Bad Is Turning Good- From SICA To IBC-The Journey Of Bad Loans In India

India's bad account market is turning good. Investors are upbeat and banks are also looking for alliances to start funds.  Huge amount of money from global and domestic capital market is being pumped-in in stressed assets market in India. Big assets undergoing Corporate Insolvency Restructuring Process (CIRP) under Insolvency and Bankruptcy Code, 2016 (IBC) are hot targets. Funds are hoping for big in next round of big tickets cases which might end up before National Company Law Tribunal (NCLT) under IBC especially power, engineering, and hospitality sector.

Fund Tie-ups: BlackRock Inc, which manages assets worth more than $6.3 trillion is reported to be entering Indian stress assets market and targeting to raise $2.5 billion. BlackRock will thus be joining the big players such as Blackstone, KKR, Apollo Global, Baring and so on. Blackstone has already acquired controlling stake in International Asset Reconstruction Co. Pvt Ltd and invested about $150 million. KKR  has already got approval to operate ARC in India.

ICICI and Apollo have floated new ARC AION Capital. Earlier, Caisse de depot et placement du Quebec (CDPQ), also picked up 20 percent stake in Edelweiss Asset Reconstruction Company with an expected investment of Rs. 5000 crore. Other notable deals were Kotak Mahindra Group teaming up with Canada Pension Plan Investment Board for an investment corpus of $525 million, Brookfield Asset Management committed Rs 7,000 crore in partnership with State Bank of India, and Piramal Enterprises together with Bain Capital Credit plan to invest upto $1 billion. JC Flowers & Co has tied up with Ambit Holdings. International Finance Corporation (IFC), is reported to be targeting $100 million in the new fund, alongside the sponsors' investment of $200 million.

These funds are playing a big role in battle currently being played at NCLTs to control big steel and cement firms. A consortium of Bain- Piramal along with Dalmia Cement is gunning for Binani Cement and is facing stiff challenge from Ultra Tech. Reliance Industries has bid jointly with JM Financial Asset Reconstruction Co. to acquire Alok Industries. ARCs had bought Rs 370 billion of NPAs from banks in 2016-17. However, the funds available with ARCs are not at all anywhere considering the extent of NPA in the Banks. As per the study carried out by ASSOCHAM-Crisil, owing to capital constraints, growth of ARCs is expected to come down significantly. "While growth is expected to fall to around 12 percent until June 2019, however the AUM (assets under management) are expected to reach Rs one lakh crore, and that is fairly sizeable".

State Bank of India is floating fund to take over 14 stressed power plants, of firms like KSK Energy, Indiabulls and RKM Powergen. SBI will invest Rs 10 crore in every project while co-lenders will bring in equity on a pro-rata basis, or to the extent of their exposure to the project. Indiabulls Ventures is raising around Rs. 2,063 crore via share sale to foreign investors to capitalize and fund its two subsidiaries-—IVL Finance, Indiabulls Asset Reconstruction Company.

Change in FDI Rules: The shift in flow of funds was preceded by important changes in Foreign Direct Investment (FDI) rules, whereby 100% FDI was allowed in Assets Reconstruction Companies (ARC). Foreign Investors could invest upto 100% of each trench of Securities Receipts issued by such ARCs. Amendments were also affected in the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act) under which non-institutional investors were allowed to invest in SRs. Sponsor were allowed to have stake in ARC beyond 50%. Conversion of debt into equity was permitted as part of restructuring plan. Another important change was an exemption of stamp duty in assignment transaction of distress assets. Implementation of Insolvency and Bankruptcy Code, 2016 is considered to be one of biggest factor which has changed the outlook of distress fund.

