Early evidence from the personal insolvency framework in India

by Karan Gulati, Chitrakshi Jain, and Anjali Sharma.

In 2016, India enacted an insolvency and bankruptcy law, the Insolvency and Bankruptcy Code (IBC), which included corporate and individual insolvency provisions. However, except for a narrow use case, the insolvency of personal guarantors (PG) to corporate debtors, the provisions for personal insolvency are yet to be notified. These provisions for PG insolvency were notified in November 2019 and were upheld as constitutional in November 2023.

PGs represent a unique and narrow category of individual debtors. They are often promoters, key shareholders, or directors of corporate entities and thus provide guarantees for loans taken by these entities. Lenders can invoke these guarantees when the corporate entity defaults, making PGs liable for the loans. The terms of these personal guarantees may allow lenders to seize and liquidate the assets of the PGs to recover their debts. As per the Bankruptcy Law Reforms Committee (BLRC), it is common practice that Indian banks take a personal guarantee from the firm's promoter when they enter into a loan with the firm.

In this article, we examine the data on PG insolvency cases to understand two key issues: (i) can such cases serve as proof of concept for the broader implementation of personal insolvency provisions under the IBC?; and (ii) what feedback loop is emerging for lenders from enforcing personal guarantee contracts through insolvency proceedings? However, we restrict this examination to the outcome of PG insolvency cases (approval of a repayment plan) and exclude the input (the insolvency process itself). Thus, we do not attempt to explain the gap between the applications filed and those admitted or between the applications filed and the appointment of resolution professionals.

Importance of personal guarantees

Limited liability protects a firm's shareholders from personal liability for its debts during distress, allowing them to retain their assets and wealth even during debt recovery or insolvency proceedings. This protection encourages entrepreneurship and risk-taking. Individuals often choose to incorporate to benefit from limited liability. However, when a firm faces distress and the value of its shares falls, two things can happen: (i) limited liability can encourage risky business decisions, and (ii) the firm's promoters may alienate its assets in their favour. One way to balance limited liability with accountability for the firm's promoters is through personal guarantee contracts. If promoters enter into personal guarantee contracts with lenders, lenders can seize the promoters assets if the debts of the incorporated entity remain unpaid. These contracts can moderate risk-taking by making guarantors internalise the costs of default and disincentivise the firms promoters from alienating its assets in their favour.

The interplay between limited liability and personal guarantees affects creditor rights during firm distress. Personal guarantees widen the pool of assets available to lenders when a firms assets are insufficient to cover its debts. In this context, guarantees offer lenders additional collateral for loans to corporate debtors while preserving the principles of limited liability and enhancing the debtors creditworthiness.

Given the role of promoter-owners in managing firms in India, personal guarantees have become a common feature of corporate lending. These guarantees are often used alongside other forms of collateral. RBI guidelines also encourage personal guarantees when lending to closely held or higher-risk firms to enhance loan security and ensure management continuity. Additionally, the RBI has incorporated personal guarantees into its restructuring debt framework. While data on the proportion of corporate loans secured by personal guarantees is unavailable, disclosures by the largest five public-sector and four private-sector banks as of 31 March 2023 suggest that guarantees cover 4% of the advances extended by these banks (authors' calculations).

PG insolvency as a lab for personal insolvency implementation

As per provisions for personal insolvency under the IBC, PGs propose repayment plans based on their ability to honour the guarantee. A resolution professional submits this plan to the committee of creditors, as defined under section 79 (11) of the IBC. Once creditors vote in favour of the repayment plan, it is then approved by the NCLT. Generally, from admission to approval of the repayment plan, this process takes a little over a year.

As of June 2024, 3134 PG insolvency applications involving claims of approximately Rs. 2 trillion have been filed across National Company Law Tribunals (NCLTs) and 50 such applications have been filed before the Debt Recovery Tribunals (DRTs). Of these, 468 applications were admitted, and the NCLT approved repayment plans in 26 cases. Although overall data for the number of corporate debtors that correspond to PG applications is not available, the 26 cases studied in the article correspond to 4 corporate debtors.

In the 26 cases in which the NCLT has approved repayment plans only one featured a joint application for resolution filed by the corporate debtor and its PGs. In the remaining cases, actions against PGs were initiated near or after the conclusion of the corporate debtors insolvency resolution process. In one case, the PG also acted as the resolution applicant in the corporate debtors insolvency process. Table 2 summarises the outcomes of the PG insolvency processes (PGPs) alongside those of the corresponding corporate resolution processes.

Table 2: Outcomes of personal guarantor and the corporate debtor resolution processes
Corporate debtor	No. of PGs	Date of Admission of PGP	Amt. claimed against PGs (Rs. cr.)	Recovery against PGs (%)	Amt. claimed against Corporate Debtor (Rs. cr.)	Date of Liquidation/Resolution (Corporate Debtor)	Outcome of the Corporate Debtor case	Recovery against Corporate Debtor (%)
Bluefern Ventures	2	30-09-2021	30.3	39.6%	38.7	Unclear	Liquidation	NA
Vishwa Infrastructures	12	15-2-2022	1441.6	0.8%	1318.5	14-06-2019	Liquidation	4.3%
Chadalavada Infratech	7	21-09-2022	278.1	24.5%	440.4	11-04-2022	Liquidation	2.4%
Pradip Overseas	5	27-04-2022	3017.5	0.4%	2663.0	14-10-2021	Resolution	4.8%
Total	26	-	4767.5	2.2%	4460.6	-	-	4.1%
Source: IBBI Quarterly Newsletters, NCLT Orders in cases

Personal guarantees are meant to hold promoters accountable. Table 2 shows that, despite variations in the number of guarantors and the amounts claimed, PGPs have yielded an average recovery rate of 2.2%. However, these recovery rates should be viewed in the context of the poor outcomes in the corporate debtor insolvency process and the extent to which these debts have devolved on the PGPs. In three cases, the corporate resolution processes resulted in liquidation. The average recovery rate for the four cases was 4.1%.

The purpose of a personal insolvency framework is to provide the debtor with a way to exit a debt contract. Of the 3184 applications which have been filed, only 468 have been admitted. The tribunals have approved the repayment plans in only 26 out of the 468 admitted cases (till June 2024). These gaps cannot be explained by merely looking at the outcomes in the PGPs which have been completed. The next section underscores how the insolvency process may just be a costly detour, for a substantial number of PGs are unable to honour their obligations under the repayment plan. While the outcomes can only be studied for 26 cases, they are underwhelming and it would be useful to conduct an evaluation of both the process and outcomes in the PGPs before extending the coverage to all classes of individual debtors under the IBC framework.

A feedback loop from PGPs

Since lenders may turn to personal guarantees due to poor value realisation in recovering debts extended to firms, enforcing personal guarantee contracts is important to provide creditors with an efficient means of recovery and to ensure that debtors can discharge their obligations. Before the notification of personal insolvency provisions for PGs to corporate debtors under the IBC, creditors relied on frameworks under the SARFAESI Act, the RDDB and FI Act, and the Indian Contract Act. These frameworks did not allow creditors to collectively enforce their rights.

Most corporate lending in India is secured by collateral, enforceable through the corporate debtor resolution process under the IBC. Enforcing personal guarantees under the IBC offers an additional recovery mechanism. The BLRC also recognised the importance of enforcing these guarantees and recommended establishing a framework to ensure the completeness of the corporate insolvency process. While the IBC extends the recovery process to include personal guarantees and provides a pathway to discharge an individual debtors obligations, it remains to be seen whether the framework is effective and represents an improvement over previous statutory recovery frameworks.

However, early evidence from the outcomes under this framework provides valuable inputs to lenders, helping them to make informed decisions about the value of personal guarantee contracts and their utility as collateral security for credit to firms. In two cases, the repayment plans of PGs resulted in better outcomes 24% and 39.6% compared to nil and 2.4% in the respective corporate processes. However, out of the 468 admitted PGPs, 108 were closed due to the non-submission or rejection of a repayment plan (IBBI Newsletter, Apr-June 2024).

