Resolving municipal distress in India

by Adam Feibelman and Bhargavi Zaveri-Shah.

In recent years, municipal bodies in India have been increasingly accessing the public debt markets. In the four year period beginning 2017 to August 2021, nine municipal corporations made bond issuances aggregating to Rs. 30 billion. In contrast, in the immediately preceding two decades, ten municipal bodies had issued bonds aggregating to less than half this amount. This is generally a positive development. Tapping financial markets expands the resources available to cities for critical services and development. Like firms that access the public markets, municipal bodies that subject themselves to market discipline are held up to higher standards of transparency and local governance. A key missing element in this story, however, is the lack of clarity about municipal creditors' rights in the event of a default by a borrowing municipal body. In a chapter published in the 2021 annual publication of the Insolvency and Bankruptcy Board of India titled Quinquennial of Insolvency and Bankruptcy Code, 2016, we argue that the time is ripe for policymakers in India to develop a re-organisation framework for financially distressed municipal bodies. We evaluate the potential of a formal bankruptcy regime as the model for such a framework.

The case for a municipal re-organisation framework

We make three arguments. We begin by demonstrating the weak state of municipal finances in India. For example, in the decade beginning 2007-08, municipal revenues stagnated at 1% of the GDP, significantly lower than comparable countries. Municipal bodies (urban local bodies or ULBs) are disproportionately reliant on state governments for grants in aid and loans. They are shown to have consistently under-invested in capital infrastructure. The pandemic has exacerbated the weak state of municipal finances in India. The size of the municipal debt market is, therefore, likely to grow as municipalities seek additional resources.

Second, we argue that the current legal regime in India provides neither opportunities for collective action against municipal debt default nor clarity on the treatment of creditors (bond holders, banks and financial institutions, state lending agencies, employees and vendors) in the event of the borrowing municipal body's insolvency. Very few municipal bonds are guaranteed by the state government. At one end of the spectrum, this creates the possibility of aggressive sale of public assets, owned and operated by the ULB for the benefit of the public, by 'powerful' creditors of the ULB. On the other end of the spectrum, this deprives the system of the benefits of early recognition of financial distress in ULBs. It minimizes the possibility of salvaging a ULB's operations through a mutually negotiated and court-supervised re-organisation exercise. The growing levels of municipal borrowing from the public markets and the impact of the COVID-19 pandemic reinforce these concerns.

Third, the standard re-organisation framework applicable to private borrowers does not apply to ULBs as they provide public goods, and most of their assets are presumably for public use. Several countries have enacted differently designed re-organisation frameworks for resolving distressed municipal bodies. We highlight the key features of one such framework, namely, Chapter 9 of the US Bankruptcy Code. To be sure, Chapter 9 has its critics. However, with more than 100 municipal entities having used Chapter 9 for their resolution, it has proven to be a viable municipal bankruptcy regime. It is a rule-bound process, but one that is flexible enough to be able to address the complex problems of government financial distress, which inevitably combine important commercial concerns with essential necessities of social well being. At the least, it helps frame a number of threshold and critical questions that should be part of any discussion on the reorganization of distressed municipal entities.

Key legal and institutional challenges

We conclude by underscoring some key legal and institutional challenges to the idea of a municipal bankruptcy law in India. First, while bankruptcy and insolvency is in the concurrent list of the Constitution, municipal governance is an intrinsically State subject. A union municipal bankruptcy legislation will raise complex questions of federalism and will require provisions that allow states to retain their autonomy in applying a union legislated bankruptcy law to their ULBs. What might be the institutional tools for preserving such autonomy?

Second, experience from the US suggests a pro-active role for courts in administering a municipal bankruptcy. Any framework in India will need to determine whether the court or administrator heading the process will have the power to supervise the functioning of public services during the ULB's insolvency proceedings. If so, this would be a fundamental departure from the design of the Insolvency and Bankruptcy Code, 2016, which seeks to minimise court intervention in the insolvency proceedings and provides for the appointment of Insolvency Professionals for running the debtor's operations. Similarly, the scope of relief that the process can legitimately provide in a ULB's bankruptcy proceeding will need to be considered. Can a resolution plan for a ULB contemplate an increase in taxes? Can it provide for the sale of the ULB-owned public property? How can it do so without impinging upon decisions that are the prerogative of a city level legislature or the state's power?

Enacting a municipal bankruptcy law will require the resolution of these questions and prolonged negotiations with states much like the enactment of the GST framework. However, this should not deter policymakers from beginning the process. The gains of a clear municipal bankruptcy framework, in the face of the severe impacts of the COVID-19 pandemic and the deteriorating state of India's cities, should provide a motivation for doing so. The fact that municipal bonds are set to become an important asset held by Indian households adds an additional imperative and responsibility to ensure that there is a framework in place for addressing municipal financial distress in India.

Adam Feibelman is a Professor of Law and Director of the Center on Law and the Economy at Tulane Law School. Bhargavi Zaveri-Shah is a doctoral candidate at the National University of Singapore.

IBC (Amendment) Bill, 2019: Implications for judicial review of resolution plans

by Pratik Datta and Varun Marwah.

Shroff and Misha (2019) had earlier highlighted that excessive judicial discretion in corporate insolvency resolution is contrary to the express provisions of the Insolvency and Bankruptcy Code, 2016 (“IBC”). Indian policymakers have now recognized this problem. Accordingly, the IBC (Amendment) Bill, 2019 (“2019 Bill”) has been passed by the Parliament.

The immediate trigger for this reform was the National Company Law Appellate Tribunal (“NCLAT”) judgment dated July 4, 2019, in the resolution of Essar Steel Ltd. (“Essar judgment”). In this case, the NCLAT found ArcelorMittal’s resolution plan to be discriminatory. Accordingly, it went on to modify the plan such that the financial and operational creditors enjoy the same recovery rate. In the process, it obliterated the distinction between secured and unsecured creditors. Moreover, the NCLAT also held that the statutory waterfall under section 53 of IBC does not apply to distribution under a resolution plan. By disrupting the basic fundamentals of banking, this decision caused much concern in the Indian financial sector. Among others, the 2019 Bill seeks to address these concerns as well.