Challenges Before Banks: Advances of Indian banks as of September 2017 were around Rs 65-70 lakh crore ($ 1-1.25 trillion) of which 11-14 percent is bad or under stress, this opens up about $100-150 billion for such ARC and global funds. As per RBI Report on Financial Institutions: Soundness and Resilience [June 30, 2017], gross non-performing advances (GNPAs) ratio of SCBs rose from 9.2 percent in September 2016 to 9.6 percent in March 2017. The net non-performing advances (NNPAs) ratio of SCBs increased marginally from 5.4 percent in September 2016 to 5.5 percent in March 2017. The stressed advances ratio declined from 12.3 percent to 12.0 percent due to fall in restructured standard advances. While there is a fall in stressed advances ratio in agriculture, services and retail sectors, the stressed advances ratio in the industry sector, however, rose from 22.3 percent to 23.0 percent mainly on account of sub-sectors such as cement, vehicle, mining & quarrying and basic metals. Accretion of new NPAs from restructured standard advances declined in 2016-17.

• RBI Report further note that large borrowers account for 56 percent of gross advances and 86.5 percent of GNPAs of SCBs, whereas, top 100 large exposures account for 15.2 percent of gross advances. Non-performing accounts within top 100 exposures contribute to 25.6 per cent of GNPAs of SCBs. While the level of GNPAs of large borrowers increased between September 2016 and March 2017, their restructured standard advances declined during the same period resulting in reduction of total stressed advances by 1.8 percent.


• As per the RBI Report- Stress tests on banks' credit concentration risks, considering top individual borrowers according to their exposures, showed that the impact (under three different scenarios) was significant for two banks, comprising about 1 percent of the aggregate assets, which may fail to maintain 9 percent CRAR in at least one of the scenarios. The losses could be 60 percent of PBT under the scenario of a default by the top individual borrower and 105 percent in case the top two individual borrowers default. The impact on CRAR at the system level under the assumed scenarios of default by the top three individual borrowers will be 96 basis points.


• Given the high GNPA, existing PCR, it is estimated, Banks could take haircut of 47% without any further provision or capital requirement, however, recent tend in resolution under IBC indicated that that banks may have to take a haircut of 60-70%.

The Journey: Health Code System for borrowal accounts was introduced in November 1985 and asset classification of restructured accounts was explicitly prescribed for the first time in April 1992 with the introduction of objectively defined asset classification norms. The Narasimham Committee Report recommended creation of an asset recovery fund which would acquire and recover stressed assets and enable banks to focus on their core business.

The Narasimham Committee Report triggered and brought the issue of NPA into focus. It highlighted that the huge backlog of NPAs had severely impacted profitability of Banks. But it was until implementation of SARFAESI Act that a focused law to govern formation of ARC was introduced. Pursuant to this and the enactment of the SARFAESI Act, many ARCs were formed in India, with ARCIL being the first. As on November 2017, there were 24 ARCs. Edelweiss being the largest ARC.

Major landmarks in the journey of stressed assets were:

1. Establishment of Board for Financial Reconstruction in 1987;


2. Debt Recovery Tribunal were establishment in 1993.


3. Narasimhan Committee Report on Banking Sector Reforms were released in 1991 (First Report) and in 1998 (Second Report).


4. SARFAESI Act came into existence in 2002.


5. Government liberalized foreign investment in Indian ARCs and SRs in 2005 with allowing foreign direct investment (FDI) of up to 49 percent.


6. FDI/FII investment ceiling in Indian ARCs was increased to 100 percent in May 2016.


7. Framework to Revitalise the Distressed Assets in the Economy was introduced in January 2014.

Implementation of IBC has played a major role in changing the outlook of debt resolution in India, a system which was marred by delays and failures under the then existing regime under SICA.

• The Sick Industrial Companies (Special Provisions) Act, 1987, popularly known as SICA was enacted to address sickness in the industry. It was under this enactment BIFR was formed to oversee the rehabilitation of the sick units. But instead of addressing sickness in the industry it itself became a sick institution and a refuge ground for defaulting borrowers who used to approach BIFR just to take advantage of indefinite moratorium under SICA.


• Another mechanism that was tried to address issue of sickness and stress was Corporate Debt Restructuring (CDR) System (established in 2001) which was purely a contractual arrangement between lender and corporate. As per the figures available, CDR cell approved 530 cases with a total loan of over 4 trillion for debt recast, of which 165 cases with loans worth Rs.56,995 crore had exited on account of failure in implementing the debt-restructuring package as approved by their lenders. The number of failed exits as on 31 March 2014 stood at 121 cases, with loans worth Rs.29,980 crore. Prudential norms on restructuring of advances were comprehensively revised in August 2008 which allowed impetus incentive for resolution of case under CDR but this was subsequently withdrawn from April 1, 2015 after which CDR mechanism also lost its purpose.


