The ‘prepack’ adds a more versatile means of financial restructuring. To trigger the prepack, the company needs to pass a special resolution of its shareholders, have the directors pass a board resolution and obtain the approval of 2/3rds of its unrelated financial creditors.

Corporate distress varies in its causes, magnitude and impact. However not all cases of distress can effectively be resolved under the Insolvency and Bankruptcy Code-2016 (IBC) process. Admission of IBC leads to dissolution of the board, appointment of lenders’ nominee as the resolution professional (‘RP’) and typically, sale of the entity to a new bidder.

This approach prevents bespoke solutions required for individual cases. Corporate distress due to reasons extraneous to the capital structure, such as managerial incompetence, shrinking markets, or rising input costs may be ripe for the IBC process to achieve a complete operational and financial turnaround. But in companies where the distress arises due to over-leverage or undercapitalisation, we need a hybrid mechanism which achieves financial restructuring without compromising operational debts or affecting a change in control.

The ‘pre-pack’ adds a more versatile means of financial restructuring. To trigger the prepack, the company needs to pass a special resolution of its shareholders, have the directors pass a board resolution and obtain the approval of 2/3rds of its unrelated financial creditors.

The promoter is expected to share a resolution plan (called ‘base resolution plan’) with the lenders before triggering the prepack to get their in-principal approval. Once triggered, the NCLT appoints an RP chosen by the creditors to supervise and monitor the prepack process. During this phase, the promoter has control over the company, but it is under close supervision of the RP and broader oversight of the lenders.

The base resolution plan will restructure the financial debt, must ensure that operational debts are discharged in full, and must be approved by the lenders and the NCLT within 120 days.

Advantages Offered By Pre-pack  

The pre-pack offers several advantages. First, it lets the promoters remain in the saddle. In cases where the promoters are indispensable to operations and the distress is purely financial, prepacks permit retention of managerial expertise. At the same time, promoters are not given a free rein and remain accountable to the lenders. Secondly, prepacked plans are likely to get approval more expeditiously at the NCLT. Regular IBC can be long drawn leading to loss of revenues and consumers, trust deficit from suppliers and regulators, and exodus of personnel.

Since the base resolution plan has already been prepacked, it is likely to obtain NCLT approval swiftly after commencement of the process. This will save valuable time and increase recoveries for lenders on an IRR basis while ensuring operational creditors do not suffer any losses. Thirdly, unlike resolution under RBI’s June 7 Circular, the pre-pack is accorded judicial sanction thereby insulating lenders from hair-trigger investigations from various authorities.

However, pre-pack is still considered a dirty word in the traditional banking landscape. The perception is that prepacks give a free pass to defaulting promoters, permit self-dealing and stifle competition from bidders making the process susceptible to abuse. But these fears are wildly exaggerated. The law has sufficient guardrails to precisely address such concerns.

First, the requirements of the stringent s.29A of the IBC, debarring errant promoters from bidding, continues to apply in prepacks. These disqualifications range from criminal conviction, to being classified as a wilful defaulter to being barred from trading in the securities market. The primary disqualification is running an NPA business for more than one year. This prescription would in fact incentivise defaulting promoters to trigger prepack at the first sign of incipient stress and not wait till the company reaches the precipice.

Second, if the promoter is mishandling the affairs of the company during a prepack, lenders can remove him and grant full board powers to their chosen RP by triggering regular IBC. Third, the RP is empowered to investigate the company for fraudulent, undervalued, and preferential transactions undertaken in the zone of insolvency. This will allay concerns of potentially unscrupulous promoters syphoning off assets of the company or entering into related party transactions before triggering a prepack.

Lastly, lenders have the right to reject the base resolution plan and invite bids from third parties if they deem fit. They are also at liberty to use a ‘Swiss auction’ or other means of price discovery if there is scope for higher recoveries.

The prepack currently exists for MSME companies. However, it has been rarely used, either because those companies do not have multiple lenders and can easily negotiate settlement terms with the anchor bank; or the transaction costs associated with the process may be too high for MSMEs.

At the same time, in a sophisticated economy with potential for large corporate distress varying from tech decacorns, airlines, real estate and renewables, the ability of working with the right promoter may lead to vastly superior outcomes than the displacement to labour, capital and markets that traditional insolvency resolution entails.

The MCA is likely to bring in a slew of reforms to further strengthen the law in the upcoming monsoon session. Extending the prepack mechanism to all companies regardless of size is an imperative to declutter NCLTs, achieve faster resolutions, reduce haircuts, and empower lenders.