What is Insolvency? How Do Companies Go Bankrupt?

We often come across reports of companies being declared bankrupt or ‘insolvent’. We also see large investment firms or business groups entering into tough competition to acquire these insolvent companies. Recently, Piramal Capital acquired debt-ridden DHFL for Rs 34,250 crore! Let us have a detailed understanding of what insolvency means and look into the insolvency procedure followed in India.

What is Insolvency?

At some point in time, a company or an individual may not be in a position to pay off their debt or other financial obligations. This may be due to a variety of factors such as a sharp decline in revenue (or income), increase in competition, poor market conditions, bad financial management, lack of proper budgeting, high debt, and failure of debt recovery procedures. The state of being unable to make repayment of debts by a person or company is known as insolvency. Those entities that are in a state of insolvency are said to be insolvent. In most cases, the insolvent company or person has to convert their assets into cash to pay off their lenders.

Types of Insolvency

1. Cash-flow insolvency - This is when a person or a company has enough assets to pay what is owed, but does not have an appropriate form of payment. For example, a person (the debtor) may own a large house or other valuable properties, but may not have enough liquid assets to pay his debts when it falls due. [A liquid asset is anything that can be converted into cash easily, within a very short period of time. Eg- cash, stocks, savings account in banks, etc]

2. Balance sheet insolvency - This is when a person or a company does not have enough assets to pay all of their debts. In most cases, these entities might enter bankruptcy, which is a legal process through which they may seek relief from some or all of their debts. Once a loss is accepted by all creditors (or lenders), the parties would negotiate and resolve the situation.

The Insolvency & Bankruptcy Code, 2016

Until 2015, an insolvency resolution in India took an average of 4.5 years to complete. There were constant delays in court proceedings and a lack of clarity. The entities involved in these cases used to incur very high legal costs. Thus, Indian lawmakers wanted to introduce a more structured and time-bound procedure for completing the entire insolvency process. 

The Insolvency and Bankruptcy Code (IBC) was brought into effect in 2016. It is the one-stop solution for resolving insolvency cases in a very economical manner. The code protects the interests of small investors and makes the process of doing business more efficient. The IBC has over 255 sections and 11 Schedules.  When a default in repayment occurs, creditors (lenders) gain control over the debtor’s assets and must make decisions to resolve insolvency within a 180-day period. The code also provides a framework for creditors and debtors to have detailed discussions on how to resolve the issue.

Insolvency Procedure

Let’s say a company- ABC- is in a poor financial state and is unable to pay off large debts. The lenders of the firm submit a plea for insolvency to the National Company Law Tribunal (NCLT). The NCLT is the adjudicating authority for insolvency proceedings in the case of corporate entities. It looks into the financial records and information provided by the lenders of ABC and must reject/accept their plea within 14 days.

• If the plea is accepted, the tribunal has to appoint an Interim Resolution Professional (IRP), who will draft a resolution plan for ABC within 180 days (this can be further extended by 90 days).
• A resolution plan is a proposal that seeks to resolve the company's insolvency by finding methods to pay off creditors. During this period, the Board of Directors of ABC will be suspended. The promoters do not have a say in the management of the company.
• The IRP will manage ABC’s assets and provide information to its creditors and assist them in decision-making.
• The insolvency professional forms a committee of creditors (CoC) who lent money to ABC. The CoC will decide the future of the outstanding debt owed to them. They may choose to revive ABC’s debt by changing the repayment schedule or by selling (liquidating) the assets of the company.

In case the Corporate Insolvency Resolution Procedure (CIRP) fails to revive the company within 180 days, the liquidation process is initiated. This means that all of ABC’s assets will be converted into cash through auctions or direct acquisitions. Proceeds from the sale of these assets will be distributed to the creditors, priority shareholders of ABC, and equity shareholders. The IRP will also receive remuneration for his contribution to the insolvency proceedings.

A Recent Example

Dewan Housing Finance Corporation Ltd (DHFL) was the first financing company in India to go through insolvency proceedings. It had been facing liquidity issues (cash crunch) and had defaulted on loans. Upon further investigation by the Enforcement Directorate (ED), it was found that DHFL had diverted thousands of crores illegally. In November 2019, the Reserve Bank of India (RBI) filed for an insolvency proceeding to be initiated against DHFL. The financial creditors of DHFL submitted claims worth Rs 86,892 crores against the company! The share price of DHFL, which was trading at ~Rs 600 levels in 2018, fell to Rs 15 within a year

The Committee of Creditors (CoC) of DHFL failed to formulate a resolution plan within 180 days. It was decided that the financing company and its assets would be put up for auction. In October 2020, several reports stated that Adani Group, Piramal Enterprises, US-based Oaktree, and Hong Kong’s SC Lowy had placed bids for acquiring DHFL. After months of negotiations and counter-bidding, Piramal Capital emerged as the successful owner of DHFL.

Now, you may wonder why these firms had shown interest in acquiring a company that was poorly managed and involved in illegal activities. The main factor is the cost of the acquisition. Buying a company in the same industry is often time-consuming and expensive. When these investment firms and large corporations want to expand, it is easier and more economical to acquire distressed companies at very discounted prices. Moreover, Piramal took a risk and found value in the DHFL brand- which has a great hold in semi-urban and rural markets.