• JLF Framework: Framework to Revitalise the Distressed Assets in the Economy which was introduced in January 2014, under this Central Repository of Information on Large Credits (CRILC) was established and mandatory required for formation of the Joint Lenders' Forum (JLF). This also introduced the concept of 'non-cooperative' borrower category and disincentives for them.


• The JLF framework was supplemented with specific loan structuring tools for project loans such as the 5/25 Scheme in July 2014. Strategic Debt Restructuring (SDR) Scheme with a view to facilitating exit of management of defaulting units. But due to legal issues there were very few success stories under this regime.


• Sustainable Structuring of Stressed Assets (S4A) was also introduced for over-leveraged stressed accounts and provided for division of debt into sustainable and non sustainable portion. But, S4A did not allow the banks to offer any moratorium on debt repayment as was available under CDR. Banks were also not allowed to extend the repayment schedule or reduce the interest rate. A valuation system was established for conversion of part of debt into equity or qausi-equity instruments and the 20% of the total outstanding debt or 40% of the debt that is seen as unsustainable were to be provided for, which substantially more than the then provisioning norm of 15% which the Banks were to provide for bad loans in the first year. Further, this was limited to projects that have started commercial production. There was no scope of changing the terms and conditions of the loan. But, in the absence of proper legal backing and also investors, the system failed to take-off as there were few opportunities for banks to exist equity which was practically without return and had no tax advantages. We had instances of debt of Rs.1,355 crore of Kingfisher Airlines Ltd into equity but the efforts failed for want of investors.


• The issue of NPA was further compounded by certain practices followed in the financial sector such as involvement of advisors hired by corporate in the appraisal of large value projects, implementation of risky projects under Special Purpose Vehicle and also lack of proper and scientific approach in the handling of PPP projects.

Beginning of new regime IBC: The measure mentioned above were found to be inadequate to address problem. Lack of confidence of investor in the available legal system and absence of favorable ecosystem lead to the implementation of the Insolvency and Bankruptcy Code (IBC) in 2016.

IBC attempted to address all the legal and operational issues which were responsible for failure of the existing system to address sickness. IBC laid down a robust ecosystem to address sickness and financial default in time bound manner. It also tried to address the issue of judicial intervention in the financial matter by setting up intuitions such as Insolvency Professionals and Committee of Creditors so that adjudicatory authority (which do not have requisite expertise to handle financial turnaround matters) do not have much say in deciding financial insolvency of firms. It laid down the strict timeline for all the functionaries to complete the resolution process. IBC, in fact, introduced the concept of Separation of Function in Adjudication Process. IBC also addressed another aspect of resolution mechanism which was reason for failure of earlier regime, it made the outcome of resolution process binding on all the stakeholders, including firm, lenders, operational creditors, statutory bodies, Government, guarantors. It also provided for priority of secured creditor over statutory dues in waterfall mechanism. Similarly, it has also laid down proper mechanism for valuation of assets.

 However, despite its apparent advantage over the existing legal framework, the Banks were initially reluctant to move NCLT. Till May 2017 only 18 cases were filed by the financial creditors out of which only 7 cases were by Banks which covered default of around Rs 1,376.6 crore. This led to Government issuing ordinance to amend Banking Regulation Act, 1949 and authorising RBI to direct Banks to initiate resolution process under IBC. On December 07, 2016, Ministry of Corporate Affairs  notified the Companies (Transfer of Pending Proceedings) Rules, 2016 for the transfer of proceedings from the High Court to NCLTs where the petition for winding up had not been served on the company making NCLT the sole authority to deal with the corporate resolution process and liquidation.

At present about 1000 cases are there before NCLTs where CIRP is under process. About 94 cases are undergoing liquidation process. While share of Bank in cases filed under IBC is  only about 2%. 11 cases out of 12 filed by Banks, resolution are still being worked out and are mostly on extension of time.

