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Thursday, November 12, 2015

Inconsistencies and forum shopping in the Indian bankruptcy process

by Aparna Ravi.

The current legal framework for resolving bankruptcy in India is broken, and a committee created in 2014 has proposed a new legal framework to fix it. The effort to fix a broken law is not unusual by world standards. Most countries, even those with stable bankruptcy outcomes that earn them high rankings in the World Bank Doing Business report, appear to be continuously creating new statutes or amending existing ones. For a sense of perspective, the current UK bankruptcy framework was put in place in 2002. In the US, the 1978 Bankruptcy Reform Act was the single biggest change that established specialised bankruptcy courts. But this has been followed by changes in 1984, 1994 and 2005, indicating a decadal cycle of review and reforms.

What is unusual about the Indian reforms is that these reforms stemmed from a general discontent with the system, rather than specific tangible evidence on measured outcomes. This is a problem particularly for creating a new legal framework, because you would expect that such evidence is a prerequisite to guide the nature and the form of the required reforms. One analysis that was available to the Committee was a paper in the Journal of Corporate Law Studies by Kristen van Zweiten, 2015. The paper analyses an extensive set of high court judgments related to liquidation in India. The analysis of these judgements reveal judicial biases in the form of a pro-rehabilitation stance at the High Courts, which in turn, leads to a reluctance to liquidate a business that is judged unviable. The paper records that the bias has contributed to delays and ineffective resolution of corporate insolvencies in India.

However, liquidation is only one part of a bankruptcy framework. The bankruptcy resolution framework is typically made up of three parts:

  1. Enforcement of debt by creditors, individually or as a group;
  2. Collective assessment of whether the debt can be maintained through a financial rearrangement or entity reorganisation to keep the debt viable; and
  3. Bankruptcy, where debt is liquidated if it is found to be unviable.

As in other parts of the world, the Indian framework has separate laws for each part. But unlike in other parts of the world, the Indian framework deviates in not having single law but, rather, is fragmented across multiple laws. More importantly, the different laws apply differently to different participants. For example:

  1. Debt enforcement is available only to banks and selected financial institutions through the Recovery of Debt due to Financial Institutions (RDDBFI) Act, 1993, and Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
  2. Collective action on enforcement are found in separate legislation depending upon the form of the debtor. For firms, it was first introduced in the Sick Industrial Companies Act, 1985 (SICA), and is now in the Companies Act, 2013. For partnerships, it resides in the Indian Partnership Act, 1932, and in the Presidency Towns Insolvency Act, 1909 and Provincial Insolvency Act, 1920 for individuals in the Presidency towns and for the rest of India.
  3. Bankruptcy of organised enterprises are covered in the laws related to the enterprise. For example, a firm is covered by the provisions on winding up in the Companies Act, 1956 and 2013, while that of individuals is covered in the respective individual laws listed above. [1]

In a recent paper, An analysis of collective insolvency resolution and debt recovery proceedings in India, I extend the evidence about the failure of legal performance of firm insolvency and bankruptcy by analysing a broader set of judgements in insolvency and bankruptcy resolution. I analyse 45 judgments, heard between 2003 and 2014, that were selected to provide for a variety of different proceedings, and to involve different types and numbers of creditors and other stakeholders.

Even this relatively small sample is useful in identifying two themes that contribute to poor outcomes in insolvency and bankruptcy. The first theme is the pro-rehabilitation stance adopted in adjudication during liquidation, which is consistent with the finding in van Zweiten, 2015. The second theme identified are conflicts arising from having multiple laws and multiple fora for adjudication. One of the core objectives of a bankrutpcy process is to incentivise the debtor and creditors to negotiate towards an outcome that maximises economic value in insolvency. The paper finds that, in India, multiple laws that make up the bankruptcy framework incentivise creditors and debtors to act in their own best interests during this process.

Further, the analysis highlights the conflicts that arise from having the jurisdiction of these multiple laws resting with different adjudicating fora. For example, the High Courts are the adjudicating forum for the winding up process under the Companies Act 1956 and 2013, the BIFR the adjudicating forum under SICA 1985 and the civil courts the adjudicating for the individual insolvency acts. On the other hand, the adjudicator for the debt enforcement laws are the Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs). This results in the process being diverted from swift resolution to one with extreme and frequent delays. Different laws being implemented across multiple jurisdictional fora is a key element that exacerbates the ability to delay the process of resolution.

Findings


The first outcome from the analysis is a measure of the delays in arriving at the final judgement. 17 of the 42 High Court judgments, for which data was available, took over 10 years for resolution (as measured from the date of commencement of the first action). 24 of the 42 took over 5 years. Seven of the 13 DRT/DRAT judgments took over 5 years for resolution. One of the causes for delays is the existence of multiple fora that the creditors and the debtor need to traverse to reach a resolution. In several of the cases reviewed, there was typically at least a few years of time lost between the BIFR providing a liquidation opinion and the High Court issuing a winding up order.

