## Wednesday, May 18, 2016

### Indian bankruptcy reforms: Where we are and where we go next

by Ajay Shah and Susan Thomas.

Note: The 2017 state of the art is out.

Bankruptcy reforms have been moving forward at a blistering pace for the last few weeks, with the Insolvency and Bankruptcy Code ("IBC") being enacted by the Lok Sabha and then the Rajya Sabha. In this article, we take a look at where we are in Indian bankruptcy reform, and where we need to go next.

### 1   Bankruptcy reforms in the context of Indian economic reform

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 labour 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. This is the best outcome for society at large. In such a world, there would be more entrepreneurship, more risk taking, more debt, more unsecured debt, and more non-bank debt.

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.

As a financial agency with a keen interest in good bankruptcy outcomes for banks, RBI has led many attempts at bankruptcy reform. These include CDR, SDR, wilful defaulters, and ARCs. However, these have not delivered results. Even if these policy initiatives had been better designed, the role of RBI in the credit market is inherently limited because there is much more to lending than lending by banks. The bankruptcy process requires a machinery that is grounded in Parliamentary law, which is beyond the powers of regulations or informal arrangements made by a financial agency.

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' (version 1.0 in 2013 and then version 1.1 in 2015) 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 in Para 90(i) of 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.

### 2   The journey to the law

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. In late 2014, MOF setup the Bankruptcy Legislative Reforms Committee or the BLRC, led by Dr. T. K. 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 was in Volume 1 and the draft bill was in Volume 2. These materials were put on the MOF website. A modified version of this bill, with public comments incorporated, was tabled in Parliament in the winter session on 23 December 2015.

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.

### 3   The key ideas of the BLRC report

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.

For firms who have significant organisational capital, the value of the firm as a going concern in the eyes of a buyer would exceed the liquidation value of the assets of the firm. Such firms are likely to attract bids where the value of the firm is more than the value of its physical building blocks. However, organisational capital rapidly depreciates. Hence, it is critical for the IRP to begin quickly and move forward quickly, aiming to get closure while the firm is still a going concern, so as to avoid value destruction with the firm becoming defunct.

Speedy resolution is incentivised in the IBC by having a time limit of 180 days for the IRP. If, in 180 days, 75% votes in the Committee of Creditors do not favour one resolution plan, the debtor is declared bankrupt. The IBC then provides clarity about which assets are available for liquidation, and a clear prioritisation of who has rights to these assets for recovery, in liquidation.

In general, the recovery rate for creditors is lower when a firm goes into liquidation. This creates incentives for the creditors to be rational about their activities in the critical 180 days.

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.

Another innovation concerns an individual who has offered personal guarantees to support firm loans. When the firm default triggers these guarantees, it is likely to stress the personal guarantor to default and trigger individual IRP. Under the IBC, ordinarily, this individual insolvency case is heard at a Debt Recovery Tribunal (DRT). S.60 establishes that the IRP of the personal guarantor will be heard in the same court as the firm IRP, which is the National Company Law Tribunal (NCLT). This can lead to a quicker resolution and recovery for creditors who lent to the firm based on the personal guarantee.

This is the essence of the IBC. In order to make this work in India, IBC envisages four critical pillars of institutional infrastructure:

1. Robust and efficient adjudication infrastructure will be required, on the lines of the Financial Sector Appellate Tribunal that is proposed in the Indian Financial Code.

2. A new regulated profession -- of Insolvency Professionals (IPs) who can be Resolution Professionals and Liquidators -- is required. India has a long history of failure in regulation of professions, as is seen with lawyers, chartered accountants, doctors, etc. The success story here is the regulatory system run by exchanges for brokers. These ideas need to be brought into making the insolvency profession work.

3. Delays destroy value, and disputes about facts in India can drag on for years. A new industry of information utilities' (IUs) is required who will control trusted data, pertinent to the operation of the IRP as well as used during Liquidation. This would draw on the success that India has had with the working of the securities markets depositories.

