Mr. G. N. Bajpai*
In the streets of the financial market at Mumbai, there has been a standing epistolary for long time. It states ‘Starting a business enterprise in India is like a ‘chakravyuh1; one can get in with Abhimanyu’s abilities of Sam, Dam, Dand, Bhed, navigating all the Maharathis at various check posts, but cannot get out.’
Every business enterprise, big or small, has either of the two propensities, success or failure. In the case of success, the entrepreneurs and all other stakeholders, including providers of financial capital enjoy the benefits of success, albeit in varying degree. However, if the business fails, all the stakeholders suffer, more so the owners of financial capital. The system must, therefore, provide at least an easy exit in the event of failure so that the pain is minimised and the salvage value is optimised and quickly put to better use. Unfortunately, until the Insolvency and Bankruptcy Code, 2016 (Code) was introduced in 2016, the exit journey of failed businesses was arduous, long and messy, and travelled through the ultimate process of painful winding up in most cases. In fact, many of the business enterprises remained in a kind of animated suspension, like vegetated bodies on life support until the ‘brain’ is dead.
Any commercial activity, and in particular, a formal enterprise necessitates engagement of all the three factors of production viz. land, labour and capital. The owners of land, labour and capital look for opportunities to deploy their surpluses with a view to earn adequate returns with safety and liquidity. Entrepreneurs, people with ideas, competence and risk taking ability, look for resources to convert their imagination, invention and innovation into useful products and services, and commercialise them to create wealth for the economic good of all the stakeholders. Markets provide a platform where owners and users shake hands and engage to deploy available resources gainfully with full freedom and abundant opportunity, and efficaciously share the wealth created; while contracting to share the risks involved in the process.
EFFICIENT MARKETS AND THE REGULATORY PARADIGM
Liberalised markets lead to more efficient use of capital and other resources. The important pillars of efficient markets, inter alia, are ease of ‘entry’ and ‘exit’. The ease is necessary not only for establishing, running and/or for closing down an enterprise, but also for quick engagement and disengagement of resources so that idleness or sub-optimal use of resources is minimised, if not eliminated altogether. Globalisation has provided wheels to financial resources, in particular to shop across geographies in search of lucre with lower risks and easier passage. It is in this perspective that globally, managers of economies have been at pains to improving the ease of entry and exit along with laying down a pragmatic framework of ground rules and effective enforcement mechanisms to guide the behaviour of participants in the market.
The intended outcome of an efficient market is optimal wealth creation out of the resources employed, which goes to help the nations to eradicate economic deprivation and bring about prosperity. Empirical researches suggest that growth of Gross Domestic Product (GDP) of an economy, a barometer of wealth creation, is higher in countries with more efficient markets. And that most of the economically prosperous countries have liberalised and efficient markets.
Among the three factors of production the most important is capital. This is so because financial resources help an enterprise to buy/hire land and labour and conduct operations. Hence, the availability and cost of capital become an important factor for the commencement, growth and sustainability of businesses. In efficient and vibrant capital markets, the availability of financial resources is easier and higher, and the cost lower. The greater success of larger number of enterprises makes it expedient to build efficient financial markets. Architecturing efficiencies and enhancement of its robustness require an appropriate legislative and regulatory framework and efficacious processes including ease of ‘entry’ and ‘exit’ of engagement of the financial capital.
Unfortunately, India did not have a clear, concise and composite exit policy until the Code was introduced in 2016. Exit policy has been one of the signature structural reforms of the NDA Government during its tenure of 2014-19. Bankruptcy academics firmly believe that a bankruptcy policy is an important element of any set of institutions designed to speed up economy recovery. 1 Modi Government’s 1.0 inherited a declining economy. Its recovery in addition to paving the road for high growth trajectory was uppermost in the mind of the Political Executive.
It might be worthwhile to note here the findings of research of Mariana Succuro,2 University of Colombia, Italy. She, inter alia, outlines that empirical evidence suggests:
In fact, a number of other empirical researches have also revealed that the growth of gross GDP is positively associated with an efficient bankruptcy system.
Needless to say that without adequate investments the wheels of an economy cannot run. The higher the rate of investment, greater is the growth of GDP. The author believes that there is a kind of 4:1 relationship between investment and GDP growth; an investment of 40 per cent of GDP can lead to 10 per cent GDP growth.
