Abstract
Reorganization or revival of the financially distressed corporate person is the prime objective of insolvency law. To rationalize the said objective, the insolvency law in India—Insolvency and Bankruptcy Code 2016 has adopted the manager-displacement model of the insolvency regime. It has become progressively evident from existing literature that the development of corporate governance mechanisms may have imperative implications on the aptness of a nation's legal system and its accomplishments. The existing evolutionary theory asserts that corporate bankruptcy and corporate governance structure complement each other. The historical account of corporate ownership structure in India represents a predominance of concentrated ownership patterns. Through the perspective of the existing evolutionary theory of corporate insolvency, the paper analyzes the corporate ownership structure and development of corporate insolvency law in India. The article also explores whether corporate ownership structure as a corporate governance mechanism can explain the progression of the insolvency regime in India. The findings of this paper would be of significance for jurisdictions that are considering reforms within their existing corporate insolvency law.
Introduction
It has become progressively evident from existing literature that the development of corporate governance mechanisms may have imperative implications on the aptness of a nation's legal system and its accomplishments. 1 The existing evolutionary theory asserts that corporate bankruptcy and corporate governance structure complement each other. 2 Put differently, a manager-displacing insolvency regime or creditor-oriented regime complements an insider governance structure (concentrated ownership pattern), while a debtor-in-possession (DIP) or manager-driven insolvency regime complements an outsider governance structure (dispersed ownership pattern). 3 Thus, logical apprehension may ascend that corporate ownership as a corporate governance mechanism (which is nation-sensitive) may impact the aptness of a specific insolvency model in India. India's Insolvency and Bankruptcy Code (IBC) 2016, which ostensibly adopts a manager-displacement approach which is more likely to result in liquidation on a breakup basis, seems then to be in tandem with the country's concentrated ownership pattern. This seems to be the case despite the legislative thrust toward corporate rescue and revival that the manager-displacement insolvency approach helps, therefore, to explain the apparent statistical paradox 4 that a considerable majority of resolution cases under the revival-oriented IBC end up in liquidations, rather than in rehabilitations.
The historical account of corporate ownership structure in India represents a predominance of concentrated ownership patterns. Existing literature evidence asserts that the development of complex company ownership structures was driven by corporate law reforms led by the country's economic priorities and development policies at different intervals representing distinct development regimes. 5 Through the perspective of the existing evolutionary theory of corporate insolvency, 6 the paper analyzes the corporate ownership structure and development of corporate insolvency law in India. The article also explores whether corporate ownership structure as a corporate governance mechanism can explain the progression of the insolvency regime in India. The findings of this paper would be of significance for jurisdictions that are considering reforms within their existing corporate insolvency law.
Evolutionary theory of corporate insolvency regime: An account
The existing evolutionary theory predicts that the determination of the configuration of corporate bankruptcy in a particular jurisdiction depends on the roles played by the corporate managers of a specific jurisdiction. 7 Discussing the same in plain terms, in a jurisdiction where ownership and control over corporations exist in an arm's length system/outsider system of governance or dispersed ownership exists (U.S. or U.K.), the outside investors exercise erratic supervision of the managerial body of a corporation. Disciplinary mechanisms such as vigilant outside directors, the market for corporate control, managerial labor market motivate managers of financially distressed to orchestrate turnaround strategies and plans while they remain at the helm of corporate management. 8 In contrast, in a jurisdiction where an insider system of governance prevails (Germany or Japan), the manager-displacement insolvency regime is adopted to stiffen the control of prime lenders or investors (such as banks). 9 The idea behind adopting the manager-displacement model of insolvency law is that corporate managers/executives are mindful of the consequences of corporate insolvency (i.e., they will be divested with executive powers of the business with the onset of insolvency proceedings). 10 The managers will be apprehensive that they will be ousted from their jobs if formal insolvency proceedings are initiated. Hence, the executives will confirm allegiance to the creditors’ interest during preinsolvency. The manager-displacement model is analogous to a situation where debt is concentrated because creditors due to the reduction in agency cost can exert the threat of removal of management if they disregard the lender interest, and cause underperformance of the company leading to insolvency. 