Thursday, December 1 2022

In the insolvency of a company under the Insolvency and Bankruptcy Code, 2016 (IBC), potential bidders bid for the purchase of the insolvent company. Before placing such bids, potential bidders should delve into the financial situation of the business and arrive at a value proposition for buying the business. This assessment requires balancing: (i) the individual interest of the potential bidder in which taking over the insolvent company makes commercial sense, and (ii) giving the highest possible returns to the company’s creditors insolvent (after all, it is the creditors who have the final say on the successful bidder). It is a highly competitive process in which potential bidders are often willing to win the lowest possible value, resulting in marginal profits and attempting to give creditors a fair return on their investments under of the company’s insolvency process.

By performing this type of financial analysis outside of the context of a financial institution, a potential bidder ideally has two ways of assessing the true equity of an insolvent business. First, the potential bidder can value the immediate tangible assets available on the records of the insolvent company. These assets may be in the nature of immovable property (such as land) and/or movable property (such as machinery). Assigning a value to these tangible assets is a fairly easy task for potential bidders when assessing the actual value of the insolvent company for the purpose of the tender. For example, land owned by an insolvent company may be valued based on the prevailing circle rate. The additional way to assess the net worth of the insolvent company is to rely on the tangible assets that could be recovered later by the potential offeror in the event of avoidance/fraud avoidance transactions. However, for financial institutions, the true value of the company is locked in its loan portfolio and the way of assessing the net worth of financial institutions based on good and bad loans is exponentially more difficult than that of non-financial institutions.

BAC recognizes that key corporate executives often engage in fraudulent transactions to frustrate the interests of creditors and successful bidders, and to enrich themselves unfairly. For example, just before company A was about to be declared insolvent, the director of company A (that’s to say Mr. X) transfers the assets (worth INR 100) from the company at a rate well below the market rate (that’s to say at INR 1) to a sister company of the company, namely company B, of which Mr. X is also a director. In the absence of any provision to avoid/undo such a fraudulent transaction, Company A would have lost the real value of the property (that’s to say the amount of the balance of INR 99 (INR 100 – INR 1)) and Mr. X who drove company A into insolvency will benefit from such a transaction. To prevent such fraudulent behavior, the IBC introduced the concept of fraudulent transaction avoidance/reversal to prevent unjust enrichment. In such circumstances, the winning bidder is entitled to initiate proceedings in the Tribunal established under the IBC for voidance/avoidance of fraudulent transactions and recovery of amounts. In the case of tangible assets such as land, the potential bidder is able to quantify the approximate value likely to be recovered if it successfully avoids such a transaction in court. This value is then taken into account when assessing the net worth of the insolvent company for the purposes of the tender.

In insolvency proceedings involving financial institutions, the method of assessing the net worth of insolvent companies is quite different. A financial institution doesn’t really have any tangible assets like other bankrupt businesses. The real value of a financial institution is in its loan portfolio. This portfolio of loans indicates the value that may be recoverable at a later date – some will be good loans (that’s to say chances of collection are quite high) and others may be bad debts (that’s to say chances of recovery are not so high). However, a potential bidder will have to take a chance by evaluating the loan portfolio containing the good and bad loans and hope that eventually the majority of the loans will be recovered during his tenure.

Furthermore, the assessment of transactions to be canceled/avoided by potential bidders in the context of a financial institution is much more delicate than in the context of a non-financial institution. In the context of a financial institution, consider an example where the prevailing market interest rate for a loan is 8%. Prior to Company A’s insolvency, its key management personnel, namely Mr. Y, issued a loan at an interest rate of 1%, that’s to say well below the prevailing market rate, to company B (fictitious company formed by Mr. Y). Company B in turn transferred the loan amount to Company C (another shell company formed by Mr. Y). In such a scenario, the successful bidder from Company A seeking to reverse the fraudulent transaction would need to prove the chain of transaction through compelling evidence such as bank statements, to prove that the eventual recipient of the loan was Company C. In In many cases, by the time these proceedings end, shell companies are often dissolved/no longer in existence, making recovery of monies nearly impossible. Therefore, given the lack of a concrete basis for the valuation of these transactions, a bidder may value these transactions from “zero” to the declared value or even more in certain exceptional cases.

In conclusion, the insolvency of financial institutions (mainly involving intangible assets) and non-financial institutions (mainly involving tangible assets) is as different as chalk and cheese. The IBC was designed leaving enough flexibility for potential bidders to arrive at a true value of the insolvent company by adopting the mechanism that best suits it while retaining the ultimate right of creditors to accept such offers. Therefore, it follows that if potential bidders for financial institutions assign a face value of INR 1 to fraudulent transactions to be avoided/cancelled, this cannot be dismissed as an aberrant and unacceptable bid simply because such cases do not arise. not usually occur in the non-financial institution context.


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