A wake-up call for promoters

The Insolvency and Bankruptcy Code will strengthen lenders' rights and transform corporate behaviour by discouraging profligate borrowing and cavalier attitude towards debt servicing

Nobel laureate Ronald Coase, a pioneer in the discipline of law and economics, posited corporate governance as an attempt to address a classic principal-agent problem. In large companies, the principals (i.e. shareholders) tend to be widespread and diversified, whereas the agents they appoint (i.e. managers or directors) to run the company are a handful. Given her miniscule share, each rational shareholder estimates that the cost of personally monitoring the behaviour of agents is prohibitively expensive. Consequently, agents are able to indulge in self-serving behaviour such as short-termism, deriving excessive perquisites and empire-building through overleveraging. Laws try to reduce agency costs by imposing checks on directors’ sphere of influence, increased disclosures to shareholders and requirement of shareholders’ approval for major decisions. 

However, unlike other jurisdictions, Indian equity ownership is so concentrated that owners themselves tend to be the managers, thereby dissolving the bi-polar system of checks and balances under corporate law. The crisis of Indian corporate governance has less to do with promoter-manager conflict and more with promoter-manager collusion, which poses heightened conflict of interest vis-à-vis minority shareholders and the external stakeholders of the company. While there has been some recent reform to protect minority shareholders, until now, corporate law has not come to the rescue of external stakeholders. In particular, external providers of capital (ie, lenders) have had a raw deal in safeguarding the sanctity of their repayment terms.

Perverse incentives for promoter-managers are higher when the company is in the “twilight zone” where there is acute financial distress and insolvency is imminent. At that stage there is a clear information asymmetry between promoter-managers and external stakeholders such as banks. Being aware of incipient stress, promoter-managers are prone to indulging in desperate practices such as asset stripping, off-market related-party transactions and creation of fresh encumbrances for friendly lenders to divert assets from the bankruptcy estate.

Banks typically tackle this through strong information sharing rights, strict financial covenants and close monitoring rights in their loan agreements. However, this protection is merely contractual in nature and lenders can at best accelerate their loans in the event of default. Even the “nuclear option” of filing for bankruptcy of the company remained toothless before the Insolvency and Bankruptcy Code (IBC) due to the delays endemic to a winding-up petition under the Companies Act.

The IBC offers strong statutory deterrence against such self-dealing by the promoter- managers by allowing scrutiny of certain “avoidable transactions” likely to be conducted in the lead-up to bankruptcy. For instance, the company may repay intra-group loans prematurely or create fresh mortgages so as to put related parties in a more beneficial position in a liquidation scenario. Second, the company may sell its assets outside the ordinary course of business and below market price to friendly buyers for warehousing or safekeeping for the benefit of the promoters. Third, promoter-managers may defraud creditors by siphoning off assets of the company.

The IBC imposes a positive duty on resolution professionals to investigate such transactions and make applications to the National Company Law Tribunal (NCLT) for their reversal. Moreover, the IBC also imposes civil and criminal liability for erring directors of the company. The civil liability extends to disgorgement of personal assets of directors, whereas in cases of actual fraud, falsification of books of account and siphoning off of funds, the IBC imposes fines and imprisonment. In the first few months of the IBC, resolution professionals filed very few avoidance applications, but after a timely advisory from the newly formed insolvency watchdog, Insolvency and Bankruptcy Board of India, several such applications have been filed at the NCLTs — including in relation to the 12 large accounts referred to bankruptcy on the directions of the RBI.

Corporate governance is also bolstered by the introduction of the English law concept of “wrongful trading” under the IBC. Conventional corporate law perceives the primary duty of directors to act in the best interests of shareholders of the company — a duty which becomes detrimental to lenders in the twilight zone of insolvency. The IBC imposes an obligation on directors to cease operations or take all possible steps to minimise losses to creditors of the company if they have adequate material to be satisfied that insolvency of the company is inevitable.

The mischief this section seeks to address is that when a company nears insolvency, the promoter-directors are prone to borrowing recklessly and at high interest rates to tide over cash-flow problems to save the sinking ship — especially since benefits of a turnaround in business fortunes would accrue primarily to promoters, whereas the downside risk is of the last-mile lender. Notably, the threshold test of “insolvency” under the IBC is a mere payment default of Rs 100,000 as opposed to an actual balance sheet or cash-flow insolvency prevalent under English law. Therefore, the IBC effectively compels the directors to flip their fiduciary duties away from shareholders and in favour of the lenders at the earliest signs of financial distress. If a director continues to operate in “business as usual” mode without mitigating losses to lenders, she will be forced to account for the losses caused to banks from her personal assets. 

The most critical deterrent against poor corporate governance under the IBC is the promoters’ fear of loss of control over their enterprise. On admission of an IBC petition, the incumbent promoter-directors immediately lose management and control rights. Moreover, the notorious S. 29A of the IBC practically bars promoters of companies which have turned into non-performing assets, or companies where directors are facing any disqualification, or companies which are disqualified from accessing the security markets by Sebi, from bidding for their own or any other company undergoing an IBC process. For the first time in India, poor governance could mean that promoters could lose control over their businesses. 

For too long, corporate governance in India has ignored the largest external stakeholder in corporate India — the banking sector. Strengthening lender rights via the IBC will engender a positive change in corporate behaviour by disincentivising profligate borrowing, cavalier attitudes towards debt servicing and corrupt practices. The IBC is proving to be a wake-up call for promoter-managers that the rules of engagement have been irreversibly altered.   

The writer is a senior associate in the insolvency practice at AZB & Partners, Mumbai