This article has been authored by Himanshu Chandel, a third-year law student at Campus Law Centre, Delhi.
This is the second part of the article. The first part may be accessed here
The aspect of confidentiality dispenses a contradictory dilemma in the Indian Context. Pre Packs promotes confidentiality during the whole process, thereby avoiding unfavorable limelight of the company as opposed to a CIRP under the code which leads to goodwill deterioration and a sharp decrease in the value of a company but at the same time the process becomes less transparent.
In cases where connected parties purchase the business of the debtor through a pre-pack sale, there is a concern that the lack of transparency results in the perpetuation of ‘bad businesses’ without allowing for a genuine restructuring or exit of the debtor. Bankers themselves may hesitate to restructure liabilities outside of an open bidding process for fear of their decisions leading to investigations by agencies. Unlike in the case of a full-fledged CIRP which allows for price discovery, in the case of a pre-pack the NCLT would only be able to evaluate a resolution plan based on submissions by the creditors and the investor. The interest of stakeholders, mostly the operational creditors is negated.
Even where we have a more developed system of IBC such as in the UK, there is a concern that as the pre pack is not a court administered process or public process and therefore unfair to certain stakeholders and dissenting creditors. Informal workouts, by virtue of being outside the purview of the Code, would not be scrutinised and approved by the Adjudicating Authority under the Code. So, to be skeptic about the mechanism, we have to ask this question as to who will actually benefit from not having an adequately public exercise and why do we not want to have the cost of a court process.
Since the process is typically confidential, and receives only the approval of secured creditors, there is not enough incentive to carry out extensive marketing that would be in the interests of all creditors, especially unsecured creditors. Given this, the value due to unsecured creditors may be captured by other stakeholders. The fear that value will be captured is exacerbated in cases where the pre-pack results in a sale to parties that are connected or related to the debtor.
The Paradox of Connected Party Transactions
The Code was specifically amended by The Insolvency and Bankruptcy Code (Amendment) Act, 2018 (Amendment Act) to inter alia address the issue of connected party involvement in CIRP of a corporate debtor. The Amendment Act under section 29A has effectively barred the existing management of the corporate debtor from taking any steps which would permit them to regain control over the assets of the debtor company. The resolution plans should not contemplate the purpose of resolution process in which the existing management may return to manage the corporate debtor. The creditor centric approach under the Indian context has been established through various judicial pronouncements such as in the case of Essar Steel and pre packs will provide an image of deterring from this creditor friendly approach which will be met with criticism. The Section 29A under the IBC is a fundamental disconnect as it prevents the existing management from putting in resolution plan. On the other hand, there is no incentive for the existing management to cooperate under the IBC and other mechanisms such as RBI’s June 7 circular which offers an alternative to formal insolvency proceedings to resolve financial distress. Once a company goes under a CIRP, it comes under the management of a resolution professional but often there are cases of non cooperation by the existing management and the solution to which is filing an application under Section 19 of the code and seek cooperation by the promoters. Potentially a similar concept could be extended in a pre pack and that would facilitate a clean process but at the same time a fundamental aspect of a pre pack will be lost whereby the existing management is not allowed to manage the company as a going concern. Replacing the existing management can act counterproductive especially under a pre pack as they have served the corporate debtor and will be in a better position to revive the company. In the case of pre-packs, the incumbent management retains control of the company until a final agreement is reached. Transfer of control from the incumbent management to an insolvency professional as is the case in the CIRP leads to disruptions in the business and loss of some high-quality human resources and asset value. This can certainly be avoided under a pre pack but will the mechanism be tampered with to go against the established creditor centric approach remains to be seen. Whether an RP can carry out a marketing exercise in a sufficiently good manner without the cooperation of existing management in the Indian context has to be observed.
Existing mechanisms akin the Pre Pack:
Out of Court settlements being non-statutory and voluntary processes suffered from the threat of minority dissenting creditors jeopardising the negotiation process by initiating legal proceedings against the borrower. In case of the RBI's “Prudential Framework for Resolution of Stressed Assets”, or the “June 7 circular” as it is more popularly called, the lenders need to huddle in a room and within a month decide whether or not the company which is in stress deserves a resolution plan and if the answer is in the affirmative then all the lenders sign an agreement to behave in a certain manner. The lenders or the resolution applicant whoever is a stakeholder would have the comfort of getting the appropriate representations and warranties, if an RP is implemented, the lenders would sign Inter Creditor Agreement (ICA) during the Review Period. An agreement signed by lenders representing 75 per cent by value of outstanding or 60 percent of lenders by number would be binding on all lenders. One key feature of the circular is the binding Inter Creditor Agreement to achieve resolution in a time-bound manner. June 7 circular is a useful experiment in pre packs although there are some aspects of the circular which don’t quite translate that well. The core problem with the circular was mindboggling provisioning requirement that are worth taking note of. For instance, if there is no resolution of the asset, within one year from default, it will attract provision of 50 percent – 15 percent normal ageing provision and 35 percent additional provisions. Such high provision requirement and its impact on profitability of banks will nudge them to refer cases to NCLT (National Company Law Tribunal), if no resolution is in sight in a time-bound manner. An inter Creditor Agreement can be utilized in the context of pre packs and as the process is out of court, the provisioning requirement can be done away with. Arrangement or Compromise under the Companies Act, 2013 is another process on similar lines with Pre packs but is also not utilized after the inception of IBC.
