In Urjit Patel’s ‘Overdraft', a Peek at How India's Bankruptcy Code Was Slowly Diluted

'If resolution outside the IBC is the preferred mode, then is the code a fifth wheel at best?'

In his new book Overdraft, former Reserve Bank of India (RBI) Governor Urjit Patel has cautioned that the limited progress so far on recoveries from loan defaulters under Insolvency and Bankruptcy Code (IBC) could turn out to be a false dawn, and, therefore, India’s victory over crony capitalism is at risk of being, at best, short-lived.

“Undoubtedly, some reversals around regulation and execution of the IBC have occurred, which underscores that it is fragile…. The distinct possibility that promoters/sponsors would lose ownership rights over their defaulting businesses, which had reset incentives for timely debt servicing, has receded…”

In the book dedicated to the Indian saver, he writes that extensions and dilutions have rendered the resolution under the IBC process, the Modi government’s most significant reform initiative, open-ended. This has ensured that the time-bound threat of an insolvency application is not credible anymore.

The book released on Friday, about 19 months after the author stepped down from RBI in December 2018, sheds light on how stakeholders – both official and private players – succeeded in ensuring climb-downs from the original intent behind the IBC although it was made and passed by the Modi government.

Borrowers and disgruntled bidders are increasingly exploiting vagueness in some key provisions of the code to stall bankruptcy proceedings. Credit: Wikimedia Commons

Under Patel, the RBI had instituted an IBC recovery process, which removed all leeway banks had to go easy on large and influential corporate defaulters. The new process replaced banks’ discretion to treat defaults on a case-by-case basis with a rule for starting resolution within a day of missing a debt service payment.

This new regulatory regime introduced in February 2018 favoured change of ownership of firms that were in default. Defaulting promoters risked losing control of their firms under IBC which created incentive for them to better manage their business risks and ensure minimum chance of defaults on loans. It also created incentives for the lenders to come up with turnaround plans so that an account would not become a non performing asset (NPA). Therefore, early recognition of stress, it was expected, would reduce the likelihood of slippage of accounts in stress to NPAs.

In June 2019, the RBI changed the definition of what constitutes a default by allowing for a 30-day review period after the circular issued during Dr. Patel’s tenure was struck down by the Supreme Court. He writes that the RBI “diluted” the 1-day rule even though the apex court had not found the one day default problematic.

The diluted rule, he cautions, will require banks to set aside capital if a resolution is not in place in 180 days and then in 365 days after the review period. “In sum, there are no hard consequences for errant borrowers as compulsory recovery/liquidation is off the table… [Government] Banks will [as a consequence] make provisions, book lower profits and write off capital as living-dead borrowers stay afloat.”

Also read: There Could Be Severe Consequences to Suspending India’s Insolvency and Bankruptcy Process

On economic implications of the Supreme Court’s decision to strike down the circular, Dr. Patel writes, “It is difficult to fully understand, at least for those of us who are not lawyers, that a transparent rule is untenable, but discretion on a case-by-case approach is kosher… Striking down the February 2018 circular has made the insolvency regime vulnerable, possibly brittle”.

The rule removed brought a number of large defaulters to the National Company Law Tribunal (NCLT) with concomitant change in ownership and enabled banks to recover about Rs. 1.5 trillion from the large cases. With the dilution of the rule, “the gains from the time-bound resolution of loans in default may get squandered,” he writes.

Government pressure?

Until mid-2018 the finance minister and he were on the same page on the IBC, Patel writes, without naming names. Requests were received on diluting the IBC after that, as the government felt that the IBC had already created a deterrent, he writes. However, deterrence is created, he argues, when defaulters face economic consequences in a reasonable time frame.

The reference here could be to the tenure of Piyush Goyal as additional charge for the finance ministry during the period when Finance Minister Arun Jaitley was away to receive treatment for cancer. In 2018, Goyal had in fact called for the circular’s dilution, noting that “loans cannot be arithmetically classified as NPA after 90 days” in his statements to the media.

The book also refers to statements from government officials all of which suggested an unmistakable preference for settlements outside the IBC framework. The suggestions are that the IBC should not be the first resort for banks to pursue resolution and it should not be used in all cases.

Also read: How Do We Ensure India’s Insolvency and Bankruptcy Code Keeps Working Well?

“If resolution outside the IBC is the preferred mode, then is the code a fifth wheel at best?” Patel writes.

He cautions that, “We have to be vigilant that U-turns don’t usher a serial bout of ever-greening and zombie borrowers; otherwise, victory over crony capitalism will, at best, be short-lived, and that the limited progress so far could turn out to be a false dawn…. Direct stakeholders, in particular savers, have to be vigilant against risks emanating from (potential) creeping regulatory and policy complacency. Shortcuts or, worse, sweeping problems under the carpet is unlikely to work; it will only delay the unlocking of capital, hold back growth and come in the way of financing future investment efficiently”.

Puja Mehra is a Delhi-based journalist and author of The Lost Decade (2008-18): How India’s Growth Story Devolved Into Growth Without A Story.