Our analysis of 26 cases in which the NCLT has approved repayment plans reveals that these cases have not yet been marked as disposed of. A closer reading shows that this is because the PGs have failed to fulfil their obligations under the plans. Data on the implementation status of the repayment plans of PGs is available for 19 of the 26 cases (corresponding to two out of corporate resolution processes). Their details are presented in Table 3.

Table 3: Status of implementation of the repayment plans for PGs.
	Vishwa Infrastructures (CD)	Chadalavada Infratech (CD)
No. of PGs	12	7
No. of PGs that have defaulted on plan	7	5
Value of default (in Rs. cr.)	8.0	47.5
No. of PGs discharged	5	2
Value realisation from discharged PGs (Rs. cr.)	3.1	20.6
Total liability devolved on PGs (Rs. cr.)	1441.6	278.1
Recovery rate total	0.8%	24.5%
Recovery rate from discharged PGs	0.2%	7.4%
Average time to default after approval of repayment plan (in days)	274.0	81.4
Average time to discharge after approval of repayment plan(in days)	126	83
Source: Orders of the NCLT, Hyderabad

As of June 2024, of the 12 PGs associated with Vishwa Infrastructures, only 5 have fulfilled their obligations under the repayment plan. The remaining PGs have either been declared bankrupt or are in the process of filing for bankruptcy. Similarly, of the 7 PGs associated with Chadalavada Infratech, only 2 have been discharged from their obligations. The remaining have either been declared bankrupt or have filed for bankruptcy.

Feibelman and Sane (2020) also recognised the challenge of defaults in repayment plans within personal insolvency, noting that adhering to the requirements of the plans might just be a detour for some individual debtors. They recommended standardising repayment plans to identify debtors who should proceed directly to bankruptcy. Our examination of PGPs supports their recommendation.

According to the IBBI, 56 bankruptcy applications for PGs have been filed across DRTs and NCLTs as of June 2024. Completing these bankruptcy proceedings will provide a complete picture of how the IBC operates in personal insolvency cases. However, The low recovery rate and the failure of PGs to submit viable repayment plans suggest that the realisable value from guarantee contracts may be minimal, mirroring the declining fortunes of the corporate debtor. Thus, the likelihood that personal guarantees will cover the shortfall in recovering corporate debts is low. This should prompt lenders to reconsider the role of guarantees in corporate credit contracts.

Conclusion

In 2015, the BLRC had insisted that corporate insolvency provisions are incomplete without a personal insolvency framework. The PGPs that have resulted in approved repayment plans under the IBC have shown limited effectiveness as a value discovery mechanism for lenders and guarantors. Given that many PGs have been unable to fulfil their obligations under the repayment plan and have subsequently filed for bankruptcy, it remains to be seen how extending the coverage of the personal insolvency framework will balance the interests of the debtors and creditors. A careful evaluation of the process of insolvency should be conducted before the IBC framework is extended to all classes of personal debtors.

References

Designing a Personal Insolvency Regime: A Baseline Framework, by Feibelman A and Sane R , 2020, IBBI, Insolvency and Bankruptcy Regime in India - A Narrative.

Velvet Bankruptcy, by Hahn D, 2006, Theoretical Inquiries in Law, Volume 7 Number 2, pp. 523:554.

At the time of writing, the authors Karan Gulati and Anjali Sharma were researchers at TrustBridge. Chitrakshi Jain is currently a researcher at TrustBridge. We are grateful to Adam Feibelman and Renuka Sane for their comments. Views are personal.

An evaluation framework for public procurement processes

by Karan Gulati and Anjali Sharma.

Governments require and use goods and services to operate their machinery and deliver schemes and programs to their constituents. However, self-production cannot meet this need for goods and services. As a result, governments rely on public procurement. However, India does not have an optimal public procurement system. Tenders often undergo modifications, the government incurs significant debt due to payment delays, competition is limited, and contract execution is frequently delayed. Procuring entities also tend to favour large private companies by setting eligibility criteria that exclude small and medium-sized enterprises or providing them with private information that offers a competitive advantage.

Given this experience and the limitations of existing literature, integrating international and best practices can facilitate strategic evolution and ensure that the Indian public procurement system is conducive to achieving broader objectives of efficiency and effectiveness in public resource allocation. By methodically aligning with these practices, India can foster a competitive market environment, attract better vendors, and achieve effective and sustainable procurement outcomes. Specifically, such methodological alignment can help establish an evaluation framework with clear benchmarks and indicators that enable the measurement of procurement processes across departments, identify systematic weaknesses, and explore opportunities for reform.

In a new TrustBridge Rule of Law Foundation Working Paper, we propose "An evaluation framework for public procurement processes" that recognises the government's dual role as the state and a market participant throughout the procurement life cycle and can be deployed to evaluate public procurement across sectors and procuring entities. It contributes to India's growing field of evidence-based literature and policy interventions. Based on the UNCITRAL Model Law on Public Procurement, OECD Recommendations of the Council on Public Procurement, the World Bank's Benchmarking of Procurement, FIDIC, ADB, and NEC standard contracts, and relevant literature, the evaluation framework includes the following benchmark:

• Transparency
• Integrity
• Documentation
• Capacity

• Timeliness
• Negotiation
• Monitoring
• Dispute resolution

It divides these benchmarks along two axes. The first pertains to the role of the procuring entities, either as (i) the state or (ii) a market participant. The second pertains to procurement stages: (i) pre-award to award, (ii) award to completion, and (iii) completion to payment. For instance, as the state, procuring entities must ensure transparency before awarding a tender. To evaluate transparency, the framework assesses whether procuring entities publish procurement plans, which aids in planning and reduces the need for emergency procurement. It also evaluates whether the entity conducts pre-bid consultations, which are beneficial for identifying suppliers early in the process.

To assess the effectiveness of the framework, we evaluate the procurement processes of the National Highways Authority of India (NHAI), India's largest public procuring entity, with tenders worth over 3,70,000 crore rupees (USD 44.5 billion). Its parent ministry, the Ministry of Road Transport and Highways, accounts for over half of India's capital expenditure on procurement. This operational experience should have endowed NHAI with expertise that reflects a spectrum of procurement processes and methodologies. Furthermore, the government's focus on infrastructure development, especially in road transport, underscores the NHAI's role as a driver of public procurement by the Indian state. Thus, evaluating NHAI can provide insights into public procurement processes in large-scale procuring entities and the efficacy of our framework.

Through this first-of-its-kind and illustrative evaluation, we identify several areas for improving India's public procurement system, thus optimising the allocation of public resources, curtailing opportunities for rent-seeking, and fortifying public trust. This includes better estimation of project timelines, improving the role of independent monitoring, and conducting performance evaluations. It also highlights that procuring entities need to enhance transparency not just in their operational processes but also in their data collection and reporting practices. These results validate the efficacy of our evaluation framework. Its comprehensive nature, encompassing a range of benchmarks, allows for a detailed evaluation of public procurement processes. Its application to NHAI demonstrates its potential to evaluate and improve procurement processes across procuring entities.

Extending this evaluation framework is essential to building on this foundational work. The task now involves evaluating other large-scale procuring entities. This endeavour is about identifying areas for improvement and understanding the patterns that define public procurement processes. The insights from this work can inform policy-making and catalyse systemic improvements, contributing to enhancing and refining the public procurement system.

References

Anirudh Burman and Pavithra Manivannan, Delays in government contracting: A tale of two metros, Leap Blog, 23 December 2022.

Anjali Sharma and Susan Thomas, The footprint of union government procurement in India, XKDR Working Paper No 10 of 2021.

Charmi Mehta and Diya Uday, How competitive is bidding in infrastructure public procurement? A study of road and water projects in five Indian states, Leap Blog, 29 March 2022.

Karan Gulati and Anjali Sharma, An evaluation framework for public procurement processes, TrustBridge Rule of Law Foundation Working Paper No 4 of 2024.

Prasanta Sahu, Forget stimulus, clear your dues: Rs 7 lakh crore unpaid dues to industry by central govt depts and PSUs, Financial Express, 8 September 2020.

