Altman Z-Score

A slew of unforeseen corporate failures in India has brought to the fore the need for a reliable bankruptcy indicator.

 

Multiple companies – Jet Airways, Videocon, and Reliance Communications, to name a few – have crumbled into insolvent pitcher plants, seemingly from positions of strength. Jet Airways, for instance, had a market share of 13.9% in November 2018, second only to IndiGo Airlines, before it went belly up earlier this year.

 

Further, the debt of companies such as travel major Cox & Kings and Dewan Housing Finance Limited had healthy long-term ratings, with very low-to-moderate risk of non-payment, before they ultimately defaulted.

 

In hindsight, it appears that their financial strengths were merely an accounting facade, and credit rating agencies have been caught napping.

 

There is a need, therefore, to evaluate companies on an academically proven parameter that is consistent across jurisdictions. One such time-tested early warning system for corporate distress is the Altman Z-Score.

 

A brief history

Edward Altman, in 1968, introduced the Altman Z-Score as part of a scholarly article published in the Journal of Finance. Altman, currently professor emeritus of finance at New York University’s Stern School of Business, analysed companies based on five financial ratios.

1. Liquidity: the availability of financial assets that can be quickly converted to cash.

2. Solvency: a measure of the assets possessed by a company that will help in meeting its long-term debts.

3. Profitability: an indicator of a firm’s ability to sustain its profits in the long-run.

4. Leverage: how much capital comes in the form of debt?

5. Activity: how effectively a firm uses its operating assets to convert them into sales or cash.

 

In a subsequent paper in 2002, Altman examined 86 distressed companies from 1969-’75, 110 bankrupt companies from 1976-’95, and 120 bankrupt companies from 1997-’99. The Z-Score had an astonishingly high accuracy of 82%-96%.

The methodology rose to prominence during the 2008 financial crisis when it successfully predicted corporate defaults that ultimately led to the bust of Lehman Brothers.

The Z-Score

Here is how a company’s Z-Score is calculated:

Z-Score (Z) = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = Working Capital/Total Assets

B = Retained Earnings/Total Assets

C = Earnings Before Interest and Taxes/Total Assets

D = Market Value of Equity/Total Liabilities

E = Sales/Total Assets

The score translates to the financial state of a company as follows;

Z - Score	Corporate Distress
Z < 1.81	Distress zone (High probability of bankruptcy)
Z is between 1.81 and 2,99	Grey zone (moderate chance of bankruptcy)
Z > 2.99	Safe zone (negligible chance of bankruptcy)

Indian context

Does the Z-Score work in the Indian context? Let us undertake an analysis of a few stocks.

The stocks selected are either on the verge of bankruptcy or under tremendous financial stress. To avoid any confirmatory bias; every stock is being put under the scanner based on their annual reported financial figures as of March 2018 – well before their troubles started making headlines.

1. Infrastructure Leasing & Financial Services: IL&FS, which lent to infrastructure companies, was the harbinger of India’s shadow banking crisis. In September 2018, the company defaulted on its payments, which spelt trouble for its many investors, which included banks, insurance companies, and mutual funds.
   Z-Score = 1.2*(-0.254) + 1.4*(-0.031) + 3.3*(0.073) + 0.6*(0.071) + 1*(0.352) = 0.29

2. Dewan Housing Finance Ltd: DHFL has been a victim of the double whammy of a liquidity crunch and financial irregularities. In June this year, the company delayed interest rate payments, which hit mutual funds that had lent to it. Initially, its troubles were considered a casualty of the IL&FS crisis, but lately, after a forensic audit, massive irregularities by promoters have been highlighted.
   Z-Score = 1.2*(0.939) + 1.4*(0.082) + 3.3*(0.089) + 0.6*(0.164) + 1*(0.101) = 1.73

3. Cox & Kings: The travel and tourism company is undergoing insolvency proceedings after it defaulted numerous times on its loans this year due to a liquidity crisis. The International Air Transport Association has terminated its licence to sell air tickets.
   Z-Score = 1.2*(0.167) + 1.4*(0.297) + 3.3*(0.091) + 0.6*(0.621) + 1*(0.595) = 1.88