IBC has also thrown open certain challenges for Banks in the form of large haircuts which turned baldness in some cases such the case of Synergies Dooray Automotive (which is before NCLAT) where recovery for Banks is around 5%. Cases like Kamineni Steel & Power and Jekpl Private the resolution value is found to be lower than the liquidation value whereas the going concern value has to be more than liquidation value which aim at sale of assets in piecemeal manner. Further, in resolution plan also Banks are not getting immediate recovery and payment plans are stretched for more that 10-12 years that too with haircuts ranging from 40 to 95%. This is expected to play a major role in Bank going back and reworking their model of credit appraisal and assets valuation methods.

While implementation of SARFAESI Act gave much-needed fuel for realization of stress assets IBC is expected to improve the insolvency resolution process. IBC being still at its initial stage, judicial processes and intervention continue to pose a greater challenge for the strict time line prescribed under the Act. NCLT has already declared for itself [J.K. Jute Mills Co. Ltd. v/s Surendra Trading Co] that 14 days time allowed for admission of matter under IBC is only directory and not mandatory. The result is that the application filed by Union Bank of India against Era Infra Engineering Ltd (involving amount of Rs. 681 cores and which was in the first list of cases issued by RBI in June 2017) was admitted only last week.

NCLAT has recently in the matter of Quinn Logistics Pvt Ltd, has laid down that while the CIRP has to be completed within 270 days time but the time spent in litigation stay is to be excluded from such period.

Though most of the issues are slowly getting addressed still IBC has long way to go given the litigant culture in the Country and very liberal approach adopted in courts to admit all sorts of applications and cross litigation. There is no denial of the fact that speedy judicial process is sine quo non of any effective insolvency regime and quicker we realize this better before IBC is turned into another civil litigation system.  Banks and corporates have to adopt a very realistic approach in evaluation of project and valuation of assets to avoid large haircuts which would certainly be looked into Banks internally. This issue has been highlighted again by resolution plan approved in Monnet Ispat which only account for 3-3.5 crore of recovery for lenders. Banks would certainly relies that all the cases which would go before NCLT were not as hot as Binani Cement. Further, there will also be challenges for promoters on account of legislative restriction on resolution applicants under section 29A of IBC (Essar Steel being the case for examination).

Inexperience Resolution Professional and their role in some of the cases is also another issue of concern. IBBI has though taken prompt action to address this and disqualified erring professionals. Instances like that of Synergy Dooray and United Seamless where Edelweiss and Indian Bank have complained of foul play against RPs needs to be taken care of .

While some firm would certain try to drag the matters to civil litigations and devise new means for that including collusive suits, however, this time the IBBI and the Government appears to be focused on successful implementation of IBC. The Government has placed the report of the 14-member insolvency law committee for discussion and action. Recommendations are expected to address some of the challenging issues like status of home buyers, letting lenders to decide on turnaround scheme or liquidation by 66% vote, down from 75%, redefining persons disqualified from bidding for bankrupt firm, rules for interim finance to bankrupt firm, lenders holding equity from earlier debt recast will not be barred from voting on turnaround scheme,  action against guarantors to bankrupt firms will not be barred and allowing promoters of small businesses to submit resolution plans etc.

The government has issued Fugitive Economic Offenders Ordinance, 2018 to block escape routes for defaulting borrowers and allowed confiscation of their assets in India and abroad. It is noticeable that legal process in foreign jurisdiction have also take note which has resulted in Vijay Mallya loosing legal battle in blocking execution of DRT orders against him in UK.

In another positive development, United States Bankruptcy Court has directed appointment of an examiner to take a closer look at Nirav Modi's ties to the US companies that filed for bankruptcy. The examiner will have to investigate to what extent Modi or any of his entities have the ability to direct or influence the conduct of Firestar Diamond Inc, A Jaffe Inc and Fantasy Inc. The examiner will also have to determine whether company executives knowingly participated in fraud or dishonesty in the management of the affairs.

Changes by SEBI: The Securities and Exchange Board of India (SEBI) is reported to have initiated the process to align its rule with provisions of IBC. The discussion papers in this regard has flagged various issues relating to disclosures, trading in stock exchanges, material related party transactions, re-classification of promoters, compliance with minimum public shareholding requirement and delisting pursuant to resolution plan/ liquidation.

