Insolvency & Bankruptcy Code: Regulations for IBC's Objective of 'Maximisation of Value of Assets' Are Serving Almost No Purpose
Insolvency and Bankruptcy Code, 2016 (IBC) in India has been a game changer for resolution-driven credit recovery from insolvent companies in several ways. For the first time, we have a law which enshrines the maximisation of the valuation of assets in its preamble and seeks to back it up by way of Sections 29 and 30 and several corporate insolvency resolution process (CIRP) regulations.
In terms of CIRP regulation 36, the resolution professional (RP), as an insider, is required to prepare a comprehensive information memorandum for the use of bidders (called resolution applicants in IBC). The information memorandum is designed to provide critical inputs and catalyse focused and speedy due diligence by the bidders for submitting bids, i.e., resolution plans for taking over the insolvent entity. 
While CIRP regulations 36A and 36C seek to maximise competition among the bidders, CIRP regulation 36B is designed to induce transparency in the bid evaluation. The CIRP resolution 37 permits unrestricted equity, debt, asset and business restructuring. Intense competition in bidding and transparency in bid evaluation is crucial lest the unrestricted freedom to restructure is misused by muted competition. In other words, IBC seeks the maximisation of the valuation of assets by unleashing competitive market forces. 
In any asset restructuring, which includes asset divestment, before the value discovery in the market and deal execution, the sellers undertake rigorous in-house valuation and often engage investment bankers to arrive at a possible deal value. For example, in 2012, when DuPont decided to sell its performance coating division (PCD), it knew that the PCD, being a late-stage business, would involve a leveraged buyout (LBO). To determine the possible deal value and target internal rate of return (IRR) of the bidders, it estimated DuPont Performance Coatings' (DPC) values based on earnings before interest, taxes, depreciation, and amortisation (EBITDA) growth, EBITDA growth with multiple arbitrage and EBITDA growth with multiple arbitrage and leverage. It also tried to figure out the impact of risk from leverage on the target IRR of the bidders and arrived at a range of DPC's value from US$4.80bn (billion) to US$5.40bn. Eventually, the division was sold at around US$4.90bn in a competitive setting to the private equity firm Carlyle. Renamed Axalta Coating Systems, the business continues to flourish worldwide with a market capitalisation of over US$7bn.
While the sellers and acquirers under the Companies Act 2013 undertake their own valuations to arrive at the target company's deal value, the government authorities estimate project costs or values while seeking bids for public-private partnership (PPP) projects. In cases where the authorities perceive the project value to be less than the project cost that must be undertaken for social benefits, they seek to discover the viability gap funding through competitive bidding. Similarly, for projects whose value exceeds the cost, the premium to the government is also discovered in the market.
In short, takeover deals entail systematic evaluation and valuation of the target by sellers and acquirers before commencing the deal negotiation or bidding. In such cases, among other approaches, weighted average cost of capital (WACC) or adjusted present value (APV) valuations are adopted depending on the debt-equity profiles.
For acquisitions under IBC, the RP is required to get the fair value (FV) and liquidation value (LV) of the company's assets under CIRP on the insolvency commencement date estimated by two registered valuers. These values are kept confidential and shared with the members of the committee of creditors (CoCs), who furnish confidentiality undertakings after the bids (resolution plans) are received. FV, as defined in the IBC and as generally understood, is the price (realisable value) that a willing and knowledgeable buyer is ready to pay for an asset of a willing seller in an arm's length transaction without compulsion. Similarly, LV is the realisable value of the asset to be liquidated. 
