Dr. Ajit Ranade*
The Insolvency and Bankruptcy Code (Code), passed by the Parliament of India in 2016, is one of the most important and comprehensive legal reform. For the first time in independent India, the law formally sets out a bankruptcy and insolvency resolution framework, and in doing so also strengthens creditors’ rights, swinging the pendulum away from the rights of borrowers, which was the de facto situation earlier. It may be happenstance that the law which took years to be hammered out was passed when the non-performing assets (NPAs) problem in banks was mounting alarmingly. The Code will certainly help in resolution of NPAs, but its long-term and bigger impact will be on unseen behavioural aspects in the economy. The law as it stands lends transparency and predictability to the resolution process itself. But its significant impact will be in cases which will never come up for the Code-mandated resolution, because of the deterrence and change in players’ incentives. Thus, in the coming years, the large measure of success would be in unobserved data, not in the number of cases that come up for resolution. In the long term, its effect will also manifest in behavior such as extra effort to avoid repayment default, lesser resources locked up in defaulting or under-litigation economic activity, and lower cost of credit.
A landmark law with similar intent as the Code was passed in 2002, called the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI). That law was limited in its scope as it was aimed at helping banks recover loans from defaulters. It too aimed at strengthening creditors’ rights, in the eternal tug of war between rights of debtors and creditors. Over the past two decades it is not clear to what extent that law has been effective, which is perhaps one of the motivation for a comprehensive law such as the Code.
Interestingly, the enactment of SARFAESI in India came on the heels of bankruptcy law reform in the West, which was looking to beef up rights of debtors rather than creditors. In some ways while the West was looking at diluting some of the creditors’ rights, India was coming from the other end of trying to reduce the stranglehold of debtors. The Bankruptcy Reform Act of 1978 in the US was a case in point. Prior to the 1978 reform it was easier for creditors to take debtor firms to full or piece-meal liquidation. There also was a tendency for many insolvency cases to end up in socially sub-optimal liquidation, due to perhaps hair trigger action of creditors with excessive powers. Debtors had lesser say. Indeed, in the earlier part of US history, it wasn’t clear whether the constitution even empowered lawmakers to define and enhance debtors’ rights under a bankruptcy law. The debtors’ rights were covered only under ‘insolvency laws’ wherein the debtor had inadequate assets and hence was unable to discharge his obligations. After 1978 the debtors’ position was slightly stronger, and indeed they now had an option to file for bankruptcy preemptively as a strategy to fend off creditors or to reorganise themselves. This law too was amended in 2005 that curtailed debtors’ rights with a view to prevent the abuse of the bankruptcy process. The 1978 Act was amended again in 2015 to reduce certain timelines, and effectively more curtailment of debtors’ rights. The earliest comprehensive and well-settled bankruptcy code in the US dates back to 1898 (called the Nelson Act), which underwent a major reform in 1938 (called as the Chandler Act). Thus, the experience of US bankruptcy law history shows us the dynamic nature of such legislation, which needs to be tweaked or amended as per evolving and unanticipated situations. Since it is basically a tussle to find the right balance between creditors and debtors rights, such an evolution is inevitable. Not surprisingly India’s Code which has benefited from the cumulative experience of the rich history of bankruptcy law in the west, most notably in the US and UK and other countries, has also undergone an amendment within three years of its initial enactment.
In this article, the next section briefly describes the economics of bankruptcy law, and the main challenges in the design of such laws. The subsequent section focuses on one particular aspect as it applies to India’s bankruptcy law. This relates to the conditions that must be fulfilled for a case to be admitted to the bankruptcy process. The article suggests some reform in this area, which will indirectly enhance the effectiveness of the working of the Code itself.