4. Reliance Communications: The Anil Ambani-led Reliance Group company’s plight is one of the many high-profile bankruptcy cases in India. The telco was plagued by intense price wars, ballooning debt, and plunging profitability. In March this year, Anil Ambani nearly faced a jail term for non-payment of dues to equipment maker Ericsson.
   Z-Score = 1.2*(-0.094) + 1.4*(0.019) + 3.3*(0.002) + 0.6*(0.084) + 1*(0.062) = 0.03

5. Adlabs Entertainment: The owner of the Adlabs Imagica theme park, has been struggling to pay off its loans after it took up massive debt while constructing hospitality-based assets. Its loans were declared as non-performing assets in June 2018.
   Z-Score = 1.2*(-0.084) + 1.4*(0.193) + 3.3*(-0.018) + 0.6*(0.349) + 1*(0.142) = 0.46

From the above computations, it can be deciphered that the Z-Score is significantly effective and accurate at predicting corporate bankruptcies across sectors.

 

(Courtesy - Vatsal Bhandari, qz.com) 

Contradictory judgements & Fundamental Right of Equality

Recently, I came across some contradictory judgements of the same bench of NCLAT, which are as follows;

Situation 1. Filing  Claim in  Guarantor’s CIRP (Maturity of claim - invocation of guarantee). 

The question here was whether a creditor can file a claim in the CIRP of  Corporate Guarantor, without invoking guarantee, in other words when the claim has not matured.

NCLAT (14.08.2018) In the matter of Export Import Bank of India and Ors. Vs. RP JEKPL Pvt. Ltd. and Ors. [CA No. 304 of 2017, 16 of 2018 and 302 of 2017]  

 # 53 …………. Any person who has the right to claim payment, as defined under Section 3(6), is supposed to file the claim whether matured or unmatured. The question as to whether there is a default or not is not to be seen.

 # 54. Therefore, stand taken by the respondents that the claim has not been matured cannot be ground to reject the claim.

 # 56. Therefore, we hold that maturity of claim or default of claim or  invocation of guarantee for claiming the amount has no nexus with filing of claim pursuant to public announcement made under Section 13(1)(b) r/w Section 15(1)(c) or for collating the claim under Section 18(1)(b) or for updating claim under Section 25(2)(e).

NCLAT (23.04.2019) Edelweiss Asset Reconstruction Company Limited  Vs Orissa Manganese and Minerals Limited & Ors.[CA (AT) (Insolvency) No. 437, 438, 444,500 of 2018] 

 # 26. It is also not the case of the Appellant- ‘Edelweiss Asset Reconstruction Limited’ that it has not received the amount from the ‘Principal Borrower’ on default and, therefore, it was liable to invoke the Bank Guarantee which it invokes. In this background, the claim having not matured in absence of alleged default on the part of the ‘Principal Borrower’ and for non-invocation of the Bank Guarantee, the Appellant- ‘Edelweiss Asset Reconstruction Limited’ claim cannot be accepted the debt payable by the ‘Corporate Debtor’ as on the date of the admission (initiation of Corporate Insolvency Resolution Process’).

Situation 2. Filing for  insolvency of Principal Borrower & Corporate Guarantor by the same Financial Creditor.

Question here was whether a financial creditor can file application U/s 7, against Corporate Debtor & Corporate Guarantor, simultaneously. As per sub-section (2) of section 60, of the Code, a creditor can file an application relating to the insolvency resolution or liquidation of a corporate guarantor, during the pendency of  CIRP or liquidation proceeding of a corporate debtor.

NCLAT (18.04.2018) State Bank of India Vs. D. S. Rajender Kumar [CA (AT) (Insolvency) No. 87 to 91/2018] 

- #5……….. However, it is made clear that order of ‘Moratorium’ will be applicable only to the proceedings against the ‘Corporate Debtor’ and the ‘Personal Guarantor’, if pending before any court of law/Tribunal or authority but the order of ‘Moratorium’ will not be applicable for filing application for triggering ‘Corporate Insolvency Resolution Process’ under Sections 7 or 9 or 10 of the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as “I&B Code”) against the ‘Guarantor’ or the ‘Personal Guarantor’ under Section 60(2).

