Mitigating the operational risk posed by the IBC
It is critical that the interests of operational creditors be protected by the legal system, if not by the voting process
In 1997, during the Asian financial crisis, the Thai baht went into a steep fall. Economists believed that the resulting increase in exports and reduction in imports would restore the economy to good health. However, exporters did not have access to trade credit, and the opportunity remained untapped. Capacity utilization in the Thai economy dropped from 75% to 55% over two years.
Risks of a similar nature, though not the same magnitude, can affect the Indian economy in the wake of the current process of the Insolvency and Bankruptcy Code (IBC). Recall that, in March, a day after Tata Steel emerged as the highest bidder for Bhushan Steel, engineering and construction major L&T, an operational creditor (i.e, an unpaid vendor) of Bhushan Steel, moved the National Corporate Law Tribunal (NCLT) claiming ₹962 crore. Their plea was rejected based on the consideration that the demands of secured financial creditors held priority. On 20 May, the National Company Law Appellate Tribunal agreed to hear their petition challenging the NCLT order.
The legal action of L&T reflects a systemic flaw in the current IBC process. Operational creditors are normally not members of the committee of creditors that is empowered to adjudicate on resolution plans of bidders, unless they have dues exceeding 10% of financial creditors. In any case, they have no voting rights. In the past, courts could have taken a view based on considerations of justice, but today their hands are tied by the law as contained in the IBC. In such a situation, operational creditors are likely to feel short-changed by the process. In the future, this perception is likely to make them behave in a risk-averse manner, especially on accounts where exposure is large. They would tend to either pull out of such accounts or insist on full financial security, upon early signs of financial trouble. The increased risk aversion of trade credit would have an extremely deleterious impact on the business environment.
It is critical that the interests of operational creditors be protected by the legal system, if not by the voting process. We seek to estimate the amount that might be considered as a fair payout.
For simplicity, it is assumed that the claimants are restricted to secured financial creditors and operational creditors. The interaction between these two groups is modelled through a non-cooperative bargaining model, referred to as the Rubinstein alternating offers game. Assume ₹100 has to be divided between two parties, A and B. The process for division involves party A making an offer of a division, followed by a refusal or acceptance by party B. If B accepts the proposed division, the game ends. Otherwise, B makes a counter offer. Now it is A’s turn to accept or reject. If A accepts, the game ends. If A rejects, it can make a new offer. In this way the process continues, perhaps indefinitely.
The equilibrium of this game has two properties: first, the party that makes the first offer has an advantage. Second, since the process takes time, the equilibrium pay-offs are very sensitive to the level of impatience of the players, as reflected in the rate at which they discount future payoffs. The share of the pie each gets is, approximately, inversely proportional to the discount rate.
We can estimate the discount rates of secured and operational creditors by their cost of capital. A secured creditor, typically a bank, would raise money at 4-6% from the public. Factoring in reserve and capital adequacy requirements, their cost of capital would be about 8-9%. An operational creditor on the other hand would raise money from banks at 16-18%, depending on credit considerations. These rates can be assumed to represent the discount rates of the secured and operational creditors. Thus, in equilibrium, the discount rate of the operational creditor is approximately twice that of the secured creditor. Consequently, its share would be roughly half the share of the secured creditor, who would get ₹66 out of the ₹100.
We apply this solution to the division of the proceeds of resolution between the secured and operational creditors as follows: given the seniority of the secured creditor, we assign them the role of the first mover. We then examine the amount outstanding with respect to the operational creditor. This is the “contested amount”. We divide this contested amount between the secured creditor and the operational creditor in the ratio 2:1. The remaining amount is given to the unsecured creditor.
Let us assume that the secured creditor claims 150 units, the operational creditor claims 30 units, and the value of the asset is 110 units. Then 30 units will be divided in the ratio 2:1, giving 20 units to the secured and 10 units to the operational creditor. The remaining 80 units of the asset will be given to the secured creditor, giving a total payout of 100 units to the secured creditor and 10 units to the operational creditor.
In contrast, we could divide the contested amount equally between the secured and operational creditors, assuming an equal discount rate. Now the 30 units are divided equally, and the remaining 80 units go to the secured creditor, giving a total payout of 95 units to the secured creditor and 15 units to the operational creditor. The courts could decide on any point between these two extremes based on the details of the case.
It is critical that the IBC protect the salubriousness of the future business environment while taking care of distressed assets of the past.
Rohit Prasad and Yogesh B. Mathur are, respectively, a professor at MDI, Gurgaon, and a senior adviser-restructuring and former CFO at several major Indian/international groups. Game Sutra is a fortnightly column based on game theory.
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