11 Corporate ownership in India is predominantly concentrated (i.e., family/promoter owned), resembling an insider governance style. Post-India's independence, Sick Industrial Companies Act (SICA) 1985 demonstrated the first insolvency innovation. Sick Industrial Companies Act adopted the DIP model of insolvency or liberal debtor treatment during insolvency. This development is paradoxical to the existing evolutionary theory 12 of insolvency law. After the experience of failure in attaining the objective of SICA and a series of public debates, the much-awaited second innovation in Insolvency law was earmarked by the enactment of the IBC, 2016. The Code made a significant departure in the approach of insolvency from SICA by adopting a creditor-oriented approach. The creditor-driven insolvency law in India may be driven by compelling logic in terms of justice attribution. 13 With the maturity in corporate insolvency culture in India, IBC has yet again undergone a partial organic change by adopting Pre-Packs Insolvency Resolution Proceedings (DIP approach of insolvency similar to SICA) applicable to small and medium enterprises. Corporate governance is the key to answering the reasons for such a dichotomous transition in the approaches of Insolvency law. Or why a DIP approach of insolvency law persists even when the DIP approach under SICA draws the impression of negative significance for justice, political participation, and economic growth. 14 The ownership structure of corporations is the most mentioned factor of corporate governance. 15 The typical pattern of corporate ownership (i.e., concentrated ownership) might affect the question of which model of insolvency regime would be efficient in India. The identity of an efficient model of insolvency law might be path-dependent or on the corporate ownership pattern that predominantly exists in India.
Corporate ownership pattern in India: Insolvency implications
Corporate ownership in India is typically concentrated in the hands of family-based promoters/owners. These owners hold substantial equities to exert inside influence in the management of the business. With the increase in competition due to liberalization and privatization, the business model of existing corporations/large business houses has undergone restructuring or consolidation. Hence, such corporations require additional/long-term finance. Many corporations relying on internal finance have eventually sought long-term debt finance to finance the scaling, growth, and business diversification.
In contrast, their promoters of existing business ventures retained their dominance in the business. The concentrated ownership pattern is not a new phenomenon. It dated back to the pre-independence era in India and prevailed as the financial needs of large corporations were preferably met through debt finance. Debt finance was convenient for corporations with ownership concentrated in two senses. For one reason, debt finance allowed the controlling shareholders to retain control. The second is that debt finance appeared to be a cheap capital (debt capital was easily accessible due to the country's industrial development policy. The government established state-sponsored financial institutions to finance industrialization, render the economy self-sufficient in necessary commodities, and create employment opportunities. The extensive reliance on debt finance also seems logical as the equity market has been underdeveloped since the pre-independence era and yet hangs on the developing curve. Though the banks/financial institutions remain at the forefront, they are not well situated to exert an inside—influence as in the scenario 16 which otherwise exists in the European economy (Germany and Japan). The exercise of professional monitoring of the corporate borrower by the banks/financial institutions is challenging due to the severe information asymmetry issues.
Also, the need for sufficient investor protection measures deterred the participation of retail investors. It was only after the globalization of the Indian economy the standardization of the corporate governance framework in India began. Hence, the absence of corporate governance standards deterred the public trust in retail investing in the equities of large corporations. This line of argument is also substantiated by the law-matter thesis, 17 which states that in an economy that offers little protection to minority shareholders from expropriation by majority shareholders, public investments will be deterred.
The predominance of promoter ownership led to the creation principal–principal agency problems and has disrupted the development of external governance means (such as leveraged buyouts, proxy fights, hostile takeover bids, the external managerial labor market for managerial discipline, and class action suits), enormously challenging. The corporate governance mechanism has been internal to business organizations. Internal governance mechanisms included emphasizing the fiduciary duties of directors and management and information disclosure. The wisdom emanates here is that India represents an insider corporate governance system. Against the backdrop of the said corporate economy and according to the existing evolutionary theory understanding, India's insolvency regime would follow the manager-displacement model. Then the pertinent question is whether the insolvency regime in practice unfolded in this stated fashion of the manager-displacement model. The recent evidence suggests that the insolvency regime partially evolved into a manager-driven model, which is quite the opposite of existing evolutionary theory's predictions. To draw logical underpinnings, the latter part of this paper will chronologically review the development of insolvency law since the pre-independence era.
