Home / Industry / Banking /  The IBC has an incentive problem

The Insolvency and Bankruptcy Code (IBC) was introduced by the Narendra Modi government in December 2016 to expeditiously resolve claims involving insolvent companies in a bid to tackle the ‘bad loan’ problem plaguing India’s banking system. Two years on, even as it continues to evolve, the legal reform has emerged largely successful. However, it may have had an unintended outcome: shutdown of viable businesses of indebted firms.

A new study by National Institute of Public Finance and Policy’s Pratik Datta argues that such ‘value destruction’ of profitable businesses is due to certain design flaws in the law. For instance, any insolvency resolution plan under the law relies on the vote of financial creditors, whose interest in the firm may not go beyond the recovery of their own claims. As such they are likely to prefer selling off firm’s assets to cut their losses rather than evaluate the risk of letting the company run its operations. Datta argues that a well-designed insolvency law should differentiate between “financially distressed" firms and “economically distressed" firms. When the present value of the expected profits of a company is less than the total value of the assets of the company, were they to be broken up and sold separately, the company is economically distressed.

The claimants are better off liquidating such a company and selling its assets on a piecemeal basis. In contrast, if a company is not economically distressed but is merely unable to service its debts, it is merely financially distressed. The assets of such a firm are more valuable if kept together as a functioning unit. Such a firm should be sustained either by restructuring it among existing claimants, or by selling it to new investors. For insolvency resolution to be truly successful, policymakers must revisit the incentive problems implicit in the design of the law, the author suggests.

READ | Value Destruction and Wealth Transfer under the Insolvency and Bankruptcy Code, 2016

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