Blanket One-year Ban On Fresh Insolvency Under IBC: A Boon For Corporates, But Huge Burden For Banks

In a bid to offer respite to stressed corporates, in particular small businesses, Finance Minister Nirmala Sitharaman, announced suspension of fresh insolvency proceedings for a period of one year. Given that companies have been reeling under the Covid-led crisis and are staring at huge loss in revenues and earnings this fiscal, the Centre’s move undoubtedly offers a big relief to India Inc.

But as they say, one’s loss is another’s gain. If corporates have got a breather from the Centre’s move, banks that are already under stress are in for some turbulent times. If the RBI does not offer any dispensation on recognition of defaults and does not provide one-time restructuring, steep rise in provisions on account of defaults — with the inability now to proceed against defaulters under the IBC — can hurt banks severely in the coming quarters.

The FM also stated that the Central government will be empowered to exclude Covid-19 related debt from the definition of ‘default’ under the Code for the purpose of triggering insolvency proceedings. While more clarity is awaited on this, what this could imply is that lenders cannot initiate proceedings against a debt which has turned delinquent owing to Covid. The question is how does one identify such a debt? This could only lead to more wilful defaults and frauds by unscrupulous borrowers in the guise of the pandemic crisis.

The other move by the Centre to notify special insolvency resolution framework for MSMEs under Section 240A of the Code appears to follow its earlier announcement on tweaking the definition of MSMEs to bring more businesses under the ambit of the Micro, Small and Medium Enterprises Development Act, 2006 (MSMED Act). Earlier, because of the narrow definition of MSMEs, many small businesses could not qualify for relief under Section 29A (that lays down ineligible bidders). With the scope now widened to include more businesses under the definition of MSME, leeway provided under Section 240A of IBC for MSMEs can help serve the intended purpose.

The latest announcements follow the Centre’s earlier decision (on March 24) to increase the threshold for initiating insolvency plea to ₹1 crore (from ₹1 lakh earlier). This had been a welcome move, as it prevented small businesses from being pushed into insolvency. The suspension of any fresh insolvency for one year now, offers respite to larger companies too.

Tough times ahead for banks

While raising the threshold for triggering insolvency under IBC on March 24, the FM had stated that if the situation worsened, then Section 7 (initiation of insolvency by a financial creditor), Section 9 (by an operational creditor) and Section 10 (debtor files for insolvency) of the Code would be suspended for six months after April 30. With the economic fallout of the Covid crisis only worsening since then, the Centre has decided to suspend the initiation of any fresh insolvency proceedings altogether for a year.

While this offers respite to corporates, it presents several challenges for the already stressed banking sector.

One, banks are already feeling the heat of sharp slowdown in credit growth. There is also the risk of sharp rise in delinquencies in the coming months. While the three-month moratorium and the corresponding freeze on asset quality classification (for loans under moratorium) offers some interim relief, the actual picture on bad loans would emerge after the moratorium is lifted in a month’s time (in June). With about 30-40 per cent of loans across banks under moratorium currently, the risk of significant rise in bad loans remains high. In such a situation, where banks’ provisions can rise sharply in the coming quarters, inability to proceed against defaulters for a year, could hurt severely.

Two, a blanket ban on all fresh insolvency pleas could do more harm, impacting credit culture and allowing fraudulent promoters and wilful defaulters to game the system. After all, IBC had given more teeth to lenders, as promoters had feared losing control of the company. A blanket ban on insolvency proceedings for a period of one year can undo the progress on this front. Accounts that were under stress or delinquent even before the Covid crisis should have been dealt with separately. Inability of banks to proceed against wilful defaulters or unscrupulous promoters can lead to bigger issues after a year, if the fallout of the pandemic proves to be more brutal and long drawn.

Three, there could be a sharp surge in cases admitted under IBC after a year, which could further slow the progress under IBC (which has already been poor). As of December 2019, of the 3,312 cases admitted till date, only 190 have seen the approval of a resolution plan. A large number of cases undergoing resolution currently have been in the IBC process for over 180 days. Of the 1,961 cases undergoing resolution as of December 2019, 635 have been in the system for over 270 days, and 247 cases, for 180-270 days.

The sudden gush of cases under insolvency after a year, can only add to the burden of the NCLT and NCLAT benches.

Lastly and more critically, banks may have to take steeper haircuts. As such, the overall recovery rate so far has been dismal at about 35 per cent (between Dec 2017 and Dec 2019 quarter). If we exclude big cases such as Electrosteel Steels, Bhushan Steel, Binani Cements and Bhushan Power & Steel, the recovery rate falls further to 20-25 per cent.

Amid the sharp economic slowdown, the value of underlying assets is likely to erode significantly. Undue delays in resolution and even few takers for stressed businesses would force banks to take steeper haircuts going ahead. A freeze on action against defaulters for a long period of one year, can only erode value further and impede recovery for banks.

MSME relief

While banks have some tough times ahead, corporates, in particular small businesses, have got a big relief. The raising of threshold for filing insolvency to ₹1 crore (from ₹1 lakh) is a welcome move as it offers respite to small businesses (even after the one-year ban is lifted) that are more vulnerable to an economic downturn. A higher threshold will prevent large-scale applications under the IBC.

The other respite to MSMEs has come from the tweaking of MSME definition by the Centre.

Earlier, MSMEs were narrowly defined. Under the MSMED Act, medium, small and micro manufacturing enterprises were defined based on their investments in plant and machinery; for a medium enterprise the threshold was up to ₹10 crore, while for a small unit it was ₹5 crore. The Centre now has not only increased the investment threshold to ₹1-20 crore but also included turnover criteria, which brings in more businesses under the MSME definition.

From an IBC point of view, this will help more businesses to take advantage of the leeway under the Code with respect to eligible bidders.

Remember that in 2017, Section 29A was inserted in the code to keep out errant and wilful defaulters from buying back assets. But this has been a big roadblock in finding bidders for small businesses as usually only promoters are likely to be interested in acquiring such businesses. Hence Section 240A was inserted in the Code, which stated that certain provisions of Section 29 A would not apply to resolution applicant in respect of MSMEs. Essentially this meant that a defaulting promoter can bid in the resolution process provided he is not a wilful defaulter or suffers from any other ineligibility except the one arising from NPA and executing a guarantee. But the narrow definition of MSMEs under the MSMED Act 2006 had deterred promoters from acquiring back their assets and making use of the leeway provided under Section 240 A.

The widening of definition of MSMEs can help more small businesses take advantage of this leeway under the Code.