Shubho Roy and Anjali Sharma, What ails public procurement: an analysis of tender modifications in the pre-award process, Leap Blog, 26 November 2020.

Yugank Goyal, How Governments Promote Monopolies: Public Procurement in India, The American Journal of Economics and Sociology, 26 November 2019.

The authors are researchers at the TrustBridge Rule of Law Foundation. We are grateful to Akshay Jaitly, Renuka Sane, Charmi Mehta, and participants at the Joint Field Workshop on Public Procurement for their valuable comments. Views are personal.

Reducing challenges to arbitration awards: lessons from court data

by Madhav Goel, Akshay Jaitly, Renuka Sane and Anjali Sharma.

Contracts form the bedrock of economic activity in the formal economy. As an economy grows, so does its reliance on contracts. Delays and friction in contract enforcement erode trust in contracts and inhibit the pace of economic growth. In India, contract enforcement generally falls in the jurisdiction of the civil court system, which, according to the National Judicial Data Grid, has more than 11 million pending cases and takes, on an average, more than three years to dispose of a case. One of the solutions to an increasingly overburdened court system in India has been to move certain types of matters to a different judicial forum, either a specialised court or tribunal or by using an alternate dispute resolution (ADR) mechanism. Arbitration is one such alternative mechanism, the framework for which is provided by the Arbitration and Conciliation Act, 1996 (A and C Act).

Contract enforcement by private persons against the state in India brings its own set of problems. Increasingly, government contracts provide for dispute resolution by arbitration. However, anecdotal evidence suggests that the state consistently challenges adverse arbitration awards. In this article, we use Delhi High Court data on challenges to arbitration awards for matters in which the National Highways Authority of India (NHAI) was a party. We analyse the grounds on which these awards were challenged and the manner in which the court dealt with these challenges.

Our main finding is that both the NHAI and the private parties challenge adverse arbitration awards, most often on the merits, even though the A and C Act specifically prohibits this. We also find that the court generally does not interfere with arbitral awards, which is in line with the legislative intent. However, this does not deter such challenges. This may be for a variety of reasons, such as the relatively low cost of litigation vis-a-vis the award value or the incentives of decision makers within the state.

Our analysis adds to the intersection of two growing bodies of recent work in India on the subject. The first that studies government contracting, both from a public administration lens and from the lens of how the government impacts ease of doing business and business outcomes (Chitgupi and Thomas (2023), Burman and Manivannan (2022), Mehta and Thomas (2022), Manivannan and Zaveri (2021), Shah (2021), Roy and Sharma (2020)). The second studies the functioning of courts and the manner in which they deal with a variety of matters (Manivannan et. al. (2021), Damle et. al. (2021), Sharma and Zaveri (2020), Gulati and Sane (2021), Bhatia et. al. (2019)).

The organisation of this article is as follows. We first provide an overview of the legislative and judicial framework to challenge an arbitral award, i.e., Sections 34 and 37 of the A and C Act. We then describe our data set and our methodology for analysis. This is followed by our findings and some recommendations on the way forward.

An overview of Sections 34 and 37 of the A and C Act

The design of the A and C Act allows for a two-stage sequential challenge to outcomes of arbitration proceedings, first under Section 34 and then under Section 37 of the Act. Section 34 provides 5 procedural and jurisdictional grounds, along with 3 additional grounds to set aside an arbitral award. These are:

• Procedural and Jurisdiction:
• The party was under some incapacity while entering into the arbitration agreement;
• The arbitration agreement was not valid under the law to which the parties have subjected it;
• The party making the application was not given proper notice of appointment of arbitrator or of arbitral proceedings, or was otherwise unable to present its case;
• The arbitral award dealt with a dispute not contemplated by or not falling within the terms of the submission to arbitration, or it contained decisions on matters beyond the scope of the submission to arbitration; or
• The composition of the arbitral tribunal or the arbitral procedure was not in accordance with the agreement of the parties or the A and C Act, as the case may be.
• Additional Grounds:
• The subject matter of the dispute was not capable of settlement by arbitration;
• The award is in conflict with the public policy of India, i.e., award is affected by fraud or corruption, or is against the fundamental policy of Indian law, or is in conflict with the most basic notions of morality or justice; or
• The award is vitiated by patent illegality appearing on the face of the award.

It is useful to note that Section 34 proceedings are not appeals (Delhi Airport Metro Express (P) Ltd. v. DMRC (2022)), and the grounds for challenge are limited by the A and C Act itself (Union of India v. Annavaram Concrete Pvt. Ltd. (2021)). Under the scheme of Section 34, an arbitral award cannot be set aside on merits, that is, on the grounds of erroneous application of law or by re-appreciation of evidence (MMTC Limited v. Vendanta Limited (2019); PSA SICAL Terminals (P) Ltd. v. Board of Trustees of V.O. Chidambranar Port Trust Tuticorin (2021)). Therefore, unless an arbitral award is set aside under the grounds laid down in Section 34, it is ready for execution as a civil court decree against the award debtor. Section 37 of the A and C Act, on the other hand, is an avenue of appeal against an order under Section 34 of the Act. Accordingly, proceedings under Section 37 are governed by the Code of Civil Procedure, 1908 (CPC) and are in the form of an appeal. However, through consistent judicial pronouncements, the grounds for appeal under Section 37 have been restricted, even as compared to the grounds under Section 34 (Mahanagar Telephone Nigam Limited vs. Applied Electronics Ltd. (2014)).

While the A and C Act is, to a large extent, modeled on the UNCITRAL Model Law on International Commercial Arbitration, 1985, it deviates from the Model Law in two important ways. First, it introduces an additional ground to challenge an arbitral award: patent illegality appearing on the face of the award. Second, it provides for a two-stage appeal process, where Section 37(1)(c) of the Act allows an appeal against an order under Section 34 setting aside or refusing to set aside the arbitral award. These two deviations from the Model Law have implications for the efficacy of the arbitration framework in India. The ground of patent illegality introduces ambiguity and discretion in the otherwise procedural nature of the process of challenging awards. The two-stage appeal process adds to this ambiguity and discretion, and introduces delays in the enforcement of the award. Section 36 of the A and C Act, under which an award is enforced as a decree, adds to these challenges. Section 36(2) specifically gives the court the power to stay the enforceability of an award. Section 36(3) specifies the conditions under which the court may grant such a stay.

Data and methodology

For our analysis, we collected judgments from Delhi High Court for the years 2018 and 2019 pertaining to matters where the NHAI is a party. Our choice of Delhi High Court is due to its importance as a court for arbitration matters, as well as because NHAI matters are likely to be brought before it.

Our choice of the years 2018 and 2019 is driven by three factors. First, the arbitration framework has undergone significant legislative change since 2015 and more recent data reflects the current framework. Second, the period from 2020-2022 was marked by disruptions in the judicial system due to the COVID-19 pandemic, and therefore, may not represent the ordinary course of dispute resolution. Finally, the choice of 2018 and 2019 allows for the possibility of extending our analysis to studying the entire life-cycle of such litigation all the way to the Supreme Court.

We focus on the NHAI because of its status as an autonomous, specialised statutory body that has been tasked with development, maintenance and management of India's national highways. NHAI is also one of the largest contracting bodies within government, accounting for nearly 10 percent of the total union government expenditure on public procurement (Sharma and Thomas (2021), Chitgupi, Gorsi and Thomas, (2022)).

We find 96 judgments in Delhi High Court where NHAI is a party. Of these, 82 pertain to matters under Sections 34 and 37 of the A and C Act (details can be found by clicking here) From these 82 judgments, we collect the following details:

1. The nature and quantum of claims filed before the arbitral tribunal;
2. The party that won the arbitration;
3. The time taken between filing the petition under Section 34 or 37 of the A and C Act to the final judgment;
4. The nature of disputes and grounds for the petition under Section 34 or 37; and
5. Which party won, and the quantification of the claims that were upheld/set aside by the Court.

Findings

Our main finding is in regards to the win-loss record for a challenge to an arbitral award under Sections 34 and 37 of the A and C Act, i.e., the likelihood of success in challenging the arbitral award (Table 1).