The conflicts that can arise from having fragmented laws and adjudicators is best illustrated with an example. One of the cases reviewed involved the following different actions [2]:

  • Secured creditor 1 files an application in the DRT for debt recovery.
  • Secured creditor 2 filed a company petition for winding up in the High Court.
  • Secured creditor 3 entered into an MOU with creditor 1 to get paid upon recovery for creditor 1.
  • A trade creditor that leased machinery to the debtor initiated proceedings invoking the arbitration clause in the contract.
  • Secured creditor 4 initiated proceedings under the SARFAESI Act and sold assets by auction.
  • Unsecured creditor 5 that had supplied a boiler to the debtor filed for debt recovery in the civil court.

While this may be at the extreme end of the spectrum, the majority of cases involved at least two or, more often, three parallel proceedings in different fora. In addition, the present law permits the process of winding up the firm and debt recovery from the same firm to run in parallel to each other. Particularly where the judiciary is fragmented across courts and tribunals, this leads to further confusion for creditors as well as debtors. Creditors remain uncertain of recovery even after proceedings have closed as it could always be challenged on the basis of another debt recovery or winding up action initiated on the same debtor. This is exacerbated by a pervasive lack of common information for cases against the same debtor. Often in the review, there were situations where one creditor initiates debt recovery unaware that similar actions have been initiated against the same debtor until much later in the process. Thus, the analysis demonstrates that the lack of a single, linear law compounded by the lack of common information leads to several instances of conflicts in using the law to resolve insolvency and bankruptcy.

When there is a lack of clarity in the law, the responsibility of resolving conflicts across these different laws and their interaction fall upon the High Court judge. Examples of some questions these judges had to grapple with are:

  1. Can the debtors assets be sold pursuant to enforcement action under SARFAESI while a winding up petition is pending in the High Court?
  2. Can a creditor initiate proceedings under the RDDBFI Act while SARFAESI enforcement action is ongoing?
  3. Does the High Court have jurisdiction over debt recovery proceedings in the DRT once the winding up process has commenced?
  4. If the Board for Industrial and Financial Reconstruction (BIFR) under SICA 1985 has referred a company for liquidation to the High Court, but the High Court is yet to pass winding up order, can a creditor bring an action for debt recovery in the meantime [3]?

Needless to say, the High Courts across the country interpret these conflicts differently. For example, on (a), the High Court of Telangana and Andhra Pradesh [4] held that the debtors assets could be sold in an auction pursuant to a SARFAESI enforcement action, while both the Madras and Karnataka High Courts ruled that the consent of the official liquidator was required for such a sale [5]. On (b), the DRT ruled that a creditor could initiate proceedings under SARFAESI while debt recovery proceedings under the RDDBFI Act were ongoing [6]. Nearly two years later, the Patna High Court held that the reverse did not apply and that proceedings under the RDDBFI Act could not be initiated if SARFAESI enforcement action had begun [7]. More than the letter of the law, how effective it is in implementation is shaped by the case law that emerges from its practice on the ground. Such conflicts in case law causes confusion in the resolution of similar future cases, further compounding the lack of certainty in the resolution of insolvency and bankruptcy of firms.

The final observation from case analysis worth touching on is that despite the law enabling debt enforcement even without the requirement of a court order (as is enabled in SARFAESI), this does not always work in practice. Debtors have the ability to challenge the enforcement of SARFAESI actions in the DRT. When this occurs, courts and tribunals often misinterpret the extent of their jurisdiction under Act. Under Section 17(2) and (3) of the SARFAESI Act, the role of the DRT or court when considering a challenge to enforcement action is to examine whether the secured creditors action was taken in accordance with the provisions of the SARFAESI Act and related rules. In practice, however, the DRTs and DRATs often overstepped this line to go on to adjudicate the substance of the claim itself. One such example is the question of how to determine the amount owed, or to impose or change conditions imposed by the creditor such as the amount of a deposit. It is, of course, difficult to ascertain the proportion of cases in which SARFAESI enforcement has been allowed to go unchallenged as opposed to those occasions on which it has been challenged in court. However, it appears that in cases where a debtor does challenge SARFAESI enforcement, creditors have experienced long drawn out struggles in the courts.

Implications for bankruptcy law reform


The UNCITRAL Legislative Guide on Insolvency, for example, states nine broad objectives of an insolvency law regime all of which also rest on having a collective mechanism for insolvency resolution:

  1. Provision of certainty in the market to promote efficiency and growth;
  2. Maximization of value of assets;
  3. Striking a balance between liquidation and reorganization;
  4. Ensuring equitable treatment of similarly situated creditors;
  5. Provision of timely, efficient and impartial resolution of insolvency;
  6. Preservation of the insolvency estate to allow equitable distribution to creditors;
  7. Ensuring a transparent and predictable insolvency law that contains incentives for gathering and dispensing information;
  8. Recognition of existing creditor rights and establishment of clear rules for ranking priority of claims; and
  9. the establishment of a framework for cross-border insolvency.

