For better IBC recoveries, incentivize resolution professionals

Photo: Mint
Photo: Mint

Summary

Resolution professionals need a larger interest in shoring up the value of an insolvent firm

While the Indian Bankruptcy Code (IBC) has been under fire for low recoveries, my previous column showed that despite value erosion at disbursal due to poor credit discipline, when compared to alternate resolution mechanisms and Chapter 11 bankruptcies in the US, the IBC has yielded impressive recoveries so far. However, the Code has also been criticized on several other grounds, many of which are questionable.

A major barb that has been hurled rather unkindly at the IBC is that it leads to a disproportionate number of liquidations. This is a disingenuous argument. The economic purpose of any resolution mechanism is not to minimize liquidations, but to maximize recovery. If recovery can be maximized by liquidating assets, then liquidation is a desired outcome of the process. Bankruptcy laws are not designed to save companies from liquidation, but to maximize value using market mechanisms. Even so, delving deeper into the numbers reveals that this is not a fatal failing that is specific to the IBC, as critics are making it out to be. So far, close to half of all cases under the IBC have ended up in liquidation. To sceptics, this is an abnormally large number that implies its failure. However, another comparison with the US Bankruptcy law reveals that this is not true. According to data from US Courts (bit.ly/39mb0lh), of the 22,780 business filings for bankruptcy in 2019, only 7,020 were under Chapter 11 for reorganization, while the rest were under Chapter 7 for liquidation. This proportion has remained roughly the same in the last five years. Thus, in light of the fact that twice as many US firms file for liquidation than they do for reorganization, the proportion of liquidations (50%) under the IBC is not a cause for concern or criticism.

Lastly, many have criticized the long resolution times under IBC. Currently, the IBC process takes between 400 to 500 days, during which the firm is likely to lose considerable value. However, long as it might seem, for a new bankruptcy law, a lead time of 400 days is not unusual. Foteini Teloni (‘Chapter 11 Duration, Preplanned Cases, and Refiling Rates: An Empirical Analysis in the Post-Bapcpa Era’) shows that till 2005, the average duration of a Chapter 11 bankruptcy in the US was 480 days. It dropped considerably to 261 days after 2005 with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act, which fostered the adoption of pre-pack bankruptcies with shorter lead times. Thus, while resolution times under the IBC are long, they are similar to the US before widespread diffusion of pre-packs, and thus they are likely to go down with greater adoption of pre-pack resolutions, which now supplement it.

Notwithstanding the IBC’s achievements, it remains a work in progress and some kinks need to be ironed out. Primarily, it does not adequately address the fact that the ability to reorganize a business during bankruptcy is a vital driver of recovery values. Corporate bankruptcies are an opportunity for businesses to become leaner and more efficient. In the US, many firms employ bankruptcies strategically and use the freedoms under Chapter 11 to renegotiate contracts and streamline fixed costs. This is less visible under the IBC because, unlike Chapter 11 where debtors retain management control of the bankrupt firm, firms under IBC are managed by resolution professionals. Therefore, some think-tanks have suggested that Chapter 11-style debtor-in-possession provisions be introduced in the IBC, so as to allow the management to retain control of the bankrupt firm and incentivize them to streamline operations and maximize recovery.

However, given the poor state of our judicial and enforcement agencies and the fact that most firms in India are owned and operated by promoter families that often have little understanding of the distinction between personal and company resources, debtor-in-possession is a recipe for disaster. It will incentivize promoters to strip assets funded by banks, declare bankruptcy, and then use their control retention over the firm’s management to cover up their tracks and force creditors to accept smaller recoveries. This will also substantially increase the duration of bankruptcies, since promoters with management control will have no incentive for a quick resolution. This model of asset-stripping has been widely documented in several Chapter 11 bankruptcies, like Caesar’s Entertainment and J.Crew, where private equity owners transferred valuable intellectual and physical properties to overseas jurisdictions beyond the reach of creditors before declaring bankruptcy.

A better way to improve recoveries further and spur reorganization of bankrupt firms is to incentivize resolution professionals, since they take charge of a bankrupt firm’s management under the IBC. While many IBC cases have used a ‘success fee’ model to motivate reorganization, the Insolvency and Bankruptcy Board of India’s recommendations of a “fair and reasonable" fee have been a dampener. Restructuring and turning around a bankrupt firm is a specialized skill and unless resolution professionals are adequately incentivized, they are unlikely to do what’s best. Moreover, an incentive fee structure based on a percentage of recovery will also attract talented managers to their pool, thereby boosting IBC resolution quality.

In conclusion, while the IBC has made tremendous strides in a short span of time, its effectiveness can be sharpened considerably if our authorities take a broader economic approach to incentivizing reorganization for maximizing recovery.

Diva Jain is director at Arrjavv and a ‘probabilist’ who researches and writes on behavioural finance and economics. Her Twitter handle is @Divajain2

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