, Josh Felman
Published: May 11, 2020 1:55:23 am
In our previous column, we argued that reviving the post-COVID economy will be exceptionally difficult because the crisis has damaged many balance sheets. India has been here before, as balance sheets were also impaired following the 2008/09 Global Financial Crisis (GFC). But this time is different: The damage is much greater, covering many more firms, in many more sectors, much more seriously. As a result, a gradualist strategy, which was pursued last time with decidedly mixed results, will not be feasible. The corporate and bank balance sheets will need to be fixed, urgently.
Why is speed so important now? First, because it is the only way to revive the economy. As revenues have dried up, most firms have been forced to let workers go and delay payments to suppliers, causing cashflow problems to cascade down the supply chain. Firms will consequently be unable to restart production unless they first get credit to pay their suppliers and workers. But impaired firms cannot get credit and impaired banks cannot provide it. So, the entire economy will be stuck unless the balance sheet problem is sorted out.
Speed will also minimise the losses from the COVID crisis. The value of bankrupt firms decays rapidly over time, and the bill for this loss will have to be borne ultimately by the government. So, speed is necessary to contain the damage to the government’s financial position, which has been badly eroded by the COVID crisis. But moving quickly will be difficult. The only real mechanism that currently exists to handle stress and bankruptcy is the Insolvency and Bankruptcy Code (IBC) system, which has been suspended for six months.
Some commentators have therefore argued for bringing the IBC back into operation as soon as possible. But such a strategy would not be a panacea. The system is slow, with many cases taking two years or more; it could easily become overwhelmed completely if it is forced to absorb a large new set of bankrupt firms. In addition, the IBC envisages that banks maximise their recoveries by auctioning off the bankrupt firms to the highest bidder. But in a nation (and indeed a world) where all balance sheets are damaged, it is not obvious who would be able to buy these firms, or at what prices. So recovery rates from sales could be low, undermining the objective of the exercise.
Even if strong bidders could be found, there is a fundamental political, even philosophical, question of whether it is really right to take these firms away from their promoters. After all, many of these firms did nothing wrong; they got into financial difficulties because of the corona crisis. Firms stopped production for the sake of the nation’s health, and at the direct request of the government. Surely, the nation should not repay them by punishing their promoters.
Such an exceptional situation calls for creative solutions. What is needed is a new set of procedures that utilise much of the existing IBC framework, but are simple, straightforward, and prompt, with a built-in expiry clause. Call them the Special Non-Adversarial Procedures (SNAP). As soon as the lockdowns are largely over, the IBC creditor committees (CoCs) could meet to assess the new wave of NPAs. The largest, most complex cases — say, those with debts exceeding Rs 10,000 crore — would be sent to the IBC for regular treatment. But all other cases would be eligible under SNAP. After all, the wider the set of companies that are put back on their feet quickly, the stronger the recovery will be.
Under SNAP, CoCs would, over the next three months, examine delinquent firms’ financial records, checking to see whether they are actually viable, undone solely because of the lockdown. If so, these firms would be designated as Lockdown Affected Enterprises (LAEs), eligible under SNAP.
Since the basis of the designation would be that the firm is fundamentally sound but for the COVID impact, an Insolvency Professional (IP) appointed by the CoC would work with existing management (who would continue to run the firm) to arrange for interim finance. Then, the IP would assess how much of a debt reduction the firm needs, and within three months would present a specific proposal to the CoC. If the CoC can reach a two-third majority in favour of the proposal, the promoter would keep the firm, while the firm would be granted a haircut and immediately released from bankruptcy. Since the National Company Law Tribunal (NCLT) is already overloaded, it would not be involved at all in SNAP.
If the CoC cannot reach agreement within the three-month deadline, or if at any subsequent point the firm defaults on its newly reduced debt, it would be sent to the IBC for resolution. SNAP would be disbanded no later than end-December 2020.
Such a system would have a series of checks and balances, to prevent firms from securing undeserved debt reductions. Banks would need to certify that defaulters are truly LAEs; IPs would need to certify the size of the debt reduction; a large majority of creditor banks would need to agree to the IP’s proposal.
With these checks and balances in place, the government should then commit to two things. First, it should provide some legal cover, ensuring that bankers would not be subject to investigations by the anti-corruption agencies, as long as they followed the LAE rules. Second, the public sector banks would be compensated for the costs of the haircuts, automatically and fully.
Besides speed, SNAP would have one further major advantage: It would reduce the adversarial nature of the IBC process, arising because promoters are forced to cede their firms. Under the proposed system, promoters would not only have incentives to cooperate; they would actually want to take the initiative, applying for LAE designation themselves, in the hopes that they could get back to business as soon as possible. Such a system might seem difficult to envisage, but it is certainly feasible: It is a design feature under Chapter 11 of the American bankruptcy act.
In other words, if SNAP succeeds, some of the special procedures could be introduced permanently into the IBC framework, adding a new dimension: Not just liquidation and rehabilitation under new promoters but rehabilitation under existing management.
Then, repair of the financial system would have to go back to addressing the long-standing problems, which will have been aggravated by the crisis. Firms that were unviable even before the COVID crisis would be sent directly to the IBC, but with the IBC reformed along the lines we proposed in our December 2019 paper.
The government should issue guidelines: Focusing the CoCs on the goal of maximising value, disregarding non-commercial objectives, which are now luxuries that cannot be afforded. Directing the NCLT courts to focus on the CoCs’ adherence to procedure rather than on the merits of their decisions. Increasing competition in the auction (and thereby maximising recovery values) by allowing promoters to bid for their assets, as long as they have not been declared wilful defaulters.
For the power and real estate sectors, we think that a sui generis approach via the creation of a bad bank is still the best way forward. The reasons, as we explained in the December paper, are straightforward: The viability of power assets is inextricably entwined with government policies, so the government would need to be heavily involved in any solution to electricity firms’ problems. Real estate resolutions need to take into account the interests of home-owners, something that is almost impossible to do under the IBC.
In sum, we propose a three-pronged attack on today’s balance sheet problems, aimed squarely at maximising recoveries from stressed assets. First, special, expedited, non-adversarial and time-bound bankruptcy procedures (SNAP) for COVID-affected firms. Second, a reformed IBC focused squarely on loss-minimisation, for firms that were unviable even before the COVID crisis. And, third, bad banks for stressed assets in the power and real estate sectors. Introducing this strategy quickly would set the stage for the economic recovery India badly needs — one that saves lives and saves livelihoods.
Subramanian is former chief economic advisor to the government of India and Felman is former IMF Resident Representative to India
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