DISTRESSED DEBT AND PRE-PACK INSOLVENCY MECHANISM


Author: Mohini Chaturvedi , Sharda University









Massive economic reforms have been initiated by the Indian Government to make the country viable for doing business. A major development in the past was the step of globalization. In order to promote healthy competition in the market, entrepreneurship, credit availability in the economy, and specifically, to rescue businesses from financial stress, a modern insolvency regime has been established. The Government is continuing its drive to improvise ‘resolving insolvency’ mechanisms by enhancing the insolvency regime where the focus is on the time-bound rescue of businesses.


MEANING OF DISTRESSED DEBT

Distressed Debt[1] means securities that have made default, are under the bankruptcy process, or struggle with situations that could likely lead to bankruptcy. These are usually issued at large discounts in comparison to their par value or face value. There is a high level of risk involved when these securities are purchased or sold because financial distress or bankruptcy may lead to these securities becoming worthless or even of no value. These securities have the rating which is below-investment-grade rating. Investment-grade ratings are enlisted by credit risk agencies, which signifies the risk attached with particular securities or bonds. Categorization of companies that are facing financial stress or are on the verge of being bankrupt mainly belongs to distressed debt.


INVESTORS IN DISTRESSED DEBT

Large institutional investors also referred to as “vulture funds” deliberately purchase debt securities, and invest in these debt instruments or bonds, either to gain a significant high profit if the company does not face bankruptcy or else getting control of the business in case, it does become bankrupt as they are prioritized over shareholders and will get their due payments. If the company does not go into bankruptcy, then investors will realize a high return on their current purchase of securities at a significant discount which is thus a strategy behind such investment. Private equity firms, hedge funds, mutual funds, and specialized debt funds are the leading investors in the market who undertake distressed debt investment.


BENEFITS OF DISTRESSED DEBTS-

•Distressed debt investors can get the ownership or control over the company which is under financial strain through negotiation if the company falls into bankruptcy.

•Buying debts or bonds at a higher discount in contrast with face value widens the way for the higher interests.


DRAWBACKS OF DISTRESSED DEBTS-

•Risk involved is enormously at peak

•Its nature is unforeseeable thus it needs an adept investor who has command over risk management techniques and its related strategies to enter into this arena

•Negotiation at the time of the bankruptcy of the company becomes arduous due to the presence of stiff competition between the leading investors.


PRE-PACK INSOLVENCY MECHANISM

A pre-pack[2] refers to an agreement between secured creditors and investors for the resolution of the debt of a distressed company instead of a public bidding process. This mechanism paves a path for distressed companies to negotiate terms with their creditors and a purchaser before entering into formal insolvency proceedings.


CURRENT STATUS OF PRE-PACK INSOLVENCY MECHANISM IN INDIA

The Insolvency and Bankruptcy Code (Amendment) Bill, 2021 has proposed the element of pre-pack insolvency mechanism which was introduced to amend the insolvency law and provides for a prepackaged resolution process for stressed Micro, Small, and Medium Enterprises which will replace the IBC Amendment Ordinance, 2021. It proposed that the ‘pre-packs opt as an alternative insolvency resolution mechanism for MSMEs[3]. This mechanism provides that the main stakeholders such as creditors must identify a prospective buyer and negotiate the terms instead of a public bidding process. Thus, for initiating the pre-packaged insolvency mechanism, a minimum threshold of not more than Rs 1 crore is required.


WORKING OF PRE-PACK INSOLVENCY MECHANISM

In a pre-pack insolvency scheme[4], the shareholders or proprietors possess control over the enterprise. The creditors will have an agreement with the proficient investor and seek approval of the resolution plan from the NCLT. The financial creditors who are not related to the corporate debtor must give approval (at least 66 percent in total) would be required before a resolution plan is submitted to the NCLT. The NCLTs have the choice to either accept or reject the application.


NEED FOR THE MECHANISM-

Due to the pandemic situation, the government had suspended the insolvency act for one year. The remedy for the complex issues of creditors led to the initiation of a pre-pack mechanism for debt resolution. The pre-packs will provide MSMEs an opportunity to restructure their liability and will incorporate the consensual restructuring of debt with lenders.

ADVANTAGES OF PRE-PACK MECHANISM OVER CORPORATE INSOLVENCY RESOLUTION PROCESS (CIPR)-

The existing structure is based on Corporate Insolvency Resolution Process (CIRP) which refers to a recovery mechanism for creditors under the IBC, 2016. CIRP involves prolonged litigation hence, a time taking resolution process. A threshold of 270-days has been exceeded in the majority of cases resulting in delays whereas a limitation of a maximum of 120 days with 90 days available to the stakeholder in bringing the resolution plan to the NCLT has been provided under the pre-pack mechanism. Under the CIRP, the existing management loses its control and a resolution professional takes control of the debtor as a representative of financial creditors. On the other hand, in the case of a pre-pack mechanism, the management retains control.


KEY FEATURES OF PRE-PACK INSOLVENCY MECHANISM-

● Pre-pack mechanism is a consensual process where prior understanding among stakeholders concerning stress of a corporate debtor, before invoking the formal part of the process minimizes litigation.

● The current promoters and management generally have the exclusive right or first right to purchase the business of the corporate debtor or submit a reorganization plan.

● Pre-pack, which enables a faster resolution, preserves and maximizes value and increases the possibility of resolution


CONCLUSION

Every distressed asset has a life cycle that gets affected by the flow of time. The more duration of time, the more value of assets depletes which further affects the corporate debtor. The pre-pack insolvency mechanism plays a vital role in saving distressed assets by minimizing formal processes and maximizing the economic value. Thus, the pre-pack insolvency mechanism must necessarily opt for quick resolution, and it is a life-saver for a troubled company facing financial stress and its creditors.








[1] https://www.bankrate.com/glossary/d/distressed-debt/ [2] https://www.civilsdaily.com/news/what-is-the-pre-pack-under-insolvency-and-bankruptcy-code/ [3] https://www.ibbi.gov.in/uploads/whatsnew/34f5c5b6fb00a97dc4ab752a798d9ce3.pdf [4]https://www.researchgate.net/profile/Ram-Mohan-M-P/publication/344351741_Pre-packs_in_the_Indian_Insolvency_Regime/links/5f6b38d6299bf1b53ee9f9f1/Pre-packs-in-the-Indian-Insolvency-Regime.pdf?origin=publication_detail https://www.researchgate.net/publication/41792884_Trends_in_Distressed_Debt_Investing_An_Empirical_Study_of_Investors'_Objectives https://crackittoday.com/current-affairs/insolvency-and-bankruptcy-code-amendment-bill-2021/

18 views0 comments