Essar insolvency ruling risks damage to India debt market

India’s insolvency tribunal has made a dangerous decision. Unless its judgment is quashed, credit costs for India Inc. will surge, shares of state-run banks will swoon and foreign investors will flee.
The case concerns the country’s most high-profile bankruptcy, Essar Steel India Ltd. Insolvency judges recently ruled that creditors whose claims are backed by collateral won’t get preferential treatment in the $6 billion sale of the company’s plant to ArcelorMittal. Secured creditors will stand in line with unsecured creditors.
This isn’t how it works anywhere in the world, and for good reason. In loans backed by collateral, the lender expects to be paid first out of bankruptcy proceeds. That’s why they accept a lower interest rate than unsecured creditors in the first place. For unsecured lenders to receive any of their money back, there must be something left over after paying the
secured creditors.
Of the many twists and turns taken in the Essar bankruptcy, this is the most damaging. India has been attracting foreign distressed-debt specialists to help clean up its $200 billion-plus of bad loans. The ruling, if it survives, may kill that trend.
Under an agreement with the Essar creditors’ committee, ArcelorMittal’s offer would have made secured financial lenders more than 90 percent whole. While that’s a good recovery rate, it’s less than 100 percent, meaning unsecured operational lenders should have had to go empty-handed. In the insolvency judges’ view, though, the committee has no role to play in distributing the sale proceeds. While collateral gives seniority in a liquidation, everyone’s equal in a bankruptcy resolution. Or so the judgment says. As a result, financial creditors will see their take shrivel to 60.7 percent of claims, while that of the operational creditors will swell to the same level.
Those who can expect a bigger share include Standard Chartered Plc, which was complaining about being offered less than 2 percent of its claim after lending to an Essar Steel subsidiary.
Consider the implications for future Indian deals. If a secured creditor sells to a distressed-debt specialist, the investor will have overpaid thinking its claim would get settled first and that it would make, say, 40 cents on a 20-cent investment. That won’t happen if the bounty is to be shared much more widely, restricting the payout to, say, 10 cents.
The Essar saga has already gone on for more than 600 days, when the original legal limit was 270 days. Since billionaire Ruia family that founded Essar didn’t want to cede its crown jewel to ArcelorMittal, an intense legal skirmish was unavoidable. But if India’s 2016 bankruptcy law ends up making matters worse, then the signature reform of Prime Minister Narendra Modi needs an urgent overhaul.

—Bloomberg