The middle seat

I’ve been watching the airline bankruptcies/ restructuring efforts around the world with interest so it was great to watch a webinar put together by INSOL International, on the topic. One of the questions put to each of the panellists (from South Africa, USA, Australia and UK) was what the future looked like for airlines. It was interesting to hear that South Africa had only allowed domestic business travel. Australia and New Zealand have opened up domestic travel to everyone. Some international flights have resumed as well. But the question is whether airlines can sustain flights running on low capacity. Even if there is demand, there has been a push to keep the middle seat vacant. Different countries have taken different approaches.

This week, India’s Bombay High Court ruled that airlines were not required to fly with empty middle seats as long as they complied with the Aviation regulator, Directorate General of Civil Aviation’s (DGCA) guidelines on measures to be taken to prevent spread of the coronavirus.

The relevant portion of the DGCA guidelines states:

c. If physical distancing cannot be achieved due to passenger load, then additional protective measures should be provided to the individual occupying the intervening seat like ‘wrap around gown’ …along with mask and face shield.

These guidelines were made after the Supreme Court order dated 25th May, 2020, saying that the DGCA “is free to alter any norms he may consider necessary during the pendency of the matter in the interest of public health and safety of the passengers rather than for commercial considerations”.

Although the Supreme Court order suggests that commercial considerations should not be a factor, I would think that it should be, albeit secondary to health and safety considerations. If alternative safety measures allow us to ensure that spread of Covid-19 is prevented, while keeping airlines viable, that should be the preferred choice. Airlines running with empty middle seats would raise prices and make flying inaccessible to many people. As the string of airline insolvencies across the world shows, the sector is bleeding and government bail-outs will not be enough to save the airlines (and with it, the livelihoods of employees).

New IBC sections, new ambiguities

After almost three weeks of uncertainty the Indian government has made good on its promise (or threat, depending on your perspective) of suspending filings under the IBC. This amendment to the IBC, introduced via an ordinance dated 6^th June 2020, is the latest response to deal with the economic fallout of Covid-19. (Anchal Jindal has the entire chronology of recent amendments to the IBC here.)

Irrespective of your views on the suspension of filings under the IBC (I’ve made no secret of mine on the subject) if you were hoping to finally have some clarity, prepare to be disappointed.

Section 10A has been introduced to suspend filings by the corporate debtor and by creditors “for any default arising on or after 25^th March 2020 for a period of six months”, thus creating a safe harbour of sorts. It then goes on to say that no application shall ever be filed with respect to debts incurred during this six-month period. The government has retained the right to extend this safe harbour to one year. Presumably, 25^th March is used as the cut-off date because that is when India imposed a nation-wide lockdown to prevent the spread of Covid-19.

There is also an introductory statement in the ordinance which says that the purpose of the amendment is to exclude debts incurred as a result of the pandemic.

It is ambiguous whether the NCLTs should read the introductory statement into section 10A and only allow the safe harbour to be availed of if the defaults arising after 25^th march 2020 are in fact due to the pandemic.

Even more concerning is the addition of section 66(3). Section 66(1), the operative part of the provision states:

If during the corporate insolvency resolution process or a liquidation process, it is found that any business of the corporate debtor has been carried on with intent to defraud creditors of the corporate debtor or for any fraudulent purpose, the Adjudicating Authority may on the application of the resolution professional pass an order that any persons who were knowingly parties to the carrying on of the business in such manner shall be liable to make such contributions to the assets of the corporate debtor as it may deem fit.

Sub-section 66(3) has been added to ensure that defaults caught during the six month safe harbour period cannot be the subject of a fraudulent trading application. This sub-section is misguided and will mean that there is no remedy against fraudulent activity. Since section 66(1) already requires an “intent to defraud creditors” no modification was required. While it makes sense to provide some relief to firms affected by the pandemic, it is backwards to also provide relief where the company has engaged in fraudulent activity.

All these ambiguities are bound to create more work for the NCLTs which are already dealing with huge back-logs.

Another reason why suspension of filings under the IBC is a bad idea

I’ve argued previously that India’s decision to temporarily suspend filings under its somewhat newly minted insolvency law (IBC) is counter-productive.

A second order effect of suspending IBC filings is that the thriving market of insolvency resolution professionals that had developed since the introduction of the IBC will struggle.