Thus, in CIRP, the FV / LV estimates indicate the range of likely credit recovery. In contrast, the surplus of the EV over the aggregate allocations to the creditors (D) by the bidder constitutes value of his equity. This can be expressed as under:
Equity value = Max (EV-D, 0)
EV = Enterprise value estimated by the bidder
D = Aggregate allocation to the creditors in the resolution plan, paid from upfront equity / quasi-equity and cash flow during the term of the resolution plan
V - D = Value of the equity
If the bidder determines that the stand-alone EV (i.e., during CIRP) is less than the total admitted claims, he seeks to write off the entire equity of the acquisition target and also part of the debt. His offer for D is guided by his estimate of post-takeover EV which is enhanced by expected efficiency gains in a way that the equity value V - D must embed required returns on his equity invested in the acquisition target. A competitive bidding for acquisition maximises 'D'.
Thus, it may be inferred that IBC aims at twin objectives of maximising asset value, which will result in maximised credit recovery in a range of LV and FV or more, and maximised post- takeover EV due to efficiency gains under the new and better management. In other words, IBC is designed for credit recovery, emphasising a resolution that can optimise EV. The desire for better management also seems to be an unstated objective of Section 29A of IBC which forbids the promoters of the CIRP except MSME (micro, small and medium enterprise) promoters, from submitting resolution plans.
Current Scenario
For approval of the resolution plan, it is not mandatory for CoCs to be guided by FV / LV. So, CoCs do not use these values, except for calculating liquidation values for dissenting financial creditors and operational creditors. 
CoC's evaluate resolution plans in terms of evaluation matrix (EM) in which, among other factors, the present value (PV) of the value to the creditors (i.e., allocation to the creditors in the resolution plan), discounted at pre-announced rates, is used. Even this process is not sacrosanct since the ultimate winner is the resolution applicant who gets the maximum votes by value which should be 66% or more. 
For example, a resolution plan 'ABC' scores 90 marks in terms of the EM parameters and another resolution plan 'XYZ' scores 80 marks, yet if 'XYZ' scores more votes by value of say 90% and 'ABC' scores say 80%, the winner is 'XYZ'. The EM score comes into play only if there is a tie between the two competitors.
Judicial Pronouncements
In the CIRP of United Seamless Tubular Pvt Ltd, average estimates of the FV and revised LV were Rs818.97 crore and Rs597.54 crore, respectively. Going by the implicit assumption underlying FV and LV computations, these estimates reflected a range of likely credit recovery. However, the resolution plan, which was voted with 87.10% votes, allocated Rs477 crore for the creditors. This was disputed, and the national company law appellate tribunal (NCLAT) ruled that the allocation to financial creditors should be increased by Rs120.54 crore to match with the revised LV. In the matter, the Supreme Court (SC) set aside the NCLAT order and upheld the national company law tribunal (NCLT), Hyderabad order, observing that IBC does not have any provision or regulation under which the bid of any resolution applicant has to match the LV. In other words, the SC accepted the proposition that the offer in the resolution plan to the creditors of an amount lower than the LV was in order. The SC further observed, "It appears that the object behind prescribing such valuation process is to assist the CoC to take a decision on a resolution plan properly." 
A resolution plan is feasible only in going concerns where the post-takeover EV is expected to exceed the FV / LV. Hence, it is logical to expect that the present value of the aggregate allocations to the creditors should be at least equal to LV, which factors in the market downsides. As there is no regulation which would require the CoC to record how the FV / LV have been used while approving a resolution plan, the FV / LV values are rendered irrelevant for resolution plan approval.
CoC's acceptance of lower value, i.e., aggregate allocation to the creditors than LV, implies that (i) either the CoC considers the FV and LV estimates as unreliable, or (ii) it is accepting a sub-optimal resolution plan. In case of (i) the CoC should insist on a credible valuation. In case of (ii), the CoC should restart the bidding afresh.
Limitations of FV and LV
The registered valuers are expected to adopt the internationally accepted valuation principles for estimating the FV and LV of the three classes of assets, viz., land and buildings, plant and machinery, and securities and financial assets. These can be estimated for manufacturing firms but pose challenges for certain types of businesses, such as PPP projects and real estate redevelopment under schemes of authorities such as slum rehabilitation authority (SRA). 
