Insolvency: The Process and What It Does to Claims

Insolvency is the condition of not being able to pay everyone who is owed, and what it does to a claim is turn an amount owed into a place in a queue. Meghdoot Coated Products Limited owes Rs 900 crore and can carry about Rs 210 crore, so the live question stops being how much is owed and becomes who is paid first. The steps themselves are set in law.

Three things sit underneath that answer, and each of them is settled elsewhere. The first is the set of sustainable levels worked out at the opening of this sequence. The Rs 210 crore comes from that set. The second is the split of Meghdoot Coated Products Limited into Rs 620 crore of secured claims and Rs 280 crore of unsecured claims. The third is what security over an assetA lender's right over a named asset of the borrower, written into the loan papers on the day the money goes out. Lending covers how it is created and documented. Here it is taken as already in place. means. Lending settles that, and it is taken here as a given.

What does insolvency actually mean, and what does it not mean?

Insolvency is a condition, not an event. It is the state of a business that cannot pay everyone it owes. The definition is that short, and it is worth holding onto. The word gets used for at least three other things in ordinary conversation, and each of those uses drags in an assumption that is not true.

Insolvency is not the same as being loss-making. A business can report a loss every year for a decade and never be insolvent. It keeps paying what falls due when it falls due. Plenty of young businesses spend years in exactly that state on purpose. Profit and cash arrive on different timetables, so a business can be handsomely profitable on paper and still fail to meet a payment on the day it is due. Profit is an opinion about a period. Paying is an event on a date.

Insolvency is also not the same as a formal proceeding. The condition can exist long before anything is filed anywhere, and in most cases it does. A business notices it first, then its lenders notice it, then, sometimes, a proceeding starts. The gap between the condition and the proceeding can be months. The arithmetic of who can be paid does not wait for paperwork, so it runs inside that gap as much as inside a proceeding.

And it is not a judgement about anybody. Earnings before interest, tax, depreciation and amortisation measures what a year of operations throws off. Meghdoot Coated Products Limited, an invented coating business, carries Rs 900 crore of borrowings against EBITDAEarnings before interest, tax, depreciation and amortisation. A rough measure of what the operations themselves throw off in a year, before the cost of borrowing and before charges that move no cash. of Rs 60 crore. Rs 900 crore of borrowings against Rs 60 crore of earnings is a leverage multipleBorrowings divided by one year of earnings, quoted as a number of times. The multiple compresses a debt load into a single figure, and businesses of very different sizes can then be set beside one another. of 15.0 times. The record carries that position and carries nothing at all about how it came about. The arithmetic that follows from the position is the knowable part.

What does insolvency do to a claim that was simply an amount owed?

Think about what a claim is on an ordinary Tuesday, before anything has gone wrong. A lender is owed Rs 100 crore and there is a date. The amount and the date settle everything. On the date, Rs 100 crore arrives. If it does not arrive, that is a problem to be dealt with, but nobody is confused about what was supposed to happen. The amount is the operative fact.

Now the cash runs short. The amount does not change by a single rupee, and it stops deciding what arrives. Almost every confusion in this subject comes from missing that line. Nobody has reduced the Rs 100 crore. The Rs 100 crore is still owed. The books still carry it at Rs 100 crore. The amount has been demoted from deciding the outcome to merely stating the size of a claim, and something else has been promoted into that job: where the claim stands relative to every other claim.

Why this matters shows in what it does to a conversation. Outside insolvency, two lenders each owed Rs 100 crore have identical positions and nothing to argue about. Inside it, those same two lenders may be looking at completely different outcomes, and neither of them did anything different from the other. Their claims are the same size. The two lenders are simply standing in different places. Standing in different places is uncomfortable, and it is the reason a restructuring negotiation is so often about order rather than about money.

Where does the money that gets shared actually come from?

Before any rule can divide anything there has to be something to divide, so it is worth being precise about where the pot comes from. The pot comes from whatever the business or its assets can actually produce. The pot does not come from what is owed, from what anybody hoped for, or from what the assets cost when they were bought.

For Meghdoot Coated Products Limited the earnings are Rs 60 crore a year. The sustainable multiple is a judgement rather than a measured property. The opening of this sequence worked out what a business with those earnings can sustainably carry, and put three levels on the table rather than one. At 3.0 times the business supports Rs 180 crore. At 3.5 times it supports Rs 210 crore. At 4.0 times it supports Rs 240 crore. The pot is fixed at the middle level, Rs 210 crore, and the other two levels stay in view as a reminder that the middle level was chosen by somebody rather than discovered.

