IBC as a preventive for funds diversion

Hindustan Times

4 hours ago

The Supreme Court ruling annulling its earlier order on the liquidation of Bhushan Steel under Insolvency and Bankruptcy Code (IBC) reignited the debate on the credibility and transparency of the existing corporate debt resolution framework. On May 2, the Supreme Court ordered the liquidation of Bhushan Power and Steel Ltd., marking one of the most significant tests of the IBC since its enactment in 2016. In that order, the court revoked the resolution plan by JSW Steel and directed the National Company Law Tribunal (NCLT) to initiate liquidation proceedings. The order, which was based on the finding that the resolution plan had procedural flaws and violated the IBC, was annulled on July 31. With promoters and creditors locked in courtroom battles, a key question arises: Does the bankruptcy law have hidden benefits? The prophylactic effects of such legislation often go unnoticed. A well-implemented bankruptcy law can act as an effective deterrent because the penalties arising out of bankruptcy accrue privately to the managers and lead to a large reduction in the need to conduct deep financial audits. (Mint)
An important consideration in the context of India is the effect of the IBC reforms on how managers divert resources. The last decade saw several high-profile cases of fund diversions, leading to financial distress at firms and adverse consequences for their lenders. Can stronger creditor rights reduce fund diversion? The standard approach of using large-scale financial audits to achieve reductions in fund diversions is very costly and is unlikely to work given the fact that auditors are hired by the firms. A well-implemented bankruptcy law can act as an effective deterrent because the penalties arising out of bankruptcy accrue privately to the managers and lead to a large reduction in the need to conduct deep financial audits. Such hidden effects would, therefore, be a panacea to any country that cannot conduct large-scale audits every so often. A well-functioning bankruptcy law is, therefore, a substitute for the costly, time-consuming, and highly uncertain process of financial audits.
The effect and the underlying mechanisms are tested in a research paper by the author of this article, along with Prasanna Gai, Akshat Singh, and Asha Sundaram. We studied the impact of the IBC reform within Indian business groups, focusing on financially distressed firms. Indeed, IBC does reduce fund diversions (using suspect Related Party Transactions, or RPTs, as a proxy). The strongest effect of the reform was seen in the form of reduced related party loan outflows — a clear indication of a reduction in fund diversion.
What explains this change? The IBC law contains provisions that act in both directions — for creditors to force firms to reduce diversions as well as for firms to willingly reduce diversions to avoid bankruptcy. On the creditors' side, higher and quicker expected recoveries would make them more willing to initiate insolvency proceedings against firms. A streamlined, time-bound resolution process and the establishment of specialised courts (NCLTs and the appellate courts) further increase creditors' hopes of higher recoveries. On the firms' side, the fact that the control of the company shifts to a professional resolution manager upon admission of insolvency disincentivises managers when it comes to fund diversion. This threat in itself makes pre-default fund diversion a much costlier proposition.
The research finds that after IBC, firms voluntarily reduced fund diversions and repaid banks. This is an ideal outcome, given the lower costs associated with voluntary changes in behaviour. Firms relied on internal funds by cutting back on dividends and related-party payments to reduce bank debt. However, there was no improvement in firm profitability, sales or investment after the reform, indicating that the reduction in dividends and RPTs was a result of improved financial discipline rather than firm performance.
For the policy to continue to generate sound financial behaviour over time, the threat of penalty under bankruptcy must be sustained. The fact that most cases under IBC do not adhere to the prescribed timelines is not ideal. In line with this hypothesis, in the study, the most pronounced effects were observed in the first two years following the reform. The signs of early deterrence were strong as financial RPTs ceased altogether in many cases. By 2019, the effect weakened, becoming smaller and more uncertain, hinting that the law's grip may have loosened over time.
The early outcomes from the IBC are promising and encouraging, though they also highlight the areas that require sustained attention. Amidst this, allowing creditors to start the insolvency process outside the court system — under the new Insolvency and Bankruptcy Code (Amendment) Bill — is a much welcome provision. Ensuring timely resolution, strengthening creditor rights, and addressing practices that undermine transparency can contribute to building a more resilient corporate insolvency framework.
Gautham Udupa is with the Centre for Advanced Financial Research and Learning (CAFRAL), Mumbai. The views expressed are personal