PROJECT WORK

WEALTH TRANSFER UNDER IBC, 2016

SUBMITTED TO: SUBMITTED BY:

Ms. Pratima Soni Manjeet Singh Rathore (L/1509)

Assistant Professor Student

School of Law School of Law

Raffles University Raffles University

INTRODUCTION

India experienced a major structural change with the enactment of the Insolvency and Bankruptcy
Code, 2016. Before this, it did not have any comprehensive modern statute on corporate
insolvency.1 Intermittent attempts were made at various points of time to develop a modern
insolvency law framework.2 In 2014 the Finance Minister made a budget announcement about
the government’s plan to usher in an entrepreneur friendly legal bankruptcy framework.3 Later
that year, the Bankruptcy Law Reforms Committee (BLRC) was set up.4 In 2015, the BLRC
submitted its report along with a draft legislation, which finally culminated into the enactment of
the Insolvency and Bankruptcy Code, 2016. Since the enactment of the Insolvency and
Bankruptcy Code, 2016, India’s ranking under the Insolvency head in the World Bank Group’s
Doing Business report has sharply risen from 136 to 103.5 India was also awarded the GRR Award
for the Most Improved Jurisdiction in restructuring and insolvency regime, surpassing even
European Union and Switzerland.6 However, at the same time, Insolvency and Bankruptcy Code,
2016 has also thrown up new challenges.7 Two such challenges are particularly important. First,
there are concerns that companies entering formal insolvency under the Insolvency and
Bankruptcy Code, 2016 often experience avoidable value destruction. For instance, a legitimate
apprehension arises if insolvent companies with viable businesses on entry into formal insolvency
are inadvertently pushed into liquidation instead of being successfully restructured or its business
being sold as a going concern. In the context of Insolvency and Bankruptcy Code, 2016, this
apprehension has been triggered due to the fact that more companies are being liquidated than
successfully salvaged under the Insolvency and Bankruptcy Code, 2016.8 Since the enactment of
Insolvency and Bankruptcy Code, 2016 till September 30, 2018, out of the 1198 cases admitted
to insolvency resolution process, 118 were closed on appeal or review, 52 yielded resolution,
while 212 resulted in liquidation.9 In other words, till end of September 2018, only 20% of the
cases were successfully resolved, while 80% ended up in liquidation.10 In one particular case,
allegations were made that a viable company was pushed into liquidation.11 Value destruction
could also happen if entry into formal insolvency makes it more difficult to preserve the value of
an insolvent company. For instance, a company on admission into insolvency resolution process
under Insolvency and Bankruptcy Code, 2016 reported severe strains on its working capital and
decline in level of operations, impacting the carrying value of its assets.12 Such cases have raised
apprehensions about the potential risks of value destruction under the Insolvency and Bankruptcy
Code, 2016. Second, there are wide-ranging concerns that the Insolvency and Bankruptcy Code,
2016 unjustly discriminates against operational and trade creditors.13 The constitutionality of the
Insolvency and Bankruptcy Code, 2016 is currently facing legal challenges primarily on this
ground.14 The issue had gained prominence during insolvency of major real estate companies,
where home buyers being unsecured creditors were left without any effective remedy.15
Subsequently, some aggrieved home buyers filed a public interest litigation in the Supreme Court
challenging the constitutionality of the preference given to financial creditors under the
Insolvency and Bankruptcy Code, 2016.

