Sequencing issues in building jurisprudence: the problems of large bankruptcy cases

by Ajay Shah.

Sequencing in the construction of State capacity in the bankruptcy process: an abstract argument

A big idea in the field of State capacity is that of learning to do simple things before doing difficult ones. Applying this wisdom, in the early days of the Indian bankruptcy reform, it made sense to bring smaller cases into the fledgling process. At an early stage, bringing 12 big cases was problematic.

This is based on a relatively abstract argument:

The stakes are highest with big bankruptcies. The persons who face large losses owing to the working of the bankruptcy process will hire high powered legal teams, and spend money on all means fair and foul, to push the loss to someone else.

A tangible argument

Josh Felman has a tangible argument of how things go wrong when large cases are brought to a fledgling bankruptcy process.

Sophisticated thinking about procedural law is based on thinking about the overall system of incentives, and the overall outcomes, that flow from a certain element of law. The danger lies in looking at an individual case and trying to do justice. Doing justice in an individual case may often harm justice on a larger scale.

The most important innovation in IBC was the 180 day limit for the Committee of Creditors (CoC). If they are not able to make up their minds within 180 days, the company goes into liquidation. Given the difficulties of banking regulation in India, banks have an incentive to delay matters indefinitely, and claim that an asset is worth Rs.100 when in fact it is worth Rs.40. The threat of value destruction in liquidation within six months (where the realisation will be Rs.20) solves the wrong incentives of poorly regulated and poorly governed Indian financial firms.

For this to work, we must have sanctity of process. A default takes place, the CoC is setup, it has 180 days to make a decision, and then the firm goes into liquidation. There should be no possibility of reopening the matter at a later stage.

In any individual case, it may be the case that there are gains from delay, or from reopening the matter after the CoC has made a decision. This may result in increased value realisation in the small (in the one case that we are looking at). But it harms the performance of the bankruptcy process in the large.

Consider the problem of reopening the CoC process after a decision has been made. Once the NCLT makes it known that it is open to such possibilities, it is efficient for a bidder to not participate in the insolvency resolution process (IRP), see the outcome there (e.g. Rs.40) and then go to NCLT promising Rs.41. This would harm the incentives of anyone to participate in the IRP.

What will happen when such situations arise in front of the judge? Suppose there is a Rs.10 million case, where sacrificing the process yields a value gain of Rs.1 million. In this case, it's easier for a judge to be more intellectual, to say that it is a small cost of Rs.1 million for one person in front of him versus the larger gains to society from sanctity of the process.

But if there is a Rs.1 trillion case, the judge will find it harder to be intellectual. She is more likely to be swayed by an attempt at subverting the process in return for a value gain of Rs.0.1 trillion. Once a few cases shape up like this, in favour of justice and not the rule of law, the body of law will be contaminated.

Conclusion

The right way to build State capacity for the bankruptcy reform is to first bring a large number of small cases to judges. At the time, judges are themselves new to this field. A few small mistakes will be made, but jurisprudence is more likely to build up in the right direction: to look for the performance of the overall bankruptcy process rather than to do justice for one plaintiff. This jurisprudence will value the rule of law, and the sanctity of process, over immediate notions of justice. It will induce justice in the large by sometimes sacrificing justice in the small.

If, on the other hand, at a fledgling stage, a large transaction of Rs.1 trillion is brought in front of a judge. This judge is herself relatively unsure about the ideas of the bankruptcy process, and is not adequately guided by prevailing jurisprudence. In this case, the judge is more likely to succumb to the temptation of doing justice in the small, even if this does harm to the rule of law. This will harm the sanctity of process, and contaminate the working of the bankruptcy process.