Informal corporate rescue mechanism

Corporate Insolvency

Informal Corporate Rescue Mechanism: Approach and Implementation in India.'

Introduction

Modern corporate and banking practices around the world have, over the years, adopted various measures to deal with distressed companies and distressed debts/loans. Various factors, such as size of company, extent of distress, extent of individual lender exposure, future viability etc. play a part in the final decision and actions therein. The particular insolvency regime involved is a major factor which determines the ease with which one particular option can be exercised as compared to the other. Thus a creditor-oriented regime makes it easier for the lenders to take charge of proceedings and pursue measures to recover their dues, which ultimately may lead to the winding up of the debtor company. In contrast, a debtor-friendly regime leans towards recuing the company.

The present economic recession has resulted in widespread debt-defaults and company distress. Since the present scenario is a result of a systemic failure rather than individual instances, winding-up of companies do not look like the best option to be followed. Rescuing companies and putting life back into them (provided they are viable for the future) is what is being pursued commonly. Rescue mechanisms are of two kinds, formal and informal. The formal rescue process would involve a court-led or supervised procedure which ultimately leads to rescuing of a company, through measures such as change in management and debt restructuring. The best examples would be the Administration process under the Insolvency Act in U.K. and the Chapter 11 bankruptcy procedure in USA (though scholars such as Dan Prentice are of the view that the Administration process does not have as its main focus the restructuring and continuation of business of a company, when compared to the Chapter 11 proceedings in USA, which mainly concentrates on restructuring and rescue. ).

Out-of court rescue procedures through workouts/debt restructurings have seen a gradual but steady growth worldwide. Workouts typically involve a reduction of debt and an extension of payment terms. The main costs associated with debt restructuring are the time and effort to negotiate with bankers, creditors, vendors and tax authorities thus making it a less expensive and preferable alternative to winding up proceedings. Companies facing short-term liquidity problems find such workouts a viable mechanism to get back on track. Creditors would also find that the possibility of getting higher returns would be much greater in case they are able to successfully restructure the debts of the company and keep it as a going concern. This would be more evident in cases of companies having high debt exposures and showing high going concern value.

Though the roots of out-of-court corporate debt restructuring practices can be found in the history of sovereign debt defaults (arguably originating in the medieval period and continuing throughout into the 20th Century, peaking in the 19th Century), the genesis of present day informal restructuring can be credited to the Bank of England guidelines, commonly referred to as the “London Approach” . The London Approach which had its inception in the 1970's has developed over the years, adapting itself to the various financial innovations and the dynamics of a growing economy. Over the years the degree of direct involvement that the Bank of England has had over restructurings under the London Approach has reduced considerably owing to various reasons. However the principles enunciated remain strong and has been the source of reference and inspiration for similar mechanisms in other jurisdictions. India is a recent additions to this list.

India's foray into informal debt restructuring has been comparatively recent. Prior to 2001, there was lack of a systematic mechanism to expedite informal debt restructurings and other company rescue processes. The statutory framework in India for recovery of distressed companies, the Sick Industrial Companies Act, 1985 , authorised the Board of Industrial and Financial Reconstruction (BIFR) to supervise the re-organisation process. However the BIFR's role in the process was and remains very unsatisfactory. This led to institutionalisation of informal rescue through debt restructuring via the Corporate Debt Restructuring (CDR) mechanism established by the Reserve Bank of India (RBI), in 2001. This platform was largely on the lines of the London principles and has been used quite extensively in recent times. Various Circulars have been issued by the Reserve Bank of India with regard to the CDR procedure. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act 2002 was another step in the right direction as far as corporate rescue procedures were concerned. The Act provided for the setting up of Asset Reconstruction Companies (ARC) in India with the main purpose of undertaking the management of non-performing loans acquired from secured creditors.

This project proposes to broadly go through the various facets of informal corporate debt restructuring and rescue in India. As a backdrop, part II of the project looks into the London Approach, its history and development, its features and various issues which have hampered its viable continuance. Part III looks into the Indian position. Firstly it describes the Indian position prior to 2001. Then it goes on to the Corporate Debt Restructuring mechanism, its features and the various issues of concern that continue to plague the CDR system in India. Further, it looks at the work of the Asset Reconstruction Companies (ARCs) in India, its effectiveness and issues of concern. I wish to propose a more flexible system which can imbibe the qualities of both debt restructuring under CDR and non-performing asset reconstruction by the ARCs, whereby some of the issues of concern can be effectively addressed.

Informal Workouts in UK: London Approach

Early development

The 1970s, which witnessed a period of prolonged industrial recession in the UK, represents the Bank of England's initial foray into restructuring and rescuing companies. While high inflation and unemployment gripped the country, the industrial companies experienced a massive financial crisis. Mass liquidation would have made matters even worse, eroding the very economic structure in the country. The formal procedure under the existent insolvency law was unsuited to ‘constructive survival'. The Bank of England realised that more than a formal set of rules to enable a more structured format to workouts, what was needed was an intermediary who could organise discussions between creditors and debtors, while working on the basis of a set of guiding principles to engage in implementing a viable recovery package. The Bank decided to take on the role itself, since it was best placed as regulator of banks to organise and lead the other commercial banks. One of the main reasons why the Bank was able to engage in such a role was because its functions were not fully described in the Bank's statute. This meant that there was no regulatory road-block affecting the Bank's role as an intermediary. Other reasons were that firstly, the Bank was trusted by companies and banks alike; secondly, the help that the Bank provided did not demand any remuneration.

The Bank, in case of a workout for a distressed company, would call upon and organise a meeting of the various participant banks. A lead bank would usually be appointed. The issues would be hammered out and decided by the creditor banks together on a consensus basis, with the Bank facilitating discussions and helping the lead bank with the restructuring package proposal. The solutions within the package would involve various kinds of workouts including interest holidays, additional finance with or without the backing of any special arrangement for security purpose, change in management, fresh investment, debt-equity swaps etc.

