CORONAVIRUS: TURNING HEALTHY COMPANIES INTO “ZOMBIE COMPANIES”?
The Coronavirus (“COVID-19”) pandemic has adversely impacted the global economy. Business houses and companies have been affected on a large scale. On June 5, 2020, the Union Government of India, to avoid a large number of corporate insolvencies and to alleviate the distressed state of companies affected by the pandemic, promulgated1 the Insolvency and Bankruptcy (Amendment) Ordinance, 2020 (“Ordinance”) and inserted Section 10A to the Insolvency and Bankruptcy Code, 2016 (“IBC”) which has suspended the operation of certain provisions of the IBC.
The enactment of Section 10A has resulted in the suspension of Sections 7, 9, and 10 of the IBC, which means that no insolvency proceedings can be initiated against the Corporate Debtor by the Financial Creditors (under Section 7), Operational Creditors (under Section 9), or by the Corporate Debtor himself (under Section 10).
In September 2020, the Parliament enacted2 the Insolvency and Bankruptcy (Second Amendment) Act, 2020 (“Amendment Act”) and repealed the Ordinance whilst keeping the same provisions. Furthermore, the Ministry of Corporate Affairs vide a recent notification3 dated December 22, 2020, has extended the suspension of the aforesaid Sections for another three months i.e. until March 25, 2020.
Albeit the suspension gives considerable relief to some of the companies, however, it has led to economic predicaments as it is encumbering the growth of businesses in the market. Every company has to follow a natural course of action when it is unable to run its business with sufficient profits in a healthy manner or when its debts exceed its assets on the balance sheet. This natural course consists of two methods, the first method would be to restructure the company to pay off the debts while maintaining the status quo and the other method would be to proceed into liquidation and winding up of the company.
Through the enactment of this Amendment Act, the government has obstructed this natural process by suspending the insolvency laws which has a long-lasting impact on the economy. In such volatile times like these, it is a paramount task to identify the non-viable market players, i.e. the companies and businesses, and provide them with an option to proceed with either of the two methods as discussed above to ensure the smooth functioning and de-congestion in the market.
In a recent interview with CNBC4, the former RBI Governor and Professor of Economics at the University of Chicago, Dr. Raghuram Rajan, has also highlighted the repercussions of suspending the insolvency laws. He argues that putting the companies on life support will only increase the number of “Zombie Companies” in the market as they have been prohibited from availing the recourse to the natural process of liquidation and restructuring.
This article examines the Amendment Act and the legal issues in relation to the suspension, and further highlights the approaches to insolvency taken under different jurisdictions. Furthermore, it makes a critical analysis of how suspending the insolvency proceedings is leading to the rise in the number of “Zombie Companies” in India and the other examined jurisdictions.
A “Zombie Company”5 can be defined as any corporate entity (including LLPs and partnership firms) that is not able to meet its liabilities and pay off its debts when they are due. It does not generate enough cash flow to pay off the debts completely but only generates sufficient cash flow to continue mere existence by paying the interests on the debts. These companies are neither alive nor dead, and they do not possess any potential to come out of this vicious debt cycle.
The term can trace its origins to the onset of the economic crisis of the Japanese Asset Price Bubble in 19866 wherein the staggering low-interest lending by the banks led to an exponential rise in the number of companies which were unable to generate revenue and such companies, consequently, stagnated the whole economy. Thus, such companies, on account of their inability to meet their financial interests and the surrounding unhealthy financial conditions, were termed as “Zombie Companies”.
Economists Caballero, Kashyap, and Hoshi in their 2008 paper published in the American Economic Review7, have argued that the presence of zombie companies imposes a tax on the healthy companies, who suffer a loss in profitability and growth prospects, impacting the aggregate growth of the economy. COVID-19 has led to an unprecedented upsurge in these zombie companies, adding more to the existing mounting heap of the zombie companies, taking an even greater toll on the financial health of the economy.
SUSPENSION OF INSOLVENCY AND BANKRUPTCY PROVISIONS
The Amendment Act suffers from certain ambiguities. It suspends any insolvency proceedings for the defaults arising on or after March 25, 2020, for an indefinite period of time. A proviso of Section 10A states that, “No application shall ever be filled for the initiation of corporate insolvency resolution process of a corporate debtor for the said default occurring during the said period.” This suggests that the creditors can never file an application for the recovery of debts pertaining to the defaults committed during the specified period.
Similar suspension of insolvency laws has been implemented by other countries as well. For instance, Germany has completely prohibited8 the filing of fresh insolvency applications against any company. It has further amended the laws to allow consumers and small businesses to postpone their contractual performances on account of COVID-19. Belgium9 and Russia10 have also enacted similar laws and they have suspended their insolvency proceedings by providing a long term moratorium on all activities related to bankruptcy, liquidation, and execution of companies. France11, Spain12, Italy13, The Czech Republic14, Poland15, among others countries, have also suspended their insolvency laws for the same purpose.
