband who was held guilty... “Indeed, You are the more guilty of the two, in the eye of the law; for the law supposes that your wife acts under your direction.”

“If the law supposes that," said Mr. Bumble, squeezing his hat emphatically in both hands, "the law is an ass — an idiot. If that's the eye of the law, the law is a bachelor; and the worst I wish the law is, that his eye may be opened by experience” — Charles Dickens in Oliver Twist

Two hundred years have passed. Laws have changed but the process of lawmaking and the end result seem much the same. When Parliament passed the Insolvency and Bankruptcy Code (IBC) in 2017, it was intended to herald a new era for banking. Assets — steel mills, power plants, telecom towers languishing in the never-never land of corporate debt restructuring would be auctioned and put back into use. Banks would take a hair cut but would emerge healthier. Or so it was thought.

No equality?

The government, in its anxiety to help banks, passed a law which gives seniority to bondholders and lenders over suppliers of goods and services. The Indian constitution provides for equality under the law. This is a fundamental right and a basic feature of the constitution.

It cannot be legislated away. By taking the ground that the act can pay certain types of creditors ahead of others, the IBC opens up a basic question. Can a credit card company claim precedence over the Kirana Store in a bankruptcy?

A company could source equipment from two suppliers. One supplier insists on a Letter of credit from a bank. The other would provide it without a letter of credit. The buyer would have to pay that bank ahead of the supplier who did not ask for a letter of credit.

The mere involvement of a bank or financial institution would seem to be adequate for achieving this priority. Ericsson and L&T, to name but two, have taken recourse to the courts in their recoveries from RCom and Bhushan. Banks take over assets deemed to be charged under an umbrella “present and future assets” clause. When neither the company nor the banks have parted with cash for assets, why would the principles of natural justice allow banks to get the assets for free? Should not the supplier at least be deemed to be a secured creditor with a collateral of the goods supplied?

Even if the Act was just, would it apply to supplies made and debt incurred before the Act was passed? The Vodafone case brought the spotlight on the legality of retrospective taxation.

The law had to be amended to provide for the retrospective effect. The tax involved was a fraction of the amounts at stake in the resolution of the top 25 NPAs alone. The IBC is silent on its applicability in relation to debt incurred prior to its promulgation.

The one certainty is that this legal tangle will be many years into resolution. The RBI provides for a 50% provision for secured assets which are referred to NCLT.

Provisions rise to 100% if the company is insolvent or the asset is an NPA for three years. All other ways of resolutions have been dispensed with in RBI’s February circular. As time elapses, it looks like the IBC will result in a hit to the networth of the banks. May be this dawning realisation is why the RBI allowed banks to reduce provisions to 40% for NCLT cases in late March.

Conventional wisdom is that equity ranks last — below all financial debt, trade credits and even preference shares. In India, banks can use “strategic debt resolution” by which they convert part of their debt to equity.

The devolution of powers to the committee of creditors, which comprises only secured financial lenders, has resulted in strange antics where equity gets paid before debt.

Witness that so far many offers for assets are targeted solely at the interest of the secured financial lenders by giving a repayment of secured loans in cash as well as an offer to buy out outstanding equity.

The real problem stems from moral hazard. Legislators should have aimed for fairness to all creditors and equality under law not merely because they are high-sounding moral principles, but because people can accept a sacrifice if every one else sacrifices too.

Its difficult to avoid the impression that the IBC’s legal sleight of hand is an attempt to avoid a second recapitalisation bill.

(The writer is a finance professional)