Where should Pre-packs be incorporated to begin with?
To begin with, pre packs should be incorporated for businesses that are running, for smaller companies where there really isn’t a market to acquire such companies and there is knowledge of limited players therefore (i) the RP can conduct the exercise and (ii) The cost of a public marketing exercise may not be justified. Given that pre-packs are generally more prevalent amongst small and micro companies in other jurisdictions as well and the fact that these companies tend to have a small number of financial creditors, the pre-pack framework, comprising PPIRP and PAIRP, should initially be enabled for small debtors (such as micro and small enterprises), or debtors who do not have complicated debt structures. The nature of the assets in these companies are such that they cannot survive in a prolonged resolution process. The only real buy for these companies is the person who places the highest value and that are most likely the connected parties. There is a concern that since the process is typically confidential, and receives only the approval of secured creditors, there is not enough incentive to carry out extensive marketing that would be in the interests of all creditors, especially unsecured creditors. In these cases, the value due to unsecured creditors may be captured by connected parties, while the existing management regains its control without having to bear the liability of repaying much of its older debts. There are some solutions to protect unsecured creditors (i) getting their prior approval but that will also mean that there a higher degree of transparency and the going concern value probably won’t survive due to public announcement of the process. (ii) The other way is ex post disclosure where prior permission is not required but certain rules are incorporated that very strictly regulate the proceeds towards unsecured creditors by way of information and the insolvency professional has to justify their pre packaged sale and their marketing efforts. To begin with, once the process gets settled for The MSME sector, the same can be implemented in transactions involving more diverse and higher number of stakeholders.
After the mechanism of pre-packs is introduced, a regular exercise can be carried out by mutual cooperation of the IBBI and the government to monitor the system and then bring in necessary improvements in (i) the lack of transparency due to the notion that unsecured creditors have been kept in the dark, particularly when purchasers are connected to the company, (ii) insufficient marketing of pre-pack sales, as improved marketing strategies could alter creditors’ perception of whether they are getting the best deal (iii) the lack of consideration to future viability of the business as insolvency practitioners are seen to be responsible only to creditors of the old business and not so much the future success of the new business.
During such unprecedented times, the introduction of pre-packs becomes imperative in order to strike a balance between objectives of government and corporate. Pre-pack is one such novel mechanism in the Indian context that will reduce the dependency of the financially distressed companies on the adjudicating authorities and help them in becoming financially self-reliant by following a self-regulated method rather than conventional court bound proceedings. The current blanket ban on fresh insolvency proceedings under Sections 7, 9 and 10 might not be a good step as it might lead to way of creating unscrupulous borrowers and will consequently increase more stressed debt levels at banks. Pre packs could achieve the dual objective of promoting debt enforcement and restructuring and mitigating the impact of COVID-19 on financially distressed businesses. The new framework for pre-packs should be implemented in a phased manner, starting with small debtors or others with no complications in their debt structure.
It is an opportune time to revisit the IBC process and the pending reforms. The rise in resort to arbitration in India displays a conveyance from traditional judicial processes towards out of court/quasi-judicial resolution. Therefore, there is a need to amend the present insolvency regime so as to accommodate such pre-packs into the Indian insolvency regime These reforms could explore some alternative solutions to the conventional corporate insolvency resolution process (CIRP) for resolution of distress rather than complete suspension of the initiation of IBC proceedings. Otherwise, it could end up causing huge losses for a number of stakeholders due to depletion of assets.
With a pre-pack, the company’s business and assets, together with its employees, will pass relatively seamlessly from the IP to the buyer, who will have had time to put in a place a business plan to ensure that relationship with suppliers and customers are maintained and employees are retained. A pre-pack resolution will help shorten the long-winded court process. It will also reduce uncertainty on whether the stressed assets will draw interest from bidders and whether lenders will accept their bids. It will reduce cost of third parties’ engagements such as lawyers, provide an opportunity to parties to have elaborate deliberations to avoid ex post differences, and not to mentions it provide secrecy and confidentiality of information and save the corporate debtor from embarrassment of dragging to insolvency proceedings by the creditors. The overall benefit to the Indian economy will be visible as overseas companies may well relocate activity to India for the flexible process of insolvency framework. Having said that, pre packs cannot work in the existing scenario without significant amendments being made to what we think of the resolution mechanism in India. Pre-pack mechanisms can have a far-reaching impact on corporate rescue in India. If implemented well, it will promote early debt restructuring in a manner that best achieves the Code’s objectives.