IBC 2016

The Insolvency and Bankruptcy Code, 2016 classifies creditors into financial or operational, based
on the nature of debt extended. ‘Financial debt’ is broadly defined to include credit extended
against consideration for the time value of money including against payment of interest.18 On the
other hand, ‘operational debt’ has been defined as a claim in respect of provision of goods or
services including employment and tax dues.19 The IBBI has subsequently created another third
category of creditors - ‘other creditors’ - who are neither financial nor operational creditors.20 If
a corporate debtor defaults on payment to any creditor, financial, operational or other creditor, the
Insolvency and Bankruptcy Code, 2016 allows the corporate debtor itself or any of its financial
or operational creditors to make an application before the NCLT to trigger the insolvency
resolution process.21 The application must also propose an insolvency professional to act as the
interim resolution professional.22 Within fourteen days from the date of filing of the application,
the NCLT has to decide whether to admit the application or not, based on a two-fold test.23 First,
depending on whether the applicant is a financial or operational creditor, NCLT has to follow the
relevant statutory procedure to confirm that the corporate debtor has actually committed a
payment default.24 Second, NCLT has to confirm that there is no disciplinary proceeding pending
against the proposed insolvency professional.25 Once these prerequisites are confirmed, NCLT is
required to admit the application and issue an order initiating the insolvency resolution process
against the corporate debtor.26 Simultaneously, NCLT must also declare a moratorium on any
individual recovery action against the assets of the corporate debtor.27 Within fourteen days of
commencement of the resolution process, the NCLT is required to pass an order appointing an
interim resolution professional to immediately take over the management of the corporate debtor.
The resolution professional has various important tasks,29 of which four are particularly relevant
for the present discussion. First, she has to receive and collate all claims submitted by claimants
against the corporate debtor and constitute a Committee of Creditors (CoC) of the corporate
debtor.30 The CoC comprises only of financial creditors.31 Operational creditors do not have any
representation or vote on the CoC.32 The CoC may by 66% vote by value decide on the future of
the corporate debtor - whether to continue it or not.33 Second, the resolution professional has to
prepare an information memorandum containing the overall financial position of the corporate
debtor.34 She must provide this information memorandum to each member of the CoC as well as
each prospective bidder (‘resolution applicant’) of the corporate debtor.35 Third, the resolution
professional has to invite resolution plans from prospective resolution applicants interested in
purchasing the business of the corporate debtor.36 After a resolution applicant has submitted its
resolution plan to the resolution professional, the ‘creditor protection rules’ require the resolution
professional to examine and confirm if the plan provides for:37 (a) repayment of the debts of
operational creditors which shall not be less than the amount to be paid to the operational creditors
in the event of liquidation;38 (b) specific sources of funds to be used to pay ‘liquidation value’
due to dissenting financial creditors and provide that such payment is made before any recoveries
are made by the financial creditors who voted in favour of the resolution plan.39 Going by the
interpretation used by the ILC,40 these creditor protection rules apply the break-up ‘liquidation
value’ benchmark to guarantee minimum protection to both operational creditors, who are not on
the CoC, as well as dissenting financial creditors, who comprise the minority in the CoC.41 If a
resolution plan does not satisfy these creditor protection rules, the resolution professional cannot
present it to the CoC for its approval.42 Fourth the resolution professional is under a legal duty to
appoint two registered valuers within seven days of his appointment.43 These two valuers are
required to submit to the resolution professional an estimate of the ‘fair value’ and the ‘liquidation
value’ of the corporate debtor in accordance with internationally accepted valuation standards.44
If in the opinion of the resolution professional, these two estimates are significantly different, she
may appoint another third registered valuer who shall submit another set of estimates.45 The
average of the two closest estimates of a value shall be considered the ‘fair value’ and ‘liquidation
value’ of the corporate debtor.46 The resolution professional is required to transmit these final
estimated values to the CoC.47 This information is expected to be useful to the CoC while
determining the bids received from resolution applicants and thus aid in maximising the recovery
value for the creditors.48 Within 180 days from the date of commencement of the insolvency
resolution process, the CoC may by 66% vote by value approve a resolution plan proposed by a
resolution applicant.49 The resolution plan could propose either a going concern sale or a
restructuring.50 Once a resolution plan is approved by the super-majority of the CoC, the
resolution applicant must submit the plan to the NCLT for its approval.51 The NCLT must
approve the resolution plan if it is satisfied that the resolution plan meets the mandatory legal
requirements (including the creditor protection rules) and that the plan was approved by a vote of
not less than 66% of voting share of the financial creditors.52 Once approved by NCLT, the
resolution plan becomes binding on all stakeholders including the corporate debtor, its employees,
members, creditors and guarantors.53 However, if the NCLT rejects the resolution plan for non-
compliance with mandatory legal requirements or if the resolution plan is not submitted before
the NCLT within the statutory time limit, the NCLT is required to pass an order initiating the
liquidation of the corporate debtor.54