Table 1: Outcome of Section 34 and 37 Challenges

Categories	2018	2019	Total
Petitioner won	4	4	8
Petitoner lost	44	30	74
Total	48	34	82
Source: Delhi High Court judgments

We find that in 74 of the 82 cases (90.2%) involving NHAI, the court refused to interfere with the arbitral award, irrespective of whether the party challenging the award was the NHAI or the private party. This suggests two things. First, the Delhi High Court's action of ordinarily not setting aside the arbitral award is in line with the legislative intent of Sections 34 and 37 of the A and C Act. Second, despite the court not interfering with the award, parties continue to mount such challenges. This is especially so for NHAI, which is the petitioner in 67 out of the 82 matters.

When we look at the grounds under which awards are being challenged in court (Table 2), we observe that the bulk of the challenges, 77 out of 82 (93.9%), are under Section 34(2A), which is unlike the provisions of the UNCITRAL Model Law, and is an Indian innovation that allows the award to be reviewed on the basis of the substantive merits of the case. Patent illegality is a subjective formulation whose treatment may change from case to case and from court to court.

Table 2: Nature of Section 34 challenges

Provision	2018	2019	Total
S. 34(1)	2	1	3
S. 34(2)	-	-	-
S. 34(2A)	45	32	77
S. 34(3)	1	1	2
Source: Delhi High Court judgments

The findings from Tables 1 and 2 together indicate that award debtors routinely challenge arbitral awards on substantive merits, even though the courts routinely turn down such challenges.

We also find that, on average, it takes the court 805 days (2.2 years) to dispose of a Section 34 challenge and 208 days (0.6 years) to dispose of a Section 37 challenge. A matter in which both Section 34 and 37 challenges are brought will be in court for about 3 years after the award has been made by the arbitral tribunal.

In 36 of the 82 matters, we get data for the size of the claim. The total value of claims, across these 36 cases, is Rs. 17.5 billion and the average per case claim value is Rs. 485 million. While these may not be significant for an entity of NHAI's scale, for private parties dealing with NHAI, these may be consequential. And so may be the additional time of three years and the cost of litigation to secure these claims.

Some simple calculations also give us a sense of what these challenges with minimal chance of success mean for the government. At an interest rate of 8% per annum (MCLR during 2018 and 2019 was in this range), compounded annually, after the three year litigation challenging the arbitral award, the government will have to bear an additional interest cost of Rs. 4.5 billion on these awards. This does not take into account the cost and time consumed by the litigation.

Why do parties challenge arbitral awards?

There may be two main reasons why parties continue to appeal even though the chances of the award being overturned are low:

• Low costs: for large value awards, the cost of the litigation challenging the arbitral award is lower than the expected benefit to the award debtor even at low probability of the award being overturned (Mehta and Thomas (2022) supra). Additionally, for the government, the economic considerations around litigation costs may not be as relevant as for private litigants. Empanelled lawyers for the government and its agencies are often remunerated far less than lawyers representing private parties. Further, incentives of the bureaucracy are often such that they do not accept adverse outcomes in contractual disputes and litigate till the last available forum, regardless of cost.

• Delaying the enforcement: parties may resort to challenging the award to delay enforcement. Filing a petition under Section 34 of the A and C Act often forces the award holder to delay an execution petition under Section 36 of the Act. This could be because of the uncertainty regarding the outcome of the challenge, and due to potentially wasteful litigation costs, should the award be stayed or overturned. Anecdotal evidence shows that the executing court is often cognizant of the filing of a petition under Section 34 while taking substantive decisions under Section 36 of the Act. The executing court typically awaits the outcome of proceedings under Section 34 or 37 before taking any coercive action against the award debtor. Therefore, it is likely that much of the litigation under Sections 34 and 37 is a means of delaying enforcement of the award, and not because the litigants expect to succeed.

Legislative solutions

Disincentivising litigants from challenging arbitral awards on merits, especially if the litigant is the government, is important to ensure that the A and C Act remains relevant as an alternate dispute resolution mechanism. This can be achieved through two levers. First, that courts take up Section 34 challenges only in cases where there is a high likelihood of the challenge succeeding. Second, the cost of challenging the award either under Section 34 or Section 37 are high enough to alter the economic incentives of the award debtor. To this effect, we suggest three legislative solutions:

1. Amending Sections 34 and 37 of the A and C Act to introduce a prima facie test of satisfaction: As the law stands currently, the courts must hear petitions under Sections 34 or Section 37 and decide them on merits, irrespective of the grounds of challenge and the chances of success. This takes up significant resources. Introducing a prima facie test of satisfaction will enable the Court to dismiss the petition at the pre-notice stage itself, unless the petitioner is able to satisfy the court that it has a good case on merits. This will be similar to the procedure adopted by the Supreme Court while hearing fresh special leave petitions under Article 136 of the Constitution of India. The decision of the court to entertain a petition under Section 34 or Section 37, based on a prima facie view of the merits, has cost advantages to the litigants as well as the court. Dismissal at the pre-notice stage means that the litigants do not bear the cost of a full appeal and the court also spends less time and resources in deciding the petition on merits (Shavell (2010)). Further, deciding the merits at the pre-notice stage may also reduce time and costs during the full appeal as part of the assessment of the merit will already have been done by the court.

2. Amending of Sections 34 and 37 of the A and C Act to introduce a mandatory pre-deposit of fees proportionate to the arbitral award for the admission of petitions to set aside arbitral awards: As pointed out earlier, the economic incentives are stacked in favour of a challenge to the award. One way of counteracting this would be to increase the cost of a challenge. This can be achieved by adopting a mandatory pre-deposit of a proportion of the award value with the court before a challenge can be instituted. Such a pre-deposits can be tiered, with a higher proportion being required under Section 37 as compared to Section 34.

Another way of achieving this outcome will be to amend Section 82 of the Act to introduce a clarification that empowers the courts to frame rules to introduce barriers to unmeritorious challenges. These could include, as suggested above, a prima facie test or a mandatory pre-deposit of a proportion of the award value under challenge. This method leaves the discretion of framing such rules, and the substance of these rules with each High Court which could take into account local conditions while framing them. Further, the desired objective will be achieved without hard coding too much detail in the statute itself, which might make it inflexible and require more amendments going forward.

In October, 2021, the General Financial Rules, 2017 (GFR), the procurement rules for union government and its agencies, were amended to introduce Rule 227A which requires government departments challenging arbitral awards to pay 75% of the award value into an escrow account, to be used sequentially for the settlement of lender's dues, project completion and then as payment to the contractor. However, the impact of this change is in respect of of government challenges to arbitral awards. Our analysis shows that even private parties routinely challenge arbitral awards, and hence an amendment to the A and C Act introducing a pre-deposit may be desirable.

3. Amending Section 37(1)(c) to remove the second challenge avenue for the award debtor: Section 37(1)(c) of the A and C Act permits an appeal of the order of the court either setting aside or refusing to set aside an arbitral award under Section 34. This affords the award debtor a second avenue to continue litigation and stave off enforcement of the award. Our analysis shows that while courts generally uphold the award even during this challenge, both time and resources of the court and the litigants are consumed. Further, even at this stage courts may adjudicate the matter on merits, despite this already having been done at the award stage and at the Section 34 stage. Further, as mentioned earlier, no analogous provision to Section 37(1)(c) exists even in the Model Law as well as the United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards.

   One possibility is to completely remove Section 37(1)(c) from the A and C Act and align the framework for challenging an arbitral award with the Model Law. Alternatively, Section 37(1)(c) could be amended to remove the appeal available to the award debtor, but retain the appeal available to the award holder. This will protect against frivolous appeals by the award debtor, while providing adequate remedy in matters where an award has been erroneously overturned under Section 34.