Insolvency regime in a socialistic attire of corporate law developments
From the pre-independence era till 1985, the legal framework dealing with corporate insolvency dates to the pre-independence period, i.e., the Companies Act 1936. The Companies Act 1936 provided for a court-administered process with a delegated institution (official liquidator). The law prescribed a court-ordered winding up of an insolvent company. 18 Consequently, a liquidator is to be appointed to ensure that the liquidation proceeds from the assets of the distressed corporate debtor are realized or distributed among its creditors. The liquidator (formally known as the official liquidator) takes charge of the debtor's assets. Winding-up emerged as a necessary consequence of default in debts in most of the cases.
This insolvency regime has been heavily factored by the development agenda of the then industrial policies 19 of self-sufficiency in resources and channelization of home-grown financial capital to capital-intensive and industrial policy-prioritized sectors (promoted-owned/state-owned). The said provisions of company law were more driven by the approach of promoting debt finance to the prioritized sector of the industry in India. The private entities that obtained a license 20 to do business highly relied on informal internal equity finance advanced by family networks, friends, and retained earnings. As the capital market was underdeveloped during the post-independence era in India, the government emerged as an investor in industrialization not only through public sector enterprise but also in private business through sponsored financial institutions in the form of industrial credits. Private lending was a preferred mode of raising external finance as it was a cheaply available capital, and this preference disrupted the growth of the public debt market. Nevertheless, debt finance also met with fiction, i.e., the agency cost of debt in corporations with concentrated ownership. For instance, a company pursues a high load of debt finance to finance risky long-term projects, where the risk of substantial default is amplified. 21 The financial institutions held representations within the corporate board as a corporate control mechanism. But the absence of incentive to exercise control over the corporations proportionate to the interest of equity holders appeared as a challenge for such corporate control mechanisms. The lack of incentive 22 is due to information asymmetry and the high cost of processing and consumption of available information. 23 The information the financial institutions have access to may be inadequate or irrelevant. They mostly rely on debt covenants as a means of exerting governance mechanisms for their corporate borrowers. Also, the secured creditors conventionally relied on recovery-oriented law (i.e., SARFAESI) or resorted to winding-up of insolvent companies. Further, as a supplementary protection of law, they assumed control with the advent of the insolvency of companies under IBC. This approach of law may also mitigate the need for creditors to exert control before a company becomes insolvent.
The disciplinary effect of debt on corporations in India has been significantly impacted in practice due to a need for more sufficient incentives for banks/financial institutions. However, the practice changed in the later years after the liberalization, with the economy becoming more market-oriented. 24 Hence, corporate environment in India lacked the market for corporate control. The then-agency problem inevitably stirred out of the corporate financing pattern and served as the explanatory factor for the bias toward innovation in liquidation commandments within the Companies Act. Thus liquidation-oriented insolvency laws have flourished in a favorable fashion and enticement to the lenders/creditors subjected to priority sector lending encouraged by the industrial policy.
The primary effect of liquidation is the dissolution of the corporate debtor, and the managers of the corporate debtor will be ousted from their jobs. This system of insolvency implicitly represents the manager displacement model. The manager-displacement model implied strengthened control of lenders. These situations connect to the existing evolutionary theory, which posits that a manager-displacement model of insolvency complements a concentrated ownership structure. 25 The manager-displacement model intuits that corporate managers will be aware of the consequences of insolvency proceedings, i.e., divestment of powers of management or immediate ouster. 26 Hence, they may be incentivized to boost corporate performance. However, the later development in the insolvency regime in India creates paradoxical results in the context of existing evolutionary theory.
Sick Industrial Companies Act: An innovation in insolvency regime in India
As a part of several economic law reforms during the post-independence era, the enactment of the SICA 1985, manifested an innovation in the corporate insolvency regime in India. Determination of sickness, the revival of companies capable of being revived, and the liquidation of companies’ incapable of revival was the prime objective of SICA. The SICA was premised on the approach of determining of industrial sickness of a company by Board for Industrial and Financial Reconstruction (BIFR) and developing a revival package for the same. The law was applicable to the organized manufacturing sector only. To qualify as a sick company, a company must demonstrate that, at the end of any fiscal year, accumulated losses are equal to or more than its whole net worth 27 and report to the Board of Financial and Industrial Reconstruction for a revival opportunity. The Board will direct an operating agency (a financial institution or bank) to prepare a revival strategy when it believes it is impractical for a sick industrial company to revive within a reasonable amount of time and that doing so is essential or expedient in the interest of the public. When proceedings under SICA were initiated, the board of directors or management remained in control over the business affairs of the company, and a moratorium was applied to suspend the enforcement of any rights against the sick company. Sick Industrial Companies Act allowed the incumbent management of distressed debtor to retain control over the corporate debtor business (DIP approach) upon inception of insolvency proceedings.