WEALTH TRANSFER PROBLEM

Going concern sale and its limitations

A financially distressed company has going concern surplus, which should be preserved.93 One
way of preserving the going concern surplus of a financially distressed company is by selling its
business at the enterprise value. 94 Such enterprise value may be much greater than market value
of asset sale (and therefore, liquidation value) because a living business has organisational value
which is lost if its assets are sold separately, even if they could be sold at market value. 95
However, a going concern sale of a financially distressed company at enterprise value may not
always be possible because of myriad reasons. First, the company could be in financial distress
because of industry wide factors. Its competitors in that industry may not be in a position to offer
the enterprise value to expand their businesses.96 Second, industry wide factors may push other
companies into financial distress, creating an oversupply of similar businesses in the market. This
may create the risk of auctions at ‘fire sale’ prices, which may be equivalent to the liquidation
value.97 Third, auctions work well when there is adequate financing and competition among
bidders. Countries with less developed capital markets naturally will be at a disadvantage. Even
in countries with well-developed capital markets, if a very large company’s business is put up for
auctioning, it will be difficult to raise financing. The only solution is to raise money from some
big institutional investors, who will be prepared to buy the business only at a discount because of
the substantial risk they will be bearing.98 Fourth, participating in an auction process involves
transaction costs. But only the winner is able to recoup the costs. Consequently, even though there
could be many potential bidders who could raise the financing, not all of them will participate.
This may cause a lack of competition problem.

Restructuring

Because of the above mentioned reasons, sale of the financially distressed company as a going
concern to new investors may not raise the enterprise value of the company. In such an event,
instead of selling the company to new investors, the claimants of the financially distressed
company would be better of by ‘selling’ the company to some or all of the existing claimants
themselves.100 This ‘hypothetical sale’ is commonly referred to as restructuring (or
reorganisation).101 Restructuring could be implemented voluntarily if all the claimants could
come to an agreement. However, this is difficult because of two reasons. First, when there is a
dispersed set of claimants, the coordination cost is too high.102 Moreover, a prolonged
negotiation could be disadvantageous and impractical if the debtor is facing an acute liquidity
crisis.103 Second, there is a possibility that one or more claimants may hold-up the process to try
and get a better deal for themselves. For instance, one or more claimants may withhold consent,
file individual recovery action or petition for winding up of the company.104 The situation is
worse if the claimant holding-up restructuring efforts is an out-of-the-money claimant, who would
not receive any payment or other consideration if the corporate debtor is liquidated instead.105
State supplied insolvency laws are necessary to overcome these two specific problems - co-
ordination costs and hold-up costs. Insolvency law could facilitate restructuring by allowing a
majority of claimants to impose a restructuring plan on a dissenting minority. This could be
structured in different ways. For instance, insolvency law could allow a restructuring plan to be
imposed only on dissenting claimants of a particular class if the majority of that class consents. It
could also allow the restructuring plan to be imposed on whole classes of dissenting claimants -
the cross-class cramdown provision.106 Such provisions help reduce the coordinal tion and hold-
up problems that make contractual restructuring difficult to achieve.

Sources of wealth transfer

When insolvency law provides cramdown powers to facilitate restructuring, it raises the
possibility of abuse, and in particular of wealth transfer from one class of claimants to another.107
The wealth transfer problem could arise when insolvency law allows majority claimants to gain
control over the restructuring of the corporate debtor.108 The majority claimants being in control
of the process may be able to advantage or disadvantage different groups of beneficiaries by
structuring of the securities, contract rights or other property received by each.109 They could
even abuse this control to derive disproportionate private benefits by transferring wealth away
from the dissenting minority claimants through the restructuring plan.110 Adequate safeguards
are therefore necessary to protect the interests of the dissenting claimants.111 Insolvency laws
across jurisdictions usually provide this safeguard to dissenting minority claimants through
judicial supervision.112 The main objective of such judicial supervision is to ensure that a
restructuring plan does not make the dissenting creditors worse off than what they would have
been in the event of liquidation of the corporate debtor.113 The starting point for the court is to
consider the counterfactual, namely what each creditor would receive if no restructuring could be
agreed upon. In that case, the company could either be liquidated on break-up basis or its business
sold as a going concern and the corporate structure could be liquidated.114 Therefore, the court
could use either the break-up ‘liquidation value’ or the going concern ‘liquidation value’ as the
benchmark for determining how much should be paid to the dissenting creditors. If the court uses
the break-up ‘liquidation value’, it would obviously provide lesser protection to the dissenting
creditors of a merely financially distressed company, causing wealth transfer from them.115 It
has therefore been suggested that for corporate debtors in mere financial distress, a going concern
‘liquidation value’ is a more appropriate benchmark than a break-up ‘liquidation value’.116
Wealth transfer could also happen if valuation of the corporate debtor is left to one particular class
of creditors. Senior creditors have an incentive to undervalue the company’s business, while junior
creditors have an incentive to overvalue it. For instance, in a restructuring involving conversion
of debt to equity, if the value of the company is lesser than the value of the senior claims, then
senior creditors could have the right to all the equity since the junior creditors would be left with
no economic interest. In contrast, if the value of the company is more than the value of the senior
claims, then the junior creditors will also have to be offered equity in the company. Therefore, if
the issue of valuation is left to either the senior creditors or the junior creditors, they could engage
in strategic valuation, leading to wealth transfer from the other.117 Even when this issue is subject
to judicial supervision, courts need to be prepared to resist any attempt at strategic valuation and
instead choose the valuation method best suited to curb the wealth transfer problem.118 Even in
cases where the court feels it appropriate to use the going concern ‘liquidation value’, another
critical question of valuation arises, namely, how to determine the going concern value.
Restructuring being a hypothetical sale to the claimants themselves, a proper market test may not
be possible.119 Therefore, it would be necessary to determine the going concern value based on
valuation opinions from expert valuers. This process being subjective may generate disputes and
litigation, making the valuation exercise time-consuming and messy.120 These valuation
problems have to be resolved by courts while protecting minority claimants against wealth transfer
in a restructuring.

