Dr. Shubhashis Gangopadhya*
Banks’ willingness to lend depends on their ability to get back the money that they have lent out. Banks lend to risky projects that are able to meet the debt repayment Schedule when they are successful but are unable to meet the banks’ claims when they fail. In classical economics, the rate of interest is sufficient to handle the riskiness of projects with those that have a higher probability of failure being asked to pay a higher rate of interest compared to a project that requires the same amount of loan but has a lower probability of failure. The fundamental assumption here is one of symmetric information – the bank and the debtor have the same knowledge about the probability of failure associated with the project.
However, in real life and financial markets in particular, information asymmetries are more the norm than the exception. The debtor has more knowledge of the project than the bank has. Consider project A and project B where B has a higher probability of failure. Owner of project A should pay a lower rate of interest than that of project B for the same amount of loan. Even if the bank is aware of the two types of projects it may not be in a position to know who owns project A and who owns project B. The two project owners, however, know what type they own. In such a situation, owner of B may want to masquerade as owner of project A. Since the bank knows this it plays safe and makes sure that it hands out contracts that assume all projects are of type B. Or, it demands a greater exposure of the owner, more owner funds or equity involvement, by restricting its own loans to the project. In other words, fearing project owner B, the bank gives less loans than it would have ifB-type projects were not around. In such situations, the rate of interest alone is not the relevant factor in loans. The economics literature on adverse selection (Stiglitz and Weiss, 1981)2 studies this in great detail.
Any project that a lender lends to goes through three broad phases – investment and creation of assets with initial investment, cash flows resulting from the operation of the asset thus created and, finally repayment of all outstanding non-shareholder claims. The problem with lending is that banks lend at the beginning of phase one and get back their full loan repayment at the end of phase three. The operational decisions in the second phase of the project are under the control of the management chosen by the shareholders. One part of the literature on credit rationing shows how moral hazard (Holmstrom and Tirole, 19973, Tirole, 2006), or opportunistic behaviour by the debtor in the second phase, is an important determinant of banks’ willingness to lend. More is the ability of banks to anticipate and prevent moral hazard greater will be the bank’s willingness to lend. By opportunistic behaviour we mean actions taken by the debtor, in the second phase of the life-cycle of a project, that transfer value away from the lender to the shareholders.
In addition to probability of default on loans and the presence of asymmetric information, there is a third factor that determines the terms and conditions under which a bank lends. This is the set of rules that govern the distribution of assets in a failed project. The rules and the procedures implementing them constitute the bankruptcy institution. This kicks in only when a project becomes insolvent and enables the bank to anticipate the extent of default when the debtor is unable to pay the full outstanding claim.
Bankruptcy institutions are of both research and policy interest because of their impact on bank’s willingness to lend. This is of special significance in an economy where employment and growth, through the financing of new and on-going businesses are major development concerns. A sustainable financial market institution that enables a larger measure of positive net present value projects to be implemented is considered better than one that is either not sustainable or, reduces the amount of funds available to business. The degree of willingness to lend is measured by the extent of credit rationing by banks. If banks are flush with funds, classical economics suggests that price of borrowing, or the interest rate on loans, should come down to encourage borrowers to increase their demand for loans. However, we have seen how, because of asymmetric information between borrowers and lenders, interest rates alone do not determine the demand and supply of loans. In other words, excess supply is not sufficient for the price (i.e., the rate of interest) to fall and mop up the excess supply of loans. This is clearly an inefficiency as banks make less profit than they can as they end up with unutilised funds. This, in turn, slows down the growths of both employment and income.
Financial market infrastructure performs three fundamental roles in the real economy: run the payment system, channel savings to new investment and, reallocate failed investments to new investments with positive returns. The ease with, or the cost at, which the third happens is a function of the bankruptcy institution. Maksimovic and Phillips (1998)5, Wihlborg, Gangopadhyay and Hussain (2001)6 and Bernstein, Colonnelli and Iverson (2018)7 study the efficiency of different bankruptcy systems in the world.
To appraise the efficacy of the bankruptcy institution, it is important to distinguish between two opposing forces that affect efficiency of investment during bankruptcy or, when a firm becomes insolvent. A firm is insolvent at any time when it is unable to meet a financial obligation that has become due at that point in time. Economists often refer to an insolvent firm as a distressed firm and distinguish between two types of distress. A firm is said to be in economic distress when its net present value (NPV) has become negative. In this definition of distress there is no reference to the firm having missed a financial obligation or, being declared insolvent because of a default.8 When calculating the NPV of a firm, or a project, all the future net returns (revenue minus cost) from the project are taken into consideration and discounted to the present. If this is negative, the NPV is negative. In economics, the project cost includes the opportunity cost of investment. Often when the value of an on-going project is calculated, the opportunity cost is not taken into account.
