Haircut that was never there: Whether a loan account had become an NPA needs to be taken into account while assessing the haircut from its resolution under the IBC

A news item also talked about ‘tonsur’, referring to the apparent minimum recovery by creditors as a proportion of their claims.

by Debajyoti Roy Chowdhury

Recently, there have been reports on ‘haircuts’ taken by lenders as part of resolution plans approved under the provisions of the Insolvency and Bankruptcy Code (IBC). A haircut, in this context, refers to a reduction in the recovery of creditors compared to their claims presented to an insolvency professional, as part of a borrower’s insolvency resolution process. A news item also talked about ‘tonsur’, referring to the apparent minimum recovery by creditors as a proportion of their claims.

While in some cases the amount of haircut may seem high, it has been observed that in many of these cases, insolvency proceedings were initiated after the assets were classified as NPA in the books of the lender. If an asset is classified as NPA, it ceases to earn any interest. However, upon initiation of insolvency proceedings, notional interest on the NPA account is calculated by the lender and included in the claims. There is nothing wrong with this approach, as an NPA pays no interest, but must be funded by a liability that has a cost. However, this aspect has to be considered while computing the ‘haircut’, as the creditors’ recovery is being calculated as a percentage of claims, even though these are not acknowledged by the lender in its balance sheet.

Worrying about the haircut is certainly not wrong, but it should also have something to do with the value of the company. Valuation of a company is a function of its goodwill in the market, the customer base it has, its employee strength, proprietary software and workflow etc. As the stress created by non-repayment of loans in the company, employees start leaving, customers look for alternative sources, goodwill is lost and hence, the company’s valuation gradually deteriorates. Meanwhile, the liabilities remain the same and, at times, increase even if the company is able to access additional debt to meet liquidity issues; The inability to repay the same increases the interest burden. Therefore, the haircut—a measure of reduction in protection compared to creditors’ claims—has already taken place, often not even before the insolvency process has begun. Accordingly, some of these assets were not even in the books of the lenders. Insolvency resolution under the IBC has ensured that the process is finalized and the residual assets are put to productive use.

The delay in initiating the insolvency process also means that creditors, due to their miserable experience, are more inclined to get their money back and walk out with whatever haircut. However, if insolvency resolution is initiated at an early stage, there may be a true resolution, which can address the causes of bankruptcy such as obsolete technology, inept management or even over leverage. Existing creditors could then remain and this would give them the opportunity to cut their hair in the future through additional business from the company. They can also benefit from a change in the fortunes of a company by taking an equity stake. Over time, as some resolution plans see successful implementation (as there are many), creditors may be encouraged to take this approach.

The IBC has been in force for less than five years; At five years old, a child learns to find his bearing in the real world. The insolvency act 1986 of UK is old while insolvency rule in US is more than 200 years old. It takes years for a law to settle down and a jurisprudence to develop. The results of the Code should be analyzed from this point of view, lest the child becomes jealous of the weight of the expectations of its stakeholders.

The author is Chief General Manager, IBBI