Dissecting the Equation: Understanding the Nexus Between FC Control and Recovery Rates in CIRP

Mohd. Fahad Ansari*

Introduction

This exposition contends that the diminished success rates observed within the Corporate Insolvency Resolution Process [hereinafter, “CIRP”], as governed by the Insolvency and Bankruptcy Code, 2016 [hereinafter, “Code”], are an outcome stemming from the delegation of extensive authorities to the financial creditors [hereinafter, “FCs”. The substantial allocation of near comprehensive oversight of the CIRPs, as enshrined within the Code, imparts a substantial incentive upon the FCs to undertake decisions that align with their personal interests. This inclination toward self-serving determinations by the FCs becomes evident when observed within two distinct contexts. Firstly, it becomes apparent in the dynamics between FCs and other involved stakeholders upon the initiation of the CIRP. Secondly, it manifests in the decision-making conducted by the FCs themselves, who operate as the chief architects of the CIRP. To achieve this objective, this discourse is partitioned into three segments.

The initial segment delves into an analysis of the causative factors behind the suboptimal rates of recovery witnessed under the purview of the Code. In this pursuit, the article employs the social-psychological construct termed the ‘discontinuity effect‘ as a tool for scrutinizing the interplay between diverse actors in the context of CIRP initiation. The subsequent segment builds upon the foundational principles of the ‘discontinuity effect,’ seeking to explore the motivating influences shaping the actions of these actors, while simultaneously addressing the ramifications of the asymmetry in information distribution within a CIRP. In the concluding segment, the article culminates by positing the assertion that the cumulative impact resulting from the ‘discontinuity effect,’ divergent incentives, and the prevalence of information asymmetry within the CIRP paradigm collectively underpin the underlying rationale for the observed diminishment in recovery rates.

Navigating the Divergence: Reorganization Goals vs. Liquidation Outcomes

In order to gain a deeper understanding of the factors contributing to the modest recovery rates, it becomes imperative to delve into the fundamental objectives of the Code. As elucidated by the Preamble, the Code is designed to facilitate the “reorganisation and insolvency resolution of corporate persons, partnership firms, and individuals within a stipulated timeframe.” Particularly noteworthy is the insight from the Report of the Working Group on Tracking Outcomes under the Code, which identifies reorganization as the sole aim of the Code. Within the purview of the Code’s intended objective, it is reorganization, not liquidation, that should serve as the prevailing method of concluding CIRPs. This reorganization necessitates the comprehensive restructuring of assets and liabilities, thereby ensuring the continuous operation of the business. Through this commitment to maintaining ongoing business operations, the Code seeks to enhance returns for creditors of all categories.

A recent pronouncement by the Supreme Court, encapsulated in K.N Rajakumar v. Nagaraj and Ors., witnessed Justice Gavai affirming the overarching approach of the Code, emphasizing that every endeavor should primarily be geared towards revitalizing the business and preserving its status as a going concern. Moreover, it is an established fact that instances of reorganization generally yield more favorable returns for creditors across all categories compared to liquidation. However, a meticulous examination of the Code’s practical implementation reveals that liquidation, rather than reorganization, has predominantly emerged as the prevailing outcome for concluding CIRPs. A perusal of the Quarterly Newsletters published by the Insolvency and Bankruptcy Board of India [hereinafter, “IBBI”] from 2018 to 2022 reveals that, on average, approximately 48% of concluded CIRPs culminated in liquidation.

This underlying cause of the disconnect between the Code’s intent and its outcomes can be attributed to the phenomenon termed the ‘discontinuity effect.’ This term encapsulates the characteristic occurrence wherein groups display heightened competition and self-centered behavior when interacting with other groups as opposed to individuals interacting with individuals. As an offshoot of this self-interested conduct, groups tend to adopt a mode of thought known as ‘groupthink.’ This phenomenon essentially involves an inclination towards consensus-seeking within the group, often at the expense of a pragmatic evaluation of alternative courses of action.

Within the framework of CIRP, both the discontinuity effect and groupthink manifest themselves in the context of decision-making and control wielded by the FCs. Notably, the concentration of “near-plenary control of CIRP” by confining voting membership within the Committee of Creditors [hereinafter, “COC”] to the FCs subsequently compels these creditors to prioritize swift returns. This pursuit of swift returns by the FCs simultaneously exemplifies the attributes of the discontinuity effect and groupthink. This manifestation is evident in the recurrent preference exhibited by FCs for their monetary gains over other considerations, such as equity and reciprocity towards other stakeholders, including Operational Creditors [hereinafter, “OCs”] and the corporate debtor.

Furthermore, this manifestation becomes evident in the propensity to opt for liquidation over reorganization, even when the anticipated recovery rates tend to be relatively low.

Judicial Deference in CIRP: Insights from Supreme Court Verdicts

Significantly, the Supreme Court [hereinafter, “SC”], in the case of Swiss Ribbons Pvt. Ltd. and Anr. v. Union of India and Ors. held the FCs who exert predominant influence over the decision-making process within the CoC accountable for disregarding the claims of OCs. This imperative underscored the equitable treatment of all creditors, even those with limited influence in the CIRP. However, a meticulous examination of subsequent judicial verdicts reveals the adoption of an exceptionally deferential standard. Notably, the judgments rendered in Karad Urban Cooperative Bank Ltd. v. Swwapnil Bhingardevay and Ors. and Kalpraj Dharamshi and Anr. v. Kotak Investment Advisors Ltd. and Anr. conspicuously illustrate this stance of extreme deference embraced by the SC. These aforementioned cases revolved around allegations of confidentiality breach during the course of CIRP. In both instances, the SC exhibits deference towards the CoC’s decisions driven by commercial wisdom. Interestingly, the SC’s disposition in these cases does not explicitly reference the Code, indicative of a lack of nuanced evaluation regarding circumstances warranting deference to the CoC’s commercial wisdom.

