Mirza & Associates, Advocates & Attorneys

An article by Ms. Kaushiki Ranjan legal researcher at Mirza & Associates, Advocates & Attorneys

Recently, “haircuts” have been reported by lenders under resolution plans approved under the provisions of the Insolvency and Bankruptcy Code (IBC). A haircut, in this context, refers to a reduction in creditors’ recoveries compared to their claims presented to an insolvency professional, as part of a borrower’s insolvency resolution process.

A haircut means a reduction in the value of an asset and, in relation to an IBC, it means the difference between the loan amount and the actual value of the asset used as collateral to lenders or creditors in such situations or having to bear the brunt of it. It reflects the lender’s perception of the risk of deterioration in the value of the asset. But in terms of loan recovery, it is the difference between the actual amount due from a borrower and the amount settled by them with the bank.

HOW EXACTLY DOES IT WORK?

An example of how this works is when central banks lend money to commercial banks. For the exchange of loans, as insurance, the central bank will ask for collateral. However, this would entail a haircut, that is, a reduction in the value of this collateral. Taking the example of central banks above, assets of €1 million at fair market value, but given a 20% haircut, would only be enough to obtain a loan of €0.8 million.

Central banks need to ensure that the money lent by them will be returned. Of course, the first line of defence that can be used is an agreement with the borrower regarding repayment. But if the borrower fails to repay the loan, then the central bank will sell the collateral. Hence there is a need to ensure that it will be able to sell the collateral at a price that will cover the amount of the loan. But assets can go up and down in value and with respect to central banks selling specific assets may require some time. A haircut, therefore, provides a buffer of all kinds of impairment and the time needed to sell the warranty.

To illustrate this, let’s consider a house of €1 million. It may now cost €1million, but there is no guarantee that it will actually be possible to get €1million when the time comes to sell it. The house may have been damaged by a storm, or the area it is in has become less attractive. The euro system, which is made up of the ECB and 19 central banks in the euro area, does not accept real estate as collateral, but the logic is the same for assets that do accept it, such as high-quality bonds and other shorter-term securities. These can also decrease in value for a number of reasons. This is why properties with a current market value of €1 million are not enough to get a loan of the same amount.

WHAT DETERMINES THE SIZE OF A HAIRCUT?

The lender should consider what size of haircut is sufficient to cover the risk of not being able to sell the asset at its current price. It will depend on the factors mentioned above, including how risky that type of asset is, which means how volatile its price is and how easy it is to sell it quickly without loss of value. Coming back to an example, an old manor house (for which there is little demand) is known for its thunder (putting it at risk of damage) compared to a new two-bedroom flat in a city center would receive a larger haircut. Similarly, in the context of a central bank, government bonds are relatively safe, liquid investments and receive a shorter haircut than bank loans, which can also be used as collateral and be less liquid.

ISSUE OF HAIRCUTS

• In finance, a haircut refers to the deduction applied to the principal loan amount during insolvency resolution settlement.
• Haircuts have been in the range of 80% and banks have lost about four-fifths of the money lent to companies involved in the process of IBC.
• The National Company Law Tribunal (NCLT) recently took the public by surprise that Vedanta’s Anil Agarwal was “paying almost nothing” to take over Videocon Industries.

HOW DOES THIS HAIRCUT AFFECT THE OPERATIONAL & FINANCIAL CREDITOR?

Haircuts made by operational creditors under the Insolvency and Bankruptcy Code (IBC) are not materially different from those of financial creditors. Operational creditors will realize approximately 42 per cent of claims for 92 corporate insolvency resolution plans (CIRPs) that have received a resolution plan commensurate with the receipt of financial creditors (44 per cent). As of March 31, 2019, 49 per cent of the cases admitted by the NCLT under the IBC were referred by operational creditors.

“Since operational creditors are not part of the Creditors Committee (COC) which assesses resolution plans, it is the duty of financial creditors who are part of the COC to ensure that operational creditors receive their fair share of claims. So that their financial condition should be maintained. A short-sighted view of the financial creditors, to increase their own realization from the resolution applicant, may affect the sustainability of the businesses of the operational creditors, thus impacting the position of the concern of the corporate debtor in the long run.”

WHETHER THIS HAIRCUT IS NOT ALLOWING THE GOVERNMENT & JUDICIAL SYSTEM TO ACHIEVE THEIR GOAL WHICH WAS EXPECTED AFTER THE ENACTMENT OF IBC?

In December 2016, the IBC came into force and the first case under the IBC was referred to the National Company Law Tribunal (NCLT) in January 2017. The first insolvency resolution order under the IBC was passed in August 2017 for Synergies-Dooray Automotive, an automotive parts maker, where lenders (banks + other creditors) were forced to take a 94% haircut. Since then several cases have been referred to the NCLT by the lenders for speedy resolution. The IBC process was deemed a panacea for recovery of NPAs or bad loans and the government in April 2018 claimed that more than Rs. 4 lakh crore NPAs were recovered through the IBC process. However, later RBI data showed that the actual figures for recovery were much lower. The NPA accounts of 40 companies referred by RBI for the resolution process came into the limelight as they together account for 60-65% of bad loans in the banking system.

The Insolvency and Bankruptcy Board of India (IBBI) was constituted under the Insolvency and Bankruptcy Code (IBC), 2016, where the IBBI is a member of other entities such as insolvency professionals, insolvency professional agencies, and information utilities. Recently, about a fortnight ago, IBBI released data on a list of insolvency cases in which resolution under the Corporate Insolvency Resolution Process (CIRP) was received till June 30, 2018. So far only 32 companies have been included in the list. CIRP is the procedure for the resolution of insolvency of a corporate debtor as provided under IBC. A corporate debtor means a corporate person who gives loans to an entity. The corporate debtor includes a company, a limited liability partnership firm or any other person incorporated with limited liability under any law, but does not include a financial services provider. Apart from the corporate debtor, an operational creditor or a financial creditor can approach the NCLT for an order to admit the company (or corporate debtor) under the corporate insolvency resolution process. Financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or debt security, viz. A bank lending to a company. Operating creditors are those whose liabilities to the entity come from transactions on operations, eg. a company supplying raw materials to a manufacturer. The IBC provides that when a company is brought under CIRP, the resolution process must be completed within 180 days, which may be extended up to 90 days. All the financial creditors of the corporate debtor collectively form a Committee of Creditors (COC) who are required to approve a resolution plan by a majority of 66% for the defaulting company. If the resolution plan cannot be passed for a company, the company eventually goes into liquidation. In CIRP, other companies or financial companies in the concerned sector make a bid to buy out the defaulting companies, through which the creditors can get back a certain percentage of their stuck money.

WHAT ARE GOVERNMENT PLANS AND PREPARATION TO CURB THIS HAIRCUT SYSTEM?

The government plans and preparation to curb this Haircut system can be done by reviewing the bankruptcy code as public sector banks (PSBs) have started accepting haircuts of up to 94% to spare the biggest corporate defaulters. Although IBC’s intentions regarding rapid resolution and maximizing asset value are bona fide, it does not have a solid ecosystem to guarantee an effective manifestation of this intention. For example, even if the number of banks in the judgment authority (eg. NCLT) was increased but even less when looking at the quantum of cases. In addition, the deadlines provided under the Code are violated almost in all cases on pretext or another. Sometimes, the same is due to the pending applications before NCLT.