The DIP model of insolvency enables the management or the debtor to maintain control of its operations, assets, and restructuring activities, which ultimately leads to efficiency in the maintenance of going-concern value and the prospect of revival is higher. 28 As the existing management of the debtor is always well-positioned to be conversant with the prospect and business affairs of the debtor, the existing management could steer the negotiation with the creditors or claimants on restructuring or revival efforts. Such a prospect is challenging in the case of a trustee appointed to manage the business of the corporate debtor under the control of creditors, as the acquaintance of the trustee with the complexities of business operations is a costly mission in terms of time, effort, and information asymmetry. Also, the existing evolutionary theory states that DIP is an apt mode when creditors of the corporate debtor are dispersed, as it reduces the coordination cost in decision-making relating the business control. 29
The shift in approach under SICA is a response of the government toward the premature liquidation of companies and liquidators’ inefficiencies while serving as an insolvency institution. 30 The enactment of the said law was not primarily driven by any data on the company's ability to revive from insolvency but largely stirred by preserving industrialization and the need to protect the interests of the workforce employed in any financially sick company. 31 Protection of employment opportunity was the primary concern addressed by insolvency law (i.e., protection from the closure of a sick or distressed company) rather than protection from the closure of a sick company due to its ability to revive based on a commercial basis. 32 The promoter-driven management of the debtor relied upon as a fiduciary for creditors during industrial sickness. 33 These narrations indicate a notable divergence with the prediction of existing evolutionary theory in the context of concentrated ownership patterns. The DIP approach under SICA was adopted during a time when debt finance continued to be heavily concentrated. This status quo of the insolvency regime challenged the operationalization of existing evolutionary theory in the Indian market. The adoption of the DIP approach under SICA was less driven by the then prevailing pattern of debt finance, and rather more driven by factors such as the release of investment tapped within unviable companies and redeployment in productive sectors, strengthening industrialization by preventing closure of companies, and enabling takeover of distressed entities by the state.
It is also pertinent to note that the enactment of SICA was not to preclude any consequences of lack of corporate control market (also as the corporate control market was nonexistence). When the banks/financial institutions advanced loan to the corporations, they held representations by nominees appointed as directors on the board (as a mechanism to allocate corporate control through financial institutions). But such a control mechanism rendered inefficiencies as evident from high financial leverage, diminished firm value, exaggerated agency conflict between equity and debt, and added corporate financial distress. 34 Promoter-dominated corporations are sustained as a unique feature of the Indian corporate governance culture, where financial institutions are rarely found to oppose the decisions/influence of promoters in the management of corporate debtors. 35 Much later, the lack of corporate control in the hands of creditors was addressed by enacting two recovery-oriented laws (enabling debt enforcement). The first enactment is the Recovery of Debts Due to Banks and Financial Institutions Act (1993) (the RDDB Act), and the second enactment is the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act. Though these two developments appear significant, they apply only to banks and financial institutions. Other creditors are devoid of taking recourse under the above two laws; hence, they are left with ordinary options to pursue their enforcement rights under the agreement.
