Working through the bankruptcy maze

The Bankruptcy Bill, as introduced in the Lok Sabha in the winter session, is a significant step in the right direction and should be welcomed

Updated - March 24, 2016 12:36 pm IST

Published - December 29, 2015 01:42 am IST

India’s financial distress resolution mechanism is broken. Companies that fall into hard times spend six or eight years trying to resolve the situation. Banks are saddled with massive amounts of non-performing loans that are a drain on their resources and also affect their willingness to lend to new and deserving projects. Ultimately, the honest and successful companies and individuals that borrow from the banks pay for these inefficiencies in terms of higher interest rates. In light of this, the Insolvency and Bankruptcy Bill, 2015, which has now been referred to a joint committee of Parliament, is a significant step in the right direction.

Over the past 20 years, there have been a number of attempts to reform India’s insolvency regime. While the Sick Industrial Companies (Special Provisions) Act, 1985, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 were laws aimed at helping speed up the bankruptcy resolution process, corporate debt restructuring is a Reserve Bank of India-sponsored scheme that has tried to sidestep the courts to resolve financial distress. None of them have been fully effective. While one can find a number of micro reasons for their failure, the one overarching reason (at least in the case of laws) is the lack of legal infrastructure to effectively implement the laws. Our courts are overburdened, understaffed and lack basic physical infrastructure. Some of the Debt Recovery Tribunals are known to be operating out of car showrooms. India is a classic case of strong laws diluted by weak implementation.

So how will a new law resolve this situation? The current Bill acknowledges the creaking legal infrastructure and tries to overcome it by privatising the insolvency resolution process. The Bill proposes a new breed of insolvency professionals who will be responsible for managing the process. The courts will be required to rule on a limited number of issues. On paper, this is an effective way to overcome the lack of legal infrastructure. Having said that, this solution will work only if the private sector infrastructure develops and the courts confine themselves to their limited role. While one can encourage the former with the right incentives, the latter is a question that only time can answer.

Time-bound process

The other important aspect of the Bill is the strict, time-bound process that is specified. The Bill mandates that the decision between restructuring and liquidation should be made by the bankruptcy professional within six months of a firm being referred to the bankruptcy process. Under certain limited circumstances, there can be one extension of three months after which the firm will have to be liquidated to settle its claims. The spirit of this time-bound process should be applauded, as the defining inefficiency in India’s bankruptcy regime is the inordinate delay. Having said that, the implementation of the process depends crucially on the above-mentioned infrastructure being in place and the courts sticking to the time limits.

The third important aspect of the law is the significant influence the current lenders (read “secured lenders”) will have over the reorganisation process. Given the nature of India’s financial system, much of the lending is collateralised with physical assets. Any committee of creditors required to vote on a restructuring package — as envisaged in the current Bill — will be dominated by secured lenders. While at one level it is reasonable to give secured lenders priority when it comes to getting their money back, giving them the power of veto over what happens to the firm in insolvency can sometimes result in inefficient outcomes.

Knowing that they can recover their money by liquidating their collateral, secured lenders may sometimes prefer liquidation over restructuring even if the latter results in higher value for the firm’s equity holders. An alternative structure, one that is followed in the U.S., is to give unsecured lenders, who have lower priority than secured lenders, some say in the bankruptcy process. Given their lower priority, unsecured lenders may have greater interest in picking the alternative that maximises recovery. The current Bill chose not to do this in the interest of simplicity. While that is a reasonable argument, it may have some adverse consequences for the development of a market for unsecured loans. This may be a small technical point that only an academic will worry about, but the importance of a market for unsecured debt to spread economic opportunity in a knowledge-based economy such as India cannot be overemphasised. But that is a topic for another day. Despite the limitations highlighted in this article, the Bankruptcy Bill, as introduced in the Lok Sabha in the winter session, is a significant step in the right direction and should be enthusiastically welcomed.

(Radhakrishnan Gopalan is Associate Professor of Finance, Olin Business School, Washington University, St. Louis . )

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