Suppose A runs a taxi company and has drivers and cars as assets (as well as dedicated customers). And, suppose A has a small amount of outstanding debt and little capital cost because her taxis are depreciated out and the revenue A earns is sufficient to service her debt, maintain the fleet of cars and pay her drivers enough to make them continue with her. However, because of Uber and commercial car leasing companies emerging on the scene, A is better off closing down her company, pre-paying her loan and starting an entirely new business. If A is considering only the net cash flow as her net returns, her company is both solvent and has positive value. If, however, A takes the opportunity cost of her managerial effort and time (i.e., the higher profit her time and effort will earn her in some other business), her company is of negative NPV. This is an example of a company that is solvent (for A can meet all her financial obligations) but in economic distress (since his NPV is negative).
Alternatively, a firm is in financial distress when it has defaulted on a payment obligation that has become due. Again, consider A’s taxi company but in this example, A is doing a roaring business. A is also a good financial manager of her company and does not keep excess liquidity lying around. A is supposed to make a debt repayment by the end of day today and A’s usual daily revenue and planned liquidity are together sufficient to make that payment. However, due to unexpected circumstances, the petrol stations shut down for the day, making it impossible for her to run her taxis and earn her usual daily revenues. The little revenue that she makes today and the accumulated liquidity together are not sufficient to pay the loan instalment that is due by the end of day. It is possible for the bank to claim that she has defaulted and take her to the bankruptcy court.
In such a scenario, if capital, or financial markets are perfect, it would be possible for A to raise a new loan to pay her dues to the erstwhile lender. The new lender would be willing to extend the loan to A as it knows that her business is of positive NPV and A will be able to pay it back. All that A has suffered is a shock to her cash flow and a days revenue losses will be easily made up in the future. At one point of time in such a scenario, A is staring at her erstwhile creditor getting her declared as an insolvent firm by the end of day. If she cannot arrange for the new loan to repay her due payments (because of imperfect capital markets) A becomes an example of a company in financial distress but with positive NPV.
Economic efficiency demands that her taxi company in economic distress be wound up, or liquidated, while in the second case (financial distress but positive NPV), her taxi company continues either with her or with some other management. To make matters more complicated, companies could be in both financial and economic distress. An efficient bankruptcy institution ensures that an efficient outcome is more likely.
Table below categorises the various issues involved here.
Table: Types of Distress and Efficient Action
|Economic Distress||The NPV of assets is negative under any management team||Piecemeal liquidation of assets|
|The NPV of assets is positive under a different management team||Sale of assets as a ‘going concern’ to enable a change of management|
|Financial Distress||The present value of cash flows is positive but it is lower than the value of claims by non-shareholders||Debt reduction along with restructuring and/or ownership change, if value of assets there by can be enhanced|
Source: Wihlborg, Gangopadhyay, Hussain (2001)
In only one of the four possible cases of distress liquidation is most efficient. This is because, in principle, the whole is larger than the sum of its parts. When a company is closed down, or liquidated, the intangible assets of the erstwhile company are dissipated. The most important loss comes from the dismantling of the ‘team of workers’. This is a recognition of the fact that employees work in teams and the gains made by them through coordination, specialisation and complementarity are lost when they are broken up. Consequently, an efficient bankruptcy institution is one that engenders a low likelihood of liquidation (i.e., liquidate only when necessary) and a high likelihood of reorganisation or capital restructuring, thus keeping it as a going concern.
One thing that has been widely observed is that the longer it takes for companies to pass through the bankruptcy process, the greater is the loss of asset value. This is usually proxied by the proportion of outstanding claims in an insolvent company that is recovered at the end of the bankruptcy process. Consequently, the two quick measures that economists use to compare the performance of different bankruptcy institutions are (a) extent of recovery and (b) the time it takes for the bankruptcy process to be completed.
ROLE OF THE CODE
India passed a comprehensive and new Insolvency and Bankruptcy Code (Code) on May 28, 2016. Prior to this, institutional debt defaults were handled through a number of different laws and regulations, like the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) ; the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI) ; the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI) ; and the Companies Act, 2013. In addition, for companies above a certain size, the High Courts had to be involved, especially in winding up decisions. The existence of these various laws made for a confusing and inefficient process and meant that people could file cases in different courts and tribunals delaying the restructuring process of bankrupt companies. The Code, being a uniform code, was meant to reallocate assets more efficiently and quickly.