The pot is small, it is fixed, and every rule that follows divides it rather than adding to it. Rs 210 crore set against Rs 900 crore of claims shows the shape of the problem before any rule is named. In full rupees the borrowings are Rs 9,00,00,00,000/- and the pot is Rs 2,10,00,00,000/-. Rs 690 crore of claim is standing outside what any arrangement can reach, at the middle level, and the three levels move that figure between Rs 660 crore and Rs 720 crore without changing the picture. Nothing that follows makes the pot bigger. Everything that follows is about who gets which part of it.

What happens under strict ranking, and who receives what?

The first of the two rules worked here is strict ranking. Under it, one group is paid in full before the next group receives anything at all. There is no sharing and no partial overlap. The pot flows into the first group until either the group is paid out completely or the pot runs dry, and only then does anything reach the second group.

Run it. The pot is Rs 210 crore. The secured claims are Rs 620 crore, a great deal more than Rs 210 crore, so the pot runs dry inside the first group. The secured lenders receive Rs 210 crore. Set beside the Rs 620 crore that group is owed, Rs 210 crore is a recovery of 33.9 per cent. The second group is left with nothing at all, and nothing against their Rs 280 crore is 0 per cent. Both bases are named in that sentence on purpose.

Notice what the secured group did not get. The secured group did not get paid. Rs 210 crore against a Rs 620 crore claim leaves Rs 410 crore of that claim unmet, and the group that came first in the order still came away with roughly a third. Being at the front of a short queue is much better than being at the back of one, and it is not remotely the same as being paid.

What happens under pro rata, and who receives what?

The second rule is pro rata. Every rupee of claim is treated identically, so the pot is shared in proportion to the size of each claim and no claim is preferred over any other. There is no order at all: order is precisely the thing this rule refuses to use.

Run it on the same Rs 210 crore. The secured claims are Rs 620 crore out of the Rs 900 crore total, and that group takes Rs 620 crore over Rs 900 crore of the pot, or Rs 144.7 crore. The unsecured claims are Rs 280 crore out of Rs 900 crore, and that group takes Rs 65.3 crore. Nothing has been created or lost, so the two amounts add back to Rs 210 crore exactly.

Now the recoveries, each on its own base. Rs 144.7 crore against Rs 620 crore is 23.3 per cent, and Rs 65.3 crore against Rs 280 crore is also 23.3 per cent, and the two rates are identical because identical rates are the definition of pro rata rather than a coincidence. If the two figures had come out differently, the sharing would not have been pro rata. Each rupee of claim, wherever it happens to sit, comes back at the identical rate.

Why does the same pot produce such different outcomes?

Put the two results beside each other and something strange appears. Under strict ranking one group receives Rs 210 crore and the other receives nothing. Under pro rata one group receives Rs 144.7 crore and the other receives Rs 65.3 crore. The two results look like two different situations, and they are not. The pot was Rs 210 crore both times, the claims were Rs 900 crore both times, and nobody added or removed a rupee.

The way to see it is to stop measuring recovery on each group and measure it across the whole of what is owed. Under strict ranking the total handed out is Rs 210 crore against Rs 900 crore of claims, or 23.3 per cent. Under pro rata the total handed out is also Rs 210 crore against Rs 900 crore of claims, and again 23.3 per cent. Both rules land on the same aggregate of 23.3 per cent, for the plain reason that nothing touched the pot, so a ranking rule settles who ends up holding the money and has no effect whatever on how much of it there is.

An argument about a restructuring looks like an argument about arithmetic and is very rarely one. The arithmetic settles the size of the pot and stops there. Everything anyone actually fights about is the order, and the order is worth exactly Rs 65.3 crore here. Rs 65.3 crore is the sum that changes hands between the two groups in moving from one rule to the other. Neither group did anything different to earn or lose it.

What is security actually doing in this arithmetic?

Here is where a widespread intuition goes wrong. Asked what security does for a lender, most people answer something close to it makes the claim safer or it makes the claim bigger. The second half of that is simply not true, and the first half is true only in a very particular way that is worth stating exactly.

A secured claim has a specific asset standing behind it. The asset does not increase the amount owed by one rupee. A Rs 100 crore secured claim and a Rs 100 crore unsecured claim are both Rs 100 crore, on the books and in the loan papers and in the ledger of whoever is counting. Security buys position, not amount, and position is worth everything only because the pot is short.