A recent Economic Times article says: “Currently, about 115 insolvency professional entities are registered with the Insolvency & Bankruptcy Board of India (IBBI) and 3,009 insolvency professionals are registered with the board.” This is the size of the market that will be disrupted. The same article notes that boutique firms focused on providing insolvency professional services will suffer from the sudden suspension.

As Professor Gurrea-Martínez emphasizes in a recent paper (insolvency law in emerging markets), although developing a sophisticated insolvency profession is important for an insolvency law to work effectively, this takes “time, resources and political will”. India is squandering the gains of the last few years by disrupting the market for insolvency professionals.

Since the government has been looking into introducing pre-packs, insolvency professions will most likely be looking to provide necessary services in that regard. However, this will be a different ball game that firms and individual professionals will have to adapt to. Many small and boutique firms may get left behind. When the government lifts the suspension of IBC filings, there will be a fresh demand for insolvency professionals, some of whom may have already moved into other professions.

Creditor cooperation duties proposed – India should take a look

In a recent post Professors Horst Eidenmüller and Kristin van Zwieten propose that “creditor cooperation duties” should be developed to stabilise corporate workouts. At a minimum, they say that the duty would require various creditors to negotiate in good faith. Such duties would kick in only after a workout process has been initiated and to the extent that they were necessary to stabilize a workout.

They give many reasons for the need for such duties but I will focus on one reason here:

…we cannot rely on the threat to force a formal bankruptcy process such as Chapter 11 to discipline holdouts, because this threat is not credible in every jurisdiction. Bankruptcy courts are or will be overwhelmed by failing firms.  Even more important, the bankruptcy costs for firms that may fail because of the pandemic are very high (the overwhelming majority of these firms will just have a cash flow problem).

Well, in India, because of  filings under the IBC being suspended, there is no threat of filing at all. So the proposal for creditor cooperation duties is even more relevant.

 

 

TRYING TO MAKE BAD DECISIONS WORK

India’s move to suspend filings under the IBC is mistaken. However, the government seems to have gone ahead and approved an amendment to suspend filings under the IBC (by introducing s 10A into the IBC). As Mr. Shardul Shroff has rightly said in a well-reasoned op-ed, “there has been no dialogue with industry or with financial creditors of these severe consequences when Section 10A is introduced and becomes law”. This is indeed true and it is unfortunate that the government has not attempted to take stakeholder opinion or even international best practice on board at such a crucial time.

Suspending IBC filings will leave companies and creditors in limbo and while in this state, a number of concerns emerge. Mr. Shroff has outlined some of the key issues that need to be addressed now. While I disagree with his general concern about the merits of a debtor-in-possession model, he has raised some very important points. Like him, I think that we need to have some rules around directors’ duties in the zone of insolvency.

In an article written prior to the COVID-19 crisis and the suspension of IBC filings, I had proposed a modified Revlon duty which would require directors who have entered the zone of insolvency and are actively seeking bids, to either sell to the highest bidder or initiate the resolution process under the IBC. This proposal aimed to prevent promoters seeking to retain control and reject bids merely because they were conditioned on the promoter ceding control. (Jet Airways is a prominent example of a company that could have benefited from such a duty.)

Now that IBC filings have been suspended, new rules should be devised for directors in control of companies that are insolvent or in the zone of insolvency. As Mr. Shroff notes, when a company is insolvent or near insolvent, the directors’ duties shift from shareholders to creditors. Mr. Shroff has rightly suggested that “a new ‘Code of Corporate Governance’ and ‘Duties of Directors’ during the period of applicability of Section 10A (proposed) for discharging the obligations towards creditors should be urgently introduced…”. Here, I will discuss some principles to be borne in mind while such a code or set of duties is proposed.

Once a company is in the zone of insolvency or insolvent, the directors will have two choices. The last choice is to liquidate the company. The more preferable option for a viable company is to attempt to restructure by negotiating with creditors. However, this would only be possible if there is a moratorium on all actions against a company and so as a first step, the government will have to allow companies to activate the moratorium despite IBC filings being suspended. The next step is for directors to call a meeting of the creditors and attempt to restructure. All parties may be able to agree upon appointing an insolvency professional to help with restructuring. These professionals have gained expertise since the introduction of the IBC and it would be unwise not to utilise their skills.

While these restructuring efforts are being undertaken, the directors should act primarily in the interest of creditors. Professor Amir Licht has proposed in a recent post on the Oxford Business Law Blog that at the point when the duty to creditors is triggered the directors’ duty of care changes.