The Code was drawn up with the objective to ‘consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India (IBBI), and for matters connected therewith or incidental thereto’9. Notice the stress on efficiency, the promotion of entrepreneurship and increasing the availability of credit in the objective of the Code.
Any unpaid creditor can approach the National Company Law Tribunal (NCLT), the sole judicial Adjudicating Authority for matters related to insolvency, which is effectively the bankruptcy court. Once the company is registered at the NCLT, it appoints an interim resolution professional (IRP) suggested by the applicant. A resolution professional (RP), who could also be the IRP, is appointed after the IRP submits its report (within 30 days). The (resolution process) is required to come up with a plan within 270 days of the registration of the insolvency proceedings. The objective of the resolution process is to come up with a restructuring of the claims that are acceptable to creditors. Only when that is not possible, will the company be liquidated. Clearly, the focus is on continuance, rather than abandonment, of the project.
From its inception in 2016 till the end of 2018 (the Code was implemented in December 2016), the Code has helped recover Rs. 1210 million in 61 big corporate debtors (CDs). The recovery rate is 46 per cent compared to 26 per cent under the previous bankruptcy regime. Within the first 2 years, 115 cases had completed the resolution process of which 92 were liquidated and 23 were reorganised through what has come to be known as the corporate insolvency resolution process (CIRP). The CIRP ends with either a resolution plan or an order for liquidation and liquidation commences only after CIRP has failed. The CIRP cases have taken an average of 243 days; while the average time for the liquidation order was 224 days. The Code had set a target of 270 days by which the resolution process was to be completed.
The decision to accept the resolution plan or go for liquidation is taken by the Committee of Creditors (CoC). The Code distinguishes between financial creditors (FCs) and operational creditors (OCs). Simply put, the FCs give investment loans while OCs are more like suppliers who are yet to be paid. According to the Code, only FCs are a part of the CoC with voting rights which are in proportion to their outstanding dues. The directors of the company and OCs (if their dues are more than 10 per cent of the total outstanding debt) can sit in the meetings but do not have voting rights. It is the CoC that receives, evaluates and votes on resolution plans.
The average realisation of FCs through CIRP was Rs. 215 crore (49.70 per cent of their outstanding claims). The first thing that is done before the resolution process begins is estimating the liquidation value of the CD. If these cases had ended in liquidation, the value received by the FCs would have been Rs. 119 crore (27 per cent of their outstanding claims). This is a rough and ready measure suggesting that the issues raised in Table above have been adequately addressed.
A better picture emerges if we take more recent data. Between January, 2017 and June, 2019 (i.e. in 2.5 years), 2162 companies went through the CIRP under the Code. Of these, 870 have seen closure and 1292 are still in process. Of those where the resolution process is ongoing, 445 or 34 per cent have gone through more than 270 days. This is largely because the process is halted by various entities appealing to courts against the decisions taken, or the processes followed, by the RP. Ours is a ‘rule of law’ society and parties who feel aggrieved have a right to go to the court. The court, through its various judgments and directions, creates the case law that sets the precedent for future disputes. Once the dust settles, there will be less uncertainty in the process and its outcomes and the CIRP under the Code will become smoother and faster.
Of those with closure, liquidation has been recommended in 475 cases, i.e. in 55 per cent of the cases. This may be misconstrued as a bankruptcy process that liquidates a majority of insolvent companies. In economics, restructuring is always better than liquidation especially if, restructuring is accepted by creditors over liquidation. This signals that the restructured entity has greater value than the liquidation of the erstwhile insolvent entity. Recalling Table above, liquidation, after all, is only one of the four possible efficient actions. However, what must be kept in mind when looking at these figures is 348 of the 475 (or 73 per cent of liquidation) cases are for companies that were already in Board for Industrial and Financial Reconstruction (before the Code came into effect). These were largely defunct entities with outstanding claims but with little more than scrap value. If these 348 cases are removed, we then have 522 closures, of which 127, or 24 per cent were liquidated.
A successful resolution plan needs the votes of at least 66 per cent of the CoC. If no resolution plans are proffered or accepted by the CoC then the firm is liquidated. The resolution plan could be a restructuring of the outstanding claims with or without a fresh inflow of equity or, liquidation.
