Unsecured creditors deserve better

S Murlidharan | Updated on November 22, 2019

There is no effective substitute for taking advance precaution against credit default   -  istockphoto

It is true that unsecured creditors can’t rank at par with secured creditors. But, shouldn’t the government take steps to protect the former as well?

Many Indian drug companies export without any safeguards against credit default, just to stay alive and thrive. They are not alone in doing so; a bulk of the indigenous sales too, especially by the MSME sector, has no security against credit default.

The much-touted factoring services — offering collections with the default risk being borne by the factoring company — haven’t taken off, as a huge sliver of the sale proceeds is lost by way of commission for such enhanced services. Home-buyers, though strictly speaking not creditors, have also often lost their shirts to the crafty builders.

Precautionary steps

Is it fair for the Parliament and the government to let the unsecured creditors stew in their own juice? The government can’t just say: “Well, if you didn’t take the precaution of insisting on security, it is your funeral” and be done with it. To be fair, the successive governments haven’t said this so arrogantly and in such an indifferent manner, but it is the message that has gone out.

At the same time, it must be conceded that there is no effective substitute for taking advance precaution against credit default, by way of a letter of credit from a credible bank, guarantee from promoters, lien on goods, hypothecation of business assets etc.

Cynics might say even security given by borrowers is often not worth the paper it is written on, given the huge NPAs in the country despite such securities and the 60 per cent haircut secured creditors are driven to taking under the IBC resolution mechanism. Yet, something can be done. Arbitration appears sensible; but in India, it has been a massive failure, with the aggrieved party ultimately going to courts and defeating its very rationale.

Legislative measures

Under the Micro, Small and Medium Enterprises (MSMEs) Development Act, 2006, MSME suppliers are eligible for compound interest at the bank rate in case of default, but that hasn’t exactly set the Thames by fire! Big buyers know how to dilly-dally and keep even a solemn law under bay. Disputes can be invented both on quality and quantity fronts. What the government can do is legislate comprehensively for credit default in favour of the entire class of operational and other unsecured creditors.

The lynchpin of such legislation should be a deterrent and exemplary compound interest at about 18 per cent per annum. All disputes should be referred to a special commercial court set up for this purpose, to which admission should be restricted only to those who cough up at least 50 per cent of the bills before petitioning.

Needless to say, such courts should decide the matter expeditiously, taking not more than two months. Appeals should be permitted only on deposit of the entire disputed amount, minus the 50 per cent already paid as aforesaid.

This is by no means a criticism of the Supreme Court verdict in Essar Steel case on appeal from the free-wheeling interpretation made by the NCLAT of what exactly was the order of preferential or priority payments. The NCLAT had cast aside the time-honoured principle of secured creditors being paid first by unnecessarily queering the pitch. It had said all creditors, operational or financial, secured or unsecured, shall rank at par when the spoils are distributed under the IBC resolution mechanism. The Supreme Court rightly upturned this interpretation.

But it can, after all, only interpret the law. It is for the government to step in when the law is inadequate to address the concerns of an important constituency.

The writer is a Chennai-based chartered accountant

Published on November 22, 2019

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