An IBC roadmap for firms such as DHFL

Debasish Mallick | Updated on January 21, 2020

A finance company includes a large number of retail depositors. Secured and unsecured creditors should be treated at par

DHFL has been admitted as the first IBC (Insolvency and Bankruptcy Code) case from the financial sector. This is a new case in every sense. It would create precedence in financial sector insolvency cases. Judgments in past cases (non-financial), however, may not be readily applicable in this case. The nature of industry is different. Trust and confidence of customers and other counter-parties, and positive public perception, are essential for survival of finance companies.

The finance industry is liquidity intensive, and can be conceived as one where money (liquidity) is the business raw materialintermediate goods, finished product and receivables. As there are not many instances of promoters being able to meet funding requirement on a continuing basis, the industry needs to carry liquidity and obtain continuous infusion of fund, from secular sources, including depositors.

It is, therefore, necessary that the insolvency process is carried out in a systematic and orderly fashion involving least possible time. And, settlement of dues of liability holders is done with utmost care. Satisfactory settlement of liability would be the primary determinant of success of the IBC process.

Failure to achieve this goal will erode confidence and land a severe blow to the NBFC sector. Earlier resolution attempts had failed due to conflict of interest between banks, mutual funds (MFs) and depositors. Inter-creditor agreement could not be finalised.

MFs, which were disinclined to join the earlier restructuring proposal, are now participating in IBC along with banks, and trustees of debenture-holders and depositors. They will comprise the Committee of Creditors (CoCs). Primacy of the CoC’s decision is now a settled question, as upheld by the Supreme Court in the recent Essar Steel judgment. The CoC is, however, likely to encounter “conflict in interest” and other challenges.

The first and overpowering challenge is to crystallise eligible dues. Apart from the conflicting interest, “securitisation” carve-out has already vitiated the resolution process. Solution to this vexed problem is to be found. The liabilities of DHFL comprise unsecured deposits and debentures (both secured and unsecured). Subscribers to such instruments are retail (household) and institutional investors. MFs, insurance companies, PF trusts and other trusts/funds are institutional investors. Borrowings are of diverse maturity comprising a few days to months, years and even decades. Creditors — banks, MFs and depositors — are disparate in their goals and ability to accept hair-cuts and/or deferment in payment of dues.

There are further conflicts between various classes of debenture-holders and depositors as well as MF subscribers. Depositors, MF subscribers and bondholders (including PF) will have to directly bear the loss in the resolution process. Loss of such deposits (not covered by DICGC cover) are unlikely to be accepted well. The long-term sustainability of the NBFC would require deep restructuring/waivers. The question is how to accommodate conflicted claimants.

The present exercise must distinguish the complexities fully and work out a solution keeping in mind the need to satisfy the expectations of investors, by creating different “investor classes”. The CoC may like to examine the possibility of creation of various appropriate investor-class-wise liability “buckets”, for the purpose.

It is important for the CoC to note that the liability profile of any finance company includes a large number of retail depositors/ bondholders. Though unsecured, such retail liability holders need to be better factored in any resolution plan, to arrest erosion of trust/faith in the system.

The first step is to remove the distinction between secured and unsecured creditors, and consider investors pari passu. Liabilities of a financial services company are largely secured by assets it creates and not by assets it possess — that is, by loans/advances made by the NBFC and not physical assets having independent market value. With the significant slowdown in collections, the underlying loans (which provided security), may have actually lost reasons for enjoying primacy.

The next step would be to identify investors with common need and aspirations and club them in respective investor classes. Size-wise segregation of investors and setting up of a “cut off” limit, could also help. There is no restriction in the IBC guidelines on the number of liability classes which can be created for the purpose. However, it is necessary to create “investor classes” in a meaningful manner, so that a resolution plan to meet particular aspirations of classes can be arrived at. The success or failure in the resolution would depend on how imaginatively this segregation of investor classes is made.

The writer is a former Deputy Managing Director of EXIM Bank

Published on January 21, 2020

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