Why going concern status of corporate debtor important for resolution under IBC
By Archit Gupta & Vrinda Rehan
A business takes capitals from different players in the market including banks, shareholders, investors, suppliers, etc., to earn certain return on such investments. In order to ensure regular investment(s) and continue as a going concern, a business is required to earn significant revenues and profits.
However, with the dynamic business environment various reasons might lead to failure of the business as it might not be able to attain expected returns on investments. This might lead failure of the business in fulfilling the obligations to the investors and creditors. Such defaults allow the creditors and the investors to take legal action against the business. Usually, legal recourse against such defaults includes enforcement of security interest by the business or forcing the business to sort the payment out of normal course of business. No matter what action creditor(s) take, such actions would always have a direct impact on the functioning of the business and its going concern status.
Under Indian Jurisdiction, there are various options available with creditors and investors for safeguarding their rights and recovering their dues, including enforcement of security interest under SARFAESI and other laws. Regardless of the recovery mechanism undertaken by the creditors, it would always impact the going concern status of the business.
However, with the enforcement of Insolvency and Bankruptcy Code (IBC), the focus of Indian legislation and ecosystem has moved from recovery to resolution. The IBC code under section 20 explicitly lays down the responsibility on the insolvency professional to make all possible efforts to ensure the continuity of going concern status of the corporate debtor. This provision in its true essence implies that the operations of the business do not get disrupted and ensure that the business keeps running, thereby acting as an incentive for resolution and maximisation of value of assets.
The Section 5(15) of the IBC along with the Section 20(2)(c) authorizes the resolution professional to raise interim finance, while Section 25(2)(c) levies a duty upon him to maintain the corporate debtor as a going concern, allowing the interim resolution professional (IRP) to raise such finance even before the formation of the Committee of Creditors (Section 20(2)(c)).
Importance of a going concern
Importance of going concern for a business from the viewpoint of creditors has been noted by the Supreme Court in the matter of Swiss Ribbons (P.) Ltd. v. Union of India, where it has stated that a good realization can generally be obtained if the firm is sold as a going concern. The Banking Law Reform Committee (BLRC) also pointed out that the objective of code with respect to value maximisation and resolution can be met by ensuring a business as a going concern under insolvency process
Moreover, the code has provided the authority to the resolution professional to raise finance during corporate insolvency resolution process (CIRP) in order to ensure funds are regularly available to ensure going concern. Further the NCLAT, in the matter of Edelweiss Asset reconstruction Company (P) Ltd noted that the “value of a going concern is much more than a non-functional plant or concern”; therefore, deeming it unwise to let such an entity come to a ‘grinding halt’, thereby allowing interim finance to be raised for the input cost.
The concept of “going concern” is not new in the Indian Jurisdiction, previously many experts and committees’ have noted the prominence of maintaining and ensuring the going concern status for any business. The Eradi Committee Report, 2000 also made recommendations for inclusion of provisions to permit going concern sale in the process of liquidation after which an amendment in Section 457(1) (ca) of Companies Act, 1956 by the Companies (Amendment) Act 2002 was made. Under SARFAESI as well, the creditors were allowed to take over the control of the business in case of default by the debtor, however this provision was not eminent among creditors due to various reasons. Further, as per Section 166 of the Companies Act, 2013 the directors were required to act in good faith in order to promote the objects of the business. IBC by defining wrongful trading under section 66(2), modifies this position such that the duty of directors shifts away from only safeguarding the interest of shareholders towards creditors of the company once the company enters the twilight zone of insolvency. This has put more duty on directors and management of business to address going concern issues of the company as it makes management of the business personally liable for the loss caused.
IBC’s approach to ensure going concern during CIRP has reaped good results for creditors as well as the business as a whole. As per the latest published data by IBBI, out of 4008 insolvency proceeding initiated since the inception of the code, 277 has been resolved and 1025 are made subject to insolvency. Out of 1025 companies subjected to liquidation, only 270 (26%) of the company were not defunct. Out of 277 resolved corporates, 189 (68%) were not defunct. Herein, the companies which are defunct are those companies which did not have an ongoing business as on day of initiation of CIRP, therefore it can also be established that companies which are not defunct, are either already a “going concern” or have a fair chance of restarting the business once resolved.
From the viewpoint of recovery for creditors, average recovery for financial creditors where the company was a going concern on date of admission is 42% as compared to 33% for the corporates which were not a going concern. If we study the data for companies that were not defunct (270) and yet the resolution process for them ended in liquidation order, we can see that in 144 such cases, or 53% cases, resolution plans were submitted. This reiterates the fact that if a company is a going concern then the market shows more interest in providing resolution to the same.
Solutions to paucity of interim finance
IBC has already proved how maintaining a going concern status is important from the perspective of stakeholders and also from the standpoint of recovery as well as resolution. However, in India, investments are not available with respect to funds required by business for maintaining going concern during turbulent times. This makes it difficult for management to find solutions for business outside the IBC framework. Even if we study the financial history of a few large defaulters, there was some support available to them from the creditors, in terms of change in payment terms or providing new capital in form of short-term loans etc in order to ensure the operations were not forced to shut down. However, in the current scenario there is no such support available to the businesses.
Banks and NBFCs are the key players in Indian debt market and with the regulators having strong norms related to financing of defaulted loan accounts, there is hardly any incentive for them in providing support to such businesses. The availability of super priority funds would extend help to the businesses in maintaining the going concern status. This last mile or rescue financing can resolve various issues. Further, there can be certain incentives given to banks to provide some support to such businesses. These incentives may not be monetary but in the form of changing payment terms or delaying legal action to ensure the going concern status of the business.
Jurisdictions such as the United States and Singapore provide for robust financing mechanisms including super-priority status for rescue financing, either through express legislative provisions or judicial interpretation. Currently in India interim finance raised during insolvency proceeding has been given a superior priority status over debts due to all other creditors. Creditors in India are usually hesitant in giving super priority status as any new creditors who intend to inject the debt into a viable corporate debtor would have a priority over repayment of the debt, which makes the old creditor reluctant as it would defer their charge. Consequently, new creditors find it difficult to structure their funding in distressed companies and also in safeguarding their investments. This results in non-availability of funds, which impacts the overall value and the recovery of business.
Therefore, in the interest of the business and its stakeholders, it is imperative that the creditors are acquiescent to super priority advancing structure. The Indian legislation does not regulate a super priority, though the RBI does not restrict the creditors to accept the super priority status as new creditors who have introduced new monies in distress business.
Some strides have been taken by Indian Legislation in this regard, with respect to amendment brought in by the IBC Code. Section 5(15) of the IBC was amended to allow government to notify any debt as interim finance. IBBI has already notified debt taken from ‘Special Window for Affordable and Middle-Income Housing Investment Fund I’ as interim finance. This gives a new window to establish special funds to provide assistance to distressed business and have a safer avenue with respect to investment security. With the aim of providing ease of doing business and promoting a conducive business environment, there is need to provide a conducive eco-system where businesses are able to maintain their operations even though they are going through rough patch.
Archit Gupta is a chartered accountant, while Vrinda Rehan is a practicing lawyer. Both of them are currently pursuing Graduate Insolvency Programme at Indian Institute of Corporate Affairs. The Article first appeared in www.taxmann.com