Read the consequence off the figures. Take two lenders to Meghdoot Coated Products Limited, each owed Rs 100 crore, one holding security and one not. Under strict ranking the secured one rides the 33.9 per cent that its group achieves and recovers Rs 33.9 crore, and the unsecured one recovers nothing. Under pro rata both recover 23.3 per cent, or Rs 23.3 crore each. So the same claim of the same size is worth Rs 33.9 crore, Rs 23.3 crore or nothing, purely by which group it sits in and which rule is running. The lender who took security bought a place in the order, and the whole value of that place shows up only on the day the pot turns out to be short.

What does the whole build look like, with both rules side by side?

One table holds everything above, and each figure can be checked against the one beside it rather than taken on trust. The pot is fixed at the middle level of Rs 210 crore, or Rs 60 crore of earnings at a judged 3.5 times. A percentage without its base is not a fact, so every percentage in the table names the base it is measured on.

The last two rows belong with the four above them. Six of the eight recovery figures in that table differ between the two columns, and the two that do not differ are the ones measured on the whole Rs 900 crore. The match is not a rounding artefact and it is not luck. The pot is handed out completely under both rules, and that is what makes the aggregate identity worth more than any single recovery figure in the table.

One more property of the table is easy to miss. The written-down amount does not appear in it anywhere. Rs 690 crore of claim is left unpaid at this level under both rules, and whether that is called a write-downThe reduction of a debt to an amount the borrower can realistically carry, so the books stop carrying a number nobody expects to be paid. or a haircutThe everyday word for the part of a claim a lender agrees to give up. Same idea as a write-down, said from the lender's side of the table. makes no difference to the arithmetic here. The arithmetic worked above is about the Rs 210 crore that moves. The Rs 690 crore that does not move was settled at the opening of this sequence.

The headline figure everyone quotes turns out to be a band rather than a number, so the question is worth working properly. Run strict ranking at all three sustainable levels and the secured group recovers Rs 180 crore over Rs 620 crore at the low level, or 29.0 per cent; Rs 210 crore over Rs 620 crore at the middle level, or 33.9 per cent; and Rs 240 crore over Rs 620 crore at the high level, or 38.7 per cent. The single most quoted figure in this whole illustration is really a band of 9.7 points wide, and its width comes entirely from a judgement about a multiple that nobody measured.

And at every one of those three levels the secured group is short. To pay Rs 620 crore in full out of earnings of Rs 60 crore, the business would have to carry 10.3 times its earnings, more than two and a half times the top of the sustainable range. The 10.3 times says the shortfall is not a near miss that a slightly kinder assumption would close. The shortfall is structural, and no choice of multiple inside any defensible range gets near it.

Which part of this is a rule in India, and where is it written down?

None of it. The honest answer needs saying at full strength rather than in a footnote. A reader is likelier to misremember the law at this point than anywhere else in the subject.

Strict ranking and pro rata are worked here as two ends of a mechanism, chosen because they sit at the far edges of what any ordering can do while every step between them stays out in the open, and neither one reports what Indian law actually lays down. Which claims stand where, how creditors are grouped into classes, what proportions of a class must agree to anything, what clock runs from what starting point, and what a formal proceeding does to a lender's ability to pursue a borrower are all matters of law, settled at the source rather than here, and the ones that sound most familiar are exactly the ones most likely to be misremembered.

Once the ranking is known, what it does to a claim is arithmetic. Arithmetic travels across jurisdictions unchanged, and it is the part a reader can actually check. The rest is law, and it is read at the source.

What does this look like on a street, with two lenders and one workshop?

With the crores stripped away, the mechanism is something that could be watched happening on a street. A small workshop makes metal fittings. At a time when the order book was full, it borrowed twice: once from a lender who took a charge over the cutting machine, and once from a lender who took nothing but a signed agreement. Both loans were for the same amount. Both were made on the same reading of the business.

Then the orders stopped coming. The workshop has some cash from finished stock and the machine is still worth something, and between them there is a certain sum available. Both lenders are owed the same amount, and now they are standing in completely different places. The one with the charge over the machine has something specific to point at. The other one is pointing at the business in general, and so is everyone else.

Nothing in that story is a comment on anybody's judgement. The borrowing was made when the orders were there. The second lender priced a loan without security and was paid for doing so while the payments were being made. The amount of cash arriving changed, and nobody's competence did. The two lenders now find themselves in a conversation about order. The Rs 620 crore and the Rs 280 crore are having the same conversation at Meghdoot Coated Products Limited, only with more zeros.