Later Developments

Changes in the state of the economy and creditor-debtor relations saw a change in the role of the Bank of England from active participant to a more passive role of an honest broker in negotiations and formation of restructuring packages. Essentially the recession of the early 1990s was different from that of the 1970s in that it was brought about as a result of a decade of sustained economic distress backed by irresponsible banking practices and heavily geared companies. The competition for providing banking services during the 1980s owing to the economic upsurge and banking deregulation in UK, saw a huge inflow of foreign participants in the banking sector. The debt market expanded broadly as a majority of deals and transactions entered into were heavily leveraged. Adding to this, due to the growing complexities of financial arrangement the world over, the emergence of hedging instruments and multi-currency loan facilities etc, ease of transfer of facilities through loan sales, sub-participation, risk-participation etc. confirmed that the creditor-debtor relations were rapidly diminishing from a traditional relationship-based one to a purely transaction-based one.

In many ways, the 1990s recession presented a whole array of different problems to the banks and companies. Thus the traditional methods of restructuring as adopted earlier by the Bank of England needed revision. The Bank decided that this time it should restrict itself to being a passive participant, playing minimal role in review and framing a rescue package and in negotiating issues. Thus the Bank came up with guidelines, which we now refer to as the London Approach. The alternative term “London Rules” seemed inappropriate since it presumed a sort of formality to the general provisions enunciated. A formal structure was in fact deliberately avoided by the Bank after taking the opinion of the banking community; one among the main reasons being that the informal guidelines could avoid legal scrutiny from the domestic supervisors of the foreign creditor banks involved.

London Approach- features

The essential features of the London Approach have been emulated in the informal workout mechanisms worldwide, notably by the East Asian countries. The main features of the London Approach are:

i. The creditors must be ready to compromise to a certain extent by not immediately opting for enforcement proceedings such as receivership or liquidation. Thus a concerted effort towards workouts must be evidenced.

ii. The creditors must commission an un-biased group of experts, including insolvency practitioners and accountants to review the financial position of the distressed company and give an impartial account of the various parameters relevant.

iii. The company must be left in a position to trade during the period of independent review, so as to keep intact the confidence of its creditors. For this purpose the creditors must agree upon a temporary stand-still, maintaining the facilities.

iv. The Lead Bank, which is usually the major creditor, must be selected so as to lead the efforts of structuring the package.

v. The discussions need not necessarily come to a conclusion that the company must be restructured. Thus the creditors must come to an initial opinion on whether to rescue or not.

vi. In most cases, the company may not survive purely on interest deductions, or default waivers. Additional infusion of money may be warranted, either by original creditors or fresh investors. Usually such additional financing would enjoy priority during recovery/repayment.

vii. Whether it is with regard to collection of proceeds or sharing the burden of losses, pari passu principle must be followed and seniority of claims recognised.

As mentioned above, the London Approach does not provide any kind of guarantee to reviving a company to its original stature. Attempting to do so at any cost would only undermine the process and affect the viability of the London Approach as a whole. The London Approach merely aims to ensure that any decision taken, whether it be revival, or ultimate winding-up, be taken after considerable thought gone into the matter, and after a proper review is effected. Moreover the Approach does not have the object of reviving any companies or type of companies in particular, unless the macro-economic consequences of deciding in a particular manner are that great.

London Approach- Result and impact

The success of the London Approach was evidenced by the fact that a considerable number of companies were successfully revived due to a concerted action on the part of the creditors and the companies. In most cases where the companies were considered, the creditors have been agreeable to the packages proposed and have worked on those lines; cases of dissent and disagreement have been few.

The view that London Approach provides a pragmatic solution to recovery issues has been shared by creditors, not only the local banks but also the foreign banks which participated in the restructurings of 1990s. This wide-spread opinion is also one of the reasons for the success of the Approach, since its voluntary nature necessitates its acceptance by creditors as a premise for initiating the restructuring procedure.

London Approach- Issues

The London Approach after 1998 may have ceased to have as much effect since it is no longer the regulator of banks in England. Under the terms of Bank of England Act 1998, this mantle has been passed on to the Financial Services Authority (FSA). This has been the main issue which has dampened the viability of the London Approach. Various other issues have been causes of concern for the Bank of England. The powerful banks have (though infrequently) used the Bank of England censure as a weapon to get their way with smaller banks and to force them to agree to sometimes unfavourable terms in the rescue package. The cost of workouts has been another concern. In large cases, the creditors have often opted for independent legal advice and other resources instead of pooling the resources and using them commonly. This has unnecessarily added on to the debt burden of the company being revived. Furthermore, the London Approach as a modern day panacea has not stood as firm as it used to. Owing to the diversification of the creditor base which now includes bond-holders and secondary market investors and different modes of financing including securitisation and credit swaps, creditor co-ordination has become an issue not easily resolvable by the traditional approach. The globalisation of financial markets and the emergence of markets for distressed corporate debt also put strains on the London Approach.

London Approach- Extension to other Jurisdictions

The London Approach's success and viability is evidenced by the adoption of corporate workout mechanisms around the world modelled on London. These include various jurisdictions including Indonesia, South Korea, Thailand, Argentina etc. Most of these approaches have been adapted as per the requirements of each jurisdiction and the respective insolvency regimes.

Some jurisdictions show an inclination for a partially centralised system, with the Government being an active participant. In the Thailand, for example, the Bangkok Approach provides for Corporate Debt Restructuring Advisory Committee (CDRAC) headed by the Governor, Bank of Thailand, as an intermediary for negotiations. Moreover in case the creditors fail to reach a consensus, or a 75% super-majority, the final decision rests with the court.

The second approach shows a decentralised structure, where the creditors rather than the Government play an active role. In Argentina, for example, the only role of the Government was to enact emergency legislation, if necessary in order to promote standstill periods and encourage out-of-court transactions.