4. A regulator is required, to perform (a) The legislative function of drafting regulations which embed details about the working of the IRP; (b) Legislative, executive and quasi-judicial functions for the regulated industries of information utilities and the insolvency profession; and (c) Statistical system functions.

### 4   Strengths of the BLRC process

The BLRC process had four sound features.

1. Systemic reform. BLRC embarked on a systemic reform. It did not incrementally modify existing laws such as the Companies Act, 2013, or SARFAESI.

2. Using local domain knowledge. The project was staffed with people who were grounded in knowledge of India. While international experience was fully utilised, it was not mechanically transplanted. As an example, the BLRC was aware of the US debtor in possession' mechanism, and consciously chose to not use it based on wisdom about how this would work under Indian conditions. These decisions were made based on local knowledge about how alternative institutional arrangements would work in India.

3. Innovation. The BLRC was not merely imitative. The proposals were novel in many respects, with a focus on solving problems rather than reshuffling a fixed menu of possibilities. One example of this is the concept of a regulator that writes subordinate legislation in order to obtain malleability in the design of the bankruptcy process, which is not found in the bankruptcy process elsewhere in the world. Another example is the rearranging of incentives for rapid and rational thinking during the IRP, in recognition of the difficulties of banks in India.

The conventional Indian solution for information utilities would have been a government-run monopoly like MCA21. Instead, the BLRC envisaged a private competitive industry of IUs. The conventional Indian solution for regulated professionals would have been a monopolistic association, similar to ICAI, ICSI, MCI, BCI. Instead, the BLRC visualised a private competitive industry of self regulatory organisations, the IPAs, who would oversee IPs.

4. Capacity building. The journey to the BLRC report and draft law has created new knowledge (web site) and a community which has expertise on this subject. This opens the possibility of sustained progress on India's journey to bankruptcy reform, with a local community of expertise, who are committed to work on the reform over a sustained period.

### 5   Analysis of the law

Our reading of the law reveals seven areas of concern.

1. Precision of language. In all countries, insolvency and bankruptcy law is a detailed procedural law, where the efficiency of the outcome is driven by the clarity and precision of the provisions in the law. This is unlike other laws, e.g. the Indian Financial Code, which have more of concepts and less of gritty procedures. This clarity is critical to ensure that any party reading the law comes to the same interpretation of the law -- be it lawyers, practitioners or judges. Vijay Mallya and his ilk are not going to accept their loss of power and assets without a tough legal fight. IBC as passed by the Parliament has many flaws which give grounds for concern. As an example:
• The law is silent on what denotes evidence of default, which was proposed by the BLRC to be a record in an IU.
The law requires a financial creditor who has triggered an IRP to furnish a record of the default from an IU or such other record or evidence of default as may be specified by the Regulator. Similarly, the law requires an interim RP to collect claims. However, it does not specify the kind of proof that a claimant needs to submit to the interim RP. Both these provisions negate the incentive to file financial information in an IU, especially where the law is generally silent on what kind of firms need to file financial information in IUs mandatorily.
• Section 30(2)(c) says the resolution plan must provide for the management of the affairs of the Corporate debtor after approval of the resolution plan. This imposes uncertainty on how the resolution plan can be assessed, which in turn, increases the possibility of higher judicial intervention.
• The numerical values included in the law for many time limits could give cause for the adjudicator to permit an extension on the time to decide on a resolution plan. This raises concerns about the extent to which the core objective of bankruptcy reform -- speed -- would be achieved.

2. The working of the regulator. India has ample experience with bad performance of regulators. One important source of these persistent failures is the faulty legal foundations that define the working of regulators. Other countries solve this problem by having a general legal framework for the working of regulators (as in the case of the U.S., but absent in India) or in the laws that establish regulators (which is present in IFC but missing in the IBC). While the report submitted by the JPC reiterates the criticality of role of the regulator, a sound chapter in the law that establishes the regulator is absent.
Particularly worrisome are elements such as S.226 which gives the power to the government to reconstitute and supercede the Board, which hampers regulatory independence.

