Bankruptcy Code and Indian Real Estate
The Indian Bankruptcy Code (IBC) is one of the most important legislation that has been brought into existence by the current Indian government. The IBC was formulated in order to rein in errant promoters.
Prior to the IBC, promoters would take excessive loans against their assets and then flee the country.
The Indian Supreme Court has recently announced that the IBC is also applicable to the Indian Real Estate industry. This has come as a major relief to many homebuyers who were dealing with unscrupulous developers.
This move has been hailed to be consumer friendly by many experts. However, in this article, we will see why this apparently consumer-friendly move may actually end up hurting the interest of consumers.
Background
The Indian real estate sector is plagued with rogue developers. For many years, the sector has been functioning without any major legislation. This is the reason why builders have been able to siphon funds from the sales of one project to other projects.
From a moral point of view, moving the proceeds of sales from project A to project B was embezzlement.
However, since the law did not consider it embezzlement, this practice was rampant. Consumers were facing lots of troubles because of delayed possessions.
However, they did not seem to object since their investment was appreciating.
Finally, the real estate sector witnessed a slowdown. During the aftermath, many developers were found to be bankrupt.
They owed more money to financial institutions and home buyers compared to the total valuation of the project.
Hence, even if they sold everything, they wouldn’t be able to pay off everybody.
Prior to the IBC, financial institutions had the upper hand. Since they were creditors, they had to be paid in full before any money was given to the home buyers.
Now, with the IBC, the home buyers have also been given the status of financial creditors. This means that the senior claim of the bankers and financial institutions has now been diluted and the buyers are now on an equal footing.
The Problem
This decision has been celebrated by home buyers all over the country. However, if we look deeper, there may not really be any cause for celebration.
The IBC focuses on auctioning the assets of the company or selling the entire company as a going concern. The problem with real estate projects is that they are not going concerns.
They have a limited shelf life and a finite amount of cash flow that can be generated from them.
When real estate projects go to IBC, the inflows have already been siphoned off. Hence, given that the outflows are only finite, no new developers would want to pay off the creditors of the earlier developer.
Hence, in such cases, it is likely that the projects that go into IBC may not find a viable buyer at all! If the projects were viable in the first place, the old developer would have completed them.
Why IBC Will Do More Harm Than Good?
As mentioned above, the IBC may give the home buyers temporary relief by making them believe that the banks and builders cartel can’t win by marginalizing their interests.
However, it is likely that there may not be any buyers for the project at all and the money due to all parties may just get stuck in long-term litigation.
Also, sometime the projects may be viable if funds are obtained at lower rates of interests.
However, financial institutions may not be willing to lend at lower rates since their debt will no longer have a more senior claim on the assets.
The bottom line is that troubled real projects need funding and execution in order to be complete. Neither the bank nor the new developer will be willing to take over the project unless they stand to make certain profits.
What Should Buyers Do?
The Supreme Court has taken a populist decision. Most consumer activists want to make the developers more accountable.
However, that cannot be done by using the IBC. The IBC gives the builder an easy exit. They can simply file for bankruptcy of the company.
In such a scenario, the assets of the company will be taken over by the government. They will then be sold to the highest bidder.
The reality is that the appraisal and auction process costs a lot of money and there are fees incurred at every step of the journey.
In the end, expenses start mounting up. Not only do the buyers receive only a fraction of the money that they had paid in order to obtain their loans but they receive it after a very long time.
The bottom line is that once real estate projects have gone into bankruptcy, there is very less hope of retrieving cash. Home buyers would be better off negotiating with the builders and taking a haircut on their investment.
As far as new home buyers are concerned, they may not have to face this problem since Real Estate Regulation Act (RERA) has been designed to ensure that such situations do not arise in the future.
The bottom line is that obtaining the status of financial creditors is not really beneficial to the consumers. In fact, it may be counterproductive.
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