Resolution of Bank and Insurance Company Failure

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--By Bharat Raj Upreti
Nepal took initiatives to create the legal infrastructure required for the implementation of economic liberalization policies mostly during 2005-2006. This period saw introduction of the Insolvency Act 2006 and Secured Transaction Act 2006. The legal provisions covering companies’ law and security underwent substantial review and the Companies Act 2006 and Securities Act 2006 were introduced repealing the previous versions. The scattered legal provisions of the banking system were consolidated under the Banks and Financial Institutions Act (BAFIA) 2006. BAFIA 2006 also provided additional power to Nepal Rastra Bank (NRB), the central bank, to take corrective and reformative actions against the banks and financial institutions facing financial difficulties.
Similarly, NRB Act 2002 was amended in 2006 granting even wider power to NRB to take appropriate action against the failing banks and financial institutions. Sections 86 to 86N of the NRB Act 2002 are important provisions dealing with the resolution of failing banks and financial institutions. These provisions do recognize that the nature of business of banks and financial institutions is special, and thus their failure should be resolved differently, outside the general law of corporate insolvency. However, this policy does not cover the liquidation of banks and financial institutions as explained in the following paragraphs.
Why Special Legal Regime for Resolution of Failing Banks and Insurance Companies?
There is need for a separate legal regime for the resolution of failing banks, financial institutions and insurance companies. This different treatment is required for either form of resolution - re-organization or liquidation.There are several reasons, which are summarized below:
Different Nature of Business
i) The nature of business of banks and financial institutions is unique. They hold high liquid liability in the form of deposits on one side and provide long-term loans that may be difficult to sell or borrow against on short notice on the assets side. In normal time, it is not a problem because deposits and withdrawals are subject to large number of depositors and cushion of liquid assets ensure withdrawal in the normal time. Loans will be held until maturity and repaid at face value and bank’s required capitalization covers the risks of loan loss at normal time.
ii) Banks and financial institutions provide financial services, fundamental to the functioning of an economy in the form of direct and standby credit and supply of liquidity to the country’s economy in the form of loan and/or guarantee.
iii) The banks are vulnerable to the loss of public confidence and failing banks create risk to the “good banks”.
Different Objective of Law
Banking insolvency should also be considered in the perspective of primary objectives of the banking law. They are:
i) To ensure stability of the financial system as a whole and prevent systematic problems.
ii) The objective of the revival of the failed bank is to minimize the impact of a bank's failure on the banking system as a whole. But, in cases of insolvency in non-banking sectors, receiver’s primary object is to maximize assets in the interest of creditor.
iii) In addition to the protection of debtors/debtor’s interest, the banking law must consider the public interest.
iv) In certain circumstances, above considerations may justify the distortion of equality rule for creditors: i.e. small depositors and small creditors may be preferred and paid in full while larger depositors may be forced into a renegotiation of their claim. Sometimes, it may be necessary to sell assets into an unfavourable market or sell off business in a manner that does not maximize the value, in order to avoid market disruptions.
For the purpose ofachievingthe above objective, the law grants extensive authority to regulators or supervisors to intervene, take corrective action, or even close the bank where such action fails or is not viable to restore liquidators. 
The objective of the legal regime dealing with the failing banks and insurance companies (especially dealing with life insurance business) is different in many respects from the objective of the general corporate insolvency law regime. While the corporate insolvency law is focused on the protection of creditors, it also incorporates the policy objective of revival of the business.
In case of banks and financial institutions, central banks do have various tools such as taking over the bank and forced merger as a corrective measure. However, in cases where such corrective measures fail or are not desirable due to the financial health of the bank, the insolvency regime for banks is driven by the following policy objectives:
(a) Completion of the liquidation process in a timely manner, and
(b) Without panic or systematic risk to the financial sector, and
(c) Without causing disruption to the businesses which have obtained loan from such banks.
In short, the objective of the legal regime is to protect the system, not the bank. The regulator is the best judge to see if the revival is possible and it is equipped with different alternative instruments—legal as well as financial—which the court does not have.
Popular Models for Resolution of Failing Banks
Comparisons of various legal systems suggest following two models to resolve bank insolvency process:
i) Special rules for bank insolvency procedures that are administered by supervisors or deposit protection agency. This model is in practice in countries like the USA, Canada and Italy.
ii) Rules built on general insolvency framework and administered by bankruptcy court - the European model.
Insolvency Law Regime:Nepal’s Perspective
Laws dealing with the failing banks, financial institutions and insurance companies are scattered in different statutes.For example, the NRB Act 2002 deals with pre-insolvency and re-organization or remedial aspects of failing banks and financial institutions. But it does not deal with the liquidation process of such institutions and thus the general corporate insolvency law applies by default. Similarly, Section 77 of BAFIA 2006 sets the order of priority for settlement of liability of insolvent banks and financial institutions. It overrides the provision made in the general Corporate Insolvency Act 2006, which sets different priorities.