ECONOMICS OF BANKRUPTCY LAW
The brief discussion below is based on the paper by Aghion, Hart and Moore (1992)1 The modern capitalist market-oriented economy works on the foundation of the sanctity of contracts. These may be between private or public parties, individuals or corporate entities. What happens if a contract is breached? What is the recourse? Economic theory makes a distinction between ex-ante and ex-post behavior and the incentives of players involved in a contract. A contract which is attractive and mutually beneficial ex-ante, may not turn out to be so ex-post. Anticipating this, the contracting parties may find it necessary to agree a priori to have a neutral third party to enforce the contract. That is where the role of the state comes in, even in enforcing contracts between private parties. Parties have to approach a court and get a verdict on the course of action if a contract is breached.
A debt contract is a particular kind of contract wherein one party borrows money from another, with a promise to repay a higher sum in the future. If this contract is breached, it means the borrower has defaulted, either on the amount or on the timeline promised. The lender can then either seize the assets which was the collateral for the loan, or approach the third party (the state, or courts) by filing a suit. When the judgment is awarded, the enforcement machinery ensures that some compensation goes to the lender. This may involve seizing some personal property, or partial sale of assets of the borrower, or invoking guarantees if made by any third parties.
Unfortunately, such a straightforward process does not work when there are multiple creditors, or when debtors are insufficiently collateralised. Debt collection, even partially, by various creditors through uncoordinated actions can be time-consuming, costly and inefficient. There is a kind of ‘tragedy of the commons’ phenomenon that can happen in the competition between all creditors to recover their debts. As an example, if one creditor races ahead and tries to work out a private deal with the borrower to carve out a piece of the total assets, this itself may reduce the total value and lead to further value erosion. Or if another creditor brings a court order against the borrower, it may hamper the borrower’s ability to work out a satisfactory deal for all. The situation can get further complicated if the borrower deliberately takes advantage of the weakness on the creditors’ side, due to lack of coordination. As such in case of multiple creditors, the playing field is tilted in favor of the borrower, who can ‘play’ one creditor against another, or take advantage of asymmetric and imperfect information. That is why we have an arrangement of a consortium of lenders, wherein all information is shared to remove asymmetries. But even then, each creditor’s incentive may not be aligned with those of others, leading to time- inconsistent behavior, and incentive to renege on agreements. Indeed, such a description is not theoretical at all and has been experienced in Indian banking. For instance, prior to 2016, it was seen that in a consortium lending arrangement, where there was some stress on the borrower, some lenders had classified the loan as ‘non-performing’, whereas other lenders in the same consortium had shown the loan as ‘healthy’. This was creating all sorts of confusion. No wonder, the various initiatives of the Reserve Bank of India to sort out NPA problems using collective action of lenders did not produce any fruitful results. This is what ultimately led to the famous ‘February 12’ circular2 which tried to cut the Gordian knot, discontinuing all earlier schemes and asked banks to resort to the corporate insolvency resolution process (CIRP) under the Code. Unfortunately, this circular had to be struck down by the Supreme Court as ultra vires to the Constitution of India.
The above discussion highlights the difficulty of resolving breach of debt contract, simply by going to a third party i.e. a court. In case of multiple creditors there is a need to have an orderly mechanism to dispose of the assets of the debtor, and pay off various claimants, even if partially. The third party has to decide on who gets how much, with what sequence and seniority, and also to ensure that the process is fair and time efficient.
At this stage, from a theoretical point of view, we have to distinguish between liquidation and resolution. The former is the case of the debtor’s assets being sold or auctioned off, to pay fully or partially, in an agreed sequence of seniority to various creditors. The latter is the case where a standstill is imposed on all debts and due payments, and the debtor is given a chance to reorganise so as to be able to service all his debts, and returns to health and normalcy. This essentially has to be time bound and the process has to be fair to all parties. The US law distinguishes between liquidation, which is covered by insolvency law (i.e. Chapter 7 of the Bankruptcy Reform Act, 1978) and resolution and reorganisation(i.e. Chapter 11 of Bankruptcy Reform Act, 1978). Liquidation as a concept and process is more clearly defined, and can be seen as an ‘efficient, market oriented’ approach. But as Aghion et al. (1992) point out in their paper, this auction approach of Chapter 7 suffers from many drawbacks. There may not be many well-informed competing bidders, there may be absence of competition, or the incumbent management (of a debtor firm) may have an undue advantage in hiding the true value of the firm. The whole process of acquiring information about the entity is costly, consuming and hence may prove socially suboptimal. Hence liquidation is not the only solution to solving the issue of a breach of a debt contract.