NCLAT (08.01.2019) in Dr. Vishnu Kumar Agarwal  Vs  M/s. Piramal Enterprises Ltd [CA (AT) (Insolvency) No. 346 of 2018]

- #32. There is no bar in the ‘I&B Code’ for filing simultaneously two applications under Section 7 against the ‘Principal Borrower’ as well as the ‘Corporate Guarantor(s)’ or against both the ‘Guarantors’. However, once for the same set of claim application under Section 7 filed by the ‘Financial Creditor’ is admitted against one of the ‘Corporate Debtors’ (‘Principal Borrower’ or ‘Corporate Guarantor(s)’), second application by the same ‘Financial Creditor’ for same set of claim and default cannot be admitted against the other ‘Corporate Debtor’ (the ‘Corporate Guarantor(s)’ or the Principal Borrower’). Further, though there is a provision to file joint application under Section 7 by the ‘Financial Creditors’, no application can be filed by the ‘Financial Creditor’ against two or more ‘Corporate Debtors’ on the ground of joint liability (‘Principal Borrower’ and one ‘Corporate Guarantor’, or ‘Principal Borrower’ or two ‘Corporate Guarantors’ or one ‘Corporate Guarantor’ and other ‘Corporate Guarantor’), till it is shown that the ‘Corporate Debtors’ combinedly are joint venture company.

Situation 3. Distribution of funds under resolution plan approved by the CoC.

The question here is whether CoC is empowered to decide the distribution of funds under resolution plan amongst ‘Financial Creditor’ or ‘Operational Creditor or ‘Secured Creditor’ or ‘Unsecured Creditor’ and whether the same can be adjudicated by NCLT / NCLAT.

NCLAT (02.05.2018) in  Darshak Enterprise Pvt. Ltd. Vs.Chhaparia Industries Pvt. Ltd. & Ors.[Company Appeal (AT) (Insolvency) No. 327 of 2017]

- # 6. ………………………..In a particular case, what should be the percentage of claim amount payable to one or other ‘Financial Creditor’ or ‘Operational Creditor or ‘Secured Creditor’ or ‘Unsecured Creditor’ can be decided by the Committee of Creditors based on facts and circumstances of each case. In absence of any discrimination or perverse decision, it is not open to the Adjudicating Authority or this Appellate Tribunal to modify the plan.

SCI (05.02.2019) in  K. Sashidhar :Vs. Indian Overseas Bank & Ors.(Civil appeal no..10673 of  2018)

- # 61. ………………Concededly, if the objection to the resolution plan is on account of infraction of ground(s) specified in Sections 30(2) and 61(3), that must be specifically and expressly raised at the relevant time. For, the approval of the resolution plan by the CoC can be challenged on those grounds. However, if the opposition to the proposed resolution plan is purely a commercial or business decision, the same, being nonjusticiable, is not open to challenge before the Adjudicating Authority (NCLT) or for that matter the Appellate Authority (NCLAT).

NCLAT (04.07.2019) in Standard Chartered Bank Vs. Satish Kumar Gupta, R.P. of Essar Steel Ltd. & Ors.[Company Appeal (AT) (Ins.) No. 242 of 2019] 

- # 200. In view of the aforesaid observations, instead of rejecting the ‘Resolution Plan’ submitted by ‘ArcelorMittal India Pvt. Ltd.’, we modify the plan to safeguard the rights of the ‘Operational Creditors’ and other ‘Financial Creditors’. The impugned order dated 8th March, 2019 stands modified to the extent above.

From the above cases, it can be observed that NCLAT, not only had passed the contradictory judgements, but in situation 3, it had disregarded the law laid down by the Hon’ble SCI in its judgement dated 05.02.2019 quoted supra above. Probably it has lost sight of provisions of the Constitution of India & The Doctrine of “Per Incuriam”.

Constitution of India

As per Article 141 of The Constitution of India, the law laid down by the Hon’ble Supreme Court of India is binding on all courts in India. 