Informal Workouts in India

India's insolvency regime prior to 2001 can be said to have been marred by the absence a viable mechanism for restructuring. Rather than encouraging an in-depth debt restructuring strategy after scrupulous cash-flow analyses and consolidated negotiations, the Indian strategy was more or less one of rehabilitation by way of some kind of relief or concession on a superficial level. There were two connected issues which were the main causes of concern. Firstly the rapid rise in Non-performing Assets (NPAs) in India. Secondly the weak insolvency laws of the country. Following the sudden opening up of the economy through the liberalisation measures of 1991, mushrooming industries in India were commonplace. Unlike in UK, this was not complemented by a rush by banks to provide funding for the same. Banks were still restricted by a strict monetary policy, which meant that the interest rates remained high. However, the companies continued to accumulate a high ratio of gearing. India's industrial boom was evidenced at a time when global demand diminished. This meant that the assets gradually saw value erosion. The NPAs of the Public Sector Banks as of March 2001 had risen to Rs 548 billion, while those of other financial institutions had reached Rs 240 billion, causing a major concern for the banking sector which had not been used to coping with this degree of financial stress.

Individual settlements were the norm. However such settlements took much more time due to lack of an organised structure, thus resulting in further erosion of the asset base and even less returns to creditors. Further, the fact that most of the major creditors were in fact state-owned banks and financial institutions took its toll since court intervention on account of public interest litigation was an interference. Moreover the compromises and other arrangements as decided by such creditors also required the approval of, among others, the Central Vigilance Commission and the Comptroller and Auditor General.

India's insolvency regime, in any case was not helping matters. Company winding-ups were a long drawn process, taking on an average 10 years, with instances of some cases taking up to 50 years. The restructuring regime had been initiated by the passing of the Sick Industrial Companies Act (SICA) in 1985. The task of reviving sick companies was handed to a quasi-judicial body called the Board for Industrial Financial Reconstruction (BIFR). Under the Act, it is up to the Board of Directors of a sick company to refer the matter to the BIFR for consideration. The BIFR would look into the matter, and if necessary, appoint an Operating Agency (OA), usually a major creditor of the company to prepare a report on the feasibility after reviewing the financial position of the company. If the BIFR was satisfied that the company was sick and that restructuring would be a viable option, it would direct the OA to prepare a scheme of reconstruction of the assets.

Though the enactment of the SICA received praise since it had initiated a rescue culture in the Indian insolvency regime, the issues at the time of implementation meant that it was creating more harm than help. Under the SICA, a reference could be made to the BIFR only if the company under consideration was ‘sick'. The definition for ‘sick company' provided that the company's accumulated losses must equal or exceed its net worth. This meant that only a company which was technically insolvent could be referred to the BIFR for reconstruction. Thus a company with temporary liquidity problems or losses was not eligible for reconstruction and BIFR intervention would only be at a stage when the losses accumulated have made any meaningful reconstruction an impossibility.

Further, during the period that the inquiry is being made and the scheme is being prepared and implemented, the debtor company is in possession of the assets and unless otherwise ordered by the BIFR, the sick industrial company could dispose off its assets. This confers an unmerited advantage on the inefficient management of the sick industrial company.

SICA does not specify any time-frame for the rehabilitation of a company and was to be implemented with the consent of each creditor obtained in respect of any concessions or reliefs required to be granted under the scheme. It has rarely resulted in successful restructuring on account of delays in preparing the scheme or objections raised by the company or the affected creditors. Further the BIFR proceedings increasingly came to be abused by the companies' promoters. Since the initiation of BIFR proceedings automatically put a freeze on recovery and other civil proceedings by the creditors, company accounts were sometimes deliberately manipulated by the promoters. The defaulting debtors thus found safe haven under the BIFR proceedings. Moreover the law did not provide for any punitive action against this malpractice. The result is that the BIFR procedure under SICA has been a complete failure.

Corporate Debt Restructuring

Having realised the need for a more efficient restructuring mechanism which facilitates out-of-court settlements and quickens the recovery process in a fast moving economic climate, and also having taken note of the success of informal recovery mechanisms around the world, the Reserve Bank of India issued a Circular on August 23 2001 providing for the implementation of a Corporate Debt Mechanism (CDR) system and guidelines regarding the same. The objective as stated by the RBI was to ensure a ‘timely and transparent mechanism' and involving other stakeholders through an ‘orderly and coordinated restructuring programme for restructuring the corporate debts of viable entities facing problems,' not coming within the ambit and scope of BIFR or any other legal proceedings. The CDR structure and procedure has undergone various amendments, the latest being in 2008.

Structure and Procedure

The RBI envisages a 3-tier structure to the CDR system:-

1. CDR Standing Forum and Core Group - The CDR Standing Forum is vested with the highest policy making powers. It represents all the banks and financial institutions participating in the CDR system. The main functions of the Standing Forum include laying down of policies and guidelines and monitoring the progress of the CDR process. Other functions include:-

  1. Mediating between the Creditors and the Borrowers to resolve any conflicts which arise and reach a consensus upon the CDR package taking into consideration, the interest of all parties concerned.

  2. Ensuring the smooth functioning of the CDR Empowered Group and CDR Cell (Tier II and Tier III respectively), by providing guidelines with regard to “critical parameters” for restructuring.

  3. Reviewing any cases (on an individual basis) of the CDR Empowered Group and the CDR Cell, if the need arises.

The Core Group does not form a separate tier, but is a part of the Standing Forum. The main function undertaken is that of assisting the Standing Forum in its functions.

2. CDR Empowered Group - The Empowered Group is in charge of dealing with and deciding individual cases that come up before it for debt restructuring. The general standing members of the Group consist of Executive Director level officers representing the Industrial Development Bank of India, ICICI Bank, and State Bank of India. However other members are deputed to the Group on a case-by-case basis.

The procedure is initiated when a case is referred to the Empowered Group by the CDR Cell, along with the preliminary reports of the same. The Group reviews the case and decides upon the feasibility of restructuring the particular borrower. Upon the approval of the Empowered Group, the CDR Cell is empowered to structure the restructuring package along with the Lead Creditor involved, or, any other bank designated by the creditors involved. The Empowered Group is given 90 days to decide upon the viability of restructuring the borrower. This may be extended to 180 days.