In this backdrop, we contextualize the amendments proposed by the 2019 Bill within a hypothetical theoretical framework to analyse their implications on the scope of judicial review of resolution plans under IBC.

Theoretical framework

An insolvency law should have two broad objectives. First, it must achieve the most efficient economic outcome for the insolvent company. This outcome could be going concern sale, restructuring, liquidation or a combination of these outcomes. Second, the value (cash/non-cash) received from the outcome must be distributed among the claimants of the company according to the waterfall provided in the insolvency law.

In a going concern sale, the business of the insolvent company is marketed for price discovery, that is, auctioned. Potential buyers submit their price bids in their respective resolution plans. Once the best price is discovered, the price signifies the precise value of the business. The successful buyer deposits this value in cash or its equivalent in an escrow account and takes over the business, immediately putting the assets to their best use. The resolution plan need not deal with how the deposited value would be distributed among the insolvent company's claimants.

The value deposited in the escrow could be separately distributed by the resolution professional among the claimants of the insolvent company as per the statutory waterfall. This scheme of distribution cannot be altered unless a claimant(s) affected by such alteration specifically consent to it. However, the resolution plan need not deal with any of these distribution issues. Therefore, the resolution plan cannot in any way unfairly discriminate against any claimant. Consequently, there is no need for judicial review of resolution plans to ensure fair and equitable distribution in a going concern sale for cash or its equivalent. The same logic applies to distribution in liquidation involving sale of assets for cash or its equivalent.

However, going concern sales are not always possible or desirable. For instance, during a recession, there could be no buyers in the market. Or even if there are buyers, there could be an oversupply of similar assets in the market due to industry wide factors, pushing down the price for such assets. In such circumstances, instead of a going concern sale to a new buyer, the claimants of the insolvent business may be better off by “selling” the business to some or all of the existing claimants themselves. Such “hypothetical sale” is commonly referred to as restructuring.

In such a restructuring, there is no auctioning of the insolvent business to potential outside buyers. As a result there is no price discovery and the precise value of the insolvent business in cash or its equivalent is not evident. Therefore, the notional distribution of rights (that is, securities in the restructured company) among the claimants is conceptually very different from the distribution of value in cash or its equivalent in a going concern sale.

Unlike a going concern sale, the notional distribution of rights in a restructuring has to be determined by the resolution plan. This creates two unique problems. First, given the uncertainty regarding the value of the restructured business itself, there could be ambiguity about how much value should each claimant receive under the waterfall. Second, even if the value payable to each claimant is agreed upon, there could be ambiguity regarding the value of the rights (that is, securities of the restructured company) allocated to each claimant by the resolution plan. These unique problems create a peculiar risk in restructuring - the rights distributed by the resolution plan may give one or more classes of claimants a value lesser than what they are entitled to under the statutory waterfall. This is often referred to as “unfair discrimination”. To prevent such unfair discrimination, judicial review of resolution plans in non-cash restructuring transactions is necessary.

This conceptual distinction between sale (cash) and restructuring (non-cash) transactions is critical. Minority creditor protection mechanisms including judicial review is necessary primarily for restructuring (non-cash) transactions; not so much for sale (cash) transactions. For example, Chapter 11 of the US Bankruptcy Code deals with restructuring. Section 1129 in this chapter requires a restructuring plan to provide every creditor at least the liquidation value. This safeguard is not applicable to sale transactions (for cash) under Section 363 of Chapter 3 of the US Bankruptcy Code. Evidently, the US law clearly recognises the difference between sale (cash) and restructuring (non-cash) transactions.

So far we have only dealt with neat categories of going concern sale and restructuring. However, in reality, resolution plans could propose transactions that may not squarely fall within these simple categories. For instance, some new investors may pay up cash to buy some equity or take on some debt of the restructured company, while existing lenders may swap some of their debt into equity of the restructured company. Such transactions would then be a hybrid
exhibiting features of both a going concern sale for cash as well as that of restructuring for non-cash considerations. It is important to recognise that such transactions effectively help preserve the going concern value of the insolvent business. Therefore, in such transactions, each claimant of the insolvent company must get at least the amount of value (cash, non-cash or both) that it would have received had the company been sold off as a going concern for cash or its equivalent. In other words, even in such transactions, the distribution of value must follow the statutory waterfall. And this distribution function has to be performed by the resolution plan itself. Consequently, the risk of unfair discrimination may arise even in such transactions, rendering judicial review of resolution plans necessary for minority creditor protection.

Shortcomings in IBC and the proposed solutions

The IBC, as initially envisaged, differed from this ideal theoretical framework on two counts.

First, the statutory waterfall under section 53 of the IBC was initially envisaged only for distribution in liquidation. The Essar judgment held that section 53 cannot apply to distribution proposed by a Resolution Applicant. Consequently, in sale (cash) or restructuring (non-cash) transactions, a resolution plan would have to follow a scheme of distribution different from the statutory waterfall, opening up flood-gates of unfair discrimination allegations.

The 2019 Bill attempts to address this problem. Section 30(2)(b) is proposed to be amended to make the statutory waterfall under section 53 applicable to distribution in resolution as well. This clarity should reduce allegations of unfair discrimination in resolutions and help cut down on unnecessary judicial review in going concern sales.

Second, the IBC does not clearly recognise the conceptual difference between cash and non-cash transactions. Unlike US Bankruptcy Code, section 30(2) of IBC applies minority creditor protection mechanisms, meant primarily for restructuring (non-cash) transactions, to even sale (cash or its equivalent) transactions. This provision has been liberally interpreted by the NCLAT in Binani Industries to hold that every resolution plan must be fair and equitable – a vague judicially determined standard. Consequently, every resolution plan is now open to judicial review without any clear purpose. This has unnecessarily delayed many corporate insolvency resolutions. For example, the Essar resolution has been ongoing for almost 2 years, even after approval of a resolution plan by the CoC.