Conclusion

In India, delays of the court system have increasingly led both government and private parties to opt for ADR mechanisms such as arbitration to resolve contractual disputes. However, for arbitration to be used effectively, it is important that challenges to the outcome of arbitration are limited to the procedural and jurisdictional grounds laid down in the A and C Act. Our analysis shows that this may not be so, and that both government and private parties routinely challenge arbitral awards on merits. Challenges to arbitration awards appear to have become a way of delaying enforcement. The Delhi High Court has been sanguine in the manner of its dealing with these challenges, most often refusing to interfere with the arbitration outcome. However, this does not seem to have deterred challenges, especially from government agencies.

One way of disincentivising such challenges is to amend the A and C Act to remove the legislative loopholes. These include: (i) introducing a prima facie test of the merits of the challenge, (ii) seeking a pre-deposit of a part of the award value before allowing a challenge, and (iii) removing the second challenge permitted under the Act. These changes could go a long way in curbing the litigious behaviour of parties to delay enforcement of high value awards.

Contract enforcement is hard when there exists an imbalance of power and resources between the parties to a contract or where the incentives of one of the parties are not driven entirely by commercial considerations, as in the case of government contracting with private parties. Creating legislative boundaries against strategic actions by parties, whether government or private, is one way of dealing with this challenge. There are other ways, that seek to change the behaviour of government departments and agencies, through measures such as a National Litigation Policy or the government procurement rules.

References

Aneesha Chitgupi and Susan Thomas, Learning by doing for public procurement, XKDR Working Paper No. 22 (2023).

Pavithra Manivannan, Susan Thomas, and Bhargavi Zaveri-Shah, Helping litigants make informed choices in resolving debt disputes, The Leap Blog (2023).

Anirudh Burman and Pavithra Manivannan, Delays in government contracting: A tale of two metros, The Leap Blog (2022).

Aneesha Chitgupi, Abhishek Gorsi, and Susan Thomas, Learning by doing and public procurement in India, The Leap Blog (2022).

Charmi Mehta and Susan Thomas, Identifying roadblocks in highway contracting: lessons from NHAI litigation, The Leap Blog (2022).

Pavithra Manivannan and Bhargavi Zaveri, How large is the payment delays problem in Indian public procurement?, The Leap Blog (2021).

Ajay Shah, The bottleneck of government contracting, Business Standard (2021).

Anjali Sharma and Susan Thomas, The footprint of union government procurement in India, XKDR Working Paper No. 10 (2021).

Devendra Damle, Karan Gulati, Anjali Sharma, and Bhargavi Zaveri-Shah, Litigation in public contracts: some estimates from court data, The Leap Blog (2021).

Karan Gulati and Renuka Sane, Grievance Redress by Courts in Consumer Finance Disputes, The Leap Blog (2021).

Anjali Sharma and Bhargavi Zaveri, Judicial triage in the lockdown: evidence from India's largest commercial tribunal, The Leap Blog (2020).

Shubho Roy and Anjali Sharma, What ails public procurement: an analysis of tender modifications in the pre-award process, The Leap Blog (2020).

Surbhi Bhatia, Manish Singh, and Bhargavi Zaveri, Time to resolve insolvencies in India, The Leap Blog (2019).

Steven M. Shavell, On the Design of the Appeals Process: The Optimal Use of Discretionary Review versus Direct Appeal, 39 J. Legal Stud. 63 (2010).

Delhi Airport Metro Express (P) Ltd. v. DMRC, (2022) 1 SCC 131.

Union of India v. Annavaram Concrete Pvt. Ltd., (2021) SCC OnLine Del 4211.

MMTC Limited v. Vendanta Limited, (2019) 4 SCC 163.

PSA SICAL Terminals (P) Ltd. v. Board of Trustees of V.O. Chidambranar Port Trust Tuticorin, (2021) SCC OnLine SC 508.

Mahanagar Telephone Nigam Limited vs. Applied Electronics Ltd., AIR (2014) Delhi 182.

Madhav Goel, Renuka Sane and Anjali Sharma are with the TrustBridge Rule of Law Foundation. Akshay Jaitly is the co-founder of TrustBridge Rule of Foundation and Partner, Trilegal. We thank Karan Gulati, Ajay Shah and two anonymous referees for their inputs and comments.

Improving judgment enforcement: Let judgment creditors file insolvency resolution applications

by Karan Gulati and Anjali Sharma.

Judgments form the basis of a sound legal system. However, the mere issuance of judgments, without ensuring their prompt enforcement, takes away the incentive to turn to the courts. It also reduces trust in contracts and property rights, the bedrock of economic activity. This discourages investment, curbs entrepreneurial enthusiasm, and impedes national development (World Bank 2003; Chemin 2007; Rao 2020). Beyond economic consequences, a delay or failure in enforcing judgments diminishes public confidence in the judiciary (Salzman and Ramsey 2013).

In India, enforcing monetary judgments is particularly challenging, as evidenced by its low ranking on the World Bank’s ‘Enforcing Contracts’ indicator and data from the National Judicial Data Grid (NJDG). To ensure and expedite the enforcement of such awards, we propose that judgment creditors – holders of a judgment by a court or tribunal – should be allowed to initiate insolvency resolution proceedings against judgment debtors. Due to the severe consequences under the Insolvency and Bankruptcy Code (IBC), such proceedings will deter non-compliant debtors from evading their obligations.

The problem

Enforcing judgments with monetary components is an especially difficult problem. In 2020, India ranked 163rd out of 190 countries on the World Bank’s Doing Business indicator for ‘Enforcing Contracts’. This metric measures the time and cost of enforcing a standard contract in a civil court. In India, once a dispute is initiated, it takes 1,445 days till enforcement, costing 31% of the claim value. In addition to the time already spent securing a judgment, enforcement takes 305 days. As per the NJDG, while approximately 4.5 lakh new execution petitions are instituted each year, only 3.9 lakh are disposed. Even then, less than 15% result in an award or decree.

This poor track record on court-led enforcement also dilutes alternate dispute resolution mechanisms, which operate in the shadow of the law. When parties understand that enforcing settlement agreements is likely to be prolonged, often with poor outcomes, their incentives change. Consequently, such mechanisms are used not to resolve disputes but to avoid payments and cause delays. In fact, poor performance on contract enforcement may be why Indian and international businesses often include international arbitration clauses in contracts when dealing with cross-border transactions.

At present, enforcement of civil judgments is governed by the Code of Civil Procedure 1908 (CPC). To ensure enforcement, a court can attach a judgment debtor’s (a person against whom a judgment capable of execution has been passed) assets, imprison them, or appoint an individual to manage their property. Once attached, the debtor cannot dispose of or transfer the property. If they fail to fulfil the judgment claim, the attached property can be auctioned off. While the CPC comprises intricate and complex procedures, which may be necessary to deal with the myriad of matters adjudicated by the civil court system (for example, specific performance, partition trusts, inheritance rights, etc.), there are no provisions to determine the true value of the debtor’s assets or reverse undervalued or preferential transactions. This allows assets to be unduly siphoned off. Due to the non-specificity of provisions regarding monetary awards, judgment debtors can also exploit procedural gaps and employ dilatory tactics to delay or frustrate the enforcement of such awards.

A proposed solution

The IBC already recognises judgment creditors as ‘creditors’ (Section 3 (10)) with legitimate ‘claims’ (Section 3 (6)) against a debtor. However, because they have not been explicitly recognised as financial or operational creditors, they cannot initiate insolvency resolution proceedings. Instead, they must wait for a financial or operational creditor or the corporate debtor to set the ball rolling on insolvency proceedings and, even then, only file their claims during the process without any participatory rights. This inability to initiate insolvency takes away a potent lever to ensure compliance with judgments.

We propose that judgment creditors be allowed to initiate insolvency resolution proceedings under the IBC. Such a move will pose a significant threat to non-compliant debtors. This is because the IBC creates two significant deterrents against wilful non-payment of claims: (i) the displacement of the promoter when the insolvency resolution proceedings commence, and (ii) a possibility of liquidation of the company if the resolution fails. Given these grave consequences, the judgment debtor’s incentive will be to voluntarily fulfil the judgment claim. This change should be prospective, allowing all creditors to adjust to evolving dynamics.