CONSEQUENCES FOR INDIAN LENDERS AND THE ECONOMY
The Amendment Act has placed lenders and creditors in a challenging situation as they are restrained from proceeding with the recovery of their debts under the insolvency and bankruptcy laws. This is directly affecting the right of the creditors to recover their debts owed to them by the debtors, thereby creating a situation of economic tension. The suspension of insolvency provisions is the primary reason why companies are turning into zombie companies, as opposed to what would occur in the normal circumstances, because the companies cannot resort to the remedy of restructuring the company nor file for insolvency due to the suspension of such provisions.
The suspension has also enabled the companies which were already zombie companies, due to their consistent business losses prior to the lockdown, to stay alive. Such pre-existing zombie companies16 were not affected by the pandemic in any way as they were already on the cusp of going into liquidation. Such companies are neither dead nor alive and they have been put on life support by virtue of the relaxations and suspension of certain laws provided by the government. It is detrimental to the economy and the financially healthy companies due to the congestion created by the zombie companies in the market.
In times like these, it is incumbent upon the government to devise a plan to identify the zombie companies and to save the companies that are slowly turning into zombie companies, and further causing economic disruption in the market.
GLOBAL RISE OF ZOMBIE COMPANIES: DIRECT CONSEQUENCES OF SUSPENDING INSOLVENCY LAWS
The Bank of International Settlements17 published a crucial paper in 2018 written by Sr. Economists Dr. Ryan Banerjee and Boris Hofmann wherein they studied 14 advanced economies in order to understand the rise of zombie companies, and the grave consequences caused by such zombie companies. In the study, they found that the number of companies showing symptoms attributable to a zombie company had been increasing since the early 1990s, and it had reached 12% of all the listed non-financial firms among the examined economies by the year 2016. The zombie companies severely affect the growth prospects of healthy companies as they generate congestion in the market, resulting in the diversion of business from healthy companies. This congestion also creates a barrier to entry for the new prospective healthy companies.
The USA, UK, and Germany are experiencing a rise in the formation of zombie companies due to the pandemic. It is estimated that in this year, the US government’s debt has reached 131%18 of the annual economic output compared to last year, and 20%19 of all the US companies have turned into zombies companies. The former Deutsche Bank Chief Economist, Mr. Torsten Slok stated that the Federal Reserve and the US government “are interfering in the process of ‘creative destruction’.”20 He further added that the companies are being kept alive which would have otherwise gone out of business. In the UK, a leading financial expert, Begbies Traynor Group in their recent analysis of the market, reported that, “527,000 businesses are in ‘significant’ financial distress”21 despite utilizing all possible means to save the companies. Similarly, Germany’s decision to suspend the insolvency laws to rescue the companies has culminated in a total failure, and now on account of the rapid increase in the number of zombie companies (around 550,00022), the German Finance and Legal Ministries23 are reconsidering their decision of further extending such suspensions.
WHAT INDIA CAN LEARN FROM THE US, UK, AND GERMANY
These countries have reported a spectrum of zombie companies which is very alarming for their own economies as well as the global economy. India is already considered to be the hub of zombie companies in Asia with 617 zombie companies according to a report in 2018.24
Furthermore, like other countries, India has also implemented similar measures by suspending the insolvency proceedings against the defaulting companies during the pandemic. The measures adopted and imposed in the examined jurisdictions have failed to meet their objectives of reviving the companies and it has instead resulted in suffocating the financially healthy companies, thereby adding to the already mounting heap of zombie companies, as well as the whole economy. It is, therefore, imperative to take into account the outcome of such measures and reconsider whether it would be prudent to enforce them in the Indian context.
On this point, the Japan economic crisis also serves as a cautionary tale to reconsider the decision of continuing with the suspension of the insolvency laws or any such decision which leads to the creation of zombie companies as it will have a drastic long-lasting impact on the economy.
Several economists and legal experts including the Former Chief Economic Advisor Arvind Subramanian25 have expressed strong concerns over the suspension of insolvency laws and the inadequacy of relief packages, thereby stressing upon the importance of eliminating the zombie companies to save the economy from stagnation. It is the need of the hour for India to kill off the living dead and let the healthy companies survive, because otherwise, the healthy companies will also inevitably turn into zombie companies.
