Road to failure must be well paved

It is common to see a small crowd around two angry men (sometimes women) in the middle of a busy road. Sometimes, the angry voices lead to fisticuffs. And on rare occasions, a gun is pulled out and used. Other than the victory of brawn over brains, it is the lack of a process to sort out the differences between drivers that causes altercations on the road. A good insurance system that will evaluate the damage and get the person who was at fault to pick up the tab from his insurance company ensures civil behaviour on roads after an accident in mature economies.

Think about the new draft bankruptcy code in a similar manner. India today does not have a process in place for companies that are unable to pay their debts. When a firm begins to default on its loans, there is a rush among the creditors to get paid quickly. Those with the ability to arm-twist will get paid first, if at all. On the other side, owners of the firms have full control on the assets and begin asset-stripping so that nothing is left for the creditors by the time they get the legal right to get their dues paid.

The Bankruptcy Law Reform Committee (BLRC) presented its report (http://bit.ly/1X1R1c8) and the draft Insolvency and Bankruptcy Code (IBC; read it here http://bit.ly/1RYAqF7) to the finance minister earlier this month. The report is a roadmap for putting in place a process for a firm or an individual to fail. The draft law goes a step ahead and fleshes out the ideas into a legal framework. Let’s think about what the process would look like in real life. Imagine an auto parts maker that has a good business going and uses loans to fund growth. But a domestic slowdown causes demand to slow and the company begins to fall behind on its interest payments and then defaults. The information of the firm falling back and then defaulting will be stored in what will be called ‘information utilities’ that will be the central storehouse of all financial information about the borrowing firm and the creditors. This will take away the dispute between creditors and debtors as to what exactly happened and whether a default was actually a default or not. Once this happens, and the insolvency proceedings are initiated by a creditor, the Insolvency Resolution Process kicks off. Two things happen in the process. One, a ‘calm period’ of 180 days is declared. This is the time when the mad scramble that happens today (when firms strip assets and powerful creditors get paid first) is avoided. For the next 180 days, all claims of creditors are suspended and the firm can continue to function. The firm has the comfort that it will not get harassed or arm-twisted into paying off one or two creditors, thereby putting it further in the red. Creditors get the comfort that during this 180-day period, the firm is run by an ‘insolvency professional,’ preventing the owners from stealing assets. Two, a creditors’ committee is formed, which will “analyse the company, hear rival proposals and make up its mind on what has to be done”.

Once three-fourths of the creditors’ committee agree to the revival plan, it is binding on everybody else. If the committee can’t get the required majority, the firm goes into liquidation after 180 days. This will be led by a regulated insolvency professional called the liquidator and the assets of the firm will be held in trust. The IBC includes ‘operational creditors’ along with the usual ‘financial’ creditors who can initiate bankruptcy proceedings against the firm. Operational creditors include workmen and employees whose past payments are due. For example, if the IBC was in force, the Kingfisher employees could have initiated insolvency proceedings against the airline once it was clear that the airline was not going to revive. The process is similar for individuals, except that they cannot be ‘liquidated’. Individuals are given a ‘fresh start’ if they earn 60,000 or less annually, where certain kinds of loans are waived, but this information will show up on the individual’s credit record.

The proposed IBC is a four-part structure with insolvency professionals, information utilities, a regulator and tribunals. It envisages a new cadre of professionals called ‘bankruptcy professionals’ who would work in these institutions. Lawyers, chartered accountants and finance professionals would all qualify with some added certifications. The success of the IBC rests on these institutions being state-of-the-art. Most committees either suggest huge changes without thinking through the institutional entities needed to execute the new system, or they stay with what is available and make incremental changes. The good news is that instead of tinkering with the existing institutions and having a working bankruptcy process in place quickly, the BLRC took the more difficult path to be bold and recommended a new bankruptcy system along with a fleshed-out institutional roadmap to execute the recommendations. The bad news is that it will take at least a decade before all the institutions are in place for effective bankruptcy institutions and cadre to emerge.

Disclosure: I have worked with BLRC member and principal author of the report, Susan Thomas, on an academic paper and have had many discussions on the bankruptcy issue with her over the past year.

Monika Halan works in the area of financial literacy and financial intermediation policy and is a certified financial planner. She is editor, Mint Money, Yale World Fellow 2011 and on the board of FPSB India. She can be reached at expenseaccount@livemint.com