Unpacking of Pre-Packs in the Indian Insolvency Ecosystem
The macro-economic stress caused by the unprecedented COVID-19 pandemic led the Ministry of Law and Justice to suspend the initiation of corporate insolvency resolution process of a corporate debtor under Sections 7, 9 and 10 of the Insolvency and Bankruptcy Code, 2016 (“Code”) on 5 June 2020 vide the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020. Although, such suspension was a strategic move to ensure the continuity of viable businesses and prevent companies from being forced into liquidation in light of the economic stress caused by the nationwide lockdown, a surge in insolvency applications before the adjudicating authorities is foreseeable once the suspension is lifted. It is likely that the blanket suspension of insolvency process without any alternative mechanism for resolution of distress will lead to deterioration in asset value and huge losses shall be incurred by various stakeholders, forcing them to drive debtor companies to insolvency. Moreover, despite the Code providing a strict timeframe for conclusion of insolvency proceedings, the challenge of providing timely relief to distressed businesses upon lifting of suspension cannot be discounted given the inadequate number of benches in the insolvency ecosystem to handle the incoming volume of work. Such capacity constraints will inevitably lead to delays and consequent value disintegration of businesses across companies.
In view of such economic landscape, discussions have been doing the rounds to strengthen the Indian insolvency regime by introducing pre-packaged insolvency mechanism which is already prevalent in jurisdictions such as UK and USA. The Ministry of Corporate Affairs on 24 June 2020 has also passed an order to constitute a sub-committee of Insolvency Law Committee to propose a detailed scheme for implementing prepack and prearranged insolvency resolution process.
Pre-Packaged Insolvency Resolution Process (“pre-packs”)
The current rescue procedure in India for a corporate undergoing distress is broadly two-fold in nature, the company may either opt for private restructuring or file for statutory insolvency under the Code. Pre-packs are a combination of both these procedures. Simply put, pre-packs are out of court restructuring plans where sale is negotiated in advance of the company entering into formal insolvency procedure. The attractiveness of this mechanism stems from its ability to provide speedy disposal of pre-packaged insolvencies that helps in value maximization and maintenance of confidentiality which helps the company conserve its goodwill and thereby preserve its value.
Pre-packs: a slippery slope?
Despite pre-packs appearing to be the need of the hour, they seem to be packaged with their own set of concerns when applied to the Indian insolvency regime. These concerns inter alia include:
1. Backdoor entry for errant promoters
Pre-pack is usually a debtor initiated process for restructuring of a distressed company which provides a window to the existing management under whose watch defaults have occurred, to be actively involved in the restructuring process of corporate debtors and negotiate terms of restructuring with the creditors before initiation of the formal insolvency procedure. Such lack of transparency, circumvents the application of Section 29A of the Code which prevents errant promoters and its connected parties to regain control of the corporate debtor during pre-packs giving such promoters a backdoor entry into the restructured company.
2. Increase in undervalued and preferential transactions
Lack of transparency may also lead to an increase in undervalued and preferential transactions wherein the corporate debtor may siphon off its assets to other entities without consulting the lenders. Thus, pre-packs tend to disregard the object of the Code to maximize value of assets and puts the interests of creditors and stakeholders at risk.
3. Interests of unsecured creditors not considered
The interests of unsecured creditors which even during the current insolvency mechanism is given low priority may be totally disregarded in pre-packs as they may not be given any opportunity to put forth their claims during negotiations or raise objection against the transaction.
4. Operation of Moratorium
It may also be pointed out that the shield of moratorium provided under the Code will not exist during pre-pack negotiations unless formal insolvency process is initiated. This will serve as a hindrance since the negotiations during pre-packs will not have finality as the corporate debtor will always be at the risk of being dragged to the court/tribunal by any stakeholder, making other creditors vulnerable throughout the process.
Indian insolvency ecosystem is still in its nascent stage which makes it unwise to merely imitate and adopt the mechanism of pre-packs already prevalent in more sophisticated jurisdictions of US and UK. Pre-packs have to be tailored to suit the still developing Indian economy. It is suggested that to overcome the concerns regarding pre-packs, the same should be implemented in a phased manner. Pre-packs could initially be made available to companies which are professionally managed and are not promoter driven. Smaller companies having less complicated debt structure could also be given the option to opt for pre-packs in the initial phase.
Moreover, in order to keep a check on circumvention of insolvency laws through which errant promoters try to regain control of corporate debtor under a different identity, a pre-pack pool, as was recommended by the Graham Committee in the UK, could be set up. The objective behind putting a pre-pack pool in place will be to conduct an independent scrutiny of a connected party pre-pack deal. The pool will be an independent body comprising experienced business people, selected from a wide range of industries and disciplines who will opine on the deal’s outline and scrutinize whether the purchase and sale of assets made by the connected party was necessary.
Furthermore, the concern regarding prevalence of undervalued or preferential transaction appears to be less worrying as the Code already provides for a safeguard under Section 44 which gives the National Company Law Tribunal the power to pass an order on an application made by the resolution professional declaring any transactions entered into by the corporate debtor as a preferential, undervalued or avoidance transaction.
Further, the lack of transparency inherent in the pre-pack process that disenfranchises operational creditors in the pre-pack process can be countered by requiring inclusion of such creditors during negotiation process of pre-pack deals and by providing a reasonable timeframe within which operational creditors can raise objection to the plan. Cue may also be taken from the trajectory adopted under Section 30(2)(b) of the Code and a minimum amount being equivalent to the sum that operational creditor would be entitled to in the event of liquidation under Section 53 of the Code, could be mandated.
The introduction of pre-pack framework may prove to be an efficient way to strengthen the existing insolvency resolution mechanism as it will provide an alternate avenue for resolution of distressed companies. However, the Code would have to be amended and rules and regulations for pre-packs will have to be put in place. The pre-pack regime has to be well tailored to suit the Indian context while keeping in mind that this framework can only serve as an alternative to the existing statutory regime for some specific corporates and sectors and cannot replace the existing mechanism.