In fact, when allowed, admission of an insolvency application filed by a judgment creditor should be made simpler than one filed by other creditors. This is because the IBC requires that four factors be considered before admitting an insolvency resolution application: (i) whether there is a claim of a certain threshold, (ii) whether it is undisputed, (iii) whether it has become time-barred, and (iv) whether it has come to the correct bench of the tribunal. In the case of judgment claims, the first three are validated by a court or a tribunal; hence, there are no ambiguities that may delay the admission proceedings.

This is not a novel solution. Judgment creditors can initiate insolvency proceedings in both the United Kingdom and the United States of America.

• United Kingdom: Judgment creditors have specific rights to push a debtor into administration or winding up (analogous to insolvency resolution and liquidation proceedings in India, respectively). Under paragraph 11 of schedule B1, read with Section 123, of the Insolvency Act 1986, a creditor may file an administration application if an order of any court in their favour is returned unsatisfied. Under Section 122, a creditor can file a winding-up application on the same grounds. When it comes to individuals, the process is slightly different. Section 267 of the Insolvency Act allows a creditor to present a bankruptcy petition if the individual owes a judgment debt of £5,000 or more.

• United States of America: Judgment creditors possess distinct rights to push a debtor into involuntary bankruptcy proceedings. Under 11 USC § 303 of the US Bankruptcy Code, upon satisfying the prerequisites, creditors can file an involuntary bankruptcy petition against a debtor. If the court determines the involuntary petition is valid, it will issue an “order for relief,” initiating the bankruptcy process. For individual debtors, this often translates to a Chapter 7 liquidation or a Chapter 13 repayment plan.

To enable this in India, the IBC must be amended to recognise judgment creditors of a monetary award as financial creditors holding financial debt under Sections 5 (7) and 5 (8), respectively. This is because the award includes interest, penalties, or costs, and aligns with the time-value-of-money considerations intrinsic to financial debts. As loans accrue interest over time, judgment awards accumulate interest until settled, mirroring the financial obligations of the judgment debtor. Once a court has passed a monetary award, the claim is rooted in the judgment award, not the original transaction. Hence, even when the underlying dispute is related to the provision of goods or services, the judgment award should be understood to represent a financial debt. This view has been endorsed by the Supreme Court of India and should be legislatively incorporated. The Court, in Kotak Mahindra Bank Limited v A Balakrishnan (2022 INSC 630), has noted that:

Taking into consideration the object and purpose of the IBC, the legislature could never have intended to keep a debt, which is crystallised in the form of a decree, outside the ambit of clause (8) of Section 5 [financial debt] of the IBC.

Classifying judgment creditors as financial creditors during the insolvency process would also ensure that they have an influential participatory role, commensurate with the significance of court-sanctioned monetary awards.

Allowing judgment creditors the power to initiate insolvency proceedings will generate strong monitoring and compliance effects in the pre-insolvency world. Other financial creditors of the debtor will factor current and potential adverse judgment claims into their credit decisions. This, in turn, will generate strong incentives to avoid adverse judgments and to comply with judgment claims when they arise. Conversely, businesses would be compelled to take a proactive stance in settling disputes, knowing the ramifications are not just reputational but could also threaten their solvency and control over the enterprise. It will signal to the market that judgments are not just moral proclamations but actionable financial commitments.

An illustration

To better understand how this will play out, let us consider an arbitration proceeding between X Co and Y Co concerning a contract violation, where the arbitrator awards Rs. 2,00,00,000 to Y. X will likely challenge such the award under Section 34 of the Arbitration and Conciliation Act 1996 (Arbitration Act). Since the grounds for challenge under Section 34 are procedural, courts generally uphold arbitral awards.

Traditionally, Y would have been forced to then rely on the procedure set out under the CPC. However, as mentioned, enforcement under the CPC is notorious for delays. The award would remain stuck in court procedures, and Y may face a cash crunch. The money they rightfully won, tied up in legal battles, would not be accessible for business needs, growth, or reinvestment. At the same time, X would remain operational, benefiting from the liquidity that it has withheld (Gulati and Roy 2020).

However, things may be different if Y is allowed to initiate an insolvency resolution proceeding. Although X may prefer an appeal under Section 37 of the Arbitration Act, the confirmation of the award under Section 34 will convert it into a claim under the IBC (a right to payment reduced to judgment). The initiation of the insolvency proceeding will immediately shift the dynamics. Under IBC, X’s promoters could be displaced, and there may be a potential change in the company’s ownership. Thus, it will attempt to clear the dues and settle its dispute with Y. In essence, the IBC will be the much-needed lifeline for Y, ensuring it doesn’t remain stuck in the quagmire of the CPC and can promptly access its rightful claim.

Concerns

One potential concern regarding the proposal might be the risk of overburdening the insolvency resolution process and, consequently, the NCLT. While the IBC recognises that time is of the essence, it is already struggling with capacity challenges and mounting delays. Overloading this system could create an environment reminiscent of the current civil court enforcement mechanism, fraught with delays and backlogs. This would counteract the benefits and efficiencies the proposed change aims to introduce.

However, this concern does not acknowledge the strong deterrents to frivolous insolvency proceedings built into the IBC. Judgment debtors will need to comply with the minimum default value requirement of Rs. 1,00,00,000. Further, the filing of the insolvency application is understood to aid negotiations between the filing creditor and debtor, often resulting in a settlement between parties outside the purview of the NCLT. As per the Insolvency and Bankruptcy Board of India, 28% of the insolvency resolution matters are settled or withdrawn. These figures do not account for the negotiations in the shadow due to the mere threat of an insolvency application being filed. Thus, the actual strain on the NCLT might be lower than anticipated. 

Similarly, there may be concerns about whether insolvency proceedings can take away the judgment creditor’s right to prefer an appeal against the underlying judgment. These concerns can be alleviated by deferring to good design principles. One way of doing this is to only allow judgment creditors to initiate insolvency proceedings when the judgment debtor has exhausted all statutory remedies (e.g., an appeal under Section 37 of the Arbitration Act by X in our example). As an alternative, it may be recognised that even under the IBC, there is a 14-day period within which an admission application is to be decided. The judgment debtor may file a statutorily permitted appeal against the underlying judgment within this period. In practice, the time between filing an insolvency application and its admission is far more than 14 days. This gives the judgment debtor ample opportunity to prefer statutorily permitted appeals. In such cases, the judgment claim will be viewed as disputed until the appeal is decided, resulting in non-admission of insolvency proceedings. The path to be taken between the two alternatives is a procedural policy decision independent of the merits of the core proposal of allowing judgment creditors to initiate insolvency proceedings.

Conclusion

The efficacy of a legal system not only lies in the issuance of judgments and their timely enforcement. For India, where enforcing monetary judgments remains a daunting challenge, it is pivotal to usher in mechanisms that effectively bridge this gap. Allowing creditors to initiate insolvency resolution applications presents a powerful tool that can drastically transform the landscape of judgment enforcement.

Not only will this proposal push judgment debtors to be more compliant, but it will also signify a broader shift in the perception of judgments. Such reforms, emphasising actionable financial commitments, will help restore public faith in the judiciary, boost investment, and stimulate economic growth. By embracing this change, India can pave the way for a more robust and efficient legal system, thus fostering a climate of trust, accountability, and development.

References

Doing Business: 2020, The World Bank, 2020.

Judging the judiciary: Understanding public confidence in Latin American courts, Ryan Salzman and Adam Ramsey, 2013, Latin American Politics and Society, Volume 55, Issue 1, pp 73-95.

India’s low interest rate regime in litigation, Karan Gulati and Shubho Roy, 11 March 2020, Leap Blog.

Institutional Factors of Credit Allocation: Examining the Role of Judicial Capacity and Bankruptcy Reforms, Manaswini Rao, 2020, JusticeHub.

The Impact of the Judiciary on Economic Activity: Evidence from India, Matthieu Chemin, 2007, Cahier de recherche / Working Paper.

World Development Report 2004: Making Services Work for Poor People, The World Bank, 2003.

The authors are a research fellow and the research director at the TrustBridge Rule of Law Foundation. We are thankful to Madhav Goel and Renuka Sane for their insightful comments. Views are personal.