The Code came into effect when the bankruptcy institutions were in limbo. As mentioned above, a number of competing legislations were being exploited by vested interests resulting in large amounts of valuable capital being stuck in some dispute or the other. The total nonperforming assets (NPAs) of public sector banks totalled USD 110 billion, as of September, 2017. The real problem, however, is better illustrated by the situation that prevailed as of October 31, 2015 and before the Code was enacted, which was as follows:
A special feature of the Code is that the OCs have no vote in the CoC. 10 Nevertheless, the OCs received 66.40 per cent of their outstanding claims in those cases that were resolved through the CIRP.
A SPECIAL FEATURE OF THE CODE
A distinctive feature of the Code is that, for the first time, the bankruptcy law has divided creditors into two groups, viz. FCs and OCs. While FCs offer loans at a rate of interest, OCs supply services and other inputs during operations and have outstanding payments due from the CD during insolvency proceedings. This distinction becomes important because in the CoC, where both types of creditors are present, the OCs do not have any voting rights; only the FCs can vote.
This asymmetry in voting rights in the Code between two groups of creditors resulted in a number of petitions in courts. Those opposing this feature maintained that this is discriminatory and puts OCs at the mercy of the FCs. The Committee that was set up to recommend a new bankruptcy code (that led to the enactment of the Code) had mentioned a number of reasons for dealing with the two types of creditors differently in the bankruptcy process. First, most FCs are secured creditors and, in any case, are supposed to be paid off before unsecured creditors like the OCs. The economics literature argues that, under optimal contracting (i.e., debt contracts with covenants attached to them), priority rules do not matter if, once set, they are not changed during insolvency procedures. Contract terms and conditions are adjusted keeping the priority of the loan in mind at the time of signing the contract. Putting it simply, the same loan will have different interest rates attached to it if its position in the priority ladder is different. What creates a problem is tampering with the priority ladder after it has been set.
Second, the OCs are large in number compared to the FCs but together have a much smaller exposure to the CD compared to FCs. Clearly, this increases the transaction cost of decision-making without changing the decision. Why? Given the large voting share enjoyed by FCs, and the fact they are few in number, it is easier for them to vote as a coalition or, out-vote the OCs.
Third, and most important, both for economists and for meeting the objective of the Code, the FCs are more interested in re-organising and restructuring the CD rather than shutting her down. In other words, FCs have long term interest in the CD’s performance while the OC is interested in being paid, regardless of whether the CD is liquidated or continues as a new entity.
The Supreme Court upheld all these arguments and ended with a very simple observation:
‘Ultimately, the total flow of resources to the commercial sector in India, both bank and non-bank, and domestic and foreign (relatable to the non-food sector) has gone up from a total of INR 14530.47 crores in 2016-2017, to INR 18469.25 crores in 2017-2018, and to INR 18798.20 crores in the first six months of 2018-2019. These figures show that the experiment conducted in enacting the Code is proving to be largely successful.’11
To understand the rationale even more, consider the following hypothetical example: the FCs of an insolvent debtor have an outstanding claim of 100 and the operating creditors have a claim of 50. Suppose there are two resolution plans, A and B, each of which has a bidder who is willing to pay 125 and 125 is the highest bid. Plan A treats FCs and OCs equally in the pay-out (i.e., FCs are offered two-thirds (=100/150) of 125 and OCs one-third of 125). Plan B, on the other hand, pays out 100 to FCs and 25 to OCs. Clearly plan B will be chosen by the CoC and not plan A since FCs get more under B.12 This, in essence, changes the effective priority between FCs and OCs with the former having superior claims over the asset value of an insolvent CD.
This has raised two issues. First, even though unsecured creditors are treated as one class in the priority list and contain both FCs and OCs, in effect, as the example above shows, it gives unsecured FCs claim over that of OCs. This, OCs claimed, is discriminatory and it was not intended to be such under the Code. Second, they and their supporters pointed out that this will increase the cost of doing business as suppliers will charge a higher risk-premium and, hence a higher price because of the lower effective priority under insolvency.
First, what could be the possible justification for introducing such a feature into the Code? The OC usually gets into the game after the FCs have signed their loan contract with the CD. Also, in India, the OC is, often, a subsidiary, or group company, of the CD. It is well established that the firm has better information about the immediate future prospects, compared to the creditors. In particular, if a company is going to become insolvent soon, the CD will have this information before the creditor. In the worst possible scenario, the creditor will know only when there is a default on its loan repayment schedule.