Specifically, directors should change the strategic management of the company from implementing an entrepreneurial strategy to implementing a custodial strategy that focuses on protecting the company’s assets with a view to returning it to a profit-oriented, entrepreneurial strategy when practical.

He goes on to explain that the custodial strategy required of directors at this point is similar to what is required from trustees which is to preserve the trust fund.

Prof Licht’s formulation is partially suited to the Indian context where there is no possibility of entering the resolution process. As I had argued in a post responding to Prof Licht’s proposal, directors should also be incentivised to restructure and rescue the company. Thus, while good faith efforts at restructuring should be allowed, directors should also have a duty to preserve the property of the company.

These principles should inform the rules formulated to provide guidance on directors’ duties in the zone of insolvency.

Finally, the government should allow the pre-negotiated agreement to be taken to the NCLT for approval so that the agreement is not open to being challenged in court.

By proposing these principles to inform directors’ duties during insolvency and to facilitate restructuring, I am simply tying to make a bad decision work. It would of course be a better course of action for the government to simply abandon the proposal to suspend filings under the IBC.

 

IBC filings suspended. What now?

In an older post, dated April 7^th, 2020 (that is relatively old considering the speed with which the regulatory landscape is evolving in light of COVID-19) Professor Jayanth Varma proposes that we need a new chapter in the IBC to allow a DIP model of insolvency resolution to deal with the current crisis. This is because, in most cases, failure will be due to external factors rather than management fault.

He proposes the following four features for the new chapter:

• The debtor should be allowed to file even prior to a default when it demonstrates that it is balance sheet insolvent.
• The debtor continues to run the business as a going concern as a Debtor in Possession.
• The moratorium should come into force from the date of filing of the petition, though it could be revoked if the petition is rejected.
• Operational creditors should be treated on par with financial creditors.

This is a solution superior to suspension of the filings under the IBC, he rightly argues.

In any case, the government has decided to suspend filings under IBC for 6 months (despite contrary arguments from various stakeholders including myself), and has not shown any inclination to introduce a DIP model in a new chapter for COVID-19 filings, we are left with the option of pre-packs or informal arrangements that are taken to the NCLT for approval.

A panel of 11 members is apparently considering options in this regard and will eventually provide a framework. However, there are concerns with pre-packs as I have highlighted here.

Thus, pre-packs may be a temporary solution, but the government should also be considering other long-term options like the introduction of a DIP model for no-fault insolvencies. This should be accompanied by increased NCLT benches (to deal with backlogs) and also training of NCLT members to ensure that they are ready to adjudicate under the DIP model.

Don’t suspend IBC filings!

I recently wrote about how India, like many other countries, has raised the threshold requirements for creditors to initiate insolvency proceedings against companies, and more recently decided to suspend the insolvency resolution process under the new Insolvency and Bankruptcy Code (IBC) for a period of 6 months to 1 year. I had argued there that any alternative like prepacks should be available in addition to the existing resolution process under the IBC. It would seem obvious that the need of the hour, since companies are affected by the COVID crisis, is a reorganization and rescue mechanism; and thus counter-intuitive to suspend the available mechanism.

I argued that although the increased number of IBC filings might clog the system, the answer was not to suspend the resolution process itself but to channel some of the cases to alternative channels like a prepack mechanism.

On further investigation into the functioning of the NCLTs during the COVID crisis, it becomes apparent that the situation is quite different from courts in other countries which have started functioning online. In India, courts have gone online but are functioning on an “urgent-only” model. The tribunals where IBC cases are heard, the NCLTs and NCLATs on the other hand, announced in March that its  benches would be shut down till the end of the month. The NCLTs were allowing email submissions regarding urgent matters but no video conferencing was mentioned. Thus, it seems that the tribunals were simply not equipped with video conferencing facilities to start hearing matters online. This is the practical reality against which India’s decision to suspend IBC filings should be understood.

What are the options in the absence of video conferencing? One option would be for the NCLTs to allow email filings and where appropriate, recommend that a mediator be appointed to facilitate negotiations. IBC procedures in India are heavily litigated and appointment of a mediator may instil a more cooperative attitude amongst parties. (Colombia has recently introduced the appointment of a mediator for insolvencies as part of the COVID-19 measures, so this is worth looking into by Indian lawmakers.) Prepacks could be an additional option available to parties.