The Empowered Group's decision upon viability for restructuring shall be final, and once such a decision is made in the affirmative, the company immediately moves into a phase of restructuring. If the company is found not suitable for restructuring, the creditors will have to look for other means, which may include either formal recovery mechanisms or filing for winding up of company.

3. CDR Cell - Though the CDR Cell appears to play an assistant role to Empowered Group and Standing Forum, most of the ground-level work is undertaken by the Cell. The initial reference for restructuring, must be made by the creditors to the Cell. It is the Cell that initially scrutinises the proposal. Within thirty days of reference, a primary restructuring plan is made by the Cell along with the creditors. It is this plan which is submitted along with the request to the Empowered Group for approval. Further, subsequent to the approval, the Cell is in charge of preparing the detailed restructuring plan with the help of the creditors. Outside expert help is at times solicited, if the need arises.

Which Cases are Eligible - One of the main features of CDR is that only multi-lender facilities, syndicated loans etc are eligible under the CDR mechanism. Thus a single lender facility or any arrangement involving only one bank or one financial institution does not qualify for the CDR process.

Cases which have already been initiated or are pending under the BIFR proceedings cannot be usually admitted for restructuring under the CDR mechanism. However the Core Group may on a case-by case basis decide to admit large or consequential BIFR cases. This comes purely within the discretionary power of the Core Group. Further the creditors must also seek the consent of the BIFR for the transfer of such cases.

Other eligibility criteria include :-

    • The net exposure of the borrower company must not be less than Rs.100 million.

    • Companies which have been involved with fraud and malfeasance as against its creditors, even if it be in a single creditor are ineligible to restructure under CDR.

    • Companies which have been classified as wilful defaulters are ineligible (However, if the Core Group is satisfied that the earlier classification of the company as a wilful defaulter was not done in a transparent manner and that the company will be able to rectify its position if given an opportunity under the CDR mechanism, such cases may be admitted for CDR).

    • Cases where creditors have filed recovery suits against the company, the company can be still be eligible for CDR.

DCA and ICA- Providing a Legal Basis for the CDR Mechanism - Since the CDR mechanism is, as is the London Approach, a voluntary informal mechanism for debt restructuring, the question arises as to how the creditors and debtors to the CDR may be held bound by the CDR plan. The London Approach at its inception found success due to the overwhelming support that the Bank of England received from the Banking Community in UK. However the same moral ground would not be relevant due to the minimal role of the Reserve Bank of India in CDR matters. The Debtor-Creditor Agreement (DCA) and Inter-Creditor Agreement (ICA) seek to create a contractual basis for binding the parties to the CDR.

The Debtors are expected to accede to the DCA, so as to be bound by the restructuring package. This can be either by way of a contractual clause within the initial loan documentation whereby the debtor agrees to the CDR process if in case such a reference is made at a future point. In most cases however, it is made at the time reference is made to the CDR Cell for restructuring.

The ICA however is a standard contract which all the participating members of the Standing Forum are part of, with renewable validity period of 3 years. Creditors who are not part of the Standing Forum, may attach themselves to the ICA as and when an exposure arises which leads to a CDR initiation.

Stand-Still Clause - A Stand-Still clause, which is contained usually in the Debtor-Creditor Agreement, is in place so that the CDR system proceeds in a smooth manner. However the stand-still clause is binding only for a period of 90 days which may be extended to 180 days from commencement of CDR process. Essentially the agreement binds all parties from seeking any kind of outside enforcement or remedies, or other legal action. Criminal proceedings may still be allowed to continue during the stand-still period.

Additional Finance - In most debt-restructuring cases, mere interest holidays or debt-equity swaps may not be sufficient to tide over the problem. The CDR, following the London Approach, provides for additional financing to be made, if the need arises. The additional finance among all creditors will be provided on a pro rata basis. Further, the creditors of additional finance will have preferential claim over the others, with respect to the amounts obtained in recoveries.

Exit Option - The creditors who do not wish to provide further financing have the option of exiting the CDR procedure. The RBI tries to discourage this by disincentivising the exit option. Thus the exiting creditors have the obligation of either finding and arranging fresh credit from outside or existing creditors, or forgoing the first instalment of interest payment that is due to it following the CDR package coming into force.

Conversion Option - Debt to Equity swaps are a common method of reducing the debt exposure of the borrower and this is specifically provided for in the RBI guidelines. However it is upto the Empowered Group to decide upon the matter and the extent when framing the restructuring package. Such conversions are usually exempted from the capital adequacy requirements of the banks and financial institutions.

Impact

The CDR system has proved an effective alternative to the formal restructuring mechanism under BIFR. As on December 2008, the total value of cases which have been referred to CDR is Rs. 909 Billion (approx.), out of which cases involving Rs. 845 Billion (approx.) have been succesfully restructured.

One of the main beneficiaries of the CDR system in India has been the steel industry. Essar Steel Ltd, one of the major players in the Steel industry in India, had, in October 2002 landed itself with a debt burden of Rs.28 billion. The company decided to enter into a CDR arrangement with its creditors, led by the IDBI Bank. The CDR package included term loan extensions, waiver of penalty interests and liquidated damages, certain debt-equity swaps, additional financing on a priority basis. Certain minor debts were also resolved in a discounted one-time settlement basis. The CDR package was put into effect, and by 2005, Essar Steel had managed to dramatically improve its financial ratios and declare profits. By 2006, the company's net worth had gone up to Rs.43 billion. By June 2006 the company had managed to pay back the entire CDR debt. Similar turnarounds were effected in other steel majors such as Jindal Vijayanagar Steel and Ispat Industries.

Various industry majors have undergone CDR process over the years, mostly meeting with success. The most recent case is that pharmaceutical giant Wockhardt India, which is currently undergoing a major restructuring exercise under CDR.

Issues

Corporate Debt Restructuring owes its success mainly to the fact that the Indian economy is still on the path of growth, and in many ways, is nascent, compared to banking dominated economies such as UK and other developed economies of the world. This probably explains the reason why a system which has slowly but surely begun to lose its sheen in UK still finds popular acceptance and success in India.