The review presented in Ravi, 2015 identifies three observations about the bankruptcy process in India that stand against these UNCITRAL principles of a sound bankruptcy process:

  • A legal framework fragmented across separate rights of debtors and creditors in collective action and debt recovery, as well as across different adjudicating fora.
  • Lack of clarity in rights of the creditors despite strong debt enforcement laws.
  • Delays in reaching final judgement.
  • Delays in implementing bankruptcy.

The analysis points out that the fragmentation of the laws and adjudication fora has been a dominant factor in leading to poor bankruptcy outcomes, such as delays in resolution. Thus, a key requirement in the reforms of the legal framework for bankruptcy is to have a unified law. Such a law ideally ought to cover all aspects of a debtor in distress as well as apply to all stakeholders. While simply piecing together the multi-layered framework will not make all the problems go away, such a move would greatly help with the efficiency and predictability of the process, two important indicators for the success of any insolvency law regime.

A single law will also have the benefit of a single adjudicating authority to hear all cases of insolvency and bankrutpcy. One outcome of this will be to have a single adjudicating authority for all matters related to insolvency and bankruptcy, which will eliminate the incentives of debtors and creditors to undertake forum shopping to resolve insolvency.

Another critical component of change is to counter judicial innovations that have contributed to the delays in insolvency resolution. A new bankruptcy process should stipulate clear timelines for different processes, make it difficult (or close to impossible) to reverse winding up orders and provide sufficient guidance to limit the exercise of unfettered discretion by the single adjudicating authority.
Finally, it is important to consider the interaction between collective insolvency proceedings and debt recovery mechanisms. The purpose of insolvency law has often been described as providing sufficient incentives for creditors to favour collective insolvency proceedings over individualised debt enforcement actions. In India, however, most reforms in recent years such as SARFAESI have focused on providing mechanisms for secured creditors to recover through individual enforcement action. These initiatives are understandable and necessary in light of delays in court proceedings and the significant abuse of SICA by debtors who used the pretext of a stay to impede recovery by creditors. Yet, while banks and secured creditors may have had some success with SARFAESI (the extent of this success is itself questionable), this focus has come at the cost of an organized insolvency process that preserves value and benefits all stakeholders. A new unified bankruptcy code is an opportunity to reverse this trend by providing a linear and time bound mechanism for collective insolvency rather than debt recovery.

Footnotes


[1] The new Companies Act 2013 includes new provisions that deal with rescue and rehabilitation (Chapter IXX) and liquidation (Chapter XX). However, these provisions have not yet been notified.
[2] This example is based on the fact pattern in BHEL v. Arunachalam Sugar Mills Ltd., (O.S.A. Nos. 58, 59, 63, 64 and 81 of 2011, decided On: 12.04.2011), but similar parallel proceedings were found in a large majority of the cases reviewed.
[3] Sri Bireswar Das Mohapatra and Anr. V. State Bank of India, W.P. (C) No. 8567 of 2006. Decided On: 17.08.2006.
[4] Indian Bank v. Sub-Registrar, Writ Appeal Nos. 1420 and 1424 of 2013 and O.S.A Nos. 34 and 35 of 2013, decided on 11.11.2014.
[5] BHEL v. Arunachalam Sugar Mills Ltd., O.S.A. Nos. 58, 59, 63, 64 and 81 of 2011 Decided On: 12.04.2011; Kritika Rubber Industries v. Canara Bank, C .A. No. 190/2008 in Co. P. No. 167/1999. Decided On: 13.06.2013.
[6] Bank of India v. Ajay Finsec Pvt Ltd and Ors (OA No. 167 of 2001, decided on 28.11.2003).
[7] M/S Punea Cold Storage v. State Bank of India (AIR 2013 Part I; II (2013) BC 501 Patna HC).

2 comments:

  1. Absolutely spot on analysis, especially the last paragraph about debt recovery by banks and other FIs under SARFAESI trumping collective bankruptcy resolution procedures under SICA (weak as they were). Indeed, the creditors face a collective action dilemma when confronted with a distressed debtor facing bankruptcy and the Indian laws are aggravating it. The draft bankruptcy law does well to do away with the SARFAESI pre-emption. Just off the top of my head however I am wondering if the pre-eminence of banking channel of monetary transmission in our case will make policymakers wary of doing away with the SARFAESI-preemption. (I agree with Ms. Ravi that the evidence that it has worked is not unquestionable); but it is the best of a sorry lot @ present and IBA is a very strong concentrated lobby. To top it, the banking sector itself is a sovereign surrogate, 3/4ths of the asset-wise. Would be obliged if any of the readers/ Ms. Ravi have thoughts on this.

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    Replies
    1. Thank you for raising this point. There is likely to be resistance from the banking lobby to do away with SARFAESI-preemption. However, to clarify, the draft law does not do away with SARFAESI preemption altogether. It provides that during the 180 day calm period all existing SARFAESI actions will be suspended and no new ones can commence. Once the 180 day moratorium is over and if the company goes into liquidation, secured creditors can choose to enforce their security interest and stay outside the collective liquidation process. If a secured creditor chooses to do this, they will not be able to take advantage of the priority given to secured creditors in the waterfall if realization of the secured assets is insufficient to cover the total amount of debt owed.

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