• Amendments are being proposed for certain SEBI norms on the basis of three stages of Corporate Insolvency Resolution Process -- pre, ongoing and post CIRP stages.


• Listed companies under CIRP are likely to be subjected to various disclosure requirements.


• Such entities would have to disclose about filing of an application for initiation of CIRP as well as when creditors initiate the process and amount of default mentioned in the application.


• Disclose details about the number of bids received by the insolvency resolution professional, filing of resolution plan as well as approval of the plan by the National Company Law Tribunal (NCLT).


• SEBI is also looking at providing that entity a period of two years to comply with the requirement in case the minimum public shareholding falls below 25 per cent in a company after CIRP.

Thus, IBC has not only infused a much-needed sense of urgency in the system (be it judicial or financial) but also fear of losing control in promoter of stress accounts. There are a definite sign of threat of IBC working in favour of suppliers for realization of receivables. This, along with favourable market conditions, successful turnaround/restructuring could usher in more favourable condition for ARCs.

Other Recent Measures by RBI and Government: RBI and Government has also taken some interessting initiatives to address the issue of stress by introducing new concepts in Banking:

• In 2017 RBI constituted a 10-member 'High Level Task Force on Public Credit Registry (PCR) for India, which will, among other things, suggest a roadmap for developing a transparent, comprehensive and near-real-time PCR for India.


• In February 2018, RBI came out with guidelines to address stress in large ticket advances and withdrawn many of its earlier schemes such as CDR, SDR S4 and setting up a time limit of 180 to resolve the problematic accounts or initiate action under IBC.


• Banks have been permitted to use the ratings of the INFOMERICS Valuation and Rating Private Limited (INFOMERICS) for the purpose of risk weighting their claims for capital adequacy purposes. Banks may use the ratings assigned by INFOMERICS for the purpose of risk weighting their claims for capital adequacy purposes.


• LEI Code is being introduced for large corporate for improving the quality and accuracy of financial data systems for better risk management. Finance Ministry is reported to be considering allowing Banks to issue Shore –UP Certificates to the extent of provisions made in their books. As per the scheme a special trust will take over such assets for monitoring, recovery and unlocking value using IBC. Such Certificates would be redeemed as and when the assets is resolved.


• Earlier 11 Banks have been put under RBI's Prompt Corrective Action (PCA). RBI had come out with a more stringent PCA framework in April 2017 to turn around lenders with weak operational and financial metrics. Such Banks may take a year or more time to show improvement in the key regulatory indicators, which may help them come out of PCA.


• RBI has also allowed mark to market (MTM) provisions. RBI Circular dated April 02, 2018, with a view to addressing the systemic impact of sharp increase in the yields on Government Securities, allowed the banks the option to spread provisioning for mark to market (MTM) losses on investments held in AFS and HFT for the quarters ended December 31, 2017 and March 31, 2018.


• Provisioning for the secured portion of the large accounts (from the RBI's first and second list), which are currently undergoing CIRP under IBC has been brought down from 50 percent to 40 percent. This is expected to shore up the bottom line as the provisions made over the last couple of quarters are written back. However, the provisioning on the unsecured portion of the large advances has been retained at 100 percent.

 As per Monetary Policy Report RBI – April 2018 - after languishing for five consecutive quarters, economic activity in India is quickening, as estimates and high frequency, as well as survey-based indicators, etch out for the second half of 2017-18. Growth is strengthening and several elements are coming together to nurture this nascent acceleration: expectations of a record foodgrains output; strong sales growth by corporations; depleting finished goods inventories; and, restart of investment in fixed assets by corporations pointing to renewal of the capex cycle. These are some of the developments that support brighter prospects for the Indian economy in 2018-19.

Upturn in economic condition along with regulatory and legislative changes brought out by the Governments and the Regulators like RBI and IBBI, are set to usher in a new era to tackle stress in the financial system.

[The opinions expressed in this article are the personal opinions of the author. The facts and opinions appearing in the article do not reflect the views of LiveLaw and LiveLaw does not assume any responsibility or liability for the same]