One of the main reasons why CDR has been till date successful is due to the dominant Government presence in the banking sector. Most of the major creditors are public-sector banks, and thus are even-minded regarding issues which come up during restructuring. As the Indian economy matures, with a diverse range of players active in the banking sector, the scene could change. The following issues are of concern as regards the present, future and continuing success of CDR in India.

Promoter Co-operation -The CDR system involves considerable sacrifices on the part of the creditors and debtors as well as promoters. Promoters' sacrifice could be in the form of reduction in share capital, changing the composition of share capital from pure equity to equity plus preference, debt-equity conversion etc. The basic concern which may arise in such circumstances is whether the promoters would be willing to fully co-operate in such circumstances, since in any case, the promoters would reap the benefits of a restructured company, thus being free riders benefitting from the creditors' sacrifices. The threat of liquidation in case negotiations fail is one major deterrent in such cases. But again, in India, the issue does not hinge on that alone. It also depends on the negotiating power and the policy-shaping abilities of promoters who are frequently influential at Governmental level.

Legal and Regulatory Support - Even though CDR is an out-of-court voluntary mechanism, its effective implementation will require the backing of a strong insolvency and enforcement regime, at least so as to serve a deterrent effect. A court-supervised process for seizure of assets, foreclosure, receivership, liquidation, reorganisation etc. would go a long way in providing the much needed back-up for the CDR process. The Indian regime has been more or less a debtor-friendly one, where the debtor does not have enough incentive to sacrifice its own interests or co-operate much with the creditors.

A comparison may be made with the restructuring mechanisms adopted during the East Asian Crisis. It has been seen that the restructuring mechanism has met more success in Korea and Malaysia, with stronger insolvency/foreclosure regimes than Thailand or Indonesia, which have weak insolvency laws. In the former, the debtors have evidently been more willing to co-operate with the creditors for effecting a viable package, owing to repeated evidence of the creditor's and courts' ability to seize control from the debtor in case they do not co-operate.

Foreign Creditor Issues- Foreign Banks have not yet acceded to the Inter-Creditor Agreement of the CDR mechanism. This proves to be a major road-block affecting the success of the CDR mechanism. Foreign Creditors have a prominent role to play in the Indian debt market. They provide a high degree of leveraging facility to transactions involving Indian Companies. Thus in almost all cases which arise, the presence of at least one foreign creditor among the syndicate of creditors. The RBI as well as the CDR Empowered Group have at various occasions tried to thrash out the issues and resolve the differences. However no foreign creditor/bank has till date joined the CDR mechanism other than on an ad-hoc basis. The major differences that the foreign creditors have had to do are essentially with regard to additional finance. Under the scheme the Additional Finance to be provided by existing bankers is not linked to the Principal Outstanding Financial Assistance, whereas foreign banks insist that it should be so. Also the Foreign banks do not want the new credit limits to be reinstated to the earlier sanctioned limits, if the outstanding was less than the sanctioned limits at the time of reference to CDR. The concern of the Foreign Banks is that a situation should not arise such that where banks had reduced outstanding amounts below sanctioned limits and agree to take up additional finance, they be forced to disburse the amount of reduction effected, prior to taking up the additional finance.

The CDR restructuring of Wockhardt Group which is presently underway presents concerns on this front. Wockhardt has very heavy liabilities, to some Indian and many foreign banks, especially under Derivative transactions. As per reports, the CDR has prepared a scheme without involving the foreign banks that have about 30% exposure (in the form of derivative dues) to the overall debts of Wockhardt.
Not only that, under the prepared scheme, the debts owed to these banks are subordinated to the other unsecured debts of the company and will be repaid last. This is seen as not a fair treatment and not as provided under the Companies Act. The foreign creditors' concerns must therefore be resolved in a satisfactory manner so that the CDR process obtains global viability.

Cases under BIFR- Certain cases which are fit for restructuring under CDR are often pending before the Board for Industrial and Financial Reconstruction. Such cases are ineligible to be restructured under CDR, unless taken in on a case-by-case basis as recommended by the CDR Core Group. Even in such a case, the permission of the BIFR is a requisite for transfer of cases to CDR. This delays and sometimes destroys cases which may otherwise be a very good candidate to be restructured under CDR.

Creditor Confidence- The Banks' choice of what recovery option to adopt, or whether to go for recovery at all rather than liquidation, will depend mainly on the time taken on recovery as well as the extent of recovery. With regard to time of recovery, CDR does not help much in facilitating a quick recovery of the company. Prolonged negotiations and various other parameters affecting the company's financial position are factors which may lengthen the time taken to completely restructure the company. This may hurt creditors' confidence in the system, prompting them to revert back to individual recovery mechanisms.

Further the CDR mechanisms require that the creditors sacrifice their dues to an extent. Though it does not demand loan write-offs, it may still seek interest waivers or reductions, maturity period extensions etc. which could ultimately reduce the recovery to a considerable extent. Though a decision regarding the same is taken after a proper consideration of all the pros and cons, the extent of recovery can well be a deterrent for banks, especially smaller banks, to avoid being part of the CDR process.

Investor Confidence- The CDR process in India has invariably come out with a package which requires additional financing facility for the debtor company. The existing creditors may find it difficult to inject additional funds and there may be a need for looking for outside investors. This may prove to be a burden unless investors have enough confidence in the future viability of the company and in the CDR process as such. This often depends on the stature of the company and the goodwill that it has managed to generate over the years of its existence. Fresh investors are generally reluctant to assist in additional financing requirements. Since the insolvency regime in India is yet to prove its mettle in safeguarding the interests of the creditors, this issue is closely intertwined with the implementation of an effective legal and enforcement backing to the CDR mechanism.

Role of Banking Regulator - The Reserve Bank of India unlike the Bank of England has not played much part in negotiation stage of the CDR process. Even at the inception of the CDR mechanism in 2001, the RBI, other than issuing the basic guidelines and framework for CDR, has not played a more active role in the restructuring of companies, being neither a member of the CDR Standing Forum nor the Core Group.