Amongst the important features of the Indian exit policy or the Code is the departure of the erstwhile and arrival of new management to husband the resources for taking the enterprise to the route of success. This change in ownership and control has shifted the balance of power from debtors to creditors. Until recently India was a debtor-friendly economy, where creditors were at the receiving end. The shift has brought a salutary effect on the psyche of borrowers whose behaviour seem to be changing fast. The transformation is plugging the erosion of wealth, helping better utilisation of resources and enhances wealth creation. For example in some of the well-known high profile cases, which have been resolved through National Company Law Tribunal (NCLT) under the Code like Bhushan Steel, Electrosteel, Binani Cement etc, the ownership and control have changed following the acquisition by the new entrepreneurs/companies. The resources employed are being better utilised to create greater wealth and all the stakeholders, in particular lenders, are better off. Lenders have received (100 per cent in case of Binani Cement) a significant part of outstanding dues, most of the jobs have been protected and plant and machinery etc. has been put to better use.
In cases the enterprises cannot be revived, the residual resources released out of winding up are put to more efficient use elsewhere. In comparison, in the current scheme of exit through Code, resolutions are faster, realisations greater and wealth protection is higher. In the previous regimes of Board for Industrial and Financial Reconstruction (BIFR), Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI), Corporate Debt Restructuring (CDR), Scheme for Sustainable Structuring of Stressed Assets (S4A), etc. the distressed enterprises perennially remained in the state of revival. ‘There were sick enterprises owned by healthy entrepreneurs’, goes an old market adage.
THE CODE AND ITS BEHAVIOURAL OUTCOMES
It might be useful to assess how the Code is influencing the behaviour of various participants in the chain of economic growth. According to the author, they can be grouped into six broad categories, viz., lenders, operational creditors, borrowers, entrepreneurs, workforce and the economy at large.
Any lender, whether an individual or entity looks at the proposition of lending from the three cannons of investment namely safety, liquidity and return and creates an optimal mix tailored to its priorities. The lenders’ decision is based on the assessment of risks, particularly with reference to the environment around the borrower. Actually, the risks are assessed in each of the three buckets and the interest rates are priced accordingly. The safety/return of monies lent alongwith interest is one of the most important criteria.
According to game theory, borrowers’ best option is not to repay. India can provide some shining examples of borrowers’ game theory. The creditors’ option in such a scenario is not to lend. However, beyond game theory, the lenders are conscious that businesses and even individuals do fail. If there is a bankruptcy system, the lenders can broadly assess the cost, speed and the possible amount of recovery in the event of financial or even economic distress. This weaves the tapestry of the confidence of lenders beauty of, which is directly proportional to the level of efficiency of the system. Higher the confidence, greater is the willingness to lend.
The current environment of hesitation to lend validates the surmise. Further, the risk premium that lenders build into pricing comes down. Currently, risk premium in India is much higher compared to economies with the efficient bankruptcy system. Once the Code comes in full play the cost of lending should go down and the pace of lending will increase.
During the currency of the business of an enterprise, the suppliers of goods and services extend credit. In case of financial distress, these creditors also suffer. The financial distress of enterprises receiving resources results in seriously impacting the financial health of the entities extending credit. In fact, there are umpteen number of cases, particularly amongst Small and Medium Enterprises (SMEs), which have folded up as a consequence of non-recovery of receivables. In the absence of the Code, these lenders had no worthwhile recourse and had to write off the outstanding in most cases.
The Code has special provisions for SMEs, which enables them to take an enterprise to NCLT for overdues of one crore rupees and above. Anecdotal evidence suggests that recovery rate of outstandings of SMEs have significantly improved just by issue of notices.
Further, the Code provides a minimum of 10 per cent out of the resolution proceeds to be shared amongst the operational creditors. Even though, operational creditors grudge in every resolution reached so far about the low payment, their sharing has to be viewed in the context of seniority of the obligations of the distressed entity. Further, in the past operational creditors could hardly recover any amount and it used to be a total write off. In any case, now there is clarity about the risk of default and its fallout which should encourage them to de-risk by improving the contractual processes etc. Reduction of the economic pain of operational creditors also helps the economy on an aggregate basis.
The availability of credit encourages borrowing. The borrowings go to stimulate the economy through production and/or purchase of goods and services, property as also taking the risk for establishing businesses. However, distress adversely influences their future credit, reputation and self-image. Efficient bankruptcy system enables the borrowers to get out of the stranglehold with ease and certainty. The assessment of consequences enables the borrower to take risk mitigating measures. In fact, a borrower can escape being sunk in the whirlpool of debt and steer out reasonably well to a new start. ‘A generous consumer bankruptcy system provides insurance against financial risks faced by household’.3
An effective bankruptcy system is an important pillar of the entrepreneurial economy and India is more of an entrepreneurial economy. The innovations flower is an environment of success, which enthuses the flow of capital for new initiatives, ventures and ideas with potential prospects of high returns. However, high returns also envisage high risk taking, which may lead to losses.