3. Information utilities. The legal provisions for the IUs ought to have been as detailed as the Depositories Act. This has not been done. Examples of faulty provisions include:
• IUs are supposed to be a private competitive market. However, the law has failed to incorporate insights about the competitive market within which IUs were intended to operate. There was to be only one price, for data submission, and multiple IUs would compete in offering lower prices to those who submit mandatory information. The draft bill now has the concept of a one-time registration fee. It is not clear how IUs will have a revenue stream and effective mechanisms for competition.
• Provisions on authenticity and repudiability of IU records as evidence of claims and default have not been introduced into the draft bill.
• Provisions for data privacy are lacking.

4. Insolvency profession Provisions governing the legislative, executive and quasi-judicial functions of the IPAs ought to have been as detailed and complex as provisions governing the creation of exchanges and other such financial market infrastructure institutions as in the IFC. This is missing in the law.

5. Forbearance. At several places in the law, there are exemptions in the process that can be granted by the Central Government. This is a matter of grave concern. As an example, forbearance in banking regulation gave us the banking crisis today.

During the IRP, the Central Government can exempt transactions from the moratorium, in consultation with any financial sector regulator (Section 14(3)). Likewise during liquidation, while no suit can be instituted against the corporate debtor once a liquidation order is passed, the Central Government can exempt legal proceedings from this provision, again in consultation with any financial sector regulator (Section 33(6)). These provisions are dangerous.

6. Judicial infrastructure. The law does not set in motion a world class tribunal. By being silent on this issue, the draft bill ran the risk of delays and transactions costs associated with courts and tribunals in India today. A bankruptcy process that works in the unit of days is alien to today's courts that work in the unit of months.

7. Transition issues. Full care on repeals is required. Some of these are repeals of primary laws, and some are incompatibilities with subordinate legislation. However, these are absent in the law.

### 6   The way forward

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.

### 7   Work area 1: Improvements of the law

The first area of concern is a thorough review of the law. This is a law that is going to be actively litigated. Defaulters of the future are not going to cede power to the Creditors Committee without a fight. Expert input should be sought now, on anticipating these problems, and strengthening the draft. This will require an understanding of not just the law, but all the points in the process which interacts with other laws of the land.

The alternative way to fixing the law will be to run through cases that are lost in the Supreme Court over the next five years. For example, in the case of the Companies Act, 2013, many years elapsed between enacting the law and starting to solve the problems of a poorly drafted law. If such delays can be avoided with the IBC, this would improve matters.

### 8   Work areas 2: Drafting of subordinated legislation

The law embeds large areas for subordinated legislation, both rules (by the government) and regulations (by the regulator). Even when the law is faulty, it is possible to rescue things by good quality drafting of this subordinated legislation. Whether this possibility materialises depends on the choice of team, and the regulation-making process that is employed.

### 9   Work areas 3,4,5,6: Building the four pillars of institutional infrastructure

The second key concern is the four pillars of institutional infrastructure. Enacting a law does not induce the requisite State capacity. The regulator has to be built. The DRTs have to be upgraded and the NCLT has yet to be set up. An engagement with the private sector is required in bringing forth the first wave of firms who will be information utilities (IUs) and insolvency profession agencies (IPAs). Without these four pillars of institutional infrastructure, the law is infructuous.

A well drafted IBC would have created better incentives for the sound working of the four pillars of institutional infrastructure. Given the flaws in the IBC, this task has become harder. An even higher quality effort is now required, to achieve sound institutions. In parallel, the law requires many modifications as an integral part of this process of institution building.

