Business credit is the lifeblood of day to day commercial operations. Depending on the industry, firms enjoy credit on purchases for anywhere from 30 to 90 days. The Covid-19 pandemic saw these payable days stretching to 180 days, especially for MSME suppliers.

What happens if the operational creditors (OCs) — those supplying the above items on credit — begin to fear that their customer would go bankrupt and that they are likely to lose all their money in that event? This matter is of prime importance to the functioning of the commercial system, especially in times when business failure is becoming more common.

Controlled by CoC

The overarching institutional arrangement for the resolution and liquidation of bankrupt companies in India is the Insolvency and Bankruptcy Code (IBC) 2016. The insolvency resolution process is controlled by a committee of creditors (CoC) comprising financial creditors (FCs). Jurisprudence has gradually moved towards letting the CoC apply commercial considerations.

However, it has always been recognised that the claims of OCs need to be equitably addressed. Even the Swiss Ribbons v. Union of India, 2019 judgment that places the greatest emphasis on giving the CoC a free hand, states that the interests of OCs ‘…are to be placed at par with the interests of financial creditors, and if this is not done, then the Adjudicating Authority intervenes to reject or modify resolution plans until the same is done”.

In the judgment, figures pertaining to 80 cases that had been resolved up until that time were cited to show that the proportion of claims paid out to both sets of creditors was roughly the same.

The number of cases resolved at the time of the judgment was relatively small. However, as on May 31, 2022, the Insolvency and Bankruptcy Board of India (IBBI) database shows 504 cases were resolved and 1,666 went into liquidation. Analysis of the larger data set reveals new insights.

When we compare the payouts to the OCs and FCs as a proportion of their claims, we find that OCs receive a disproportionately lower amount — approximately 24 per cent against a claims proportion of 33 per cent. However, when we factor in the priority of FCs with respect to liquidation proceeds, a different picture emerges.

As mentioned by Sahoo and Nair in a recent newspaper article, the original intent of the IBC was that in case the realisation of bankruptcy proceedings is equal or lower than the liquidation value (LV), then the agreed upon ‘waterfall’ in which FCs are given priority should be followed.

However, when bankruptcy proceeds exceed the liquidation value, the OCs and FCs should be treated at par. In other words, they should share the excess over the liquidation value in proportion to their remaining claims. We use this principle to yield the minimum payout to the OC that is normatively justifiable.

Liquidation premium

We find that for a sample of 316 cases where the liquidation premium, that is, the excess of bankruptcy proceeds over the LV, is positive, the OCs recovered a higher percentage (21 per cent) of their claims than the normative distribution (18 per cent).

Statistical analysis shows the actual recovery was 1-6 per cent higher than the norm.

However, in absolute terms, they received a lower amount — approximately ₹24 crore against a normative payout of ₹35 crore. However, there is a lot of heterogeneity in the data.

For cases where the liquidation premium is less than 50 per cent, OCs have recovered between 2 per cent and 8 per cent higher in percentage terms — as compared to the normative distribution. In terms of absolute amounts recovered, there is no significant difference between the actual receipts and the prescribed norm.

When the liquidation premium is between 50 per cent and 100 per cent, OCs receive payouts in line with the normative distribution. However, when the liquidation premium is greater than 100 per cent, OCs receive lower both in terms of the percentage of claims and absolute amounts as compared to the normative distribution. The shortfall is between 3 per cent and 12 per cent in terms of percentage, and ₹2 crore and ₹8 crore in absolute terms.

The results reflect the fact that as a company switches over from being liquidated to being revived there is a sharp upswing in the fortunes of the OC.

In liquidation, the OC hardly receives anything. However, in case of revival, the OC is critical to continued business operations, and needs to be adequately compensated. But this effect ceases to operate as the liquidation premium increases.

As a result, the OCs, in cases with high premiums, end up receiving a lower percentage of their claims as compared to the normative amount. One would imagine that when there is more money to go around, the OCs have a better chance of recovering their dues, but our results show that a significant portion of the excess is appropriated by the FCs.

From our analysis we can conclude that the structure of the CoC has worked to the disadvantage of OCs. While it may seem that the OCs, on average, are receiving more than the normative proceeds, the fact is that they are losing out significantly when the overall recovery is high.

As the IBC process becomes more efficient and recovery rates increase, this behaviour can lead to disproportionate appropriation of proceeds by the FCs.

Checks and balances will need to be put in place; allowing the OCs to participate in the CoC may well be a start. Currently, the OCs are granted representation in the CoC only if there are no FCs; even the right to attend meetings is only allowed if they have more than 10 per cent of the overall claims.

A further point of concern is that more than 75 per cent of IBC cases seem to have gone into liquidation. In such cases, the OCs hardly recover anything. But that, as they say, is another story.

The writers are professors at MDI Gurgaon

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