The flow of financial resources helps in unleashing animal spirits and growth of the economy. In the absence of an efficient bankruptcy system, failure of business sticks to the entrepreneur as a stigma and sometimes leads to social ostracisation, which often culminates into the death of entrepreneurship. An efficient bankruptcy system helps the entrepreneur in case of failure to go through the resolution or winding up process in a predetermined time frame and move on in life. More and more entrepreneurs are encouraged to set up enterprises with greater confidence in countries where failure is acceptable.
The Hon’ble Prime Minister in his earnestness to promote the faster economic development of India has given a call, ‘Stand up India’, with a view to promote the rise of millions of new enterprises. In a metamorphosed environment of the day where the sustainability of success cannot be guessed, fusion of multiple life-changing ideas are causing upheavals and speed of failure descends like a tornado, the efficiency of the bankruptcy system can provide a protective umbrella to entrepreneurship and prepare them to overcome the fear of failure.
Indian bankruptcy code provides for the revival of the enterprise as the primary option. Revival with the change of ownership and control, in particular helps in saving most of the jobs and in some cases all the jobs in the enterprises under stress; Bhushan Steel and Binani Cement are cases in example. Even in those cases where revival does not become possible, winding up goes through in a predetermined time frame and thus spares human resources along with residual financial and physical resources to be gainfully employed elsewhere. The entire process reduces the eventuality of the misery of the human resources engaged in failed enterprises. The lower the misery, the lesser is the impact on the economic health of employees and on aggregate demand of the economy. In fact, it reduces the dependence of unemployed on society and spares resources, which would have otherwise been distributed amongst them. Thus the efficiency of bankruptcy code helps faster recovery and continued growth.
Economy at large
There are two obvious advantages of an efficient bankruptcy system to the economy of a country. First, it makes the financial market, in particular the debt market more efficient. Its scope enlarges to the trading of even junk bonds. The pricing becomes transparent and finer. Second, an efficient bankruptcy system reduces the friction in the movement of resources from suboptimal to higher and best use. This has been validated by Jackson and Skeel (2013).4
Apparently, in the Code, the possibility of the promoters and/or managers being dispossessed of assets and the right to manage has sent shivers down their spine. They were used to restructuring (CDR), strategic restructuring (S4A), ever greening, and haircuts. Now they are at the receiving end and have to accept the verdict of NCLT.
This exit policy is likely to eradicate crony capitalism, gold plating, under and over invoicing, serial defaulters and lead to lower leveraging, responsible behaviour and above all better allocation of capital.
The Government and the legislators must be credited for bringing about a thoughtful legislation, which substantially closes the escape routes and also lays down a watertight time frame for disposal of the cases that are referred to NCLT. The lending scene and the business environment is undergoing a traumatic transformation, which will result in better utilisation of resources and thereby higher economic growth.
The Code has been in full play only for about three years. Whereas, some positive impacts on the behaviour of various actors in the game are visible, adequacy of legal structure, the efficacy of court proceedings, the efficiency of enforcement mechanism and speed and effectiveness of the entire range of intermediary processes are required to be strengthened.
The economic agents in the Indian financial markets are trying to game the system at every stage. The aggregate game theory (of Indian Market) looks much deeper and wider. The impact thereof can be visualised in overshooting of time lines, increasing costs and lower recoveries. In quite a few cases frustrations are obvious and seepages of values visible. However, the Government and IBBI are at pains to take quick policy action to prevent the system from being gamed.
Bankruptcy system is known as the plumbing of economics. It enables the economy to flush out inefficient businesses and reallocate capital to more efficient uses. Unfortunately, in India, too many taps have been leaking for too long. Rent seekers have been thwarting the plumbing. Fortunately, the desired exercise is on and the Indian economy is poised to benefit from a modern, sophisticated and comprehensive exit policy. Once the robustness of the system is ensured, the confidence of domestic and global investors will grow further and the flow of funds will substantially increase benefitting the growth of the economy.
1 Jackson, Thomas H. and Skeel Jr, David A. (2013). Bankruptcy and Economic Recovery. University of Pennsylvania, Law School.
2 Succoro, Mariana. Bankruptcy Systems and Economic Performance Across countries: Some Empirical Evidence. Department of Economics
3 Grass, Tal, Blunder, Raymond, Liu, Feng, Notowidigdo, Mathew, J., Wang, Jialan (2018). The Economic consequences of Bankruptcy Reform. https://economics.mit.edu/files/16255
4 Jackson, Thomas H. and Skeel, David A. Jr (2013), Bankruptcy and Economic Recovery. University of Pennsylvania Law School. Faculty Scholarship Paper p. 476.
*(Mr. G. N. Bajpai is a former Chairman of the Securities and Exchange Board of India and Life Insurance Corporation.)