However, SICA was not free from issues that constrained the development of a market for corporate revival. SICA has not provided a scope of voluntary negotiation or restructuring of the distressed debtor, rather the revival of the distressed debtor was driven by an order of the BIFR 36 , 37 Financial prudence and timely intervention were the missing links in the revival attempts under SICA. 38 The said approach of SICA has been employed to discipline any promoter's expropriation efforts in a debtor in possession insolvency regime. However, the ex-post outcome upshot of the approach adopted by SICA was different from the ex-ante outcome. 39
Post SICA failure: Company law integration, and IBC, 2016
With the lessons from the abuse of SICA (in-court monitored restructuring procedure) by promoters, 40 the need for a re-revisit of the laws governing winding-up proceedings of companies by taking advice from experts emerged as an inevitable response of the government. With this reference, the Eradi Committee was constituted to bring further changes in the Companies Act in 2000 on provisions relating to insolvency. The Committee referred to the Insolvency law in the U.K. and recommended the transplantation to India on the grounds of similarities of the legal system, i.e., common law jurisdictions. 41 The Committee has recommended substantial changes to provisions for restructuring. The Committee recommended repealing SICA and integrating revival-oriented provisions under SICA with the Companies Act 1956. The adoption of the Administration Order Procedure (AOP) 42 envisaged in U.K. Law was recommended by the Eradi Committee. Based on the recommendation of the Eradi Committee, the Ministry of Corporate Affairs 43 ushered amendments to the Companies Act 1956 by the introduction of provisions for the Revival and Rehabilitation of Sick Industrial Companies. 44 Laws on revival and rehabilitation retained the debtor in possession approach of corporate insolvency as adopted under SICA. This inclination toward the debtor in possession draws the impression of due regard to the informational advantage possessed by promoters to propose a reorganizational plan compared to an outsider of a distressed debtor. The said amendment under the Companies Act 1956 also appeared as a response to rising Non-Performing Assets 45 of banks which faced severe constraints to measure the creditworthiness of promoters. 46 Under the amended Companies Act, the Tribunal may, if it deems necessary or expedient so to do for the expeditious disposal of an inquiry as to sickness of a company, require by order any operating agency to enquire into the scheme for revival and make a report. 47 Since the promoters of the sick company retained control, it was often challenging to retrieve data on finance, assets of the sick company, and different transactions entered by the sick company. This resulted in delays in the information retrieval process. Sick Industrial Companies Act required 48 the incumbent management/promoters to prepare a revival plan and evidence indicated that there was an inordinate delay 49 in the preparation of revival plans. When a financial institution believes that a company cannot be revived, it vetoes all alternative revival plans until BIFR is convinced to pass a winding-up order. By the time, the case for winding up is created, the value of the assets of sick-company has already deteriorated. When the BIFR determines that it is appropriate to conduct or cause to be conducted an investigation into any sick company, it may appoint one or more individuals to serve as a special director or special directors of the company in order to protect the company's financial and other interests as well as the interests of the public. 50 The role to be played by a special director was also very challenging due to severe information asymmetry between such directors and the management of sick-company.
The preparation of the revival plan was unliteral, i.e., by creditors or debtors. Due to a lack of negotiation opportunity between the debtor (including the promoters) and the creditor, new project appraisals by the banks were a challenging task. When banks engaged into development finance at low interest rates, some promoters often used the vehicle of a corporate entity to reap the benefits (investment in risky projects) of supply-side credits offered by public financial institutions and banks. 51 Thus, the implementation of SICA in the DIP approach was heavily undermined.
The revival/liquidation of companies was tribunal-supervised as a means to intercept the challenges of the DIP model as deliberated by the Eradi Committee. The provisions for an appointment of a special director/s on the board of such industrial companies, by the National Company Law Tribunal (NCLT), when it deems fit to inquire for determination of industrial sickness, reflects a lenient adoption of the U.K.'s AOP. The said amendment established the reluctance of the law to dispense with the DIP approach of the insolvency regime. The plausible reason might be that ownership concentration continued to be the predominant shareholding pattern in the backdrop of a weak capital mark. The market for corporate revival was limited and home-grown with limited aid from foreign investments due to opacity in the governance structure of corporations.
In an environment of strong secured creditors’ rights, even though the lenders emphasized secured credit, the promoter-dominated corporate borrowers started recourse to households and nonbanking financial firms for raising finance through the issue of corporate bonds. Yet the bond market in India remained underdeveloped. An imbalance existed concerning the consumption of credit and the size of the economy. The law reformers might have felt that creditors could be further empowered by vesting control over management on creditors during insolvency can increase the development of a public debt market. 52 The new IBC 2016 was enacted to further the creditors’ empowerment during insolvency. Insolvency and Bankruptcy Code marked a shift in the model under the former insolvency regime (SICA 1985, which now stands repealed). The IBC adopted a creditor-oriented approach 53 instead of the DIP or manager-driven approach. The model stands as an endeavor to value the maximization of corporate debtors’ assets and a parallel balance of insolvency stakeholders’ interests. It is evident that with the trigger of insolvency proceedings under the Code, the incumbent management continues to hold its position. Still, they are obliged to cooperate with the insolvency professional entrusted with the management powers under the supervision/control of financial creditors. The managers do not possess any managerial discretion that would interfere with the management of the company by the resolution professional (RP). 54 The RP is vested with the management of the business of an insolvent corporate debtor. Additionally, the RP is responsible for overseeing every step of the bankruptcy procedure, from the creation of the committee of creditors (CoC) to the adoption of a revival plan. He also takes over control and custody of the corporate debtor's assets. All of the corporate debtor's financial creditors constitute the CoC. Committee of creditor is primarily tasked with the responsibility of evaluating a revival plan based on its feasibility and viability. The CoC also oversees the task of RP to run the corporate debtor's operations.