Which brings us to the other option, i.e. reorganisation of business and resolution of the breached debt contract. In the U.S. context, this is covered by Chapter 11 of the statute, and in India it is the essence of the Code. But it may be appropriate to quote Aghion et al. here on the difficulty of the resolution process under Chapter 11 (and implicitly under the Code):
‘… (it) involves significant legal and administrative costs, (and time), not least because (incumbent) management has so much de facto power over creditors, and it is not in management’s interest to hasten proceedings if they are likely to end in liquidation… there can be a serious loss in value because of managerial distraction, incompetence or negligence; .. or a drop in demand (either because competitors behave more aggressively or because customers lose confidence)’.
There are also other disadvantages arising from low incentives of stakeholders with small stakes to be vigilant over the process, which tilts the balance of power further toward the management.
It is for this reason that a separate bankruptcy court, overseen by a judge or a similarly qualified person is necessary. From a social efficiency point of view bankruptcy proceedings cannot be mingled with other legal cases, as illustrated by the arguments above. The following section focusses on some of the salient features of the Code which explicitly or implicitly address the issues raised in the preceding section.
IMPORTANCE OF THE CODE
The passage of the Code is a historic milestone in the journey of India’s economic reforms. Some people say that the Code ranks on par with industrial delicensing of 1991, the acme of reforms from those tumultuous years. Capitalism and market economies need free entry and free exit to function efficiently. Delicensing of 1991 made free entry possible, and the Code now makes exit relatively painless. It is not as if the country has not tried to legislate how to close down businesses. The ghosts of the older institutions like Board for Industrial and Financial Reconstruction (BIFR) and laws like Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) still haunt us, reminding us of failed attempts at reviving or closing down of sick industries. The Code provides a mechanism and forum that is quick in resolving or liquidating failing businesses. Unlike under SICA where a government board played the key role, under the Code the key decision whether to restructure or liquidate is taken by the empowered committee of creditors (CoC). The CoC takes a commercial decision, collectively assessing whether a distressed firm can be revived or should be liquidated. The kingpin of the Code is the time limit hard coded in the law itself. From the moment an insolvency case is admitted, it has 270 days for the distressed firm to be restructured, or be sold off to a new owner, or else liquidation is automatically triggered on the terminal day. Creditors thus have an inbuilt incentive to hurry if they want to extract value. Most cases will try and avoid liquidation since it yields value even lower than the harshest haircut of a creditors’ forum. While in bankruptcy process, a distressed firm is as if in limbo. So, time is the enemy, and any delay just destroys value that maybe worth salvaging. Hence the time limit is an extremely crucial part of the new law.
The Code empowers a creditor who is owed an amount as little as one lakh rupees to trigger this process. It also provides for the establishment of a new regulator, the Insolvency The Economics of Bankruptcy Laws 27 and Bankruptcy Board of India (IBBI), which regulates the process as well as the insolvency professionals and institutions, and a new class called information utilities. The Code also led to the setting up of the National Company Law Tribunal, and its various benches, which admit cases destined for insolvency resolution. The amendment to the Code determined who can or cannot participate in the process. This reform was necessary to prevent promoters or related parties from getting back control of their firm at a distress value.
