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Wednesday, November 16, 2016

Runs on real estate companies?

by Shubho Roy.

A new threat

Many households in India like to invest in real estate, even though this has not worked out as a great asset class. The Indian real estate business has been facing considerable difficulties in the present business cycle downturn. The recent `de-monetisation' is expected to adversely affect this sector, as there is considerable use of unaccounted cash. There is a natural analogy with the crisis of 2008, where real estate companies were one of the first places where stress became visible.

There is an additional looming problem that has not been as widely noticed. The Supreme Court has started passing orders asking real-estate companies to refund buyers of apartments in projects which have been significantly delayed:

  • Unitech was asked to refund Rs.20 Crores to 30 buyers on 19th October, (See here).
  • Parsvnath Builders was ordered to refund Rs.22 crore to 70 buyers on 18th October (See here).
  • Supertech was ordered to return deposits of 17 buyers on 6th September, 2016 (See here).

In this article, I worry that this could set the stage for runs on real estate companies. Thinking about this problem also helps us better understand the inter-relationships between corporate finance, consumer protection and bankruptcy process.

Corporate finance of Indian real estate companies

Delays by real-estate developers are not new in India. People book apartments, putting down large deposits, then wait as the developer fails to meet deadline after deadline. Many buyers have dragged developers to court, trying to pressurise them to finish the buildings. What is new is that some of these buyers do not want the apartments; they just want their deposits back. This has adverse implications for the developers, the buyers who do not want their deposits back, the real estate industry as a whole, and all other creditors of such real estate companies. When a customer asks for the refund of deposits, there are two possibilities:

  1. The buyer thinks that the real-estate developer will never be able to deliver the promised buildings; or
  2. The buyer thinks that these buildings are not the worth the money they have committed to pay for.

In a normal market, such exit by a few buyers should not matter. However, the structure of the real estate market in India is an unusual one. Most real estate firms lack formal financing. Real-estate companies usually launch a project and collect advances from the buyer. These advances are often used as fungible working capital by the company; they are pressed into service to meet the most urgent need for cash.

While this seems to be an efficient way to employ capital while the going is good; it fails when the going gets bad. This system works as long as the real estate company is able to launch new projects and get advances from them. If new project launches do not generate advances, previous incomplete projects are also in jeopardy. The business model of the companies presumes an ever increasing demand for new projects at ever increasing prices with ever increasing number of buyers willing to make advance payments.

The new real estate law [Real Estate (Regulation and Development) Act, 2016] recognises this problem and tries to partially address it. Section 4.(2).(l)(A) of the law mandates requires:

...that seventy per cent. of the amounts realised for the real estate project from the allottees, from time to time, shall be deposited in a separate account to be maintained in a scheduled bank to cover the cost of construction and the land cost and shall be used only for that purpose

However, this law applies to deposits after 2017, and not the ones already made. There is no clarity where existing deposits of buyers have been used.

A bit like banks

Under these conditions, real estate firms in India are a bit like banks.

When you deposit money in a bank, the money enters the fungible pool of deposits of the bank. When someone else withdraws money from their account, this is withdrawn from the fungible pool. Banks do not match individual deposits to individual loans. They ensure that that the overall income from all loans is higher than the bank's liability to depositors (on the whole). This works fine as long as the depositing public is confident that the bank is making more money out of its loans than it has to pay the depositors. Banks do not keep the total deposits in liquid cash waiting to be withdrawn at any moment. If they did so, they would have no money to lend. Instead, banks keep a historical average of withdrawals (net of fresh deposits) in branches to meet the requirements. This is commonly known as fractional reserve banking.

When many people lose faith in the ability of a bank to repay its depositors, we get a run on the bank. A run is when depositors try to quickly get their deposits out before everyone else. Depositors know that if they can withdraw money, before the liquid cash kept by banks runs out, they are safe. Late comers are left in the lurch, as the bank runs out of cash.

Bank-runs are sometimes a self-fulfilling prophecy. Depositors worry that the bank is out of cash and start withdrawing their deposits at the same time. Since the loans made by the bank cannot be recalled quickly, the bank fails to refund some deposits. On the other hand, if the depositors do not panic, banks may be able to recover their loans and pay out depositors in due course.