Until the enactment of SICA, evidence of the corporate ownership pattern and the insolvency regime has correctly demonstrated the prediction of existing evolutionary theory, in the Indian context. The promulgation of SICA had unproven an alignment of corporate ownership pattern in India with the evolutionary theory. Later the implementation of IBC again confirmed the prediction of existing evolutionary theory in the context of concentrated corporate ownership patterns in India. It is essential to explore the reasons for the confirmation of the prediction of the existing evolutionary theory, preceded by a divergence under the SICA regime. The introduction of IBC in the creditor control approach focuses on empowering financial creditors. The Code prescribed the constitution of the creditors’ Committee with financial creditors. The reason behind the composition of the Committee with financial creditors only is stated as follows: “The Committee deliberated on who should be on the creditor's Committee, given the power of the credits committee to ultimately keep the entity as a going concern or liquidate it. The Committee reasoned that members of the creditor's Committee have to be creditors both with the capability to access viability, as well as to be willing to modify terms of existing liabilities in negotiations. Typically, operational creditors are neither able to decide on matters regarding the insolvency of the entity nor willing to take the risk of postponing payments for better prospects for the entity. The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors.”
The Committee's conceived idea is affiliated with strong creditors’ rights. The control emphasized in the report of the Committee was only vested upon secured creditors, and the structure of the CoC 56 devoid of operational creditors draws an impression to be a inadequate measure suggested by the Committee for developing the public debt market. 57 Thus, with the enactment of IBC, the shift in the approach of the insolvency regime (DIP to creditor-in-control) was observed primarily as a remedial measure to the gaps/flaws in the SICA and increased the dimensions of debt financing in the Indian market. In others, IBC aimed at promoting the development of the corporate bond market in India. Such motivation for reforms creates a deviation from the understanding of existing evolutionary theory 58 in the sense that a market where debt will be diffused will adopt the DIP approach of insolvency.
Advent of prepacks: Hybridization of insolvency law
With a paradigm shift in the approach of insolvency law through IBC, a trend of divergence in the prediction of the existing evolutionary theory has again grounded its base through the paradigm shift toward a legislatively recognized DIP approach of corporate insolvency resolution through the introduction of Pre-Packs Insolvency Resolution Proceedings. The prepackaged insolvency resolution process (PPIRP) serves as a special insolvency regime for micro small and medium enterprises (MSMEs) in India. It stands as both an informal and formal insolvency mechanism, where the corporate debtor informally negotiates with its creditors to strike revival plan/measures, and then the plan is subjected to approval by an adjudicating authority. It is introduced under the insolvency law to reduce the time for the conclusion of an insolvency process and also prevent the worsening of corporate value with consumption of long time for the insolvency process.
Prepacks extend to only small companies, yet there has been a growing demand for extending the prepacks to large corporate borrowers. 59 The status of extending the prepacks to large corporate borrowers is yet to take formal recognition; the possibility of such future change in the law is out of the iota of doubt. Though prepacks are susceptible to some inherent challenges in implementation in India. The possibility of extending prepack to large companies also gets well substantiated by the success rate of prepack for developed jurisdictions 60 from where the concept has been transplanted in the Indian insolvency regime.
The introduction of the prepack insolvency process within the IBC, through an amendment, illustrates the indication of distressed corporate debtors outside IBC. Prepacks aim to accommodate existing promoters of MSMEs within the insolvency process. This development in the insolvency regime also elevates India to the ranks of jurisdictions such as France, Singapore, the U.S., and the U.K., which have implemented a debtor-driven, hybrid, and consensual preinsolvency procedure activated under the Code.