A PROPOSAL FOR REFORM OF PRE-ADMISSION STAGE3
A breach of a debt contract can lead the case being admitted to the bankruptcy process. The breach can be of as small value as one lakh rupee as per the Code. The important prerequisite is that it must be established that a breach has occurred. Is there an incentive for the debtor to deny that it has happened? Is there an incentive for the creditor to hasten even before an actual breach has occurred? What if there are disagreements? That is why there is need for a third-party adjudication at this pre-admission stage.
In the current framework of the Code, an application for a case to be admitted to the bankruptcy or insolvency process, has to be subject to a judicial review. A key feature of the working of the Code is the time limit, but that clock does not start until the case is admitted. How to prevent inordinate, unfair delay at the pre-admission stage itself? If the courts or quasi-judicial bodies examining whether the plea for admission to bankruptcy itself is kosher or not, are clogged with high work load, then a delay is inevitable. Why not streamline this process and speed up the pre-admission stage wherever it is possible? Is it necessary to always apply a judicial mind at the pre-admission stage even for open and shut cases with crystal clear evidence? If a company has defaulted on its payment due to a creditor, and there is an authentic paper trail of purchase order, invoice, payment reminder notices and so on, surely admitting such a case should be an administrative matter? If there is default on the phone bill, monthly installments on home loan or credit card payment, action from the service provider company follows without it landing up in court. Similarly, if a check list approach is adopted to verify the claim of a creditor, surely the process of admission would be quicker.
Unfortunately, it is not so straightforward. The pronouncement that a ‘breach of a debt contract has happened’ is an important step. Thanks to a Supreme Court judgment4, the admission to the CIRP under the Code requires application of a judicial mind. What if the defaulting company has a counter claim against the creditor? What if there is an error in the calculation? What if the service was not fully provided for which the claim is being made? What if it is a frivolous claim? For all these reasons, the apex court opined that a judicial bench should ‘hear out’ the parties. But at this stage it can lead to untold delays by adjournments, minor objections, or simply traffic jam of cases. Indeed, there are already stories of several months of delays in merely getting cases admitted. Furthermore, the kind of situations described above can largely be taken care of by a ‘templated approach’ of filling out forms in prescribed format. The information utilities too will play a role in minimising such situations. Alternatively, the hearing at the admission stage can be a written hearing not an oral hearing, requiring parties to be physically present. Adjournments for written hearings are not possible easily. Another option could be a short hearing and not a long hearing. Otherwise unpredictable and long delays in getting cases admitted will defeat the very purpose of the law. One is reminded how applying for and getting a passport used to take months because it needed a lot of ‘application of mind’ and fraud checking. Due to a template approach, process reform and digitisation, it is now possible to get a passport in a couple of days. Same is the approach in applying for small ticket retail loans. A template approach by the bank reduces the time taken for loan disbursal drastically.
Hence, the proposal is that there is a need to strengthen the CIRP under the Code by templatising the admission process and make it largely procedural. Artificial Intelligence and other automated procedures can also help in this. For instance, in a company with hierarchies of ‘approval and clearance authorities’, the introduction of enterprising resource planning software like SAP or Oracle, greatly reduced the inefficiencies. The author is not making a case that an admission to CIRP can be decided by a machine, but posits that a great degree of facilitation is possible. Only in a small minority of cases will a judicial hearing and scrutiny be needed. This will go a long way in making this landmark law more effective.
1 Aghion, Philippe., Hart, Oliver., & Moore, John (1992). The Economics of Bankruptcy Reform. Working Paper No. 4097, National Bureau of Economic Research, Massachusetts, USA.
2 RBI Circular dated February 12, 2018 on ‘Resolution of Stressed Assets — Revised Framework’
3 Based on Ranade, Ajit. (July 24, 2018). Entry into the insolvency process needs to be made easy, Mint, New Delhi edition.
4 Dharani Sugar and Chemical Ltd. v. Union of India, 2019 SCC OnLine SC 460
* Dr. Ajit Ranade is Chief Economist at Aditya Birla Group.