The 2019 Bill attempts to address this problem too. The proposed Explanation 1 to section 30(2)(b) explicitly clarifies that if a resolution plan follows the order of priority under section 53, it will satisfy the ‘fair and equitable’ standard. This explanation should narrow down the focus of judicial review to ensure distribution as per the statutory waterfall.

Conclusion

Judicial review under IBC should be focused to ensure that distribution of value is as per the statutory waterfall under section 53. In going concern sales for cash or its equivalent, distribution of value among claimants based on the waterfall would be relatively unambiguous and should not require judicial review of resolution plans. In restructuring or other hybrid transactions involving non-cash consideration, notional distribution of non-cash value in form of rights to the restructured business (that is, its securities) is likely to be contentious, given that distribution will be provided by the resolution plan and/or issues relating to price discovery and valuation. This could create opportunities for value extraction from minority to majority claimants through resolution plans in such restructuring or hybrid transactions. Judicial review of resolution plans may be necessary only to prevent such unfair value extractions in violation of the statutory waterfall. But once distribution among claimants as per the statutory waterfall is achieved, there is nothing further to be gained by subjecting each and every resolution plan to judicial review. The 2019 Bill has now modified the law to achieve this optimal outcome. Whether this outcome is achieved in practice will depend largely on how the judiciary interprets and implements these new provisions.

References

Shroff, S. and Misha, A question of balance, via the code or otherwise, Asia Business Law Journal, May 13, 2019.

Datta, P, Value Destruction and Wealth Transfer under the Insolvency and Bankruptcy Code, 2016, NIPFP Working Paper No. 247, Dec. 2018.

 

Pratik Datta is a Senior Research Fellow, and Varun Marwah is a Research Fellow at Shardul Amarchand Mangaldas & Co. We thank Mr. Shardul S. Shroff and four anonymous referees for useful discussions and comments.

An annotated reading list on the Indian bankruptcy reform, 2018

by Rajeswari Sengupta and Anjali Sharma.

The Insolvency and Bankruptcy Code, 2016 (IBC) was enacted two years back and its provisions for corporate persons have been operational for over eighteen months now. In this post we put together a compilation of writings on the Indian bankruptcy reform surrounding the IBC. We have categorised the articles and papers in themes that broadly reflect the evolution of the IBC reform process from its inception to its current status.

• Problems in the pre-IBC framework.
• The outcomes of a weak recovery and resolution framework
• The IBC design and institutional framework
• From design to law, and expectations from the new law
• Unfolding of IBC implementation
• The way forward on the reform agenda

Problems in pre-IBC framework

Corporate Rescue in India: The Influence of the Courts by Kristin van Zweiten, July 1, 2014.	The corporate rescue framework under the Sick Industrial Companies Act (SICA, 1985) was slow and costly. Its provisions were interpreted and reinterpreted by judges in attempts to rescue companies destined for liquidation, mainly to protect the interests of workmen and employees.
The evolution of the corporate bankruptcy law in India by Nimrit Kang and Nitin Nayar, 2004.	Prior to IBC, there was no single, comprehensive and integrated law on corporate bankruptcy in India. Liquidation and reorganisation were costly in terms of time and resources, did not encourage optimal valuation outcomes, and created incentives in favour of private benefits at the cost of firm value.
Evolution of the insolvency framework for non-financial firms in India by Rajeswari Sengupta, Anjali Sharma and Susan Thomas, June 22, 2016.	The origin of the complex and fragmented framework for resolution and recovery can be traced back to its evolution. Over the years, policy adopted a piecemeal approach to reform, solving only a part of the complex problem, one at a time. This led to inefficient outcomes on the overall objective.
Inconsistencies and forum shopping in the Indian bankruptcy process by Aparna Ravi, November 12, 2015. Also see here.	Fragmentation of laws and adjudication fora was a key factor resulting in delays and poor bankruptcy outcomes. A new unified bankruptcy code is an opportunity to reverse this trend by providing a linear and time bound mechanism for collective insolvency resolution.
Concerns about RBI's 'Strategic Debt Restructuring Scheme' by Ajay Shah, June 26, 2015.	Restructuring mechanisms initiated by the Reserve Bank of India lacked legal foundation and sound economic thinking.
The Scheme of Arrangement as a Debt Restructuring Tool in India: Problems and Prospects by Umakanth Varottil, March, 2017.	Scheme of Arrangements under the Companies Act is used sparingly for debt restructuring in India. The mere presence of a legal provision does not lead to its utilisation. The context and the associated institutions play a role in determining how such legal provisions are used.

The outcomes of a weak recovery and resolution framework

NPAs processed by asset reconstruction companies -- where did we go wrong? by Ajay Shah, Anjali Sharma, Susan Thomas, August 23, 2014.	Asset Reconstruction Companies (ARCs) were not functioning well, despite their mandate under the secured credit law. Their ability to realise value was limited by an inefficient legal framework for bankruptcy. ARCs become a tool for delaying recognition of stress in bank balance sheets.
Methods for measurement of delays in the bankruptcy process by Dhananjay Ghei and Shubho Roy, November 25, 2016.	Delays in the bankruptcy process destroy commercial value. Empirical research work in this field is now being conducted using state of the art techniques.
Building a better credit market by Bhargavi Zaveri and Radhika Pandey, March 12, 2016	India lacks a deep and well functioning credit market. Secured loans given by banks dominate the credit landscape. A comprehensive bankruptcy law is an important institutional reform required to fix this problem.
Are Indian banks systematically mispricing risk? by Harsh Vardhan, January 2, 2015.	There is a systematic mis-pricing of corporate credit by banks. This impacts effective allocation of capital in the economy and could be a potential reason behind the recurring non-performing assets (NPA) crisis in Indian banking.
Balance sheet problems of the firms and the banks by Ajay Shah, July 25, 2015. Also see here.	The credit boom of 2003-2008 was followed by a period of economic slowdown in the aftermath of the great financial crisis. Banks and their corporate borrowers faced significant balance sheet difficulties. This twin balance sheet crisis was aggravated by undercapitalisation of public sector banks, deficiencies in banking supervision and regulation, and the lack of a working bankruptcy regime.
Selective default on corporate bonds by Ajay Shah and Bhargavi Zaveri, October 25, 2015.	Fragmented creditor rights enabled firms to selectively default on the claims of creditors that had weak legal protection.