To address this problem of bank runs, multiple layered safety measures have been developed in law and in financial markets. First, banks are heavily regulated by the banking regulator which is supposed to keep a close eye on the loans they make and mandate banks to keep some of their deposits in liquid cash. Moreover, when one bank faces some unusually large withdrawals, it can borrow from other banks for a short time, at low interest rates -- commonly known as the inter-bank market. Finally, the central bank of the nation acts as the lender of last resort, if a bank is unable to borrow in the inter-bank market. This is the institutional machinery required to forestall runs on banks.

Runs on real estate companies

There is no such safety system for the Indian real estate business.

Capital expenditure by real estate companies is now in the decline. They cannot rely on the old model of launching new projects to obtain working capital which is used to complete older projects.

Real estate companies can go to banks to borrow money when faced with the problem of refunding customers. Banks have cause for concern when buyers of the apartments do not want those apartments but want their money back. The fact that some buyers are approaching courts rather than finding another person to buy-out their claim means no one is willing to buy these unfinished apartments. Therefore, most of these apartments will be finished at a loss. This makes it commercially unwise for a bank to extend more loans to an entity which will not make profits.

Apartments are not fungible in the way money is fungible. When a real estate company has multiple projects, it cannot shift buyers from one project to another. Buyers have been promised a specific apartment in a specific housing project. Real-estate companies cannot move these buyers to another project. The flexibility of real estate companies when faced with withdrawals is lower than that of a bank.

The orders of the Supreme Court can possibly give a run on real estate companies. Before the Supreme Court orders, delays in delivery was a way for the real-estate companies to ride out the problem. They could wait for real-estate markets to turn around and then complete projects. Now the Court has taken away this choice.

On one hand, the order of the Supreme Court is just enforcing the law of the land:

Promises in a contract must be kept

The more such orders the Supreme Court makes, the more money will be taken out of the real estate companies. We do not know where the builder will find the money to pay for the Court order. It could be that this money comes from someone else's deposits. As more money is taken out, this could increase the balance sheet stress in real estate companies, and make it harder for them to complete their projects. This imposes externalities: it has adverse implications for people who have not filed cases against their builders to recover their deposits (including people who have filed cases to force the builder to finish their apartments). Such people may end up being the last guys in the line in a real-estate run. Every person who gets his/her deposit back reduces the chance of the project getting completed. People who wait may neither get an apartment, nor their deposits back.

The long term prospects of the real estate sector might be better. New projects under the new law will get better protection. However, the projects presently underway, and delayed, are a large block of capital, and a large block of bank loans. Many real estate firms may not survive this storm. The new law provides them no protection. In fact, the new law prevents real-estate developers from using new projects to fund older projects, thereby harming the chances of the older projects being completed.

The orders thus have adverse consequences for the real estate sector. The Court is blindly asking the real-estate companies to return the deposits (with interest) without asking from where the money will come from. The advance/deposit money collected from individual buyers is not lying in some separate account which is clearly identifiable. It has been mixed with the general assets and resources of the company. Worse, it could have been spend in some other project. When you ask a company to return the money to these buyers: what is the guarantee that the company will not take money out of another project to pay these buyers?

Fair treatment requires the Bankruptcy Code

Buyers are on sound ground when they demand a refund. When this refund does not materialise, the solution is not specific performance but bankruptcy. If a court jumps this step, and orders companies to repay large sums of money, the court may end up unfairly prejudicing other creditors of the company.

To avoid this problem, whenever courts in the US impose a large fine on a company, it asks for a financial analysis to determine whether the company will remain solvent after paying the fine. If this analysis (by accountants) returns a negative answer; then the courts force the company into insolvency with the fine/court being the last creditor.

The Supreme Court, by ordering real-estate companies to pay large sums of money to a select set of buyers, may be doing injustice to all other parties in the case. Fair treatment of all stakeholders requires the Insolvency Resolution Process under the Insolvency and Bankruptcy Code.