A more nuanced perspective suggests that the CoC’s assessment of the feasibility and sustainability of the Resolution Plan should be subject to deference. Instances where the commercial wisdom of the CoC is deemed paramount without direct recourse to the Code evoke the ‘discontinuity effect’. In the absence of robust oversight, FCs, as pivotal CoC members, engage in unrestrained interactions with other stakeholders in the CIRP, including OCs. This unbridled interaction inevitably breeds intergroup competition, as various factions endeavor to optimize their gains. In the short term, this intergroup competition aimed at maximizing outcomes often leads to a stalemate. However, when one group, such as the FCs, possesses broader authority and benefits from informational imbalances, a deadlock does not ensue. It is precisely this informational asymmetry that further elucidates the higher incidence of liquidation and diminished recovery rates.

Navigating CIRP: Information Asymmetry, Motivations, and Access to Resolution Plans

As evidenced through the elucidation of the discontinuity effect and groupthink above, diverse participants within the realm of CIRP exhibit distinct motivations. It is imperative to underscore that the FCs are impelled by the incentive to pursue debt recovery through the avenue of liquidation. A pivotal factor augmenting this propensity towards liquidation is the presence of information asymmetry within the CIRP. Prior to 2019, this information asymmetry was notable in the context of the transfer of control and management to the Resolution Professional [hereinafter, “RP”], coupled with the suspension of the corporate entity’s board of directors [hereinafter, “BoD”] upon the initiation of CIRP.

Significantly, following the suspension, the BoD of the corporate debtor found themselves bereft of access to the resolution plan, despite possessing participatory rights denoted as the privilege “to be present when required or called for” during CoC sessions. This veil of secrecy, manifested through the inaccessibility of the resolution plans, resulted in a distinct informational asymmetry. This veil of confidentiality, by preventing access to the resolution plans, led to an imbalance of information. It is crucial to note that this confidentiality approach contravened the fundamental “scope, intent, and purpose of the Code.”

The inherent reality that the former BOD would possess an understanding of both the tangible and intangible value of the assets, coupled with their vested interest in the maximization of these assets’ value, necessitated the provision of a copy of the resolution plan to them. Remarkably, the Sc’s ruling in Vijay Kumar Jain v. Standard Chartered Bank in 2019 established that the former BOD was entitled to receive a copy of the resolution plan as an integral component of the documents to be furnished, alongside the notices for CoC meetings. While this judicial decision addresses the quandary of information asymmetry to a certain extent, it is important to acknowledge that the challenge persists in some measure.

Equity in Decision-Making: Bridging Information Asymmetry in CIRP

The persistent predicament of information asymmetry reveals structural dimensions within the context of CIRP. While the CoC assumes the responsibility of assessing the feasibility and sustainability of the resolution plan while equitably considering all stakeholders, it is not mandatory for the CoC to engage in consultations with other involved parties. For instance, the CoC can certainly gain from deliberations with OCs, to whom the corporate debtor owes more than 10% of its total debt value. However, the opportunity for such deliberations remains restricted due to the rarity of instances where a single OC is owed such a substantial amount. Consequently, the CoC is under no obligation to provide Ocs with a platform to voice their concerns. This lack of involvement of stakeholders such as Ocs, an outcome aligned with the design of the CIRP framework, accentuates the prevailing information asymmetry.

However, this particular brand of information asymmetry assumes a distinctive nature as it adversely impacts the interests of the FCs. Irrespective of the discontinuity effect and the subsequent tendency of FCs to make decisions primarily aligned with their interests, the unimpeded dissemination of information could potentially empower FCs to opt for reorganization over liquidation. The fact that FCs frequently opt for liquidation despite the anticipated outcome of reduced recovery is indicative of a certain irrationality within the decision-making process. In essence, when decisions are founded on incomplete information, decision-makers might adopt courses of action that appear irrational in hindsight.

Considering that the CIRP operates as a “collective process” aimed at binding the stakeholders of the corporate debtor, it is imperative to incorporate mechanisms facilitating the active participation of non-FCs. This could be accomplished through avenues like granting them voting rights on resolution plans or through other suitable means.

Conclusion

The diminished recovery rates under the provisions of the Code arise from a fusion of two distinct elements. Primarily, the augmented dominion of the FCs within the framework of the CIRP. Secondly, the presence of asymmetrical information during the CIRP procedures. The intricate interplay of these two elements culminates in liquidation and the corresponding diminution in the rates of recovery. Despite the Code’s explicit focus on fostering reorganization, it is the actions undertaken by the FCs, who function as the constituents of the CoC, that lead to the circumvention of the Code’s underlying purpose. The realization of the Code’s intended objectives can only be achieved through the meticulous closure of existing loopholes.

*The author is a third-year student at National University of Study and Research in Law (NUSRL), Ranchi.