To appreciate the impact of the Supreme Court (SC) judgement on the
Feb 12 circular, it is important to understand the circular in its historical backdrop.
insolvency and bankruptcy code (IBC), we had highly ineffective insolvency laws. A bank could file a winding-up petition which would wallow in the high courts for years and eventually lead to liquidation. Or it could use the Sick Industrial Companies Act which was notorious for euthanizing sick companies instead of nurturing them to recovery. Or worse, the BIFR judges would impose their socialist version of restructuring on beleaguered companies with negative net worth only to prevent job losses.
Being hamstrung by ineffective laws, the Reserve Bank of India (RBI) was forced to use its general power of banking regulation to conjure a cocktail of proxy restructuring schemes to fill the vacuum starting with the formation of the Joint Lender Forum (JLF) followed by CDR, SDR, 5/25, S4A etc. The common theme was that RBI required consortium lenders to resolve distressed accounts at an early stage and a decision taken by a significant majority of banks would be binding on all JLF members. It was an ingenious way for the RBI to nudge the banking sector to take ownership over the NPA problem and to resolve sick companies.
However, these attempts were met with limited success. First, the RBI schemes did not prescribe a time limit for resolution and once referred to the JLF there was no ticking clock to force the hand of the banks. Secondly, the RBI schemes only bound banks regulated by it – so bondholders and foreign lenders could stay out of the process. Thirdly, entering JLF did not mean a stay of other proceedings such as winding up actions or SICA references thereby causing restructuring to be splintered at different forums. Last, bankers were hesitant taking decisions involving a large haircut or change of promoter for fear of allegations of corruption even if the decisions had a compelling commercial rationale. The IBC was a paradigm shift on all these fronts. It mandated a time-bound process of resolution; allowed all financial creditors to form the committee of creditors; and imposed a stay on parallel legal proceedings. Further, it gave sanctity to the resolution decision through three layers of due process – the decision of the committee of creditors, certification by the insolvency professional and the order of the NCLT – thereby reducing fears of frivolous corruption cases against public sector bankers.
After the IBC, the entire raison d'etre for the patchwork of JLF schemes fell away while the expectation was that the public sector banks would lap up the new law to resolve corporate distress. But seeing the reluctance of banks in using the IBC, the government amended the Banking Regulation Act by including two new sections. One of them, s.35AA granted the RBI the power to instruct banks to refer specific defaults to IBC on the orders of the central government. The Feb 12 circular partly relied on this section. While the Feb 12 circular was an exorcism of the JLF system, it went beyond that to say that banks should refer all large distressed accounts with debt in excess of Rs 2000 crore to IBC if they remained unresolved within 6 months of the first day of default. This caused an uproar among the well-heeled lobby of power producers who challenged the circular by claiming that they were a special industry. They argued their woes stemmed from poor coal linkage, unprofitable long-term power purchase agreements and long-standing dues from state distribution companies – for all of which they rightly held the sovereign responsible.
Supreme Court ruled in favour of the power producers and struck down the circular but did so without considering the merits of these arguments. The court took a narrow and legalistic view to hold that the circular was in excess of powers given to the RBI under s.35AA. The SC held that a generic circular directing IBC against all defaulting companies with debt in excess of Rs 2,000 crore was neither in respect of specific defaults nor was it on the directions of the central government. The SC also held that the broader powers for banking supervision and regulation under the BRA in relation to the IBC stood circumscribed because of the specific provisions of s.35AA. The pedantic view taken by the SC creates several issues and poses some difficult questions.
First, is the impact on credit discipline and promoter behaviour. The circular had imposed a stringent 6-month deadline for resolving defaults with the threat of IBC causing many promoters to cough up funds to enter into ‘one-time settlements’ with banks or to find new investors for equity infusion. Several foreign debt funds started acquiring loans from banks with the expectation of an early resolution. The healthy momentum being built up to create liquidity in distressed space could be lost.
Secondly, bankers are likely to find dealing with promoters a riskier affair. With the Feb 12 Circular, a uniform standard was imposed across industries and banks had no discretion but to refer companies to IBC if they met the prescribed objective criteria. As we have seen in the past, public sector bankers temperamentally eschew discretionary decision making to avoid any implication of bias or favouritism. The demise of the Feb 12 circular means bankers will have to evaluate each case on its particular merits, which is likely to elongate negotiations with promoters and cause inconsistent and unforeseeable resolutions. The predictability of outcomes and deal flow, which are critical to market liquidity, could well be lost.
Third, is the question of the resurrection of the JLF. The SC held that the part of the circular relating to committing companies to IBC was beyond s.35AA. So, one would imagine that other parts of the circular dealing with the abolition of the JLF for which the RBI had relied on its plenary regulatory powers would remain unaffected. But the SC has invalidated the circular as a whole. The RBI and banks would baulk at the idea of the JLF being brought back through an order of the SC. This leaves the RBI with two options – either seek a review of the SC order to seek clarity on which parts of the circular should stay; or release fresh regulations for debt resolutions. The latter is the more likely option as it gives the RBI more control and in any event, RBI’s powers of issuing a direction to banks for resolution of stressed assets were never in doubt. Either way, the RBI can still influence banks stricter provisioning norms so as to leave banks with no viable option but to file IBC against large stressed accounts.
Regardless of the powers of the RBI and the central government, all banks have the statutory right to file IBC against defaulting companies without any specific instructions issued by any authority. Policy makers need to worry about why the largest banks in the country still need to be nudged, persuaded, directed or compelled to exercise their statutory right. It is time for the banks to clean up their balance sheets without being goaded by the other agencies.
Suharsh Sinha is partner at AZB and Partners.