A pre-pack for bankruptcies
In today's Finshots, we talk about the government 's plan to expedite bankruptcy proceedings.
The Story
Corporate lending was risky business once. Banks had to constantly tussle with willful defaulters and risk losing significant capital in the process. Litigation was expensive and time-consuming. And for the most part, dodgy promoters found ways to take banks for a ride. All that changed however with the institution of the Insolvency and Bankruptcy Code(IBC) 2016.
It provided a dedicated legal framework to resolve bankruptcy-related matters. Lenders now had the power to drag defaulting companies to court and recover their dues in a time-bound manner. All they had to do was agree on a resolution plan within 330 days. They could try and salvage the business by working with the management or they could simply decide to sell it off. The balance of power shifted quite considerably and defaulting companies began to feel the pinch.
Unfortunately, the IBC infrastructure is being stretched thin as we speak. There’s a backlog of cases piling up at the courts and time-bound resolution is still a distant dream. Sure, things are better than the pre-IBC era but as it stands it takes about 376 days on average to resolve a case. This isn’t particularly reassuring and things have only gone from bad to worse in the last year.
The pandemic induced lockdown pushed hundreds and thousands of businesses to the brink. Overburdened courts were all set to face an avalanche of new cases. The government had to intervene. They knew they had to defer this problem or risk total capitulation. So in April last year, they suspended all bankruptcy proceedings, for one year. Meaning no one could take you to court even if you defaulted on your payment obligations during this time. It was supposed to be a temporary fix. But now that we are ready to move on from the lockdown, the government is all set to reinstate IBC.
The only problem — The avalanche has only gained momentum. The courts won’t have a moment’s respite if they suddenly open the doors. So they need a workaround and one solution that’s being proposed right now is a “pre-pack.”
Think of it this way. When a company becomes insolvent, lenders have two options. They can either drag the company to a bankruptcy court and initiate proceedings, or they could devise a rescue plan internally. Now the first option is codified within the IBC. The courts appoint a neutral person to oversee the resolution and all the lenders get together and work in conjunction with the professional to resolve matters. Meanwhile, the management loses control of all day to day affairs within the company and the neutral party is left to manage operations. However, this whole rigmarole is a drag on the courts.
A better option — at least intuitively is to “pre-pack” a solution before you approach the courts. That’s to say that maybe we can have a process where lenders can work with the management internally before submitting a resolution plan to the courts. This way, the courts won’t be overburdened. And the management can even retain control of their companies. Granted, this might not always be ideal, but in some cases, it might be beneficial to let the promoters run their ship. And since the pre-pack is mainly focused on smaller loans between ₹1 lakh to ₹1 crore, maybe we won’t have to worry about promoter interference as much.
However, that doesn’t mean pre-packs are foolproof. See, when a resolution professional appointed by the court oversees the whole matter, it’s pretty transparent for all parties involved. With a pre-pack, you can never be sure if all the lenders are treated in an equitable manner. Some parties can negotiate with the management independently and propose a plan that suits them best. Sure, if the others aren’t happy, nobody can compel them to sign off on the resolution plan, but if there’s no adequate procedure to resolve disputes within the pre-pack arrangement, the matter will simply go to the courts once again. That kind of defeats the whole purpose really and we’ll just be back to square one.
So maybe we will have to see how the government will design the exact mechanics of a pre-pack arrangement.
Until then…