The IBC design and institutional framework

Dealing With Failure by Susan Thomas, November 13, 2015.	The design of the IBC can have a likely impact on the state of credit market development and entrepreneurship in India.
Firm insolvency process: Lessons from a cross-country comparison by Anjali Sharma and Rajeswari Sengupta, December 22, 2015.	A review of the UK and Singapore corporate insolvency rameworks offered valuable lessons for reform of the Indian orporate insolvency resolution regime.
Personal insolvency: Lessons from the UK and Australia by Renuka Sane, December 28, 2015.	A review of the UK and Australian personal insolvency frameworks offered valuable lessons for reform of the Indian ersonal insolvency resolution regime.
Setting up the ecosystem for personal credit by Renuka Sane, November 21, 2015. Also see here.	A well functioning market for personal credit requires the presence of a machinery that deals with default. The draft IBC provisions on personal credit sought to address this objective.
A better bankruptcy regulator by Pratik Datta and Rajeswari Sengupta, January 9, 2016. Also see here.	IBC proposed setting up a bankruptcy regulator, the Insolvency and Bankruptcy Board of India (IBBI), who will function like a mini-state in regulating insolvency professionals (IPs), IP agencies, information utilities (IUs) and the resolution procedures.
How to make courts work? by Pratik Datta and Ajay Shah, February 22, 2015.	Well functioning courts are an essential ingredient of the bankruptcy reform process. This requires a complete overhaul of the underlying judicial infrastructure and procedures and ground-up reforms.
Understanding judicial delays in India by Prasanth Regy, Shubho Roy and Renuka Sane, May 18, 2016.	A better understanding of the causes of judicial delays is required in order to build judicial capacity and design better functioning courts.
Building the institution of Insolvency Practitioners in India by Anirudh Burman, December 25, 2015. Also see here and here.	A new cadre of regulated insolvency professionals play a critical role in IBC proceedings. A model of 'regulated self regulation' would enable the development of a market for these professionals, while ensuring that they are effectively regulated.
Ensuring information access during financial distress by Anjali Sharma, Shivangi Tyagi and Shreya Garg, December 17, 2015. Also see here and here.	Access to indisputable information about the claims on the debtor reduces information asymmetry. The IBC proposed a competitive industry of entities called Information Utilities IUs) to maintain credit records for access during IBC proceedings.
Land market reform is an important enabler of bankruptcy reform by K.P. Krishnan, Venkatesh Panchapagesan and Madalasa Venkataraman, January 31, 2016.	Collateral plays an important role in the credit usiness. Land and real estate constitute a large part of this collateral in India. Improved working of the land market is therefore crucial for effective functioning of IBC.

From design to law, and expectations from the new law

BLRC hands over the draft Insolvency and Bankruptcy Bill November 4, 2015.	The Ministry of Finance published the report of the Bankruptcy Law Reforms Committee (BLRC) and the draft law for public consultation.
Insolvency and Bankruptcy Bill was tabled in Parliament today December 21, 2015.	The legislative process for the IBC started.
Indian bankruptcy reforms: Where we are and where we go next by Ajay Shah and Susan Thomas, May 18, 2016.	When IBC was finally enacted on May 28, 2016, there were many open questions about the state of Indian bankruptcy reforms.
Bankruptcy reforms: It's not the ranking that matters by Rajeswari Sengupta, November 13, 2015.	The expectation that IBC would improve India's rank in the World Bank's Ease of Doing Business Report seemed to be a key driver of the pace of reform.
How will IBC 2016 deal with existing bank NPAs? by Rajeswari Sengupta and Anjali Sharma, December 5, 2016. Also see here.	By the time of its implementation in December 2016, policy discourse was positioning the IBC as a mechanism to solve the bank NPA problem. The actual scenario was much more complex than this.