WEALTH TRANSFER UNDER IBC

The Insolvency and Bankruptcy Code, 2016 empowers majority financial creditors with 66% vote
by value in the CoC to impose a resolution plan on the dissenting minority financial creditors as
well as the non-voting operational creditors.121 Such a resolution plan could inter alia modify
any security interest, extend the maturity date, change interest rate or other terms of a debt due
from the corporate debtor.122 In view of this broad cramdown power given to the majority
financial creditors, the Insolvency and Bankruptcy Code, 2016 provides three safeguards to
protect the dissenting minority financial creditors as well as the non-voting operational creditors.
First, the resolution plan must identify specific sources of funds to pay the ‘liquidation value’ due
to dissenting financial creditors.123 Second, the resolution plan must provide for repayment of
the debts of operational creditors which shall not be less than the amount to be paid to the
operational creditors in the event of liquidation.124 Third, the ‘fair value’ and ‘liquidation value’
of the insolvent business calculated by the registered valuers appointed by the resolution
professional is expected to mitigate problems of strategic valuation.125 It is important to note
here that there is no explicit provision in the Insolvency and Bankruptcy Code, 2016 that
empowers NCLT to review the fairness of the resolution plan,126 as long as such plan provides
the minimum break-up ‘liquidation value’ to the dissenting financial creditors and the operational
creditors.127 The ILC during its recent review of the Insolvency and Bankruptcy Code, 2016
recorded stakeholders’ concerns that the ‘liquidation value’ guaranteed to the operational creditors
may be negligible as they fall under the residual category in the statutory waterfall.128 The ILC
deliberated on whether instead of ‘liquidation value’, a different benchmark like ‘fair value’,
‘resolution value’ or ‘bid value’ should be used as the floor to determine the value to be given to
the operational creditors. However, none of them were deemed suitable.129 Instead, the ILC went
on to observe that many operational creditors get payments above the ‘liquidation value’ in the
resolution plan.130 Accordingly, the ILC concluded that the interests of operational creditors must
be protected, not by tinkering with what minimum must be guaranteed to them statutorily, but by
improving the quality of resolution plans overall by efforts of regulatory bodies (like IBBI and
Indian Banks’ Association (IBA)) - not the NCLT.131 Evidently, Indian policymakers do not
explicitly envisage any judicial supervision of the valuation method adopted in a resolution plan
to prevent potential wealth transfer as long as the plan pays the break-up ‘liquidation value’ to
non-voting operational and dissenting financial creditors.132 This limitation in the creditor
protection framework under the Insolvency and Bankruptcy Code, 2016 creates opportunities for
wealth transfer through resolution plans.