# Article 141. The law declared by the Supreme Court shall be binding on all courts within the territory of India.

The Doctrine of “Per Incuriam”.

i). Constitution Bench of Hon’ble SCI in Union of India v. Raghubir Singh [(1989) 2 SCC 754], observed as under:

-"The doctrine of binding precedent has the merit of promoting certainty and consistency in judicial decisions, and enables an organic development of the law, besides providing assurance to the individual as to the consequence of transactions forming part of his daily affairs. And, therefore, the need for a clear and consistent enunciation of legal principle in the decisions of a court."

ii). Hon’ble SCI  in Government of A.P. and Another v. B. Satyanarayana Rao (dead) by LRs. and Others [(2000) 4 SCC 262], observed as under:

- "The rule of per incuriam can be applied where a court omits to consider a binding precedent of the same court or the superior court rendered on the same issue or where a court omits to consider any statute while deciding that issue."

Another important question arises, whether the contradictory judgements do infringe the “Fundamental Right of Equality” of the individuals (any of the litigant) guaranteed under Article 14  the constitution of India.

Article 14. Right to Equality The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India.

I request the seniors in the legal fraternity to examine the issue for remedial measures, including filing of PIL with Hon’ble SCI & to devise a framework to prevent these situations in the future.

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.

IIIP of ICAI & “Doctrine of Double Jeopardy”

Code (IBC) provides an elaborate system of inspection, investigation of complaints & disciplinary procedures for service providers, stakeholders & other participants involved in insolvency/liquidation processes. Besides the Board (IBBI), Bye-Laws of an Insolvency Professional Agency (IPA) empowers IPA to issue show cause notice & take disciplinary action against its professional members.

In the present context lets analyse the disciplinary action taken by the Board & IIIPI in the matter of Mr. Vasudeo Agarwal.

Chronology of events 

1. Action at the Board (IBBI) Level.

- Board issues show-cause notice (SCN) to Mr. Vasudeo Agarwal on 28.07.2018.

- Mr. Vasudeo Agarwal, responded to the SCN vide letter dated 16.08.2018

- Mr. Vasudeo Agarwal, appeared for personal hearing along with the learned Advocate, Mr. Alok Dhir, before the Disciplinary Committee constituted by the Board on 23.10.2018 and made oral submission.

- Disciplinary Committee constituted by the Board vide orders dated 07.01.2019, imposed on Mr. Agarwal  monetary penalty equal to one hundred percent of the total fee payable to him as IRP and as RP in the CIRP of Upadan Commodities Private Ltd.

2. Action at the IIIPI Level.

- IIIPI, based on the orders of DC of IBBI, issued SCN dated 01.07.2019. 

- Mr. Vasudeo Agarwal replied to the SCN of IIIPI, vide letter dated 9th July, 2019, and availed the opportunity for personal hearing before the Disciplinary Committee constituted by the IIIPI on 23rd October, 2019.

- Disciplinary Committee constituted by the IIIPI, on 17.12.2019 passed the following orders;-

“# 2.0 ……………  The Disciplinary Committee of IIIPI issued SCN to respondent , based on the order passed by the IBBI in respect of his role as an interim resolution professional (IRP) or resolution professional (RP) in corporate insolvency resolution process (CIRP) of Upadan Commodities Private Limited…….

# 4.0  Taking an overall view of the aforesaid, the Disciplinary Committee, in exercise of the powers conferred under Regulation 24(1) (c) of the Insolvency and Bankruptcy Board of India (Model Bye-Laws and Governing Board of Insolvency Professional Agencies) Regulations, 2016 read with clause 15(B) of the Disciplinary Policy of IIIPI, hereby issues a warning and advise Respondent to exercise due caution and be more careful while handling any assignments".

In the above matter of  Mr. Vasudeo Agarwal  was penalized twice, firstly by the Board & later on by the  Insolvency Professional Agency. The question here is whether the “Doctrine of Double Jeopardy” is not applicable for disciplinary proceedings under IBC,2016.

“Doctrine of Double Jeopardy”

Article 20(2) of “Constitution of India” provides that no person shall be prosecuted and punished for the same offence more than once. It has been enshrined as a part of the “Fundamental Rights” under Part III, of the “Constitution of India”.

