Viewing the Insolvency Code through a Forensic Lens

The insolvency and bankruptcy process will be driven by a qualified Insolvency Professional who must possess the necessary investigative skills to do justice to the spirit of the code.

The Indian banking system is on the brink of facing a crisis in the form of bur­geoning gross non-per­forming assets (GNPA) which account for ~14 per cent in public sector bank assets, 4 per cent in private sector bank assets along with a stagger­ing 79 per cent year on year growth as of March 2016 (Source: The Insolvency and Bankruptcy Code, 2016 – Game Changer, Confederation of Indian Indus­try, March 2017). The newly introduced Insolvency and Bankruptcy Code, 2016 (“IBC”/“Code”) comes at a time when previous court and debt restructuring processes have had poor outcomes; sup­ported by an alarming fact that in India the average time required to resolve an insolvency case has been around five years, with an average recovery rate of 26 per cent. Contrast this with OECD high income countries, with an average time of 1.7 years and a recovery rate of 73 per cent or with China, which has an average time of 1.7 years and a recovery rate of 36.9 per cent. The Code, therefore, could be a game changer – looking to consoli­date the existing framework by creating a single law for insolvency and bankruptcy.

The Code seeks to deal with insolvency and liquidation proceedings in a time­bound and efficient manner in order to maximise value of assets, and enhance investor confidence by providing an effi­cient framework to deal with business failures. Further, the Code also brings about a paradigm shift from “Debtor in Possession” to “Creditors in Control” regime with creditors exercising timely control in the event of a default in the repayment of any debt (including inter­est). The new Code along with changes in the RBI Act gives lenders the ability to roll out the resolution process with­out any discrimination or fear of being questioned, which could also change the behaviour of borrowers by severely limit­ing their ability to withdraw from the resolution process.

Historically, it has been noted that any default by a debtor can occur due to a variety of circumstances such as bad business decisions, poor long term strategy, over-leveraging of the business, economic environment/ circumstances etc., however, one of the most pernicious ways in which a default can occur is when the borrowed funds are fraudu­lently either misused or diverted. Some innovative fraud schemes to divert/siphon funds that we have seen, have involved repaying loans from connected parties or banks where there are personal guarantees, clearing balances with pre­ferred suppliers, or sorting out directors’ loan accounts, etc.

1. Verification of claims (Sections 18, 39)
Forensic review of creditors’ claim to identify any potential inflated or fictitious claims including background checks
Monitor the assets of the corporate debtor and manage its operations
(Sections 18, 35)
Forensic review of business transactions during the insolvency phase to ensure objectivity and fairness and identify potential indicators of diversion or siphoning of funds
3. Committee of creditors (Section 18) Identify potential conflict of interest situations in constitution of CoC with conducting background checks
4. Related parties (Section 21) Background checks, forensic review of transactions to identify the disclosed/undisclosed related parties
5. Preference transactions (Section 43) Data analytics, forensic review of transactions to identify potential preferential transactions and quantify the financial impact
6. Undervalued transactions (Section 45) Forensic review of transactions to identify potential undervalued transactions and quantify the financial impact including independent assessment of comparative prices/value
7. Extortionate credit transactions (Section 50) Forensic review of banking facilities to identify potential extortionate credit transactions and quantify the financial impact
8. Fraudulent or malicious initiation of proceedings (Section 65) • Assistance to National Company Law Tribunal (NCLT) to identify indicators of malicious or fraudulent transactions through forensic review of books of accounts to establish potential diversion or siphoning of funds to defraud creditors
• Assistance in dispute advisory

Under the new Code, the entire insolvency and bankruptcy process will be driven by a qualified Insolvency Professional (IP) i.e. a licensed profes­sional who is appointed by Insolvency Professional Agencies and certified by the Insolvency and Bankruptcy Board of India (IBBI) to act as a Resolution Professional or Liquidator. As a result, an IP has onerous responsibilities and drives/ oversees the entire insolvency and bankruptcy process. This is evident from the fact that the board of directors are suspended during the insolvency process and the IP practically becomes akin to the CEO of the entity for all decision-making purposes. The IBBI has been mindful of the past behaviour of Indian borrow­ers while drafting responsibilities of an IP under the Code and has specifically included clauses to ensure that the insol­vency resolution process is able to protect the interest of the creditors. By including several provisions on potential fraudulent transactions, IPs are expected to unearth such transactions and report them to the adjudicating authority. A snapshot of some of the specific provisions of the Code related to fraud and responsibility of the IP is in the table below.

In order to do justice, with the spirit of the Code, an IP has to be equipped with investigative skills or be supported by forensic accounting experts. Such experts can add tremendous value to the entire insolvency process by ensuring that the involved parties don’t operate in bad faith. Forensic/investigative tech­niques such as data analytics, computer and mobile analysis, market intelligence, social media filtering can help provide qualitative information to IPs, which could help them proactively identify some of the potential issues/ red flags, thereby protecting the interest of the relevant stakeholders. Be it, by tracing the end use of funds, identifying undis­closed conflicts of interest, inflating financial statements through round trip­ping, creating preferential interest of the borrower through fraudulent transac­tions etc., forensic accountants are best placed to help insolvency professionals and other stakeholders, including the NCLT, to build greater confidence in the fairness of the entire process.  

While erstwhile laws and processes dealing with insolvency and bankruptcy proceedings may be perceived to be fragmented and therefore perhaps not as successful, however, the IBC is considered to be a milestone in a posi­tive direction. Its success or failure will, however, depend a lot on how effectively the relevant stakeholders (government., banks, NCLT, IPs, etc) implement the law in spirit. In particular, since the IP will steer the entire process of insolven­cy, they will be instrumental in driving effectiveness of the ultimate objectives of the law. The road ahead for IPs are laden with responsibilities and challenges which demand requisite skill sets includ­ing forensic/investigative skills to do justice to the role in entirety. The expec­tations are high from what is believed to be a step towards ease of doing business in India.

About the authors: KV  Karthik is Partner – Foren­sic, Financial Advisory and Rohit Goel is Director – Forensic, Financial Advisory, Deloitte Touche Tohmatsu India LLP

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