The place of short selling in the financial markets

by K. P. Krishnan, Renuka Sane, Ajay Shah, Anjali Sharma, Harsh Vardhan, Bhargavi Zaveri-Shah.

The Hindenburg report has reopened the Indian debate on regulatory restrictions on short selling. Is there market failure with activist short selling, that is, the practice of short sellers disseminating information (usually adverse) about the firms whose stocks they have shorted? Activist short sellers have the incentive to release negative information, which may be misleading or even false, aiming for maximal visibility. Does responding to adverse information impose an unreasonable burden of time and effort upon managers of the firm, and consequently higher costs on their customers? Is there a role for financial regulation to proscribe activist short selling or all short selling?

We argue that short seller activism improves market quality. The focus of financial regulation should be upon market abuse, and this includes market-based abuse and information-based abuse. In India, much of the policy discussion on short-selling is moot, given that short-selling, as is widely understood in the financial industry, is largely infeasible. In any case, in this globalised world, there is nothing that an Indian regulator can do about these activities taking place overseas.

Defining short selling

When a person has a negative view about the outlook for a financial price, she wants to sell. What happens when she does not own these shares? Short selling refers to the procedures on the market through which a person with a negative view can achieve a profit from successfully forecasting a price decline, even without directly owning the shares. There are roughly three ways to do this:

1. Sell stock futures.
2. Buy put options (or to sell call options).
3. Borrow shares and sell them.

The #3 is termed “short selling”. This involves (a) Borrowing shares (b) Selling them (c) Waiting (d) Buying back the shares from the market (at a hoped-for lower price) and (e) Returning the shares with interest.

In India, for all practical purposes, short selling is infeasible. While the institutional mechanisms for borrowing shares exist on websites of exchanges (such as the `Securities Lending and Borrowing Mechanism’ (SLBM) which was first operationalised in 2008), the liquidity available is negligible.

Methods #1 and #2 are constrained by a variety of regulatory restrictions, such as small position limits and high margin requirements. As an example, the position limit on the stock futures for Infosys (which has a market capitalisation of Rs.5.86 trillion) is Rs.30.8 million. This is 0.000526% of its market capitalisation. If a person successfully predicts a 50% stock price decline in Infosys, but is only permitted to have a position of Rs.30.8 million, the profit from a correct prediction is just Rs.15.4 million. This maximal profit (under extreme assumptions) is not large enough for professionals such as Hindenburg. One can only do such India-linked financial activities outside India.

The symmetry between longs and shorts

Everything that has been said above about short selling is true in reverse. When a person has a positive view about the outlook for a financial price, she wants to buy. Here too, the person can choose to act on her information in three ways: (1) Buy stock futures, (2) Buy call/Sell put options, and (3) Borrow money and buy shares.

The freedom to transact in the securities markets is analogous to the freedom to speak. A healthy arrangement is one where both positive and negative views are expressed. The market price is the outcome of both kinds of persons transacting with each other, and financial policy should be neutral between these two kinds. One has a long position, who may speak in the public domain about the stock being undervalued and likely doing well in the future. The other has a short position, who may speak in the public domain claiming that a stock is overvalued.

At present, in India, there is full symmetry between longs and shorts when it comes to expressing views through the futures and options (in that both optimists and pessimists have limited possibilities to put their money where their mouth is). On the #3 path, however, it is easier to borrow money when compared with borrowing shares.

A marketplace of ideas

The securities market is a classic example of a ‘marketplace of ideas’. There are many lines of reasoning which lead to diverse predictions about whether prices will go up or down. Each trader chooses an information set and an analytical strategy which makes sense to her. As Milton Friedman emphasised, there is a Darwinian process where those who forecast poorly lose their capital and end up having a lower influence on prices, and vice versa.

Sometimes, the phrase “market efficiency” is overstated to expect perfect forecasts. It is more useful to think of the market as a human construct, as an aggregation mechanism where multiple individuals, each with different sets of incomplete information, try to forecast better than each other. If this process is to deliver efficiency, it requires an environment of freedom: freedom to enter the market, to obtain and process information, to express views through trades, and through speech.

Current regulatory approach

The present Indian thinking on the role of having skin-in-the-game is confusing. On some occasions, the Indian state has held the lack of skin-in-the-game against market participants. In fact, if the person had no skin in the game, then she could say anything, and face no consequences. When she can lose money if she is wrong, the quality of the forecasts backing the speech is likely to be higher.

The Indian debate on government control upon short selling also needs to recognise that in the globalised world, the constraints on this activity in India have helped push it overseas, beyond the reach of Indian regulators.

Benefits for society from short selling

The resource allocation of the market economy is controlled by financial prices. As the old saying goes “finance is the brain of the economy”. When this brain works better, the scarce resources of the society get put into better use, thus improving the translation of savings/investment into growth.

Prices constantly fluctuate, frequently becoming a bit too high or a bit too low. The job of continuously correcting them is done by traders, who constantly look at these prices, and who form a judgement about whether a certain price is too high or too low. The people with forecasts are often not the people with the securities or money. It is efficient for society to create mechanisms through which people with forecasts are able to take buy or sell positions, thus feeding their information into prices. These activities continuously push prices towards fair value. It is best for these activities to be symmetric: buying and selling are both equally legitimate as both over-priced and under-priced securities are equally a problem.

Consider a share with a fair value of Rs.100. When mispricing takes place in the lower direction, i.e. the market is underpricing the share, the price can go as low as Rs.0. On the other side, however, the mispricing can go up without constraints. There is no arithmetic limit on how high prices can go, to Rs.1,000 or Rs.10,000 or beyond. Some entrepreneurs have pursued get-rich-quick schemes, where over-pricing of share leads to benefits such as achieving power in a society that glorifies financial success, obtaining enlarged loans against overvalued shares as collateral, and raising capital through primary issuance at elevated securities prices.

In advanced economies, the gains from short sellers are well established in the research literature and in policy thinking. Short sellers played a key role in calling out Enron’s accounting fraud, the Wirecard fraud and several other such situations with falsified financial statements. Researchers have found that short selling activity helps uncover firms that misreport financials faster. There is a well-known bias in favour of buy recommendations by stock analysts. Short sellers have often countered these over-optimistic valuations and often won the debate. Investigative reports by short sellers have often acted as cues for enforcement authorities to commence investigations into potential wrongdoing. For example, after Hindenburg’s 2020 report into the E.V. Maker Nikola, the SEC began an investigation into the company that led to conviction of the CEO of Nikola for fraud.

Every society suffers from problems of fake it until you make it. In the Indian institutional environment, there is certain appeal of schemes which generate meteoric financial success, which can help create financial and political capital for use in intimidation and fending off future investigations. Short selling is, then, particularly valuable in India given the limitations of state capacity in financial market regulation: the optimal space for short selling in India should be greater than that seen in advanced economies.

How does this connect up into financial markets regulation?

In the standard toolkit of financial markets regulation, e.g. as is done by the Financial Sector Legislative Reforms Commission (FSLRC), there are three classes of interventions by the state that address market failure:

• Market-based abuse: The use of market power on the market to force the price away from fundamentals.
• Information-based abuse: Falsification of the information set of the market so as to force the price away from fundamentals.
• Insider trading regulation: The use of insider information for profitable trades by insiders (which bring the price closer to fundamentals).

Regulators should enforce against all these three problems, regardless of whether short selling (or long buying) is in the picture. However, if it is felt that short selling (or long buying) always involves one or more of these three classes of problems, this is incorrect. There are many short selling (and long buying) transactions in this world which are free of these three problems.

In India, the `Prohibition of Fraudulent and Unfair Trading Practices’ (PFUTP) Regulations are designed to deal with market abuse of both kinds (market-based abuse and information-based abuse). PFUTP regulations have been one of the most frequently enforced regulations in the Indian securities market with a reasonably high conviction rate (Damle and Zaveri-Shah, 2022). SEBI may issue directions to pre-empt such conduct and impose sanctions in the form of monetary penalties, with the directions often having a punitive effect as well.

