29A has yielded multiple costs and limited benefits
Richa Roy and Zubin Mehta
On the second anniversary of the Insolvency and Bankruptcy Code (Code) many of its achievements deserve celebration including fostering credit discipline and improving upon a culture of impunity.
And yet, there has been a gamut of reactionary amendments to the Code, the intent and timing of several of which raise questions. The most significant of these was the introduction of the ineligibility criteria test through Section 29A. The ostensible objective was to ‘preclude unscrupulous, back-door promoters from regaining access to their companies’.
There was no such restriction in the Code as originally drafted. Was this oversight? Among the central lacunae in Indian bankruptcy frameworks prior to the Code were non-existent penalties or deterrence for promoters and management of insolvent companies.
“There are sick companies, but hardly any sick promoters” has been a constant refrain since the Omkar Goswami Report and the 1993 Union Budget. The Bankruptcy Law Reform Committee (BLRC) in 2014 which provided the intellectual nucleus for the Code (as well as its first draft) was alive to this issue. It noted that promoters remaining in control of a company even after default was a crucial reason why the debt-equity contract was broken.
The Code therefore required that immediately upon default, the control of the company would be seized from the promoter and passed to a regulated insolvency professional, reporting to a Committee of Creditors (CoC). This would prevent asset stripping and siphoning-off before and after default.
The BLRC specifically stated that the control of the company is not a “divine right of promoters”. And yet, there was no restriction on a promoter making a bid to regain control in the original Code.
This was because, the Code envisaged an “earned right” for promoters - promoters could earn back their companies as part of a fairly run resolution process, where all potential resolution applicants have access to information about the company, promoters are obliged to cooperate to share information and the CoC would have final approval. It was recognised that not all defaults involve malfeasance, not all promoters are fraudulent and honest debtors deserved second chances.
29A marks a shift from that principle and in imposing a premature and near-blanket disbarment snatches away the commercial discretion of the CoC in selecting a resolution offer. It creates a presumption that if the CoC acting in good faith elects a proposal from the promoter, then such election will be inherently wrong. It therefore elides the crucial distinction between misconduct by a promoter and genuine business failure.
It is crucial to prevent “phoenixing” or strategic bankruptcies i.e. promoters triggering bankruptcy in order to rebid for their company at deeply discounted values and to write down its debt. However, the original draft of the Code has safeguards in this regard – including stripping away control from the promoter at the instance of default itself; power to the resolution professional and CoC to review potentially fraudulent transactions from the past few years which could impose penalties on the promoters and management - these are significant costs and deterrents.
There is value in the proposition of permitting promoters to be eligible bidders for their company: Firstly, participation by erstwhile promoters or management can facilitate true price discovery without the CoC being obliged to elect promoter proposals. Secondly, where there is no evidence of malfeasance there is a genuine possibility that the promoters can partner with strategic/financial investors to proffer an efficient resolution proposal which represents genuine value for the company, creditors and its stakeholders.
Thirdly, 29A does not guarantee that persons barred by the ineligibility criteria cannot make back door entry through circuitous structures; there should be a “clean hands” approach which is transparent and helps CoC make a decision rather than a second guess on the antecedents of the applicant.
Unfortunately, despite the existence of 29A, there are several instances of promoters seeking control of their companies, which is leading to escalating legal costs as well as prevailing uncertainty. In some instances, CoCs have rejected offers, forcing companies into liquidation (where no such bar applies and therefore promoters may make a bid).
This is particularly prevalent in asset-centric businesses such as real estate where the going-concern value of the business is dispensable and is a particularly egregious example of phoenixing, that 29A has not prevented, but in fact perpetuated. There is also nothing in 29A to preclude warehousing and resale by financial entities.
29A’s ineligibility criteria casts a wide net and applies to persons who have no bearing on the functioning of the corporate debtor. The ineligibility parameters apply not only to the primary applicant but also to their associate and group companies who may have different operating models, businesses, and separate control patterns governing them. But more curious is the amendment to the Code to exempt entities such as venture capital investors, from being exempted from the ineligibility criteria test.
This exclusion was intended to apply to financial investors bidding for assets as part of a consortium, However, in cases albeit limited where companies are controlled by venture capital investors, and in some instances being in active management of a company, in effect “promoters”, it would imply that if such a company is run aground because of mismanagement, a venture capital investor would not be disbarred under 29A.
While other jurisdictions do not have promoter-led businesses, they have had to deal with the issue of recalcitrant management in insolvency proceedings. Research indicates that any bankruptcy regime should encourage the behavioural incentives that require that all responsible parties incur some costs for the firms’ poor performance including negative consequences for the managers (and in India’s case, promoters).
However, when the personal costs are too high they discourage public bankruptcy filings in favour of private negotiations as well as distortions in behaviour – as seen with 29A. Such distortions are costly and could defeat the intent of the amendment. So far 29A has yielded multiple such costs and limited benefits and therefore halted much of the promise of the Code.
In a short span of time, these amendments to the Code including 29A tend to gallivant away from the underlying principle settled under the BLRC report and the original Code – such changes are neither reflective of necessity nor based on any empirical evidence. Their rationale and impact is therefore unclear.Roy headed the corporate insolvency drafting team for the IBC 2016 and Mehta, a partner with Veritas Legal. Views are personal.