# Article 20(2) No person shall be prosecuted and punished for the same offence more than once.

This issue has another aspect also. Let’s look at the relevant provisions of Bye Laws of IIIPI & Disciplinary Policy of IIIPI.

Disciplinary Policy of the Indian Institute of Insolvency Professionals of ICAI (IIIPI)

# 15. Orders by Disciplinary Committee 

1. On consideration of documents available on record and after affording an opportunity of hearing to the complainant and the professional member, where, the Committee holds that the professional member is not guilty of misconduct, the Committee shall dispose of the show-cause notice by recording reasons in writing within thirty days of passing such order in writing and may also impose cost on the complainant, if the Committee is of the opinion that the complaint was frivolous.

2. However, if the member is found guilty of major or minor misconduct as detailed in Section 12, after considering the case in issue, the Disciplinary Committee may pass any of the following order, as it deems reasonable in view of the seriousness of the breach of the Code of Conduct:

# 15 A. Penalties for Major Misconduct may extend to:

a. Monetary penalty of not less than Rs.10,000/- upto a maximum amount of Rs.50,000,

b. Suspension from practice for a specific term which may not be less than 15 days up to a maximum period of 10 Years as decided by the Committee,

c. Removal from membership, or

d. Reference of the matter to the Board, which may include ,in appropriate cases, recommendation of the amount or compensation that may be enforced by the Board,

e. Directions relating to costs,

f. A combination of the above or other appropriate penalty, as determined by the Committee.

Bye Laws of the Indian Institute of Insolvency Professionals of ICAI (IIIPI)

# 24. (1) IIIPI shall have a Disciplinary Policy, which shall provide for the following-

(a) the manner in which the Disciplinary Committee may ascertain facts;

(b) the issue of show-cause notice based on the facts;

(c) disposal of show-cause notice by a reasoned order, following principles of natural justice;

(d) timelines for different stages of disposal of show cause notice; and

(e) rights and obligations of the parties to the proceedings.

(2) The orders that may be passed by the Disciplinary Committee shall include-

(a) expulsion of the professional member;

(b) suspension of the professional member for a certain period of time;

(ba) cancellation of authorisation for assignment;

(c) admonishment of the professional member;

(d) imposition of monetary penalty;

(e) reference of the matter to the Board, which may include, in appropriate cases, recommendation of the amount of restitution or compensation that may be enforced by the Board; and

(f) directions relating to costs.

From the provisions of Bye Laws of IIIPI & Disciplinary Policy of IIIPI, it is clear that wherever the Disciplinary Committee of IIIPI is of the opinion that penalty more / other than as provided in the Bye Laws is required to be imposed, the DC will pass orders for reference of the matter to the Board (IBBI). 

Further, if the  DC constituted by the Board (IBBI) is of the opinion that penalty more / other than as provided in the  sub-section (2), (3) & (4) of section 220 should be imposed, the DC constituted by the Board (IBBI will pass orders for reference of the matter to the Board (IBBI) to take any action under sub-section (5) of section 220 or sub-section (2) of section 236. (Regulation 13(1)(d) of “Insolvency and Bankruptcy Board of India (Inspection and Investigation) Regulations, 2017”)

From the above it is quite clear that once an issue has been considered by the DC constituted by the Board, the matter goes beyond the purview of consideration of the IPA (Insolvency Professional Agency). 

Thus in the aforesaid cases, SCN issued by IIIPI, was beyond the authority of IIIPI & was in infringement of the concerned IP’s  “Fundamental Rights” enshrined under Article 20(2) of the Constitution of India.

Reference;-

1.  Bye - Laws of Indian Institute of Insolvency Professional of ICAI (IIIPI).

2.  Disciplinary Policy of the Indian Institute of Insolvency Professionals of ICAI (IIIPI).

3.  Insolvency and Bankruptcy Board of India (Inspection and Investigation) Regulations, 2017.

4.  eBook "Offences & Penalties in IBC" by Arvind Mangla, a publication of Amazon Kindle Store.

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.