The advance payed by these buyers has most likely been used up within the firm. That money no longer exists in liquid form. The financially and legally sound solution to these requests to return advances is to place these incomplete projects under liquidation and sell them at an auction to the highest bidder. The surplus from the auction should be equally distributed amongst the buyers, whether they have asked for their deposits back or not. Buyers will probably not get back their entire deposits, but at least some buyers will not unfairly prejudice others. If the new real-estate company in the auction decides to continue building, the last buyers may deposit their pay-outs to such company.

Under the environment created by the Supreme Court, there is an incentive for each buyer to run. If, in contrast, failing or delayed projects led to a bankruptcy process, there would be no incentive for each buyer to run.

Where did we go wrong?

Why did our legal and administrative system come up with the wrong answer? The root cause of this situation lies in two elements:

  1. An unforeseen use of the Consumer Protection Act, 1986.
  2. The Supreme Court trying to solve individual problems in the interim, rather than laying down an appropriate legal principle.

The Consumer Protection Act, was envisaged as a quick and lightweight judicial system for small consumer disputes. While the law does not state it, debates about the law in Parliament indicate that the law was designed to solve minor disputes about consumer goods like blenders or phones. These are small value disputes, compared with the total capital of the companies which manufacture them. If a consumer goods company is asked to replace a blender, this will (most probably) not drive the company into insolvency.

However, the law was not clearly drafted: there is no financial limit to the jurisdiction of consumer courts. Such limits are usually a feature in similar laws in other countries. This enables people to use this law to file cases involving large sums of money.

When the dispute involves millions of rupees, the economics behind fines and compensation changes. Now a single dispute can bankrupt a company. Such disputes require more disciplined thinking about contract law, company law, bankruptcy law and laws of specific performance and monetary compensation. Disputes about real estate should not be decided by consumer courts. However, the vague drafting and the definitely pro-consumer slant of the law (low court fees, lax procedure, etc.) attracts litigants to file under this law.

All the three orders of the Supreme Court are interim orders. These orders are done without finally deciding the case on merits. They seem to be minor/incidental orders where the Court has not really thought about the implications. The court is not clear about the financial implication of imposing such large financial burden on the companies. Courts have come to see bankruptcy law as inoperable. As reported in the news it seems that the bench remarked:

"We are not concerned whether you sink or die. You will have to pay back the money to homebuyers. We are least bothered about your financial status"

Such a statement seems to indicate that the Court thinks that the effect of the fine will fall only one the management/owners/promoters of the company. But a company is a much more complicated being. The financial status of the company affects not only the management, but all creditors of the company, which include other buyers who have paid deposits/advances, banks which have lent money (in turn the public which put money in the banks and the taxpayers who will re-capitalise the banks), bond-holders of the company, employees, suppliers, etc. By making the company pay these buyers (out of turn) the Court orders may end up ensuring that all these creditors (who are not at fault) are left in the lurch and unfairly lose their rights to recover their dues from the company. It is very probable that some (if not most ) of these dues are superior (or at least of the same priority) as the rights of the buyers (who want their advances back). The Court is effectively paying some customers at the expense of others, and encouraging runs on real estate companies.

The Court seems to equate the company with the promoters/management of the company, who at this point may have very little invested in the company. The company has no incentive to openly admit that these fines will affect the solvency of the company. If it does so, it is at risk of being put under administration. This would remove the current management and equity owners (who control the company's representations before the court).

The author is a researcher at the National Institute for Public Finance and Policy. He acknowledges the help of Dhananjay Ghei and Manya Nayar in this work.


  1. Judges are not equipped to understand the larger implication of their decisions. Lack of basic knowledge of business and the workings of the economy is endemic. More often than not, they are are interested in having quotable quotes in their judgements

  2. The intended comparison with “bank runs” seems to be an attempt to put home buyers in bad light and their demand for return bank as an activity bad for the economy. In addition, the article tries to impress upon the fact that judicial sympathy for homeowner by the supreme court will be even bad for the economy.

