Economy Watch – Indian Bankruptcy Reform: Where We Are And Where We Go Next

Indian Bankruptcy Reform: Where We Are And Where We Go Next.

Background:-

Bubble and burst are platonic partners.They are akin to  any other pair of platonic coupling , such as – high-low, dark-dawn,success-failure etc.There is only two facets of any risk , especially in case of entrepreneurial risk – Few will succeed and many will fail.This happened in the 1990s dotcom boom.India is staring at two probables of success and failure of entrepreneurship and  especially given it’s recent push for more entrepreneurship ,we will soon have our own version of bubble and burst.

There is nothing bullish or bearish about it- it is just , plain reality and proper channel to deal with it is thus essential.

As India unleashes its entrepreneurial capabilities in its run up to waking the sleeping giant , we are soon going to have our own bitter-sweet experience of bubble and burst.Few will certainly succeed , many will fail – No one knows for sure , who is who though , but then again that is the beauty of risk – Nobody is ever sure.Failure usually strikes at the very unfortunate moments and when companies go bust , they tend to disrupt normal lives and the world of its employees are shaken – recall the Satyam aftermath.

So , as reality of failure stares at us, it is quite-essential that, India should build a certain institutional mechanism to deal with it , not only to give a proper winding up mechanism but also to deal with the domino effect that ensues failure.In this prospect, a perfect Bankruptcy bill is the need of the hour and a critical analysis is thus called for.

Analysis:-

All business plans are speculative views of the future. Some will inevitably go wrong, either because of failures of conception or of execution. As India lacks the requisite institutional arrangements, at present, when a firm goes into default, the management, capital and labor get stuck in an interminable mess. With a sound bankruptcy process, we would be able to rapidly resolve the situation, and everyone would move on.

In India, the lack of a sound bankruptcy process implies a flawed legal foundation of limited liability companies. The classic definition of limited liability is a bargain: Equity is in charge of the company as long as all dues to Debt are met. When the firm defaults on its debt obligations, control over the assets of the firm shifts from Equity to Debt. This is not how India understands limited liability today. We tend to think that a company belongs to its founding family no matter what happens by way of firm default.

From Bits and pieces of Bankruptcy to a full fledged Bankruptcy code:-

One component needed for bankruptcy reforms was built by the Financial Sector Legislative Reforms Commission (FSLRC), led by Justice Srikrishna from 2011 to 2013. The `resolution corporation’ in the draft `Indian Financial Code’  is a specialised bankruptcy process for two kinds of financial firms: those that make intense promises to consumers, and those that are systemically important.

This component has been slowly moving towards implementation, after MOF first setup a `Task Force’ on the subject, and then made an announcement the budget speech of February 2016. But the bankruptcy process for all other firms was a project waiting to be done. Some work on these lines went into the Companies Act, 2013, but it only partly dealt with the mechanisms of restructuring and winding up.

The Budget Speech in July 2014 had one sentence in Paragraph 106:

Entrepreneur friendly legal bankruptcy (sic) framework will also be developed for SMEs to enable easy exit.

This sentence could have been done in an incremental way. Instead, it was taken on a more ambitious scale at the Ministry of Finance (MOF) with a policy project that would go beyond just an SME bankruptcy framework for India. I

In late 2014, MOF setup the Bankruptcy Legislative Reforms Committee or the BLRC, led by TK. Viswanathan, with the objective of building a full-fledged bankruptcy code.

The work of the BLRC was placed in the FSLRC division of the Department of Economic Affairs (DEA), so as to harness the institutional memory about the working of FSLRC. The BLRC submitted a two volume report on 4 November 2015. The report is similar to the output of the FSLRC: the economic rationale and design features of a new legislative framework to resolve insolvency and bankruptcy.

After the IBC was tabled, the Joint Parliamentary Committee on Insolvency and Bankruptcy Code, 2015 (JPC) was set up on the same day to analyse the draft bill in detail. The JPC submitted its report which included a new draft of the law. This is the draft Insolvency and Bankruptcy Code (IBC) that has since been passed by both houses of Parliament.

The essence of the BLRC proposal is a formal procedure, termed the `insolvency resolution process’ (IRP) which starts when a firm or an individual defaults on any credit contract. Any creditor is empowered to initiate an IRP: a financial firm or an operational creditor whether it is a non-financial firm or an employee. An insolvency professional (IP) called the `resolution professional’ (RP) manages the working of the IRP, and is responsible for compliance with the law.

Once the IRP commences, power shifts from shareholders/managers to the Committee of Creditors. This includes the power to take over management of the firm, the ability to change management, to bring in fresh financing, to ask for all information required in order to invite bids for commercial contracts, including from the existing creditors and debtor, to keep the enterprise going. Decisions are made by voting in the Committee of Creditors.

The process of resolving insolvency is similar for firms and for individuals. In the case of individuals, however, the final resolution plan must have the consent of the debtor. There are additional innovations in the process of individual insolvency in the IBC that will increase individual default resolution efficiency in India. One is the concept of the Fresh Start, which gives a debt write-off for individuals who are below certain thresholds of wealth and income at the time of default.

The reading of the law reveals seven areas of concern:

1. Precision of language.

2. The working of the regulator.

3. Information utilities.

4. Insolvency profession Provisions.

5. Forbearance.

6. Judicial infrastructure and

7. Transition issues.

That Parliament has passed the law is a major step forward. However, in and of itself, this does not yield success in the sense of getting to the desired economic outcomes. While some elements of the process that led up to this law were well done, in many respects, there were shortcomings compared with the 11 principles of sound process design for drafting of laws. The IBC, 2016, is an important milestone, an important way station in the long journey of Indian bankruptcy reform. But it does not, in and of itself, deliver an improved bankruptcy process for India. Now, seven areas of work are required.

Conclusion

The BLRC process, and the law enacted by Parliament, are major milestones in India’s economic reform. However, they are the beginning of the journey to bankruptcy reform and not the destination.

What would constitute tangible proof of success in Indian bankruptcy reform? Two events and four key data series define the report card for this.

Event 1. When a default of a Rs.10 billion firm takes place, it swiftly goes into the bankruptcy process, which leads to a transaction where the firm is sold as a going concern to a new strategic buyer or a private equity fund, and a good recovery rate is obtained by the lenders.

Event 2. When a default by a Rs.10 billion firm takes place, the firm gets smoothly put into liquidation within a short time, and a good recovery rate is obtained by the lenders.

Four key measures. Successful bankruptcy reform should mean an increase in four measures through time:

1. The leverage of firms (holding business risk constant),
2. The share of borrowing from the financial system in the total debt of firms.
3. The share of non-bank borrowing in borrowing from the financial system.
4. The share of unsecured borrowing in total debt.

On all four metrics, things in India have become worse over the 1990-2013 period. But a strong team, with focus and competence, is needed to work on these issues, and this could yield success in a few years.

Welcome the success but have the courage to hug the failure.And on the later Bankruptcy rests its weight- the swifter , smooth and better managed exit without dominoes is the key for the bill to succeed. It had to succeed in managing failures-that’s the irony.