Analysing Debt Financing in India: A Path to Corporate Insolvency?
Siddhant Saroj
Fifth Year, BBA LL.B (Hons.), National Law University Odisha
Introduction
This rise in insolvency can be attributed to debt financing as a means of capital acquisition for corporations which has experienced a notable surge in popularity. However, excessive reliance on debt or mismanagement thereof can lead to a precarious financial position, potentially culminating in insolvency. Corporate insolvency threatens not only the continuity of businesses but also the livelihoods of employees and the interests of stakeholders. Traditionally, equity financing has been the primary method through which corporations raise capital. Equity financing involves selling shares of the company to investors in exchange for capital.
The Doing Business Report ranks India at 52 out of 190 countries in terms of resolving insolvencies, with an average resolution time of 4.3 years – a duration surpassing neighbouring countries like Pakistan and Bangladesh. Despite sharing structural similarities with efficiently functioning insolvency regimes worldwide, India’s insolvency framework has encountered practical inefficiencies.
The shift towards Debt Financing
Insolvency can also be described as the path to financial death and revival. The legal framework governing insolvency resolution underwent a significant change with the Insolvency and Bankruptcy Code (“IBC”), passed in May 2016. This single legislation marked a substantial overhaul of India’s insolvency and bankruptcy regulations, superseding all prior insolvency-related laws. Historically, from medieval Europe’s government bond issuance to the corporate bond boom during the Industrial Revolution, and the establishment of international financial institutions post-World War II, debt financing has adapted to changing economic landscapes. Debt financing essentially entails a company raising funds through borrowing. In the case Innoventive Industries Ltd. v. ICICI Bank (2017) ibclaw.in 02 SC, the court observed that “Creditors put money into debt investments today in return for the promise of fixed future cash flows. But the returns expected on these investments are still uncertain because at the time of repayment, the debtor may make repayments as promised, or he may default and not make the payment. When this happens, the debtor is considered insolvent”.
One crucial aspect of debt financing, setting it apart from equity financing, is the absence of any loss of ownership. The ascent of debt financing can be attributed to a variety of factors, Firstly, corporations have increasingly turned to debt financing due to its potential tax advantages. Interest payments on debt are often tax-deductible, providing companies with a means to reduce their tax liabilities. These factors have contributed to the growing prevalence of leveraging in corporate finance. The impact of debt financing fuels economic growth by funding infrastructure, contributes to the efficiency of capital markets, supports business expansion, influences housing markets and consumer spending, and affects financial stability and interest rates.
Impact on the Corporate Structure
The ascent of debt financing has not only reshaped the landscape of corporate finance but has also significantly influenced the structure and functioning of modern corporations. One of the significant implications of the rise of debt financing is when a company relies heavily on debt financing, it often leads to a higher level of financial leverage. This means that the company has a higher debt-to-equity ratio, indicating a greater proportion of debt in its capital structure compared to equity. This increased debt burden influences the decision-making process within the company, as it puts pressure on managers to prioritize debt repayments over other operational expenditures or growth opportunities.
Corporate Governance
Corporate governance covers the systems, processes, and structures that guide the management and oversight of a company. Companies with debt obligations must maintain robust communication and transparency with creditors. This requires reporting financial performance, ensuring compliance with covenants, and addressing concerns promptly.
Debt holders often exert influence over a company’s board, influencing strategic decisions and risk management. This may involve the appointment of creditor representatives or the inclusion of debt-related clauses in governance agreements. Debt financing necessitates risk management mechanisms to ensure debt servicing. This can lead to a heightened focus on financial risk assessment and mitigation strategies, affecting corporate governance priorities.
Capital Structure
Debt financing inherently introduces leverage, the use of borrowed capital to amplify returns, and can be a powerful tool for enhancing returns. The challenge lies in striking the balance between debt and equity. Over-leverage can expose the company to insolvency risks, especially if cash flows are insufficient to service debt obligations. Debt financing can have a pronounced impact on a company’s weighted average cost of capital. One significant advantage of debt financing is its potential to lower the weighted average cost of capital because of the tax deductibility of interest costs, interest payments on debt are usually eligible for tax deductions, reducing the company’s overall tax liability. However, servicing debt requires regular interest payments, which can strain a company’s cash flow which could be used for investments or operational needs.
Failure to meet debt obligations can lead to legal actions by creditors. The government has established a minimum threshold of ten lakhs rupees for commencing the “Pre-Packaged Insolvency Resolution Process” and one crore rupees for initiating the “Corporate Insolvency Resolution Process”, potentially resulting in Insolvency.
What after Debt Financing has caused Corporate Insolvency?
In the event of the debtor company defaulting on its debt or interest payments, a creditor has the option to initiate insolvency proceedings with the National Company Law Tribunal (“NCLT”) without prior notification to the debtor. NCLT holds the authority to either accept or reject such an application, with a decision expected within 14 days from the date of filing. If NCLT accepts the application, a Committee of Creditors (“CoC”) is formed in accordance with Section 21 of the IBC. Subsequently, an Insolvency Resolution Professional is appointed to control the decision-making powers of the company. The CoC bears the responsibility of formulating a Restructuring Plan, which needs approval from a minimum of 66% of all creditors before it can be put into effect.
IBC outlines a strict timeline of 180 days for the resolution process (270 days under certain circumstances). The failure to achieve resolution within this timeframe, the NCLT is empowered to issue an order for the commencement of the liquidation process for the debtor company. The IBC (Amendment) Ordinance, 2018 made a statement regarding the withdrawal of applications under the IBC by providing distressed companies with an alternative means of resolving disputes outside of the insolvency process and offering greater flexibility and control to the CoC. In Swiss Ribbons Pvt. Ltd. v. Union of India (2019) ibclaw.in 03 SC, the court held that “the CoC has the power to withdraw an insolvency application under Section 12A. The objective of the IBC is to ensure the revival of the debtor company and not liquidation”. Also, in the case Essar Steel India Ltd. Committee of Creditors v. Satish Kumar Gupta (2019) ibclaw.in 07 SC, the Court held that “the withdrawal of an insolvency application should be approved by the Adjudicating Authority and should not result in a loss of value for any stakeholders”.
Conclusion
Debt financing has increased in India but at only 25% of total investing. This financial strategy, which involves borrowing funds rather than raising capital through equity, has inherent advantages that make it appealing to many businesses. While debt financing offers a valuable avenue for capital acquisition, its excessive use or mismanagement can push companies into risky financial situations, potentially resulting in insolvency. The introduction of the Insolvency and Bankruptcy Code aimed to streamline and improve insolvency resolution processes, emphasizing the need for robust corporate governance and risk management to mitigate these risks and ensure sustainable financial health. Prudent management of debt and a balanced approach to leveraging is essential to mitigate insolvency risks and ensure sustainable financial health for corporations in India.