What does a recovery percentage mean, and how does it get misread?

The same Rs 210 crore has now been described as 33.9 per cent, as 23.3 per cent, as 0 per cent and as 23.3 per cent again, and every one of those was correct. Four correct answers to one question ought to be mildly unsettling, and the reason lies in a discipline the rest of this sequence depends on.

The identical Rs 210 crore reads as 33.9 per cent, 23.3 per cent or nothing at all, depending entirely on whose claim it is measured against, so a recovery figure is meaningless without its base. Three separate choices are hidden inside any recovery percentage that is handed across. Which group is it measured on. Which ranking rule produced it. And which sustainable level fixed the pot. Change any one of the three and the number changes, and none of the three is visible in the number itself.

The practical version of that discipline costs one clause: a recovery figure is never written without the base attached in the same sentence. Not in a footnote, not in a schedule three sheets back, not in a column header somebody will crop. Written as 33.9 per cent of the secured lenders' Rs 620 crore, under strict ranking, at a pot of Rs 210 crore, the sentence is longer and cannot be misread. Written as 33.9 per cent on its own, it hands the reader a number with three invisible choices baked into it.

Three things are worth noticing about that control. At the far left, both recovery bars land on the same length, and equal lengths are what pro rata means made visible. At the far right, the second bar vanishes entirely while the first reaches its longest. And at every setting in between, the third bar is the one that repays attention. The aggregate bar is frozen at 23.3 per cent at every position of the control, and the unmoving bar is the whole finding, drawn rather than argued. The arrow underneath it measures the only thing the control actually does: move rupees sideways.

A blend is where the mechanism is easiest to see working, so the middle of the control is worth stopping at. At that setting the secured lenders take Rs 177.3 crore, a recovery of 28.6 per cent struck on their Rs 620 crore. The unsecured lenders take Rs 32.7 crore, or 11.7 per cent struck on their Rs 280 crore. The two amounts add back to Rs 210 crore, exactly as they do at either end, and the aggregate on the whole Rs 900 crore is still 23.3 per cent. Notice what halfway does not mean. The two groups are measured on bases of very different sizes, so standing halfway between two rules does not put either group halfway between its two recovery rates. The secured rate has fallen from 33.9 to 28.6 per cent, a slide of 5.3 points, while the unsecured rate has climbed from nothing to 11.7 points. The same Rs 32.7 crore moved, and it read as a much bigger event on the smaller base.

Who reaches for this arithmetic, and what do they do with it?

Four kinds of reader reach for this arithmetic, and each one uses it differently.

A lender uses it before lending, not after. The whole of this guide is what a credit committee is imagining when it asks whether to take security, and the honest way to put the question is not is this loan safe but where would this claim stand if the cash ran short. Security is priced on the day the loan is made and paid for on the day the pot turns out to be short, and the arithmetic here is the only place its value ever shows up. A lender who cannot say what its position would be in a queue has priced a rate without pricing the thing the rate is for.

An analyst uses it to interrogate somebody else's number. Handed a recovery estimate, the first three questions are the three this guide keeps repeating: on what base, under what rule, at what level. An analyst who asks those three has moved from consuming an estimate to auditing one, and the difference in the quality of the resulting note is not small.

A holder of the debt uses it to work out which conversation actually matters. If the aggregate never moves, then time spent arguing about the size of the pot is time spent on the one variable the rule does not touch. Position moves, and position is settled by the ranking. So much of the effort in these situations goes into questions that look procedural and are not.

And a household uses the same shape without ever calling it this. A home loan secured on the house and a personal loan that is not are not the same obligation even when the amounts and rates are similar, and they are not the same obligation precisely because of what stands behind each of them. Nothing about that says one should be borrowed and the other should not. The two are different instruments that happen to be measured in the same rupees, and knowing which is which is worth more than any single rate comparison.

One limit applies to all four. Meghdoot Coated Products Limited is unlistedA company whose shares are not traded on an exchange, so there is no market price for it and no continuous public disclosure of its numbers. and the record carries no share count and no shareholders at all, so what percentage of the business converting lenders might receive cannot be worked out. The record holds no second year, no prior year and no path back, and refinancingReplacing an existing borrowing with a new one, usually longer or cheaper, which changes the shape of the debt without reducing what is owed. can be discussed as a mechanism here but never as a forecast. Naming an absence is cheaper than estimating around it, and much more honest.

Meghdoot Coated Products Limited is invented.
Educational material. Not advice on any investment, tax, budget or market position.