Unfolding of IBC implementation

An unsettling precedent under the IBC By Gausia Shaikh and Bhargavi Zaveri, Augist 8, 2017.	An early Supreme Court judgment was not aligned with the design principles of the IBC.
Understanding the recent Banking Regulation (Amendment) Ordinance, 2017 by Pratik Datta and Rajeswari Sengupta, May 8, 2017. Also see here.	In May, 2017, government amended the Banking Regulation Act, enabling RBI to direct banks to refer cases to IBC.
Essar Steel v. RBI: What lies ahead? by Pratik Datta, July 6, 2017.	RBI identified 12 cases for IBC referral. One of the 12 companies, Essar Steel challenged the constitutionality of RBI's actions. Supreme Court upheld constitutionality while expressing concern over the RBI process.
Jaypee: consumer angle in IBC play by Aparna Ravi and Anjali Sharma, September 18, 2017. Also see here.	IBC categorised creditors into financial and operational creditors. The question about classification of home buyers as creditors came up in the Jaypee Infratech case.
Concerns about the Indian bankruptcy reform by Ajay Shah, March 25, 2018.	The Binani Cements case raised concerns about the actions of resolution applicants affecting the timeliness of the resolution process under IBC.
Don't rush to ban promoters from the IBC process by Adam Feibelman and Renuka Sane, November 17, 2017. Also see here.	As the cases moved along, one major concern in public discourse was about permitting the promoters to re-gain control of their insolvent firms.
Understanding the recent IBC (Amendment) Ordinance, 2017 by Rajeswari Sengupta and Anjali Sharma, December 7, 2017.	The government amended the IBC in December, 2017 to introduce disqualifications for promoters and their related parties.
Sequencing issues in building jurisprudence: the problems of large bankruptcy cases by Ajay Shah, July 7, 2018. Also see here.	State capacity building requires sequencing, where the ecosystem learns to deal with simple things before taking on the complex problems. The Banking Regulation Amendment Ordinance of 2017, reversed this trend, bringing the 12 largest cases to a nascent law. This may have an impact on the sustainability of the IBC reform process.
Judicial Procedures will make or break the Insolvency and Bankruptcy Code by Pratik Datta and Prasanth Regy, January 24, 2017. Also see here and here.	Judicial procedure and judicial interpretation of IBC provisions in respect of specific cases has altered the design elements of the law.
A Limiting Principle for the NCLT's New Powers Under the IBC by Adam Feibelman, by August 1, 2018.	The IBC Amendment Act, 2018 gives the NCLT the power to reject a plan approved by creditors in the IBC process. This raises concerns about judicial interventions in commercial decisions.
The proper purpose of insolvency law by Pratik Datta and Rajeswari Sengupta, May 6, 2018.	The use of IBC to fulfill non-bankruptcy policy objectives may impact the effectiveness of the law in fulfilling its primary objective of timely resolution based on commercial decision making.
Watching India's insolvency reforms: a new dataset of insolvency cases by Sreyan Chatterjee, Gausia Shaikh and Bhargavi Zaveri, August 30, 2017. Also see here and here.	There is a need to capture data to enable empirical analysis of the working of the IBC. The Finance research Group at IGIDR has put together a dataset of NCLT orders which helps understand the admission procedure and outcomes.
The Indian bankruptcy reform: The state of the art, 2017 by Ajay Shah and Susan Thomas, July 13, 2017.	One year from the enactment of the law, several of the old questions remained unanswered and new areas of concern also cropped up. The need of the hour is the intellectual capacity to identify the problems, and come up with solutions so as to move closer to the ultimate desired outcome of IBC-high recovery rates.

The way forward on the reform agenda

Building institutional capacity

Does the NCLT Have Enough Judges? by Devendra Damle and Prasanth Regy, April 6, 2017.	Adjudication capacity needs to keep pace with the growing case-load in order to meet the prescribed timelines in IBC.
Issues with the regulation of Information Utilities by Sumant Prashant, Prasanth Regy, Renuka Sane, Anjali Sharma, and Shivangi Tyagi, July 12, 2017. Also see here.	IU regulations need review to ensure that a competitive industry of IUs come up. So far this is a missing piece in the institutional infrastructure.
Building State capacity for regulation in India by Shubho Roy, Ajay Shah, B. N. Srikrishna, Somasekhar Sundaresan, July 17, 2018.	This paper provides a conceptual framework for building state capacity in regulation in India which is a key institutional element in the IBC reform process.

Cohesive action on the reform agenda

Disclosure of default: The present SEBI disclosure regulation is adequate by Ajay Shah and Bhargavi Zaveri, January 11, 2018. Also see here.	Disclosure of default enables early identification of stress, and prevents value destruction. The disclosure principles applicable to listed firms need to be enforced effectively to facilitate disclosure of defaults by listed companies, and of stressed assets by listed creditors.
RBI's proposal for a Public Credit Registry by Prasanth Regy, August 2, 2017.	IUs, envisaged as credit information infrastructure institutions under the IBC, initially received RBI support. The RBI subsequently proposed setting up a public credit registry, which is on a parallel track to the IU concept of IBC.
Analysis of the recent proposed SARFAESI amendments: are these consistent with the Insolvency and Bankruptcy Code? by Rajeswari Sengupta and Richa Roy, May 29, 2016.	The design of the newly implemented debt recovery law, which came after IBC, continues to be at variance with the IBC principle of a comprehensive law accessible to all creditors.

The missing pieces

Anticipating India's New Personal Insolvency and Bankruptcy Regime by Adam Feibelman, January 11, 2018. Also see here and here.	The individual insolvency provisions of IBC are yet to be notified. The implementation of these provisions, will require significant preparation from stakeholders in terms of the design and capacity of institutional elements.
Cross Border Insolvency and the Indian Bankruptcy Code by Aparna Ravi, May 14, 2016.	A framework for cross border insolvency based on the principles on international cooperation needs to be put in place.
Movement on the law for Resolution Corporation by Suyash Rai, June 19, 2017.	A resolution framework for financial firms is the logical next step to the IBC, towards addressing the twin balance sheet problem.

 

Rajeswari Sengupta and Anjali Sharma are researchers at Indira Gandhi Institute of Development Research, Mumbai. The authors would like to thank the original authors of all the articles in this compilation.

This annotated reading list is open to collaborative development. If you have an article or paper that you think will enrich this list, please place it as a comment to this article and we will review it for inclusion.

Financial regulation for the fintech world

by Ajay Shah.

In India, there is a confusing term `non-bank financial company' (NBFC). This is an unfortunate phrase as the term, when taken literally, includes insurance companies, etc. In India, it denotes a $10 \times 2 \times 2$ classification of business models which are regulated by the RBI.

There is a lot of confusion in the present regulatory treatment of these classes of firms. The existing levers of regulation are inappropriate, and it is not clear why RBI -- which should be about sound money and sound banking -- is doing all this work. These concerns are becoming particularly important in the context of the fintech revolution, where all kinds of new firms are being shoe-horned into NBFC regulation.