    However, following points can be considered before reaching such an appearing sympathetic inference biased towards builders:

    1)“Bank Run” cannot be equated to “Return Back Demand”:

    Bank run is defined as a withdrawal prior to maturity date. “Return Back Demand” happens after the deadline date. Hence, it would require lot of imagination to even call it as a demand. It is inafact a duty of the builder to pay back. Hence, while the bank run is a contractual right of the depositor, “return back” is a contractual and moral duty of the builder.

    2)“Bank Run” are not predominantly random or self fulfilling phenomenon:

    The notion that bank runs are self fulfilling phenomenon is too old and outdated. Post 2000, the research had shown logic and empirical proofs that bank runs happens due to negative economic indicators prior to maturity date. Hence, bank runs are a rational economic activity on part of the depositor. On the other hand, “return back” is the last resort of a buyer who has been cheated by the buider by not completing the project on time.

    3)Supreme court judgement cannot be seen from economic theory logic:

    The supreme court judgement is on account of its duty to protect the contractual right of the home buyers. It should not be assessed by economic theory. Needless to say, there are many conflicting economic theory with many different conclusions

  3. Asking a real estate company to meet its contractual obligation is different from a bank run since a bank customer can anytime ask for a refund anytime while a real estate buyer will get a refund only under certain terms. The old real estate model which was no different from a ponzi scheme is certainly dead in the water. Imagine what will happen if a client takes a loan from a bank and does not pay the same - the the bank will go after the personal assets of the borrower and the same has to be applied to the builders as well.The judiciary is merely enforcing the contract so there is nothing to find fault with them at all. Coming to the fact that existing buyers would get affected, it is true but it is a relatively small price to pay. You cannot conduct a surgery without side effects Shubho!!!

  4. I think your example is the wrong way around. What do you do if a bank refuses to pay back your deposits? Interestingly, courts cannot force banks to pay you, without the RBI first checking the bank is solvent (liquidation of banks forms a substantial part of the banking laws of the country). If you pressurise a bank too much it can just raid someone else's account and pay you. This way it can kick the problem down (and make it bigger). To prevent that RBI monitors bank on a regular basis to separate client assets from it capital and make proper "repayments" from the banks equity capital. This is why whenever there is high NPA, the question of Capital Adequacy comes up, not of deposit/cash adequacy. A bank may be sitting on piles of cash but be bankrupt at the same time.

    I am not saying that the depositor/buyer should not be paid. All I am advocating is more care to ensure that the buyer is paid out of the "equity" of the real-estate company and NOT through some other buyer's deposit/advance.

    How do you know that the real estate company is refunding these buyers from their own advances (which is probably used up) or its equity? It is very possible that the real estate company is using another buyer's advance to repay this buyer; who before the Supreme Court. If that is the case then two of your statements need to be factually reviewed:

    1. It is not sure that the price is "relatively small" or being paid by the equity holders of the realty company.

    2. It is not sure that the side effects (more deposits of other buyers lost) of the surgery is actually less than the the benefits of the surgery (a small set of buyers getting repaid).

    While this thing "looks" like a Ponzi, I am not convinced it is one. A ponzi scheme has no underlying business. Here there was one, the building of houses. If all the houses were sold at higher prices, there was some chance to be repaid. I think it was built on an business model which is problematic and in hind-sight foolish. But you know what they say about hind-sight.

    You and (anonymous) seem to think that I am against the Supreme Court ordering repayment, or siding with real estate companies. I am not. I am just asking the Court to be more careful. The Court should ensure that the money being used to repay the buyers is not coming out of other deposits or that it makes the completion of the project impossible. In both cases it is not the real-estate company which will suffer, but other buyers. My suggested solution is actually far more Draconian than the present approach of the Court ordering "interim" payments. We must appoint administrators to look into the finances of the company. Effectively put them into insolvency or liquidation, to check if they are solvent and ensure that Paul's deposit is not used to pay Peter.

    My advice to other buyers (not asking deposits back) is also a rational one. I am not getting into the merits of a bank run, all I am saying is: There is a run on your real-estate bank, do not wait patiently to get your apartment, run to get your deposits back before someone else is paid with your deposits.


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