The Insurance Act 1992 deals with certain aspects of failing insurance companies such as revocation of business license as a part of regulatory action. Section 13 of this Act grants such power to the Insurance Board, the regulator of insurance business in the country. Section 18 authorizes the government to appoint a liquidator. Similarly, Sections 16 and 4IB fix the payment priority out of assets of insurance company in liquidation. Since the Insurance Act 1992 does not deal with the liquidation process, the provision of general corporate insolvency law (i.e. the Insolvency Act 2006) will apply in the liquidation of insurance companies.
The Co-operative Act 1992 does not have specific provisions dealing with the insolvency of cooperative institutions but Section 42 of this Act authorizes the Registrar of Co-operatives to appoint a liquidator. Since co-operatives are not incorporated under the Companies Act 2006, the Insolvency Act 2006 does not apply to them.
The Insolvency Act 2006 is the general law on corporate insolvency. It has limited scope and it primarily applies to companies incorporated under the Companies Act 2006.Since all banks and financial institutions are incorporated under the Companies Act, the Insolvency Act 2006 applies in the process of liquidation of such institutions. But experience suggests that many of its provisions are irrelevant and delay the liquidation process.
In view of the provisions made in the NRB Act 2002 and BAFIA 2006, the regulatory actions to be taken against the failing banks and financial institutions by NRB may normally be planned in two stages:
i) Remedial or quasi-insolvency actions
ii) The final action, which is the initiation of formal liquidation proceedings
Remedial or Quasi-insolvency Action
This includes several corrective actions including restriction to declare dividend/take over of management, suspension of board of directors/removal of officers etc. The objective is to encourage early restructuring or resolution of the bank. The central bank can play an important role as a substitute in the re-organization procedure for ordinary insolvency law. This constitutes a component of general insolvency law framework for dealing with problematic banks.
NRB can take several corrective remedial quasi-insolvency actions against failing banks. NRB can order a total management restructuring and capital re-organization, which includes the forced sale of shares owned by promoters. Failing banks’ share capital can be reduced to the value equal to the value represented by its diluted assets, which, for example, may mean the reduction of face value of Rs 100 shares to five rupees. However, the central bank has so far not used this tool, which probably should have been used in past corrective actions. Some of the major actions that can be taken by NRB include:
i) Take over the management by a provisional management team appointed by it
ii) Suspend or dismiss the board of directors and order fresh election for the general member shareholder
iii) Order the provisional management team to sell some of the bank’s assets/or close the loss-making branches.
iv) Transfer the authority of failing bank’s board of directors and/or its shareholders to the provisional management team
v) Stop payment to shareholders and directors in the form of dividends, remuneration or in any other form
vi) Stop the sale of assets or declare moratorium on the enforcement of debt claim
vii) Forfeit the share and sell it to new investors or a team of investors capable of reviving the failing bank or financial institution
viii) Ask the government to form a new bank or financial institution to take over the assets and liabilities of the failing bank
ix) Initiate the liquidation process if NRB is of the view that re-organization is not possible
Liquidation Process
The formal liquidation process of insolvent banks and financial institutions is initiated by NRB under Section 86 C of the NRB Act. This is the final and last-resort action to be taken by NRB against such banks/financial institutions.
NRB puts an application to the Court of Appeal to initiate the process for formal dissolution or winding up. Once NRB applies to the Court, the whole process of liquidation is transferred to the Court and the role of NRB as regulator or the supervisor of the bank or financial institution in liquidation comes to an end. The matter becomes sub judicial. The process enters the regime of Insolvency Act 2006 and the Court follows the procedure prescribed by this Act which is primarily designed to manage the process of insolvent companies primarily operating in manufacturing and non-financial services.
When liquidation is used as a prudential tool, the insolvency regime should allow for liquidation without having to consider for revival. The Insolvency Act does not provide a carve-out in such regulatory actions and therefore currently even banks’ liquidation process is subjected to a two-tiered approach – first an investigation officer is appointed by the court to look at the validity of business and then the court orders liquidation only after receiving recommendation of the investigation officer who does not have the same mandate as that of the central bank. The investigation process under the Insolvency Act in case of liquidation initiated by regulators like the central bank is unnecessary; it defeats the objective of quick resolution of failed banks as adopted by the NRB Act and BAFIA 2006.
General Law on Insolvency
In absence of special laws dealing with the liquidation of banks and financial institutions, general corporate insolvency law applies to them. The Insolvency Act 2006 is the general law dealing with corporate insolvency. It primarily applies to companies incorporated under the Companies Act 2006. It does not apply to other corporate bodies unless Nepal government prescribed such corporate bodies with limited liability to be covered under this Act. So far, Nepal government has not published such notice.It is a new law, which has replaced the provision of Companies Act 2053 BS dealing with the liquidation of companies with limited liability.