While all these options will certainly help, another important issue in India is the availability of financing. As Pooja Mahajan noted, the market is not right for financing and that many cases would result in liquidation which would indeed not be desirable. New Zealand’s Business Debt Hibernation (BDH) might be an option worth looking into. A summary of the proposed BDH is below:

As the term suggests this regime will provide a moratorium on enforcement of debts.

To enter this regime, the first step is for directors to have to meet a certain threshold. This threshold is yet to be provided but the government has said it will involve solvency prior to COVID-19, prospects of trading returning to normal in the future and the hibernation being in the best interests of the company and creditors.

Step 2 is to notify their creditors that they will seek a six-month moratorium. This notice will immediately trigger a month-long moratorium for pre-existing debts.

Step 3 brings creditors to the table (electronically of course). If at least 50% of the creditors agree, the moratorium will be extended for another six-month period. Creditors are also able to impose some conditions and if they do, the moratorium will be subject to those conditions being met. This moratorium would be binding on all creditors except employees. If the 50% vote cannot be secured, the BDH will not be available to the company. However, other options like creditors’ compromise, voluntary arrangement and liquidation are still open to the company.

Once a company has availed itself of the BDH regime, to further facilitate its business continuity, the government has proposed that any further payments, or dispositions of property, made by the company to third party creditors would be exempt from the voidable transactions regime. This exemption would only be available where the transactions are entered into in good faith by both parties, are conducted at arms-length, and without an intent to deprive existing creditors.

(For a full discussion of New Zealand’s proposed insolvency measures, see here.)

Although New Zealand has not proposed a suspension of other available restructuring options like India proposed to do, making a similar debt hibernation model available to companies, while the IBC stands suspended, would be another option that India could add to its tool box. Since creditors have a role to play in the BDH process, it may also eventually lead to a prepack.

All of the alternatives proposed here are meant to be alternatives for companies to choose from. Insolvency professionals have played a very important role in India since the introduction of the IBC and their role will again be important for the proposed options to work.

 

 

 

 

 

Clogged system needs to be unclogged – not suspended

India, like many other countries, has raised the threshold requirements for creditors to initiate insolvency proceedings against companies, to tide over the COVID-19 crisis. (See my posts on reforms in Australia and New Zealand here and here.) Now, India has decided to suspend the insolvency resolution process under the new Insolvency and Bankruptcy Code (IBC) for a period of 6 months to 1 year. If you think this sounds counter-productive, you are absolutely right. A number of companies are likely to be in need of rescue procedures as a result of the COVID-19 lockdown and suspending the procedures at this time takes away the available “treatment” for such firms.

I saw an interesting post by Oitihjya Sen suggesting that, India should introduce a pre-pack (a consensual resolution that needs to be approved by the court). Sen argues that pre-packs will provide a middle ground between private agreements that could later be challenged and the full insolvency process under the IBC for multiple companies clogging the system.

Michael Murray also recently discussed pre-packs as a possible idea in the Australian context. He however cautioned that concerns about their process, transparency and fairness exist, and that the pre-pack process is currently under review in the UK.

I don’t think that the COVOD-19 crisis is the time to introduce pre-packs under the IBC since there is not enough time for a critical policy examination. Even if it is introduced temporarily to tide over the COVID-19 crisis, it should be an additional mechanism that companies, in consultation with creditors, could opt into.

If the insolvency resolution process under the IBC is being suspended because of clogging of the tribunals that decide these cases (NCLTs and NCLAT), the solution would be to provide an alternative channel to divert some of the traffic rather than to completely close the system. India has also proposed the establishment of more NCLT benches which should help with tackling some of the additional case load.

What is essential? (A tale of restaurants and auditors)

As many countries have imposed shut downs/ lock downs to prevent the spread of COVID-19, they have all allowed “essential services” to continue working. It is a no-brainer that medical services are essential in the middle of a pandemic. Since people have to eat, it also not controversial that groceries have also been deemed as essential services.

Beyond this, there have been a few amusing (or annoying) policy choices in what services the government of each country chose to designate as essential. For instance, Australia allowed restaurant deliveries while New Zealand didn’t (under Level 4). Australia’s choice has allowed many restaurants to redeploy some of the workforce into delivery, thus adapting to the lock down. It is unclear what is behind the stricter policy choice in New Zealand but at least one restaurant, Burger King no less, has entered receivership claiming that the lack down created cash flow issues.