It's hence useful to take one step back and think about  financial regulation from first principles. Where and why is financial regulation required? Financial regulation is based on exactly four motivations:

1. Consumer protection. Financial firms generally require a layer of restrictions, that impact upon their dealings with customers, that improve fair play. These problems are heightened when the financial firm directly deals with unsophisticated individuals.
2. Micro-prudential regulation. When a financial firm makes a high intensity promise to a consumer, generally there is a need for restrictions upon the risk-taking by the firm, to curtail the probability of firm failure. Such micro-prudential regulation is  (in turn) motivated by consumer protection: we wish to improve how consumers are treated in their dealings with the financial firm. When a firm takes a deposit from a household, that requires micro-prudential regulation, but when the firm lends to a household, the household is quite comfortable with the prospect of firm default, and no micro-prudential regulation is required.
3. Resolution. When a financial firm makes promises to consumers, or when a financial firm is systemically important, the conventional bankruptcy process (of IBC) is inadequate. A specialised bankruptcy process is required, which is run by the Resolution Corporation. 
4. Systemic risk regulation. The behaviour of firms needs to be restricted from the viewpoint of systemic risk. This is mostly about system thinking, and not looking at individual firms ("the woods and not the trees"). But one ("trees") element of this tends to be a reduced target failure probability for a few firms which are termed `systemically important'.

FSLRC drafted the Indian Financial Code (version 1.1, 2015). The four components of financial regulation show up there as:

1. Part VII which does consumer protection (S.105 to S.151)
2. Part VIII does micro prudential regulation (S.152 to S.184)
3. Part XII does resolution (S.286 to S.310). This has morphed into the FRDI Bill.
4. Part XIII does systemic risk regulation (S.311 to S.341).

This treatment is non-sectoral. There is no special law which defines consumer protection for banks vs. consumer protection for mutual funds. All kinds of financial business is treated identically, within these four components. The advantage of  non-sectoral law is that the law does not have to be modified when new business models are invented, or when multiple kinds of activities are undertaken under one roof.

Now let's apply this thought process to what, in today's India, would be called an NBFC. To keep things simple, consider a company which finances itself using the bond market, has no unsophisticated consumers, and gives out loans to companies. How would we think about regulating this?

1. Consumer protection: As this firm has no unsophisticated customers, this simplifies the problem of consumer protection. See Table 5.5 in FSLRC Volume 1. The protections that would have to be enforced are: professional diligence, unfair contract terms, unfair conduct, privacy, fair disclosure and redress.
2. Micro prudential regulation: As this firm makes no promises to unsophisticated individuals, there is no need for micro-prudential regulation. The bond market is what will discipline the risk taking of this firm. This is similar to how the bond market shapes the leverage and access to debt capital of an ordinary non-financial firm.
3. Resolution: Ordinary IBC processes will suffice to deal with failure. The bond market will reward more resolvable businesses with a lower cost of capital.
4. Systemic risk regulation: Until the balance sheet becomes 1 per  cent of GDP, i.e. $20 billion, the firm is not systemically important.

By this logic, for most NBFCs, there is a need for a little bit of consumer protection and nothing else. Most of the existing edifice of NBFC regulation, which seems to be inspired by the regulation of banks, is not required.

Enacting the Indian Financial Code addresses this situation at two levels. First, as described above, it gives a clear conceptual framework on how to think about financial regulation, without encoding business models into the law. Second, the FSLRC regulation-making process encourages the institutionalised application of mind. When mistaken ideas start out in the regulation-making process, there will be greater push back. The staff of financial agencies will rise to higher quality thinking when placed into the FSLRC regulation-making process.

In a previous article, Renuka Sane and I wrote about the barriers faced for the Fintech Regulatory Sandbox. The question discussed here -- the problems associated with shoe-horning fintech into the NBFC framework -- connects integrally to that. Once a project is proven in the sandbox, it will come out into the regulation making process. If the concepts and principles of the regulation-making process have basic defects, this will hamper the working of the regulation-making process, and yield poor outcomes.

Commercial wisdom to judicial discretion: NCLT reorients IBC

by Pratik Datta and Rajeswari Sengupta.

When a company defaults on loan repayment, there are various possibilities - the debt could be restructured, the business could be sold as a going concern or the company could be liquidated. The crucial policy question here is: who should make this decision about the company's future? Traditionally, Indian laws have brought an arm of the state - judiciary or executive - to bear on this decision. The Bankruptcy Law Reforms Committee (BLRC) broke away from this tradition and recommended that: when 75% of the financial creditors agree on a resolution plan, this plan would be binding on all the remaining creditors. If, in 180 days, no resolution plan achieves the support of 75% of the financial creditors, the company goes into liquidation. Effectively, no judge or bureaucrat is to substitute for the commercial wisdom of a super-majority of financial creditors. The Parliament adopted this legislative design and enacted the Insolvency and Bankruptcy Code, 2016 (IBC). Recently, the Hyderabad bench of NCLT in K. Sashidhar v. Kamineni Steel shifted this position of law.

The NCLT held that even if the committee of creditors (CoC) fails to approve a resolution plan with 75% of voting share, the tribunal could approve the resolution plan. In short, the future of an insolvent company will be determined not by the commercial wisdom of the CoC but by the tribunal. This decision is not only antithetical to the original legislative intent behind IBC, it also militates against the plain language of the statute.

Background

Kamineni Steel went into insolvency resolution in February 2017. The resolution plan proposed by the resolution professional (RP) was supported by financial creditors who had 66.67% of the voting power. The remaining financial creditors with 33.33% voting power did not support the plan. They preferred liquidation. According to them the liquidation value of the company was higher than the enterprise value. Faced with the threat of imminent liquidation under IBC, the RP approached the NCLT to approve the resolution plan supported by only 66.67% votes.

The company had also been undergoing the Joint Lender's Forum (JLF) process under the aegis of RBI. Before IBC was enacted, RBI had issued the JLF Guidelines in 2014. These Guidelines provided that on payment default by a corporate debtor in a consortium lending arrangement, the lenders were required to form a JLF to explore options to resolve the stress of the debtor. Any restructuring decision agreed upon by 75% of creditors by value and 60% of creditors by number in the JLF would be binding on all lenders. To facilitate timely decision making by the JLF, on May 5, 2017, RBI issued another notification lowering this threshold to 60% of creditors by value and 50% of creditors by number in the JLF.

