A greater market role in bankruptcy process
One of the major challenges for the Narendra Modi government in the next two years is the revival of private investment in the country. Failure on this count could hurt employment generation, exacerbate economic inequality and threaten social unrest. An International Monetary Fund paper (goo.gl/cfp4cm) by Sonali Das and Volodymyr Tulin, released last month, noted that the rise in gross fixed capital formation over the last five years in India averaged only 3.5%, compared to 12% per year over the decade ending 2011-12. A major cause of investment slowdown, the paper argues, is the rise in financial leverage of firms. This is especially true for firms whose earnings are insufficient to service their debt.
Higher leverage not only cripples the ability of firms to undertake new investments, but also impedes the completion of ongoing projects. As a result, these firms continue to suffer from low productivity. In such situations, a strong exit mechanism goes a long way in ensuring an efficient reallocation of both capital and labour to productive businesses, thereby contributing to higher output.
India’s new bankruptcy law, promulgated last year, while marking a positive departure from the old and fragmented system that existed earlier, is far from ideal. Much ink has been spilled on discussing its drawbacks. To an extent similar to the UK’s administration system and Singapore’s judicial management system, this new law provides for appointing an insolvency professional (IP) to conduct the process. The management of the firm is transferred to the IP, who is tasked with preparing and proposing the reorganization plan. This plan is then voted on by the committee of creditors (CoC). Research has shown that this approach leads to higher bankruptcy costs. It also leaves too much discretion in the hands of the IP who, in India’s case, is likely to have much less knowledge and experience in this domain.
Furthermore, the National Company Law Tribunal (NCLT), the adjudicating authority for all corporate default cases, would be tasked with resolving as many as 25,000 insolvency cases over and above other corporate cases. A consulting firm, Alvarez & Marsal, estimates (goo.gl/AJLwaa) that it may take more than seven years for the NCLT to clear these many cases.
Given the flaws in the present bankruptcy law, it may help to revisit the seminal work of four economists, namely Oliver Hart (a 2016 Nobel laureate), John Moore, Rafael La Porta Drago and Florencio Lopez-de-Silanes. In a 1997 paper (goo.gl/k2vqdZ), they proposed a radical, market-friendly approach to the resolution of the bankruptcy process. This approach was originally intended to help the developing countries of Eastern Europe, which had just witnessed the demise of socialism. These countries had underdeveloped capital markets and inefficient judicial systems. As a result, the economists argued, contemporary bankruptcy mechanisms of the West, such as the US’ Chapter 11 of the bankruptcy code or UK’s administration system, were ill-suited to them.
A much better bankruptcy system would be one that encourages decentralization, reduces the role of courts or insolvency professionals, and allows for a greater role for the markets. According to this proposal, the entire debt of the distressed firm would be converted into one common security called “Reorganisation Rights” (RR). Then, two auctions would be held. An “inside” auction would allow the claimants to purchase RRs at a preferential price, one that would reflect the seniority of the claims. Subsequently, a “public” auction would allow external investors to make cash bids for these RRs.
These external bids in public auctions would allow claimants, including those who were unable to participate in the inside auction owing to financial constraints, to be repaid in cash. A reasonable reserve price would be set high enough so as to avert the risk of RRs being acquired at throwaway prices. Once the RRs are acquired, the new RR holders would then vote on the reorganization plan and decide the future course of the firm.
To be sure, this is a simplistic explanation, the point being that a robust, market-friendly approach such as this would help reduce the economic and financial costs of bankruptcy. In this system, the courts would only have a supervisory role. This would do away with the need to establish and maintain specialized bankruptcy courts, insolvency professional agencies, or even experts for operating the firm. It would also remove the scope for discretionary decisions by IPs. Since the ownership of the firm is homogenized, owners would take all decisions through a vote.
The World Bank’s Doing Business Index 2017 states that India takes on an average 4.3 years to resolve insolvency—about two years more than the average for South Asia. Furthermore, the recovery rate for secured creditors is 26 cents to a dollar. This is 64% lower than the OECD (Organisation for Economic Co-operation and Development) average. The rate for junior claimants would be even worse. For India to improve its rankings in the doing business index, it is not enough to simply have a bankruptcy code in place. The code must be robust, decentralized, less costly, inclusive and speedy. This would help businesses exit sooner and capital to be redeployed faster to productive firms, thereby improving economic output and employment.
Harsh Vora is an entrepreneur, investor and trader.
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