For example, a build-operate-transfer (BOT) project company only has a right to design, build, finance, and operate the PPP project for an agreed concession period and transfer the same to the Authority after that. In such projects, the project land, building, plant & machinery cannot be traded freely and, therefore, are not amendable to FV and LV estimation except based on income approach. 
Hence, it becomes necessary to estimate the incremental cost for completing the project and free cash-flow to the firm (FCCF) and adopt a discounted cash flow (DCF) approach based on WACC or APV depending upon the type of debt-equity profile during the term of the resolution plan. No wonder the valuers are adopting the DCF approach in such cases. For example, in the CIRP of C&C Tower, which was an SPV for a PPP project in Mohali, the valuer adopted DCF model and estimated net value of the capital work-in-progress (with a book value of Rs399 crore) at Rs123 crore (net of regulatory liabilities of Rs60 crore). The rights and interest from the bus terminal underlying the project were also valued at Rs311 crore using the DCF approach. However, the approved resolution plan proposed to the creditors an aggregate nominal amount of Rs81.50 crore, which constituted 14.08% of the admitted claims of Rs578.78 crore. 
It is generally seen that strategic acquisitions of companies with valuable assets and profitability trigger EV as the basis for acquisition and result in creditors' value (allocation in resolution plan) exceeding LV / FV. In case of the resolution of Essar Steel, the value to the creditors was 2.65 times the LV. Same was the case with the resolution of Binani Cements. 
In case of Raj Oil Mills, a mid-corporate, the value to the creditors was 2.70 times the LV, and 2.30 times the FV. Resolution of grossly mismanaged Alok Industries also resulted in value to the creditors exceeding the LV. The non-strategic acquisitions involve bargain hunting and hence cannot generally fetch FVs but can be expected to bring values close to LV since LV estimation captures the downsides of the liquidation process.
Barring rare exceptions, most of the acquisitions under IBC involve a part of the creditors' allocated dues to be paid initially and spread the remaining over the term of the plan, unlike normal acquisitions. Hence, the CIRP regulations require the CoC to record its observations on the feasibility and viability of resolution plans to ensure eventual credit recovery. However, the CoC has no direction on the use of FV and LV. Since FV and LV represent a range of likely credit recovery in CIRPs of non-strategic acquisitions, the CoC must record its justification for approving lower value to creditors than the LV. 
A major reason for allowing a certain term of the plan for paying the allocation to creditors is to enable more bidders. Even this does not seem to garner intense competition owing to the deluge of CIRPs. This also tends to create CIRP takeover players who grab multiple CIRPs without disclosing information about ongoing CIRPs. The overtrading leads to delays, which are sought to be justified by blaming regulators. This can potentially create further distress. This needs to be checked with more rigorous evaluation of the bidders lest we repeat Amtek Auto episodes. It is also necessary that the ARCs, PE Funds, and hedge funds are incentivised through efficient legal, regulatory, and adjudicatory environments to participate as resolution applicants to achieve requisite competition and value.
To conclude, for the avowed objective of IBC for maximisation of the value of assets, the provisions and regulations for valuation are perfunctory and serve almost no purpose. It is hoped that Insolvency and Bankruptcy Board of India (IBBI) will take necessary immediate action soon.
(Dr Rajendra M Ganatra was managing director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He has over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in the above article are personal.)
4 months ago
No need to use brain in such non sense process. I beleive those who interested only written of retail shareholders value are not fall under businessmen category they are called devils. Retail shareholders are facing Black days since beginning of this non sense process.
Real business person won't play with small shareholders they only focus on their business and maximize the investor return by following fair trade practices not using round trip and Black money route...
In recent time I strongly feel that all are busy to loot the money...
This is not a Ram rajya .... This is worst then ravan rajya...
4 months ago
One more Indian regulation is found to serve no purpose: Reflective of India's judiciary and Bureaucracy: Perhaps the code was "reserved?
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