The RP of Kamineni Steel relied on the 2017 RBI notification to argue before NCLT that since 60% of creditors by value can make binding decisions in JLF, a resolution plan under IBC supported by the same 60% should also be adequate. NCLT agreed with this argument and approved the resolution plan of Kamineni Steel supported by only 66.67% creditors.

Analysing the judgement

The judgement was broadly based on three legal arguments.

Argument 1

It relied on section 30(4) of IBC which states:

The committee of creditors may (emphasis added) approve a resolution plan by a vote of not less than seventy five per cent of voting share of the financial creditors.

The tribunal held that since the legislature used the word "may" instead of "shall" in section 30(4), the 75% vote rule is not mandatory. The potential consequence of using "shall" in this sub-section has been overlooked in this argument. Had the legislature used "shall" instead of "may" here, it would have meant that in every case the CoC was mandatorily required to approve any resolution plan submitted to them by the RP. That is not the intent of the law. The intent of the law is to let the CoC and not the RP decide the future of the insolvent company and to give the CoC the discretion to approve or reject a resolution plan. This discretion is reflected in the use of the word "may" in section 30(4). In other words, the use of the word "may" is intentional because not every resolution plan submitted by the RP needs to be approved by the CoC. This reasoning has also been supported by Professor Varottil.

Secondly, the word "may" does not dilute the 75% rule either. Section 30(4) of IBC uses the language, "...committee of creditors may approve (emphasis added) a resolution plan by a vote of not less than seventy five per cent of voting share of the financial creditors". This implies that if the CoC chooses to approve the resolution plan, then the plan can only be approved if it has at least 75% vote of the CoC.

Finally, section 30(6) of IBC states:

"The resolution professional shall submit the resolution plan as approved (emphasis added) by the committee of creditors to the Adjudicating Authority .

This implies that if the resolution plan has not been approved by the CoC (by at least 75% voting share as mentioned in section 30(4)), then it should not be submitted to the adjudicating authority by the RP.

If the relevant provision in IBC were ambiguous, the appropriate external aid to statutory interpretation would have been the BLRC report. For example, the Supreme Court in M/s. Innoventive Industries Ltd. v. ICICI Bank, heavily relied on the BLRC report to interpret various provisions of the IBC. The report would have provided clarity to the legislative intent behind section 30(4). The judgement did not make any reference to the report.

Argument 2

The judgement relied on section 31(1) of IBC which states:

If the Adjudicating Authority is satisfied (emphasis added) that the resolution plan as approved by the committee of creditors under sub-section (4) of section 30 meets the requirements as referred to in sub-section (2) of section 30, it shall by order approve the resolution plan which shall be binding on the corporate debtor and its employees, members, creditors, guarantors and other stakeholders involved in the resolution plan.

NCLT used a broad interpretation of the words "if the Adjudicating Authority is satisfied" in this sub-section to give itself the power to approve any resolution plan which has not been approved by 75% of creditors by value. This argument overlooks the fact that section 31(1) is triggered only after a resolution plan has been approved by the CoC by 75% vote. If the resolution plan has not been so approved, the need for NCLT to check if the resolution plan meets the requirements of section 30(2) does not arise. In the case at hand, since the CoC did not approve the resolution plan of Kamineni Steel by 75% vote, the NCLT could not have used its power to review under section 31(1).

Argument 3

The judgement held that since IBC is a new law and RBI as a banking regulator has issued guidelines governing the voting share of banks, the 75% rule in IBC has to be read in conjunction with RBI's circulars.

There is an inherent problem in this argument. JLF is conceptually based on the London Approach - a non-statutory informal workout mechanism originally developed by the Bank of England since 1970s. In India, the process is guided by notifications issued by RBI under the Banking Regulation Act, 1949. Only lender banks can participate in this process. In contrast, IBC is a formal statutory mechanism for collective insolvency resolution. Unlike JLF, all financial creditors, including non-banks, can vote in the IBC creditors' committee. JLF and IBC provide for different procedures under two different statutes. In the event of any conflict between a subordinate legislation under the Banking Regulation Act, 1949 and the IBC, the IBC being a parliamentary legislation should have overriding effect.

Conclusion

The judgment of K. Sasidhar v Kamineni sets a wrong precedent in the nascent Indian corporate insolvency law jurisprudence. If the dissenting creditors appeal this decision before the relevant appellate tribunal it is likely to be overturned. It is worth noting here that the Mumbai bench of NCLT in a subsequent decision has taken an opposite stand, as highlighted by professor Varottil. The K. Sasidhar v Kamineni judgement should nudge Indian policymakers to consider two issues.

First, in light of IBC, policymakers need to question the rationale for retaining JLF. Even if they choose to retain it, there must be concrete reasons for vital differences between the two procedures. For instance, policymakers need to ask why should there be two different percentage requirements - 60% under JLF and 75% under IBC?

Second, the role of the resolution professional in an insolvency proceeding needs to be reviewed. In the Kamineni case, without securing 75% votes by value of financial creditors, the RP should not have submitted the resolution plan to the adjudicating authority in the first place. Policymakers need to explore institutional reforms to ensure that RPs act in an unbiased manner, like an officer of the court who the adjudicating authority can rely upon.

 

Rajeswari Sengupta is an Assistant Professor at the Indira Gandhi Institute of Development Research. Pratik Datta is a Chevening Weidenfeld Hoffmann scholar at University of Oxford. The authors thank two anonymous referees for their comments.

Movement on the law for the Resolution Corporation

by Suyash Rai.

Capitalism without bankruptcy is like Christianity without hell.
- Frank Borman

On June 14th, the Union Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill"). This is an important step forward for a critical component of the overall strategy of India's financial sector reforms. Shaji Vikraman has insight on this in the Indian Express. In this article, I look deeper into the concept of the resolution corporation, why it matters, how we got to this milestone, and what comes next.