For example, there are proposals today to improve adjudication infrastructure through the use of information technology. In and of itself, this will not deliver the desired results. Just as in education, it is necessary to have school buildings, but this is not a sufficient condition. The problem is much more complex, it is about establishing sound processes for the judiciary. The mere presence of a computer terminal in every court room will not deliver the outcomes desired here: to ensure that an IRP can be admitted within the day of the application, or that a creditors' committee can be finalised within a fortnight that the IRP starts.

A Task Forces' process was used to implement institutional infrastructure for the FSLRC report. MOF initiated `Task Forces' with a group of subject experts to plan and oversee the implementation. A similar approach needs to be adopted by the implementing ministry for the IBC to create the four pillars of institutional infrastructure.

### 10   Work area 7: Project management for the transition

The last one year of the old regime and the first one year of the new regime are going to require particularly careful planning and handover.

For example, the RDDBFI Act needs to be amended in order to have the DRTs serve as the adjudication infrastructure for individual cases under IBC. At present, amendments have been proposed to both the RDDBFI Act as well as the SARFAESI Act, been tabled in the Lok Sabha and referred to the same JPC as IBC. The legislative process here should be taken as an opportunity to align these laws to suit the purpose of bankruptcy reform.

### 11   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.

Here is where we are on these metrics, based on non-financial firms in the CMIE database. In all cases, values shown are the average for 3 years, centred at the year of interest, and the firms that are observed in all 3 years are used for the computation. If bankruptcy reform makes progress in India, then we will see bigger values in coming years on all four metrics:

Indicator Units 1990 2000 2013
1. Leverage Times 3.41 2.87 2.77
2. Financial debt to total debt Per cent 42.9 42.5 37.5
3. Non-bank debt to Financial debt Per cent 56.2 56.0 31.3
4. Unsecured borrowing to total debtPer cent 20.3 22.1 18.4
Number of firms 1163 5858 10594
Total assets Rs.Trn. 1.37 12.44 94.35

On all four metrics, things in India have become worse over the 1990-2013 period. Everyone is keen on the outcome: the six dimensions of success articulated above. A strong team, with focus and competence, is needed to work on these issues, and this could yield success in a few years.

Ajay Shah is a researcher at the National Institute for Public Finance and Policy, New Delhi. Susan Thomas is a researcher at the Indira Gandhi Institute for Development Research, Bombay. The authors thank Anjali Sharma, Bhargavi Zhaveri, Pratik Datta, Rajeswari Sengupta, Renuka Sane, Richa Roy, Shreya Garg, Shubho Roy and participants in a seminar at JSA for improvements to this article.

#### 1 comment:

1. Having learnt about and understood bankruptcy in shipping in the great maritime recession of the '80s as a very young seafarer shoe-horned into commercial simply because I could write and type well, I find this the key sentence in your analysis wrt India - "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."

In the '80s, Indian flag shipowners who went bust took everybody down with them, and the ships were eventually sold as junk and scrap. On the other hand, shipowners from countries where people were used to moving fast when going bust, sold their ships and every other asset they had including their personal paintings and antiques, just so they could keep their global reputations intact and rise again.

I myself worked for a short while for a HK operator, and the honesty with which he handed over ships to new buyers even when he was going downhill rapidly, was the reason why within a few years when he read the tea-leaves properly, he was right back in the middle of things, and is today amongst the biggest in the world.

The other point I want to get across is that if even a couple of cases where bankruptcies result in smooth transitions are going to happen very soon then there is a signal sent out to others. Legal tangles delaying matters is another aspect - if people have to pay their legal fees from their own personal pockets and not stick them to their sinking companies which they control, then the legal tangles may not last as long.

Finally, within Indian realities, my submission is that bankruptcies are often planned events, right from the start, NPAs and therefore bankruptcies are planned events just like are insurance frauds. A criminal forensic element needs to be strongly introduced into investigating such bankruptcies, too, because this usually includes the complete chain of players and not just the promoters.

Humbly submitted.

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