Insolvency and Bankruptcy Code did not initially introduce the concept of prepacks as the insolvency market in India needed to be more sophisticated and developed. But four years after the passage of IBC, the development of sophistication was measured with the handful of pieces of evidence in India, which established the deliberate attempts acquisition of a distressed business by a connected party to the corporate debtor. Ample shreds of evidence 61 exist that established that the offer made by the promoter (in an attempt to drive a one-time settlement) was higher than the liquidation value and hence led to an exit from the IBC process. A total of 218 cases have been withdrawn under Section 12 A of the Code. 62 As on September 2021, 18,629 applications (involving total default of Rs 5,89,516 crore) 63 for the trigger of insolvency proceedings were settled before they got admitted into the NCLT. 64 These pieces of evidence indicate a change in debtors’ behavior to resolve insolvency due to a shift in control of the management of corporate debtors in the hands of creditors, and also connect to the existence of a market for resolution of insolvency outside IBC, even before the formal introduction of Pre-Packs. The introduction of the Pre-Packs insolvency process was also cumulatively driven by the surge in insolvency cases post-COVID-19 pandemic 2020, and the availability of resolution applicants remained a concern. Lack of availability of resolution applicants despite the prospect of revival may lead to liquidation preference by creditors. Also, the cost of insolvency increases with time consumption for the conclusion of insolvency proceedings. 65 Prepacks were an indispensable retort to the necessity of flattening the rising curve of insolvencies with faster resolution. 66
Dissecting the debate on the introduction of prepacks within the Indian insolvency regime, it transpires that prepacks have laid their basis on the government committee's professed evolution of a healthy relationship between the debtor and the creditor. The Pre-Pack Committee's report discoursed that Section 29A of IBC has restored the honest creditor–debtor relationship in the insolvency regime (which was paralyzed under the SICA Regime). Though stringency of section 29A has discouraged the participation of promoters in the insolvency of the companies promoted by them, yet Section 29A can also be perceived as a means to inflict dread upon the promoter to initiate a full payment relating to the nonperforming assets in order to become eligible to submit a resolution. In the meantime, under prepacks insolvency regime, they can also continue to exercise control over the business and extend their business support to ensure or retain its going-concern value. This opportunity to continue control over business is otherwise not available under normal insolvency proceedings (creditor-in-control approach). The Committee has appreciated the fact that in the majority of cases when revival is sought, it is the promoter who may be interested in the resolution of the distressed corporate debtor owing to their situational advantage in understanding or assessing the risk appetite of the debtor, the root causes of financial distress, the prospect of revival. “The CD understands the company, its stress, and the possibility of its resolution better. In many cases, it could be the only person who is interested in resolution of the stress of the CD and can do so. In recognition of this, the prepack framework in every other jurisdiction allows only the CD to initiate the process voluntarily and obtain consent of key stakeholders before approaching the Court…..A fair debtor–creditor relationship, induced by the Code, has prompted several resolutions in its shadow or on its account.” - Report of the Sub-Committee of the Insolvency Law Committee
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Relooking at existing evolutionary theory in the Indian context
In a creditor-friendly insolvency regime and concentrated equity ownership environment, the agency cost of debt is reduced on the count that the controlling shareholders know once the business entity enters the insolvency proceedings, they will not remain in the helm of control of the business entity. 74 They may attempt to postpone the insolvency by generating opaque financial statements and increase cash flow by compromising on sustainable expenditures (such as R&D, Social impact assessments, focus on product quality, and improving customer experiences). This postponement of insolvency may lead to value deterioration for business assets. Insolvency proceedings must be initiated when a business entity is in a state of distress, not when the entity has already walked miles away after being in a state of distress. When the value deteriorates, the creditors tend to liquidate the distressed entity. The net recoverable tends to be low compared to recovery from the acquisition of the distressed entity as a going concern.
As mentioned, corporate debt finance in India is concentrated among banks very similar to the Indian counterparts, i.e., Germany and Japan. But unlike the said counterparts, the corporate control through monitoring by banks/financial institutions is a challenging task. Information acquisition mechanism from the debtor is yet again another challenge faced by the banks/financial institutions during preinsolvency relationships. Postinsolvency, the intrinsic prospect of reorganization or liquidation demands diligent calculation. Such calculation must be adequately supported by information acquired from the entity during its preinsolvency stage. The agency cost of debt driven by concentrated ownership pattern in India may lead to mistaken indications about the viability of an unviable entity. Efficiency demands that insolvency or liquidation proceedings be triggered when such attempts are prospective to the ex-post value maximization for creditors.