In conclusion, this is a vital issue which requires prompt action from the government and the concerned authorities. The Coronavirus has “infected” the financially healthy companies and turned them into zombie companies. Suspending the insolvency provisions may only serve to exacerbate this issue. The experts suggest that a proactive approach is required, whereby it would be more useful to bring changes to the current mechanism of dealing with the pandemic and the insolvency aspect on the financial front. The government should come up with new policies to counter the issue of zombification of companies in India and further reconsider its decisions of suspending the insolvency laws without undermining the rights of the creditors.
The government must devise new policies and strategies to provide incentives and encourage investment in productive companies to maintain a steady economy. The government may also provide for a reduction in the stipulated time for the insolvency proceedings to expedite the resolution process, and further establish an out-of-court hybrid framework for debt recovery through informal negotiations with financial institutions and creditors. Thus, a rigorous policy and framework are required to be implemented, which would specifically deal with the issues of insolvency, debt recovery, and the zombification of companies in India under the prevailing circumstances.
1 The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2020, available at http://www.mca.gov.in/Ministry/pdf/IBCAmedBill_05062020.pdf.
2 The Insolvency and Bankruptcy Code (Second Amendment) Act, 2020, available at http://www.mca.gov.in/Ministry/pdf/IBCAmedBill_24092020.pdf.
3 Government Notification, Ministry of Corporate Affairs, available at https://ibbi.gov.in/uploads/legalframwork/df55d4f612f270d6c637ee4b3c8131c8.pdf.
4 Propping up zombie companies will create more zombies: Former Reserve Bank of India governor, available at https://www.youtube.com/watch?v=gPblOqcFZrw.
5 What is a zombie company? Definition and Meaning, available at https://marketbusinessnews.com/financial-glossary/zombie-company/.
6 Ricardo J. Caballero, Takeo Hoshi, and Anil K Kashyap, Zombie Lending and Depressed Restructuring in Japan, available at https://economics.mit.edu/files/3770.
8 Mohd. Ali Khan and Urvashi Shahi, Impact of COVID-19 on Global Insolvency Regimes, available at https://iica.nic.in/images/Impact_of_Covid-19_on_Global_Insolvency_Regimes.pdf.
9 Impact of COVID-19 on Insolvency Laws: How Countries Are Revamping Their Insolvency and Restructuring Laws to Combat COVID-19, available at https://www.restructuring-globalview.com/wp-content/uploads/sites/21/2020/04/COVID-19-Impact-of-Global-Insolvency-Laws-29.04.20.pdf.
11 COVID-19: The adaptation of French bankruptcy law to the crisis, available at https://www.dentons.com/en/insights/alerts/2020/march/30/covid-19-firm-in-difficulty.
12 An International Guide to changes in Insolvency Law in response to COVID-19, available at https://www.dlapiper.com/~/media/files/insights/publications/2020/06/an-international-guide-to-changes-in-insolvency-law-in-response-to-covid-19—updated-1-july.pdf.
16 Sinead McIntosh, UK: Judgment Days Ahead For Zombie Companies, available at https://www.mondaq.com/uk/operational-impacts-and-strategy/946018/judgement-days-ahead-for-zombie-companies.
17 Ryan Banerjee and Boris Hofmann, The rise of zombie firms: causes and consequences, available at https://www.bis.org/publ/qtrpdf/r_qt1809g.pdf.
18 John Mason, Debt Loads Continue To Increase And The Number Of ‘Zombie’ Companies Continue To Rise, available at https://seekingalpha.com/article/4355634-debt-loads-continue-to-increase-and-number-of-zombie-companies-continue-to-rise.
19 Dion Rabouin, “Zombie” companies may soon represent 20% of U.S. firms, available at https://www.axios.com/zombie-companies-us-e2c8be18-6786-484e-8fbe-4b56cf3800ac.html.
20 Will ‘Zombie Companies’ Eat The US Economy?, available at https://www.pymnts.com/economy/2020/will-zombie-companies-eat-the-us-economy/.
21 Ric Traynor, Seven consecutive quarters of rising financial distress leaves 527,000 UK businesses in a precarious position, available at https://www.begbies-traynorgroup.com/news/firm-news/seven-consecutive-quarters-of-rising-financial-distress-leaves-527000-uk-businesses-in-a-precarious-position.
22 Germany haunted by spectre of zombie companies, available at https://www.ft.com/content/5d5d1bc1-61a3-46a9-915c-1a1e6f2e5fd2.
24 Ritwik Mukherjee, India is a top place for zombie companies, available at https://www.asianage.com/business/economy/150819/india-is-a-top-place-for-zombie-companies.html.
25 SA Aiyar, Rescue solvent companies but kill off zombies, available at https://timesofindia.indiatimes.com/blogs/Swaminomics/rescue-solvent-companies-but-kill-off-zombies/.