Finally, under present Indian law, defamation, including corporate defamation, is a civil and a criminal wrong. For instance, recently, Edelweiss sued Moody’s for defamation for misrepresenting the former’s financials, demanding exemplary damages. An analyst went to jail for writing about Indiabulls. A firm could choose to act against an activist short seller through these tools also. In these threats also, the Indian setting is different from that in advanced economies.

We enumerate these features of the Indian legal system to shine a light on the existing methods through which state power can be brought down upon behaviours adjacent to the short selling debate, and not to endorse them. The present frameworks need much improvement. The PFUTP regulations have imprecise drafting and leave ample scope for discretion. The economic logic of harsh penalties against insider trading is questionable, as insider trading takes the market price closer to fair value. The Indian limitations on freedom of speech -- all the way to the 1st amendment -- need to give way to the blossoming of enlightenment values. For the present discussion, however, we wish to point out that when we think of bad behaviour that might go alongside short selling (or long buying), there is an institutional apparatus (that needs much improvement) which addresses these. There is nothing special about short selling (or long buying) that calls for new work by way of state coercion.

What should managers do in the information space?

Finally, we turn to the burden upon managers to respond to rumours / allegations in the information space. Firms release a set of regulated disclosures into the public domain, and are held accountable for the veracity of these claims. It is the responsibility of the managers of listed companies to operate the information process through which these facts are created and disseminated. Firms with listed securities are coerced by the state to release a certain set of correct facts about the firm, into the public domain, to enable and assist the process of speculative price discovery that creates the public goods of an efficient price and market liquidity. Such firms are also coerced on not speaking publicly, in ways which release information, outside of the regulated processes for information release.

There is, however, no role for state coercion in favour of public release of facts about market participants. As there is no market failure, they should be free to trade and speak as they please, other than the rules about disclosure of insider trades.

The information space that shapes the stock price is populated with numerous elements outside the firm:

1. The full information space is vastly greater than the set of mandatory disclosures. There is an important information space of unregulated facts. Third parties can and do construct facts about the firm with no involvement of the firm, and outside of the regulated facts overseen by SEBI. For example, a private person can obtain private satellite imagery and count the number of cars parked at DMart locations, and thus estimate revenues of DMart. It should be the privilege of such a person to compute and/or release such estimates, and be fully free on using precise or imprecise methods in the computation.
2. Third parties knowingly or unknowingly do create false facts about the firm. This is a normal and healthy part of the information space. Freedom of speech contains the freedom to utter sentences that are wrong. Obtaining precise facts is difficult and should not be crushed under state coercion where persons are punished for uncovering or speaking false facts.
3. Third parties can apply diverse analytical techniques based on which forecasts are made about the operating performance or future stock price movements of the firm. These forecasts are subjective and (in a healthy society) will diverge greatly. All these are inputs for speculators who then come together into the process of price discovery on the financial markets.
4. In this rich landscape, the state cannot be the arbiter of what is true vs. what is false. The state does not have such institutional capacity -- this is the work of market participants -- and it would constitute censorship.

What should managers of firms do about this information space? Most firms voluntarily choose to have an investor relations capability, through which they are able to engage with some institutional investors and communicate the state of the firm to them. These conversations are, of course, limited by concerns about leaking non-public information to some investors and thereby giving them an edge.

Should managers do anything else, over and beyond these traditional investor-relations activities? Should managers monitor blogs and social media, and scotch false rumours about the firm? Once there is ample trading by diverse kinds of persons on the financial market, there will be reasonable levels of market efficiency. The astrologers and technical traders and econometricians will sort out their differences -- on the market. Liquid and efficient markets are quite able to absorb all manner of influences. The difficulties of information space reiterate the prime objective of financial economic policy as creating conditions for market liquidity - by having a stock lending mechanism that works, by not having tiny position limits, by freeing up capital controls, by not reducing exchanges into arms of the state, etc.

It is not the job of a cricket team to influence the speech or bets of spectators. We think that managers competing in the information space is a bad use of managerial time and energy. If we were members of the board of a company, we would generally favour the application of the resources of the firm towards strengthening the operations and the outputs of the firm. SEBI recently proposed amending its Listing Obligations and Disclosure Regulations to require large listed companies to confirm, deny or clarify false rumors in the market. We do not see the market failure that can motivate such state coercion: this should be the prerogative of the board and not forced by the government.

References

Damle, D., & Zaveri, B. (2022). Enforcement of Securities Laws in India: An Empirical Overview. Social Science Research Network.

The footprint of union government procurement in India

by Anjali Sharma and Susan Thomas.

Difficulties of government contracting are one important source of low state capacity. When capabilities in government contracting are low, problems that involve purchase from the private sector prove to be daunting (e.g. Covid-19 vaccines), and the decisions of make vs. buy are distorted (e.g. arms manufacture by the Indian state). This has motivated research in the field of government contracting. Along with a few other fields, government contracting constitutes a `horizontal' field which influences state capacity in all specialised domains such as defence, health, etc.

A foundational fact of this field is the magnitudes involved. A few researchers have worked on the problem of measuring the size of government procurement. In a recent paper, The footprint of union government procurement in India, we develop an estimation strategy based on public finance data that is available in the public domain, for the union government and for central public sector enterprises ("CPSEs").

We analyse the fiscal documents produced by the ministries and public sector enterprises of the union government: the `Detailed Demand for Grants' (DDG) submitted by various departments and ministries to the Ministry of Finance of the Union Government and the annual statement of accounts published by the Controller General of Accounts (CGA). Object head level data is collected from the DDGs, the heads that constitute public procurement are identified. and each expenditure is classified as procurement or non-procurement. Procurement expenses are further classified into procurement expenses of goods, services and works, and operating or revenue expenditure and capital expenditures. This results in an estimate for the total operating and capital procurement expenditure for a given ministry or department in a year.

This methodology generates estimates for :

1. Total procurement in a year
2. The magnitudes which are operating expenditures vs. capital expenditure.
3. The procurement magnitudes in goods, services and works.

In this work, some records are not amenable to the approach used and are excluded from the analysis. This could contain procurement activity, which is missed out. Therefore, the resulting estimates are biased on the downward side.

The paper uses 2016-17 as an example where these methods are applied. The main findings for 2016-17 are:

1. The total purchases of the union government are about Rs.3.9 trillion, and the CPSEs additionally purchase Rs.13.8 trillion. These add up to around 12% of GDP.
2. Of the total purchases by the union government, Rs.2.2 trillion are capital goods and the remainder are operating expenses. The CPSEs added Rs.2.2 trillion of fixed assets. The remaining Rs.13.67 trillion were operating expenses. This indicates that a little over 13% of public procurement by union government and CPSEs are capital expenses.

This research fits into the emerging literature on government contracting. Obtaining a sense of the empirical magnitudes involved is a critical building block of this field. We build on, and enhance, the measurement of public procurement which includes the preface to the draft `Public Procurement Bill, 2012', work by the research group at Consumer Unity & Trust Society (CUTS, 2012), and research work based on the World Bank Global Public Procurement Database (Djankov et al 2016).

Alongside this (conservative) estimate of union government procurement activities at about 11% of GDP, there are purchases by state and city governments. Khan (2012) places this total at around 30% of GDP. The magnitudes involved underline the importance of this field, of measuring, diagnosing, and improving the capabilities of government in contracting.

References

CUTS (2012), International, Government Procurement in India Domestic Regulations and Trade Prospects, CUTS, October 2012.

Simeon Djankov, Asif Islam and Federica Saliola, How large is public procurement in developing countries?, Peterson Institute for International Economics blog, November 2016.

M. H. Khan, Public procurement issues with Government of India, Presentation at LBSNAA, March 2017. 

Anjali Sharma and Susan Thomas, The footprint of union government procurement in India, xKDR Working Paper 10, November 2021

 

Anjali Sharma is Head of Strategy and Regulatory Affairs at National E-Governance Services Ltd. Susan Thomas is Research Professor of Business at Jindal Global University and Researcher at xKDR Forum, Bombay.