COVID-19 and the resulting lockdown has rendered businesses unable to carry on operations and make good on their debt repayment obligations. In lieu of this general inability to service debt, the Central Government hurriedly passed the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020 (“Ordinance”) which introduced Section 10A to The Insolvency and Bankruptcy Code, 2016 (“IBC”).
Section 10A of IBC states that no application for initiation of the corporate insolvency resolution process (“CIRP”) of a corporate debtor shall be filed for any default arising on or after 25th March 2020 for a period of six months, or such further period not exceeding one year if notified by the Central Government (“Suspension Period”).
However, the proviso to Section 10A states that no application shall ever be filed for initiation of CIRP of a corporate debtor for a default occurring during the Suspension Period. In this apparent deviation from normalcy, the proviso acts as an indefinite ban on CIRP’s relating to debt falling due in the Suspension Period.
While the Ordinance comes as a much-needed relief for businesses, the financial repercussions of COVID-19 have been shifted onto the lenders. Coupled with the fact that the primary mechanism for resolution of stressed assets has been suspended, lenders face an uphill battle to squeeze the most value out of their assets. This post seeks to understand the various measures taken by regulators to ease the burden on borrowers, and its resulting impact on Indian banks.
Loan Moratorium and Asset Classification
The Reserve Bank of India (“RBI”) has been proactive in notifying relief packages and relaxations in monetary policy. On 27th March 2020, RBI notified the COVID-19 regulatory package (“First Package”) which addressed difficulties faced by debt-ridden businesses. The First Package inter alia, allowed commercial banks to provide a moratorium on all term loan instalments falling due in the months of March, April and May 2020.
While the payment of these instalments was shifted across the board by three months, interest on the outstanding amount would continue to accrue and be payable upon the expiry of the deferment period. Payment of interest during the moratorium period has been challenged in the Supreme Court of India (“SC”) in Gajendra Sharma vs Union of India. The SC has issued an order to list the matter in the first week of August 2020.
On 23rd May 2020, RBI issued a follow up COVID-19 regulatory package (“Second Package”) providing a further deferment on term loan instalments for the next three months until 31st August 2020.
In addition to this, the First and Second Packages included a provision that stated that the moratoriums/ deferments granted to borrowers are not to be treated as concessions or a change in the terms of the underlying loan agreement.
Therefore, availing the moratorium option will not automatically result in a downgrade of asset quality till the revised due date i.e. 31st August 2020. This halt on asset classification of term loans is bound to result in an unfortunate pileup of non-performing assets (“NPA”) on the balance sheets of banks upon the end of the period.
RBI has further directed banks to maintain a higher provision of 10% on all moratorium accounts spread over two quarters. While this provision may be adjusted later against provisioning requirements for actual slippages in such accounts, it requires banks to maintain a higher threshold of reserves and provisions, which it may have a hard time in doing due to limited cash resources.
Other Measures Taken
Along with the Second Package, RBI issued a circular extending resolution timeline under the Prudential Framework for Resolution of Stressed Assets (“Prudential Framework”). The Prudential Framework was issued with a view of providing directions for lenders, regarding early recognition, reporting and time-bound resolution of stressed assets.
Under the Prudential Framework, the lender(s) must come up with a resolution plan for the stressed asset within 180-days of the end of the review period (30 days from the date of default). RBI has stated that the period from 1st March 2020-31st August 2020 shall stand excluded from the calculation of the 30-day review period. For accounts where the 180-day resolution period was underway as on 1st March 2020, the timeline for resolution stands extended by 180-days from the date on which the resolution period was originally set to expire.
In addition to the extension of timelines, the Monetary Policy Committee reduced the statutorily required cash reserve ratio for banks from 4% to 3% of their net demand and time liabilities. In addition to this, the Monetary Policy Committee later reduced the policy repo rate from 4.4% to 4% with the aim of infusing the economy with much-needed liquidity.
Impact on the Banking Sector
The proviso to Section 10A implies an indefinite ban on the initiation of CIRP for a corporate debtor for defaults occurring during the Suspension Period. This goes against the main text of Section 10A which states that no application for CIRP will be entertained for defaults for a period of six months or more as notified.
There appears to be a clear contrast within the section, and no possible harmonious interpretation. In J.K Industries vs The Chief Inspector of Factories and Boilers, the SC held that a proviso of a section may not be inconsistent with what is mentioned in the main provision and in the event of a contradiction, it is liable to be struck down.
A legal affirmation of the proviso would result in banks permanently losing out on six months’ worth of defaults and a considerable amount of money due to interim resolution plans, not to mention the pile-up of NPA’s soon after. Market sentiment is bound to be severely impacted due to the banks limited financial resources. The ripple effect will inevitably be felt by consumers and borrowers.
The credit rating agency, ICRA Limited released a report studying the impact of the Ordinance on financial creditors. It states that the suspension of fresh cases gives rise to a plethora of problems for financial creditors, and will significantly lower realisations in the FY2021.
ICRA suspects a reduction of up to forty percent of realisations from CIRP in FY2021, as compared to Rupees one lakh crore in FY2020. As a result, financial creditors will be forced to take haircuts on repayments, in order to expedite the resolution process.
The deferment of asset classification re-introduces the problem of NPA’s, by halting asset quality review till 31st August 2020. Inevitably, banks are estopped from seeking prompt resolution of these NPA’s and are prone to unscrupulous borrowers using this as a tool for the delay in performance of contractual obligations.
However, the suspension of asset classification undermines the very object and purpose of IBC, insofar as imposing a suspension of all asset quality reviews; even those that were stressed prior to the First Package.
Lastly, Section 10A bans promoters and directors from filing an application themselves for CIRP under Section 10 of IBC. Promoters and directors are therefore forced to wait out the Suspension Period even in cases where they feel liquidation is the most efficient resort.
As a result of the delay in liquidation, assets of the corporate debtor are susceptible to a depreciation in value, and ultimately harm the financial interests of lenders. Additionally, the adjudicating authority is bound to take longer with its resolution processes after the Suspension Period on account of the volume of cases.
The Way Forward
The moratorium on loan repayments and suspension of fresh CIRP’s have been regarded as a welcome measure for businesses. However, a disruption on this scale to the banking industry comes with its ramifications.
A legal overhaul of the aforementioned measures seems unlikely due to the precedent laid down in Swiss Ribbons Pvt. Ltd vs Union of India, wherein the SC stated that the court would not readily allow traditional common law principles of equity, reasonableness and fairness to prevail over purposive economic legislation and policy.
The grey area surrounding Section 10A, coupled with the suspension of asset classification forces lenders into a corner with respect to resolution processes. Not only will they have to take a significant haircut on loans, but will have to resort to other forms of debt recovery.
These other methods of recovery include compromises under Section 230 of the Companies Act 2013, applications against the debtor before the Debt Recovery Tribunal under SARFAESI Act, 2002 or initiating proceedings against personal guarantors of corporate debtors. Unlike IBC however, these methods of recovery are not time-bound and take a considerable amount of time to effectuate.
While the costs to the lenders are obvious, pushing small/medium businesses to the brink of insolvency or liquidation is not a desirable option either.
Perhaps it can be argued that the former is the lesser of the two evils. With public-sector banks already facing incredible stress due to existing NPA’s on its balance sheet, this blow to the resolution machinery may even force the central government into an infusion of additional capital.