Moreover, with the renewed emphasis on developing the bond market in India, the market is likely to be orchestrated with the extension of prepacks to large companies. 75 India's primary and secondary market has already been hoisted on the track to be endured by the issuance of bonds. As India has made significant strides in macroeconomic stability, 76 predictions indicate that the extent of raising finance through the corporate bond market in India can rise to double by 2025. 77 When business entities in India rely extensively on the issuance of public debt in the form of corporate bonds, formal insolvency is bound to be changed to accommodate the challenge of collective action consensus among the dispersed debt holders.
The primary objective of insolvency law is to ensure ex-post maximization of the asset value of the debtor for the creditors’ interest. Justice Marshall wrote: “…… if a debtor remains in possession—that is, if a trustee is not appointed—the debtor's directors bear essentially the same fiduciary obligation to creditors and shareholders as would the trustee for a debtor out of possession. Indeed, the willingness of courts to leave debtors in possession is premised upon an assurance that the officers and managing employees can be depended upon to carry out the fiduciary responsibilities of a trustee.”
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The Court also noted that when a debtor is insolvent, the interests of the shareholders must be subordinated to the interests of the creditors.
Bank or institutional debt finance still dominates public sector finance in India. In the case of corporations having concentrated ownership patterns in India, the controlling shareholders are concerned with control rights dilution, and they prefer external borrowings 79 to showcase that their management is confident in debt servicing. Additionally, external borrowing is highly collateralized either with the personal assets of controlling shareholders or assets of associate/subsidiary companies where the controlling shareholders hold significant stakes. These arrangements may reduce the agency cost of debts and aptly raise the expectation that the control of management during insolvency in the hands of existing management over the debtor will not lead to creditors’ expropriation during insolvency. 80 Thus it is evident, with equity ownership concentration and present debt ownership concentration but mild proclivity toward debt ownership dispersion through the development of the bond market, the manager-driven or DIP model of insolvency would tend to be the apt insolvency arrangement. There are debates on the appropriateness of the DIP model of insolvency when promoter-owned companies predominantly prevail in an economy. The above analysis may contribute to the argument from a theoretical standpoint.
Conclusion
The existing evolutionary theory has been subjected to a relook within the Indian dichotomy. As per the existing evolutionary theory prediction, India's insolvency regime must vigorously represent the manager-displacement model. With the introduction of Prepacks, the insolvency regime marks a sign of deviation from the prediction of existing evolutionary theory, even though in a fractional sense. Though the management-displacement approach of insolvency is represented in various gradations by the Companies Act amendment, and the IBC along with a continuum of management-displacement approach from slight to considerable, yet IBC can also be described as nominally DIP-driven legislation. Also, several evidences of withdrawal postadmission of insolvency proceedings and out-of-court works indicate an inclination toward manager-driven insolvency in practice. The paper echoes the idea that the debt ownership configuration in India and manifested agency cost have influenced the recasting of evolutionary theory.
Affording leverage and bargaining power to the broad base of lenders during insolvency is the reason for the evident bias toward the creditor-driven insolvency regime under the IBC 2016. But due to amplified liquidation cases compared to resolution cases and other associated agency costs, the legislation of prepacks has been an inevitable transition of the jurisprudence approach of the Insolvency Code since its enactment (creditor-oriented to debtor-oriented approach). The paper contends that a debtor-oriented insolvency system has remained an eternal feature of Indian capitalism. The said approach relied on the typical corporate ownership structure (concentrated ownership) that India had sustained and the possibility of connected party acquisition of financially distressed debtors. The passive shift to the debtor-oriented approach through the prepack insolvency process establishes that the policy attempts are made to solve mounting distressed assets within the framework of debtor-driven insolvency, which tends to be conventional and conversant with the SICA regime. The DIP model would also be an apt model in the context of the healthy debtor–creditor relationship developed 81 within the business economy in India, while Section 29A will take care of deterring any wayward promoters who seek reacquire control of insolvent companies.
Footnotes
Conflict of interest
The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.
Funding
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