INCORRECT USE OF VALUATION BENCHMARK

The Insolvency and Bankruptcy Code, 2016 overlooks a basic distinction between restructuring
and going concern sales.135 Restructuring, being a hypothetical sale of the corporate debtor’s
business to the claimants of the corporate debtor, some finite value has to be placed on the business
of the corporate debtor. Otherwise, it would not be possible to calculate how much shares and
other claims each claimant across each class of claimants of the corporate debtor should get in the
newly restructured entity owning the business.136 Therefore, restructuring requires a valuation
benchmark, according to which the rights of each claimant in the restructured business has to be
determined.137 No such problem arises in a going concern sale for cash to a third party after
proper marketing exercise. In such a sale transaction, after accounting for the expenses, the
resolution professional can distribute the cash received to pay out the different claimants
according to their priorities, until the money runs out.138 Therefore, there is no need for a
valuation benchmark to decide the rights of the claimants in a going concern sale. Yet, the
Insolvency and Bankruptcy Code, 2016 applies the same valuation benchmark to both
restructuring and going concern sale.139 Therefore, even in case of a true sale to a third party for
cash at going concern value, the minimum amount to be paid out of that cash proceeds to the
dissenting financial creditors and non-voting operational creditors under the resolution plan is to
be determined according to the amount they would have received in a break-up liquidation. The
remaining amount of sale proceeds could then be transferred to junior claimants.140 Such
resolution plans being in compliance with the Insolvency and Bankruptcy Code, 2016, the NCLT
cannot refuse to sanction them to prevent the unfair wealth transfer from operational creditors to
junior claimants. To illustrate, assume that a corporate debtor has entered insolvency resolution
process under the Insolvency and Bankruptcy Code, 2016. It has a going concern value of $130
and break-up ‘liquidation value’ of $110. The face value of debts owed to its financial creditors
is $100 and to its operational creditors is $30. If the company is liquidated on break-up basis, then
the financial creditors would get $100 and the operational creditors would get only $10. However,
if the company is sold for cash to a third party at going concern value, then the financial creditors
could get $100 and $30 will be left over. Applying the creditor protection rules under the
Insolvency and Bankruptcy Code, 2016, the financial creditors could legitimately approve a
resolution plan that provides only the break-up liquidation amount ($10) to the operational
creditors and pays the remaining $20 to the shareholders, who feature below the operational
creditors in the statutory waterfall.141 This resolution plan would satisfy the creditor protection
rule requiring payment of break-up ‘liquidation value’ to operational creditors and still cause
wealth transfer from the operational creditors. As discussed earlier, the NCLT has no specific
power to object to this resolution plan. This example illustrates why the Insolvency and
Bankruptcy Code, 2016 may fail to prevent wealth transfer from the operational creditors in a
going concern sale because of the ‘liquidation value’ benchmark. Evidently, this is an incorrect
use of the valuation benchmark. Restructuring and going concern sales are two completely
different concepts. For instance, Chapter 11 of the U.S. Bankruptcy Code, 2012 deals with
restructuring, which uses the valuation benchmark.142. On the other hand, section 363 in Chapter
3 of the U.S. Bankruptcy Code, 2012 deals with going concern sales, which does not use any such
valuation benchmark. The Insolvency and Bankruptcy Code, 2016 inadvertently fused both these
features into the insolvency resolution process and consequently, applied the break-up ‘liquidation
value’ benchmark to both.143 As illustrated above, this creates unnecessary risks of wealth
transfer in going concern sales under Insolvency and Bankruptcy Code, 2016. The NCLAT in
Central Bank of India v. Resolution Professional of Sirpur Paper Mills Ltd. and Ors. made an
attempt to resolve this issue. In this case, the resolution plan for a going concern sale was approved
by the NCLT. The plan provided the dissenting financial creditors an amount equal to that
provided to the majority financial creditors. This particular aspect of the plan was challenged by
one of the majority financial creditors before the NCLAT on the ground that it violates the creditor
protection rule under Regulation 38(1)(c) of the Insolvency and Bankruptcy Board of India
(Insolvency Resolution Process For Corporate Persons) Regulations, 2016 since an amount more
than ‘liquidation value’ was provided to the dissenting financial creditors under the resolution
plan. The NCLAT rejected this argument and dismissed the appeal. It held that no discrimination
can be made under Insolvency and Bankruptcy Code, 2016 between the financial creditors in a
resolution plan on the ground that one has dissented and voted against the resolution plan or the
other has supported and voted in favour of the resolution plan. The tribunal also struck down the
above regulation as ultra vires the Insolvency and Bankruptcy Code, 2016.145 Subsequently, on
October 5, 2018, the IBBI deleted Regulations 38(1)(b) and (c) of the Insolvency and Bankruptcy
Board of India (Insolvency Resolution Process For Corporate Persons) Regulations, 2016.