It may be seen that the initial success attributed to the London Approach is mainly due to the reputation that the Bank of England enjoyed amongst the Banking sector in UK, and its ability to persuade creditor banks into choosing one particular path rather than the other. Moreover the Bank of England was able to act as an impartial mediator, resolving conflicts which arose at the negotiation stage.

In my opinion, the RBI, though not as flexible as the Bank of England, may be able to play a more active role in the CDR mechanism by being the chief negotiator and organising meetings among the parties. RBI's impartial opinion will go a long way in dispelling doubts regarding bias in a particular package. Further, the RBI will be able to garner the support of the foreign creditors as well. The RBI would also be able to encourage rescue culture among the smaller banks in India. The cases referred to CDR are still overwhelmingly dominated by the larger banks. Unless CDR as a first preference mechanism is welcomed by the whole banking community, we may find it restricted to a few large banks.

Minority Lenders- Minority Lenders are often the smaller private sector banks with relatively less exposure to a particular debtor. The issue arises when their exposure is less compared to the bigger lenders, but on a strictly quantitative basis the exposure may be large as far as that particular bank is concerned. Under the RBI guidelines taken by 75% of creditors in value is binding on the rest of the creditors. The minority lenders may find that they are in a position where compromises which they accept are detrimental. Though exit routes are available, this would still entail sacrifices, which the banks (either due to their size or other circumstances) may not be able to handle with ease.

Complex Financial Arrangements- India's banking sector is relatively straightforward as compared to the more developed sectors around the world. It relies predominantly on direct lending without many intermediaries dominating the field. The standard restructuring package is still dominated by plain vanilla debts with a fixed interest rate. The CDR structure under the present system can provide an adequate remedy for distressed debts and companies. However, India is rapidly progressing on the path of financial innovations and regulatory developments, thus easing the limitations and clearing the way for various financial arrangements. Companies themselves relish the options that they find. With a growing bond market and increasing presence of financial intermediaries, the dominance of the major banks in India is getting slowly but surely uprooted. Banks worldwide, nowadays, have begun to shift their main role from being that of primary lender to one of origination and distribution wherein they are more of an arms-length trading device, arranging loans and then passing the risk to other investors in the loan market. This would mean that the number of players in the field would increase and consequently the smooth negotiations will be a thing of the past. Moreover the kind of problems that arise will also vary with the increasing complexities in the financial and capital market in India.

Public Censure- The clients of the company as well as the general public may lose confidence in the company and be reluctant to deal with them if news regarding restructuring is made public. In India it has been seen that though the details of restructuring are not in the public domain, the news regarding a company undergoing CDR process is invariably brought to light, especially in case of large companies. This is in contrast to the London Approach which was comparatively discreet in its operations. This puts the reputation of the company in jeopardy in India.

Cost Factor- The CDR process involves considerable great costs and financing and also a lot of sacrifices from the creditor's side. What has to be properly worked out is what level of costs the banks must be ready to withstand before finally deciding to pull the plug on the company. This would require a structured analysis of the various parameters concerned. A tried and tested benchmark system which can efficaciously provide an idea is warranted. The success of the CDR system would thus also lie in knowing when not to go for restructuring.

Asset Reconstruction Companies

Asset Reconstruction Companies (ARCs) in India provide another redressal mechanism to distressed debts. However rather than involving in restructuring, it plays a rehabilitating role. The ARCs essentially remove the non-performing assets from the banks' balance sheet, thereby freeing up capital for further investment. These assets are then recovered by enforcing of security or by creating a secondary market for the assets by working on them employing expert advice and guidance. Banks are increasingly turning to ARCs for their non-performing assets (NPAs) since this represents and easy mechanism to get the assets off their books. Further the banks don't have to indulge in the CDR process, spending time and money in the process. The importance of an ARC comes to light more in times of a systemic crisis, than in individual cases of bad lending tendencies. This is because in an individual case, the bank may be at a better position to gauge the borrower and may want to maintain the relationship with the borrower. However, in times of a crisis situation, as is evident in the present economic climate, banks generally fear further write-downs and bad debts, thus adopting a policy of no lending. The role of the ARC is essentially based on the fact that in such cases, more specialised knowledge and focus is required to resolve the problem of non-performing loans, leaving the banks free to pursue further lending activities and stimulating the economic growth.

Recommendations for setting up of ARCs in India to provide redressal for non-performing assets have come about on various occasions. However the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 , formally provided for the initiation of ARCs. The Act envisages a competitive private sector asset reconstruction model, with no direct government support. As of now, there are 12 ARCs fully functional in India.

According to the RBI guidelines the ARC shall, taking into account the projected earnings and the debts owed, come up with a proposal. This proposal should in no way be of detriment to the ARC itself or to its investors. The ARC may raise funds from qualified institutional buyers by formulating schemes for acquiring financial assets When the ARC buys assets from banks or financial institutions, it steps into shoes of the bank. Consequently all rights to enforce security interests will pass on to the ARC. In the case of such transfer of rights to ARCs, notice to the particular debtor is not mandatory. Notice is usually given to borrower in case of larger corporate loans as opposed to retail loans which have a much smaller value and larger number. The main consideration that the ARCs obtain is the margin between the actual asset value which maybe realised through enforcement of security interests and the reduced value that the bank charges for the assets when transferring to the ARCs. In most cases the consideration comes up to a considerable value.

Every ARC which wishes to obtain a license to start activities in India (from the Reserve Bank) must have a minimum owned fund of Rs 20 Million. Owned Fund refers to the net worth of the company. In practice it has been seen that the Reserve Bank has been generally reluctant to give licenses to ARCs unless they have a minimum owned fund of Rs 100 Million. Further the capital adequacy requirements necessitate that the owned fund must not go below 15% of the total financial assets acquired by the ARC.