The Act is based on the principal of ‘one law, two systems’. It covers both aspects of insolvency law regime dealing with the reorganization and liquidation of insolvent company. It focuses more on reorganization.The liquidation process is initiated only if re-organization is not possible.It gives only the supervisory authority to the court. The Commercial Bench of the Court of Appeal has jurisdiction on such matters.
The whole process of re-organization and liquidation is entrusted to licensed insolvency practitioners by the court. The Act does not envisage permanent office of Government liquidators. Similarly, it does not provide for setting up an office of public trustee to support or to complement the work of private sector insolvency practitioners (such as investigating offices, re-organization mangers or the liquidators). The reorganisation process ordered by the court can be converted into liquidation process on the recommendation of reorganisation manager and vice versa. The Act requires the insolvency process to be completed in three stages. They are:
i) Investigation Phase
It requires the court to appoint an investigation officer if the court is prima facie satisfied that the debtor company is insolvent.
ii) Re-organization Phase
The court examines the recommendation of investigating officer – whether to initiate re-organization process or to go for liquidation. If the court is satisfied with the recommendation for re-organization, it appoints a re-organization manager and if it is not satisfied, it orders for the initiation process along with the appointment of a liquidator.If re-organization process fails, the court appoints liquidators to initiate the liquidation process.
iii) The liquidation Phase
The liquidator takes charge of the free assets and liabilities of the debtor company. It can also function as an interim manager as required for selling the insolvent unit as a going concern.The liquidator has a wide range of power including the avoidance of fraudulent and other transactions such as preferential and/or related transactions.
If the liquidator is satisfied that re-organization of insolvent debtor is possible in view of its existing assets and liabilities, he/she can apply to the court to convert the liquidation process into the re-organization process and appoint re-organization managers.
The Insolvency Act 2006 has come into effect and is in operation for the last eight years but has not been used by the failing corporate's debtors and other stakeholders as a tool for the resolution of the related claims.It has not been effective to provide fair and effective opportunity for a restart and safe exit from the business. There may be many factors responsible for this. 
Some of them are:
i) Some provisions of the Income Tax Act 2058 BS defeat the whole purpose of the Insolvency Act. For example, Section 57 of the Income Tax act does not permit to carry forward the losses if there is change of control. This has been defined as change in ownership of 50 per cent or more in past three years. This obviously creates barriers for re-organization of failing companies.
ii) Blacklisting Directives issued by the central bank also create barrier, defeating the purpose of the Insolvency Act 2006. A borrower is automatically blacklisted on his failure to repay the loan and the lenders initiate recovery action. Similarly, a debtor is automatically blacklisted once the insolvency process is initiated in the court. The blacklisted borrower is totally debarred from access to new money, creating barriers to recognition of rehabilitation.
Looking Forward: Legal Reform
There is no special law dealing with resolution of failing insurance companies.The matter is comparatively serious in case of insurance companies operating life insurance business.
There are more than 30,000 co-operative institutions incorporated under the Cooperative Society Act 2048 BS. Provisions made in the NRB Act and BAFIA to deal with failing banks and financial institution do not apply to such co-operatives though they also deal with public deposits and carry out the lending business. Nepal government can publish the gazette notice to make the provisions of the Corporate Insolvency Act 2006 applicable to such co-operative but this has not yet been done. In view of the fact that these cooperatives also deal with public deposits on a massive scale and there are a large number of complaints against the promoters of such cooperatives, there is an urgent need for the law to deal with the insolvency of these institutions. However, due to the lack of effective regulatory and supervisory mechanism, they have been able to run away with public money.This legal and regulatory gap needs to be bridged through the creation of an effective legal regime with effective regulatory mechanism.
There is a need for harmonization of corporate sector laws such as BAFIA, Insurance Act, Companies Act, NRB directives on blacklisting and laws dealing with government ownership. Also required is reform of laws to remove barriers in doing business, modernization of out-dated personal insolvency laws formulated in 1964, review of the Insurance Act giving required regulatory power to Insurance Board, and formulation of new laws. There has to be arrangement for cross border insolvency as well. Recognition and formulation of informal workouts and arrangement for institutional support and creation of Secured Transaction Registry are also urgently required. We need to set up competent and specialized commercial courts for the effective resolution of commercial disputes, and a new rule dealing with the liquidation procedure of banks and insurance companies should be framed on priority basis. This rule should, among other things, address the following key policy issues:
a. Should the bank supervisor be in-charge of the entire insolvency procedure?
b. Who should be in-charge of the resolution of the bank’s failure?
-  The banking supervisors, or
-  The court under the general insolvency law, or
-  Some form of division of labour between them?
c. regulators/judicial personnel/insolvency practitioners.
Upreti is a former justice of the Supreme Court of Nepal. The article is adapted from a paper he presented at a seminar titled 'Insolvency Law: Local Issues, Global Views' organised by Nepal Insolvency Practitioners' Association in Kathmandu on 8-9 July 2014.

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