In India, the market regulator (SEBI) has recently sought the Ministry of Corporate Affairs’ (MCA) help in requesting the government to allow auditors of listed companies to operate during the lockdown. The reasoning given by an unnamed official is this:

Auditing of financial results involves site visits, physical verifications and interactions with the management of the companies whose financial results are audited. This would take time and effort.

Although SEBI had extended the deadline for listed companies to comply with their annual disclosure results, the same unnamed official says that it would be useful for the results to be disclosed on time because they contain “crucial information with respect to financial performance of a listed company and help investors to take informed investment decisions”. Such disclosures become doubly crucial during such uncertain times.

Obviously, this will be an issue in other countries as well and it will again be interesting to see comparative responses. AICPA Chief Auditor Bob Dohrer has offered some ways to substitute site visits. Unsurprisingly, one of the suggestions is video calls.

The overriding question is, can we use video to observe the inventory? And I think the answer is “yes.” I think some of the special considerations are around how well trained the personnel using the video equipment and technology are and what type of video you are going to use. There is great variety in video capabilities. A GoPro camera can be strapped to a person’s baseball cap or hard hat, and they can walk around and perform counting. A lot of warehouses also have security cameras that record and can be remotely controlled to focus in on different areas of the warehouse. That’s a different option for video. The other alternative that we’re hearing some firms are considering is a situation where client personnel go out and make a video recording of the counting of inventory.

These are indeed challenging times where out of the box solutions are required. With restaurants, contact less delivery has taken care of safety concerns. For auditors too, it may be a matter of putting in safety measures like face masks, maintaining the required distance between the people required on the visit, etc.

Papa don’t preach

CSR is usually associated with social/ moral obligations of companies. But in India, CSR has taken a mandatory flavour and has a definition. As I said in an earlier post, India requires companies of a certain size to donate 2% of their profits from the preceding three years. Despite this, corporate India has responded to the Covid crisis by going beyond the legislative definition of CSR and tried their best to ensure that employees continue to get paid. (Unlike in other countries, India has not provided subsidies to all businesses to tide over the crisis.) There have been other instances of Indian companies stepping up and helping the nation-wide covid fight in other ways. I’d discussed these innovative actions by companies in my previous post and concluded that excessive government regulation on CSR would curb such innovative approaches.

Since then, the Indian government has done exactly the opposite.

The Ministry of Corporate Affairs (MCA) issued an order stating that companies’ responses to the covid crisis could be classified as CSR. The companies Act only allows spending on designated categories to be classified as CSR. Since one of the designated categories is “combating human immunodeficiency virus, acquired immune deficiency syndrome, malaria and other diseases”, the order from the MCA was not too surprising. Obviously, India’s rigid definition of CSR means that innovative responses from companies that offered their resorts to be used as temporary care facilities will not be considered CSR.

While it is laudable that some companies have responded to the need irrespective of whether such a response will be accepted as CSR, it is to be expected that most other companies would seek to clarify whether their efforts would be classified as CSR. (Let us not forget that amidst this crisis, large companies have an added obligation of spending a certain amount of their profits on CSR.) As it turns out, they have indeed sound various clarifications and the MCA has responded with answers to those questions. One interesting answer is to a question asking whether payment of “salary to employees and workers, including contract labour, during the lockdown period can be adjusted against the CSR expenditure of the companies? The MCA’s answer is no but it has also indulged in some sermonising. Here is what it says:

Payment of salary/ wages in normal circumstances is a contractual and statutory obligation of the company. Similarly, payment of salary/ wages to employees and workers even during the lockdown period is a moral obligation of the employers, as they have no alternative source of employment or livelihood during this period. Thus, payment of salary/ wages to employees and workers during the lockdown period (including imposition of other social distancing requirements) shall not qualify as admissible CSR expenditure. (Emphasis mine.)

We know that salary payment is a contractual obligation and non-payment will trigger breach. However, is it the moral obligation of employers in circumstances where employees have no other source of livelihood due to a government-imposed lockdown? Moral or not, this is a responsibility that the government has shouldered in most other countries. Granted that such financial subsidies may not be possible for the Indian government but the burden cannot be shifted to private enterprises with such moral preaching, especially when it has chosen to define CSR as mandatory spending on designated activities.