One of the main aspects regarding the restructuring capabilities of an ARC or any secured creditor under the SARFAESI Act, is the right to self-help. Section 15 of the Act provides that any security interest created maybe enforced without the intervention of any Court or Tribunal . This provision over-rides the existing property law regarding the same. Thus the ARCs may, under this provision, take possession of the secured assets without delay. This is clearly a laudable provision since it creates a viable bypass to the hitherto existing weak foreclosure laws in India. One of the main aspects within this provision which highlights an ARC's role in informal restructuring, is the ability to change the management of the company. Such a power is granted more for the purpose of debt collection than company revival. However, a change in management for better realisation of assets, would (though not as directly as in CDR) in some cases restore the financial stability of the distressed company. This empowering provision under the Act requires approving guidelines from the RBI. Though the draft guidelines have been issued in this regard, the final set of guidelines are yet to be issued, due to which the ARC's scope of action is still limited, to enforcing of security interests.

The provision for abatement proceedings under the SARFAESI Act is another praiseworthy inclusion. The delay of BIFR proceedings in pending cases has been a cause of concern. However, under the provisions of the Act, where a reference is pending before the BIFR, such reference shall abate if the secured creditors representing not less than three-fourth in value of the amount outstanding against financial assistance disbursed to the borrower of such secured creditors have taken measures to recover their secured debt under the relevant provisions of this Act. This provision can be used effectively by the ARCs and is said to be among the most potent weapons of enforcement that the ARCs enjoy under the Act.

Issues

Various issues of concern result in the ARCs not being able to extract its full potential and deliver optimal results. This is more with regard to the basic distressed debt and otherwise existing general economic culture in India, than any weakness within the SARFAESI Act as such. Some of the major concerns are discussed below.

Assets in Rural Sector- A major chunk of Non-Performing Assets (NPAs) which are held, especially the ones held by the Public Sector Banks in India, belong to the rural sector. Since time immemorial, India has depended on the agricultural and rural sector to a large extent for its economic growth. However, India's rural sector, by its very nature is unorganised. Moreover various factors (some generally seen while some peculiar to India) hamper the sector. These include, inadequate financial support or market facilities, poor quality of tools and equipments used and poor quality of seeds, the general illiterate and superstitious nature of the rural agricultural community etc. The end result being low productivity, and in turn, increase in the amount of NPAs.

Assets belonging to the rural sector are usually managed by the banks operating through their local branches. The approach is much more tilted towards relationship banking than mere transaction-based banking. This being the case, the banks themselves would be in a much better position to recover the loans as well as to manage the assets. ARCs in the rural sector would not be as efficient as they aim to be as the level of network and reach required would be greater than what they currently possess. If the ARCs restrict themselves to recovering the loans of larger corporate borrowers, the end result would be better due to a focussed approach in that particular sector and more efficient use of time and resources. Such a sector-centric division of labour has not been envisaged in the statute nor have RBI guidelines looked into the matter. The main reason for that would be that the ARCs are still in their stage of growth, and the point has not reached where the sector-wise viability of ARCs can be empirically gauged.

Promoter Control- The degree of promoter control that exists in India is a concern when enforcement activities of ARCs are underway. This concern was realised even before the SARFAESI Act was passed, but sadly nothing has been done to meet the same. It is the promoters with whom the relevant documents regarding the loan agreements usually vests. Also, certain property rights such as those in trademarks and other intellectual property, frequently vest with the promoters. Thus the promoters create a control network which is hard to surpass, especially by independent institutions like ARCs. Obtaining the co-operation of the promoters is thus a must.

Illiquid Securities- The liquidity of securities in India creates considerable hassle during enforcement. Many of the securities are illiquid and made more so by the different laws. Transfer of land is often restricted by restrictions in the nature of land ceiling laws, zoning plans, etc. For instance several states have urban land ceiling laws wherein a ceiling is imposed on the amount of urban land that can be held by an individual. Further, use of land in urban areas is also regulated by zoning regulations eg. Land may have to be used in conformity with the master plans made there under. Also, often industrial land is not held on a freehold basis but is leased out by a government authority. Certain restrictions on transfer of land might have been incorporated in the lease deed. In the event a lender wants to recover the amount lent by him through sale of the secured land, it would be difficult for him to do so taking into account the above-mentioned restrictions.

Labour Laws- Further the labour law issues in the case of big industrial companies may also be of concern. Thus the labour laws provide for certain conditions and compensation requirements in case an undertaking is transferred since this would mean that the employment contracts of the employees would be affected to an extent. The Industrial Disputes Act, 1947, is the central legislation securing the rights of industrial workers. Under the Act, in case of a transfer of undertaking, which may occur by way of sale, or even change of existing management, the new management has the option of retaining the existing workforce on the same or equally favourable terms of employment. Failing this, employees are entitled to one month's notice with regard to the transfer, or one month's wages in lieu of the notice. Further, employees are entitled to compensation which shall be equivalent to fifteen days' average pay for every completed year of continuous service or any part thereof in excess of six months.

Thus immediate attempt in recovery of company by change in management cannot automatically result in immediate changes in financial stability and productivity of the company since labour laws ensure that the management, as part of restructuring activity cannot modify the existing terms of the employment contracts.

Conflict of Interest- The major aim of an ARC must be profit maximisation. This will ensure that investor confidence is maintained, and that the secondary market for distressed debt remains buoyant. However, one major road-block in sustaining this aim is the very constitution of the ARC. In most cases the major share-holders in the ARCs in India are Public-Sector Banks and other major banks, whose NPAs constitute the majority of those taken over by ARCs. Thus the conflicting case of the buyer and seller being the same entity arises. The negotiations between the Bank and the ARC in such cases would be anything but on arm's length basis.

Trying to overcome this obstacle is an equally tricky situation. On the one hand, while regulations which restrict holdings in ARCs by major banks would be warranted, on the other, such a move would discourage the growing ARC market in India, since it is these very banks and financial institutions which have the utmost incentive to start an ARC in the first place. However operational independence must be the norm as far as an ARC is concerned.