Let us go back to the last example cited above. In year t, the FC contracted for a debt claim of 100 in year t+2. In year t+1, the CD gets a signal that it will not be able to pay the FC next year. It can ask one of its group companies to over-invoice the amount of operational credit claim from 50 to 100. If the CD was buying from an unrelated party, it would have bought the material for 50. However, because the OC is a related party (group company), it can decide on a recorded price of 100. This can be done because it is difficult to find a market price of the material supplied by the OC. Given the specificity of the materials used in a market of differentiated products, it is easy to argue that the CD must have some control over its own supply chain and that would be lost if the debtor goes outside its supply chain. If it can succeed in this over-invoicing in year t+1, then when t+2 comes and it is unable to meet its debt claim by the FC, it goes into bankruptcy and gets paid (through its group company) an amount which is 0.5 of 125, instead of 0.33 of 125. This possibility of manipulation by related parties is recognised by many countries and it is not unique to India. In India, it may be more prevalent because of imperfect markets and lack of entrepreneurship.
However, the flip side is also possible as is evident in the now famous matter of Binani Industries Ltd. v. Rajputana Properties Pvt. Ltd. & Ors In the example being considered, suppose the two plans are X, which offers 90 to the FC and nothing to the OC and plan Y that offers a total of 100 to be distributed according to the proportion of each of the outstanding debt of FCs and OCs. Clearly, according to the Code’s voting rules, X will get passed but not Y though Y maximises the value of insolvent assets. Notice, however, that if the FCs had superior claims than OCs, then the resolution plan would be reworked in such a way that Y is the plan and FCs get at least what they were getting in plan X. Provided, of course, the proposer (funder) of plan Y is willing to do so.
There can be only one reason why the funder may not want to do this. She gains if OCs get paid more. This implies that the funder’s objective is aligned with the OC’s objective. And, that makes the OC a ‘related party’ to the funder. And, as the court suggests (in the Swiss Ribbons case), such ‘strategic default’ of loans, coupled with over-invoicing by related parties to take value away from (financial) creditors needs to be plugged. A little reflection will convince anyone that the voting rules in the CoC coupled with section 29A, does precisely that.
While new investment leads to growth and expansion of employment, the process can be sustained only if capital is re-deployed from economically unproductive use to economically gainful ones. The efficiency of this function of capital markets is determined by the bankruptcy institutions. Prior to the Code, the bankruptcy institutions were time consuming and, often, defunct. The Code is the first attempt in the Indian economy to set this right. The fact that it has had a positive impact is evident in the large recoveries made by FCs from assets that were tied up in insolvency processes prior to 2016. And, even after 2016, insolvent companies are being reorganised much faster than they have ever been. This should improve the credit market efficiency and, in particular, ease the credit constraints faced by new projects.
1 The paper has benefitted greatly from comments and suggestions by Dr. M. S. Sahoo, on an earlier draft. All remaining errors are mine.
2 Stiglitz, Joseph and Weiss, Andrew (1981). Credit Rationing in Markets with Imperfect Information. The American Economic Review, 71(3), pp. 393-410
3 Holmstrom, Bengt and Tirole, Jean (1997). Financial Intermediation, Loanable Funds and the Real Sector. The Quarterly Journal of Economics,112(3), pp. 663-91
4 Tirole, Jean (2006). The Theory of Corporate Finance. Princeton University Press. Princeton. New Jersey
5 Maksimovic, V. and Phillips, G. (1998). Asset Efficiency and Reallocation Decision of Bankrupt Firms. Journal of Finance, 53(5), pp. 1495-1532
6 Wihlborg, Clas, Gangopadhyay, Shubhashis and Hussain, Qaizar (2001). Infrastructure Requirements in the Area of Bankruptcy Law. Brookings-Wharton Papers on Financial Services, pp. 281-329
7 Bernstein, S., Colonnelli, E. and Iverson, B. (2018). Asset Allocation in Bankruptcy. Journal of Finance, 74(1), pp 5-53
8 This distinction will become clear soon.
9 Long title of the Insolvency and Bankruptcy Code, 2016
10 The directors of the CD and OCs can be present in the meetings but may not vote on the resolution process.
11 Swiss Ribbons Pvt. Ltd. & Anr. v. Union of India & Ors., (2019) 4 SCC 17 (Swiss Ribbons)
12 Indeed, observe that plan B will be preferred by FCs (who alone can decide) even if A has a bid of 130.
13 Civil Appeal Nos. 3638-2018
*Dr. Shubhashis Gangopadhyay is Research Director at India Development Foundation; Dean, Indian School of Public Policy; Professor of Emerging Market Finance, University of Groningen and Visiting Professor, University of Gothenburg.