Free entry and free exit of firms is the hallmark of a competitive market. While the ending of the licence permit raj in the 1990s was a significant shot in the arm of free entry, it is only the recently enacted Insolvency and Bankruptcy Code (IBC) that has created the prospect of reduced barriers to exit. The successful bid of Tata Steel for the assets of Bhushan Steel is, therefore, a historic first step.
As expected in the formative stages, the IBC is a work in progress. As of now, the process operates in two stages. As soon as an account goes into default, bilateral negotiations between the creditors and the promoter commence. If an agreement is not reached in 180 days, at the option of either creditors or the borrower, control is handed over to a committee of creditors (CoC) comprising all financial creditors, but no equity holders. The court appoints a resolution professional to manage the company under the commercial guidance of the CoC. The resolution professional is required to assess fair value and liquidation value, but this is not to be revealed until after the bidding is over. Qualified bidders are invited to bid for the asset and indicate a plan for resolution of the claims of each of the secured creditors. After the closing date of the bid, the bids are opened and the winner is decided by evaluation.
In the parlance of game theory, this is a first-price sealed-bid auction with a secret reserve price in the form of the liquidation value of the asset as assessed by the resolution professional. The question is: does the process optimize the value of the asset?
An important feature of the current process is that the promoter, except in the case of MSMEs (micro, small and medium enterprises), has virtually no locus, either as a seller or bidder of the asset. Times such as ours when bankers as well as promoters are being disparaged should not blind us to the valuable role that both play in managing the risks involved in new projects.
The promoter has valuable inside information about the company. Any process that excludes the promoter would de facto ignore an important stakeholder who drives value. Malfeasance is only one of the many reasons a business can fail. Running afoul of unforeseen cyclical changes, making honest mistakes, or simply being unlucky despite taking every available precaution are other possible causes of failure.
Therefore, we recommend that the phase of bilateral negotiation between the bank and the promoter terminate in the creation of a resolution plan by the promoter that is kept in a sealed envelope and becomes the secret reserve price of the auction. A secret reserve price with a low initial bid is believed to encourage bidder participation.
We recommend that the fair value computed by the resolution professional be a conservative estimate that is openly declared to serve as the low initial bid. After the phase of open bidding, if the promoter’s submission turns out to be the best bid, then the promoter should get the asset, provided there is no case of malfeasance upon him.
We also recommend that bidders be allowed to learn from market behaviour of other bidders by changing the auction format from a static auction where every bidder can only submit a single bid, to a dynamic three-round format, where bidders are informed about the highest bid at the end of each round, without revealing the identity of the bidder. Since bidders’ valuations are likely to be “affiliated” or correlated to each other, this would push up bids in case there are optimistic bidders or deflate bids in case of market pessimism. As creditors are protected for the downside by the secret reserve bid of the promoter, this fallout of the proposed measure need not be a cause for concern.
A bidder will typically give a repayment plan that involves an upfront payment and an allocation of equity. The valuation of the equity in the minds of the creditors depends on their perception of the long-term prospects of the industry. Many industries facing the problem of bankruptcy are hobbled by problems that require government intervention to resolve. For instance, the power sector, that is carrying up to ₹1.75 trillion in debt at risk is stymied by, inter alia, the dishonouring of power purchase agreements by power distribution companies and cancellation of coal blocks. Better prospects in the steel industry led to the resolution of the non-performing assets (NPAs) of Bhushan Steel. Much work will be required before the NPAs in the power sector can be satisfactorily put to bed. Similarly, stress in the telecom sector, where NPAs and stressed debt have also increased in the recent past, requires the government to take a view on a large number of issues, including the high reserve prices used in spectrum auctions, the nature of competition prevalent in the sector, and the regulatory hurdles preventing the buildup of an optic fibre network.
Finally, one needs to return to the stage before the asset became stressed and examine the loan sanctioning process of banks. If the banks were to exercise greater caution during upturns and less risk aversion during downturns, there would be less pressure on the institutions of the IBC. But, meanwhile, capital is still shy and there appear to be massive tranches of NPAs on their way. Our suggestions might help generate greater value from their resolution.
Source: June 28, 2018, Livemint