Distressed Debt Market- The distressed debt market in India is still in its evolving stage and is young compared to its Asian Counterparts. There is a general lack of confidence of the originating banks who are wary of underselling their assets to the ARCs. On the other hand the domestic investors are wary of investing in the distressed debt market. Price discovery and price benchmarking issues have not been fully sorted out in the Indian market. The situation has improved considerably after the RBI issued guidelines allowing 49% of foreign investment in the Asset Backed Securities Issued by the ARCs. This has helped considerably in developing a culture which encourages secondary debt trading. It may take many more years for the Indian financial sector to reach its optimal level of utilising the distressed debt market.

Political Interference- Interference through Government intermediation has been a constant presence in the Indian Financial sector, as in other sectors. In the case of ARCs, this has not been direct, nor has it been evident in any way. However, it must be noted that since the Government controlled Public Sector Banks are the most active in the NPA sector as originating banks, as well as promoters of various ARCs, the Government is in a position to determine the proceedings. In India, it has been seen time and again that the Government, more than playing a constructive and regulatory role, has only managed to put a spoke in the wheel of proceedings. This includes an unwarranted oversight into proceedings by way of Government audit and law enforcement agencies.

Stamp Duty Issues- The stamp duty that is payable on transfer of assets to the ARCs is a major cause for concern. Since the same comes under the State List, the Stamp duty laws are to be framed individually. Thus the end result of the ARC functioning would depend on the States from which the assets are transferred or rather, where the transfer documents are executed, since each State would have a different rate of stamp duty Most of the States have a high rate of stamp duty. Very few States have reduced their Stamp Duty rates in this regard for the purpose of facilitating ARCs. The Expert Committee headed by Dr. R.H. Patil had recommended, among other things, a consensus among States for a reduced rate of stamp duty. However the various State Governments are yet to implement the same. Some State Governments have introduced a cap on stamp duty for transfer and assignment of debts, ranging from Rs. 100,000- 200,000. This will be of great help to the ARCs for larger transactions. However a majority of States are still lagging behind on these measures. Another point of relevance is that, owing to the typical structure of ARC transactions, wherein initially the ARC acquired the assets from the Banks, and later transfers the same to a trust (typical of an asset securitisation), stamp duty will be incurred at both stages.

The practical consequence of the same has been that the ARCs have been indulging in forum-shopping so as to attract the least stamp duty while executing documents. This, though an alternate procedure, is however inconvenient and time-consuming.

Lack of Awareness of Court/Registrar- This proves to be a thorn in the process of quick disposal of assets and efficient functioning. Transfer documents along with proof of Stamp Duty in the case of transfer of debts are to be registered with the Sub-Registrar of Assurances. Due to its special nature and due to the lack of awareness of transfers of this kind in the country, it has often been difficult to describe the transaction to the Sub-Registrar. The transfer document has often been mistaken for a normal conveyancing document.

The Courts come into play at the time of substitution proceedings wherein the ARC wishes to substitute itself to the position of the transferor banks, with regard to any proceedings pending before the courts concerning the particular assets transferred. The time taken to educate the courts regarding the reason for substitution and the nature of the transfer has often been a long winding process, sometimes prolonging the cases to more than a year.

Concluding Remarks and Suggestions

Both systems of informal restructuring and workout mechanisms existent in India are laudable as far as their objective is concerned. With regard to their implementation a lot more needs to be done so as to provide for a more viable mechanism. As of now the Indian approach to CDR and reconstruction under ARCs has been one where, to borrow the adage, ‘CDR is CDR and ARCs are ARCs and never the twain shall meet.' Though there have been instances where ARCs such as ARCIL have been part of the CDR structure due to the fact that one of the lender banks have transferred the assets to ARCIL. This need not necessarily be the case. Essentially CDR and ARCs have occupied two different levels of asset performance, i.e. CDR has usually been employed prior to as asset/assets being declared non-performing (i.e. when they are standard, sub-standard or doubtful), whereas ARCs only deal with non-performing assets. However on a conceptual basis, though not exactly taking the two systems as they exist now, it can be seen that a few limitations of either mechanism can be resolved by adopting a framework wherein one can complement the other.

The ARC has the advantage of having turnaround specialists and other personnel specially experience with the task of reconstruction of assets. Their active participation in the CDR could ensure two things; one, a more effective means of analysing the state of financial distress of the company involved because of specialised focus on the area, and two, the banks could be relieved from dealing with prolonged negotiations and discussions, and return their focus to lending.

One main concern for banks which sell their assets to ARCs is that traditional client-bank relations get broken. The client company may look to another lender in future. The present mechanism in India presents the banks with no other alternative. However, if there were a mechanism whereby the ARC could return the assets to the respective banks, it would work out in a much better manner for the creditors and debtors. This would mean that the ARCs work would lean towards restructuring the debt rather than enforcement of security. This is where an ARC role in the CDR process would come in handy, since the ARC could directly step into the shoes of the banks while the borrower undergoes restructuring, sponsoring corporate restructuring or deleveraging funds, which may be used to manage the debt requirements and also work out any equity stakes the creditor may acquire in the borrower by way of debt-equity swaps.

Foreclosure and recovery laws are another area where co-operation could reap benefits. As explained earlier, the self-help remedy as envisaged under the SARFAESI is something which the ARCs consider as their strongest weapon. While the CDR mechanism does not provide for a similar enforcement mechanism. Thus a co-ordinated effort on the part of ARCs and banks within the CDR process could again result in a much more viable mechanism. The abatement of proceedings under the BIFR is again an aspect which the ARCs under SARFAESI enjoy, but the creditors under CDR do not. This problem can also be solved by bringing both processes under a single roof. It has been seen in most countries that the informal workout mechanism has produces faster results than the formal rescue procedure. However the maximum variation in the time and result has been evidenced in countries with a better threat of bankruptcy laws.

The stage at which the Indian economy stands today is a very crucial one. Some of the changes it may face would be similar to those that economies such as UK experienced following the 1990s recession period. Some of the other issues would be more due to the sensitive political, cultural and social fabric in the country. Various cultural and political aspects as mentioned must be dealt with through a co-ordinated effort on the part of the banking community along with the Government. Further regulations in other areas such as labour laws, land laws, tax laws etc. must be effected, or amendments to the existing regulations made to provide leeway for restructuring and rescue mechanisms.