The slow unfolding of the banking crisis reminds us of the fragility of our financial system. The financial system, especially the banking system, is generally disaster-prone. On one hand, financial firms can make mistakes and experience losses. In addition, there is a link between problems of the economy and hardship in financial firms. When an economic downturn happens, the value of business activities declines, and this induces losses upon financial positions. We need to build a financial regulatory apparatus which will reduce financial fragility. This involves three main elements of machinery : micro-prudential regulation (which aims to push the failure probability of each financial firm to a desired value), systemic risk regulation (which aims to reduce the probability of a disruption in the overall financial system, and have tools to respond to such a disruption when it does arise) and resolution (a specialised bankruptcy process for most financial firms). At present, in India, we have weaknesses on all three elements.

Consequences of a weak resolution system

When micro-prudential regulation works well, the failure probability of financial firms is at a low level chosen by the relevant financial agency. The failure probability is not zero. Failure of inefficient firms is essential for `creative destruction'. The process of failure of inefficient firms, and the shift of capital and labour to efficient firms, is essential for productivity growth. The question is: How can we make the failure of financial firms orderly?

The failure of financial firms can often be quite disorderly. Unlike real sector firms, many financial firms manage a large amount money belonging to households and businesses, with only a small amount of capital brought in by their owners. Banks in India typically have leverage of 18$\times$ to 20$\times$, which means that their balance sheet size is 18 to 20 times the amount of equity capital. Such leverage is never seen with real sector firms. When the firm gets into trouble, there is clamour by the creditors who want to see a fair and efficient process through which they get some of their money back. Matters are more challenging with some financial firms which are so large and complex that their failure could induce instability in the financial system.

An orderly failure is one where a) the consumers either get their money back quickly or continue to get services without any significant inconvencience, and b) the stability of the financial system is not threatened. If we are not able to obtain orderly failures in the financial system, this has many adverse consequences:

• Consumers of failed financial firms suffer. As an example, in India, many cooperative banks fail every year. In spite of high entry barriers, larger institutions also fail (e.g. Global Trust Bank in 2004). Consumers lose money in these failures. These bad experiences make consumers wary of engagement with the financial system, and increase the share of gold and real estate in their portfolios.
  
• Financial stability is threatened, because even if one systemically important financial firm fails, the entire system could be destabilised by a messy, long-drawn bankruptcy process. This forces government to bail out such financial firms. So, a financial crisis ends up having a fiscal consequence.
  
• When faced with the possibility of harm to consumers, and threats to financial stability, governments get cold feet in situations of firm distress. They are then prone to bail out financial firms using taxpayers' money. We in India are familiar with this story. Public sector banks are routinely recapitalised with public funds to ensure they do not fail. This is almost never a good use of public money.
  
• Regulators sometimes respond to these problems by setting up entry barriers, which harm competition and economic dynamism. They justify the every day harm to competition on the grounds that this averts harm to consumers, risks to financial stability and the fiscal cost of bailouts.
  
• Financial firms suffer from moral hazard, and take greater risks. At its worst, financial firms obtain supernormal profit from these two interlinked channels: the certainty of being bailed out and the lack of competition.
  

A system that ensures quick and orderly resolution of failed financial firms can help avoid these outcomes. The system should be such that government, financial firms and consumers believe that the failures will be orderly. The present system of resolution in India is inadequate.

First, it mostly empowers the respective regulators (eg. RBI for banks) to do the resolution. Since regulators give the licenses and are supposed to ensure safety and soundness of the firms they license, they tend to be tardy in acknowledging their mistakes. This regulatory forbearance leads to delays in recognition of failure, which increases the costs of resolution, and may lead to losses for consumers and increases risk to stability of the financial system. There is a conflict of interest between micro-prudential regulation (achieving a target failure probability for a financial firm) and resolution (gracefully closing down financial firms which are nearing failure).

Second, the present system gives very limited powers of resolution. The powers that are given are: forced mergers/amalgamation, and winding up. Some of the other powers, such as bail-in (discussed later), are not available.

Third, even these limited powers are not enjoyed over many of the financial firms. For example, regulators do not have resolution powers over public sector scheduled commercial banks and regional rural banks.

Fourth, the way the system is structured, a bankruptcy resolution can take years, sometimes even longer than a decade. This is partly because the regulators do not have powers to take timely resolution action.

The Financial Resolution and Deposit Insurance Bill

Indian policy thinking on this began in the RBI Advisory group on reforms of deposit insurance, 1999, chaired by Jagdish Capoor.

This slumbered until we got to the Financial Sector Legislative Reforms Commission, chaired by Justice BN Srikrishna, which worked from 2011 to 2013. In its full design of Indian financial regulation, it recommended a Resolution Corporation.

In 2014, a Working Group of Ministry of Finance and Reserve Bank of India, co-chaired by Shri Arvind Mayaram and Shri Anand Sinha, also recommended a resolution capability for financial firms.

In 2014, the Ministry of Finance constitued a Task Force for the Establishment of the Resolution Corporation, under the chairmanship of Shri M. Damodaran, to work out the plan for establishing the Resolution Corporation. This was part of the two-part creation of task forces for building the new institutions required in the FSLRC architecture, which came about as four task forces followed by one more.

The budget speeches of 2015-16 and 2017-18 announced a plan to draft and table a Bill on resolution of financial firms. In September, 2016, a draft of the Bill was placed in public domain for comments.

On June 14th, the Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill") in Parliament. The FRDI Bill, when enacted, will create a framework to ensure that failure of financial firms is orderly. It will establish an independent Resolution Corporation tasked with resolving failed financial firms. The Corporation will also subsume the deposit insurance function presently performed by the Deposit Insurance and Credit Guarantee Corporation.

This Bill stands at the intersection of two long-term reform projects: 1) financial sector reforms, of which bankruptcy resolution of financial firms is an integral part; 2) bankruptcy reforms, of which financial firm resolution is an integral part. So, this Bill moves both these projects forward, and is an important building block for an efficient system of capital allocation in India.

FSLRC had envisioned a separation between the resolution corporation, which would apply for most financial firms, and the bankruptcy code, which would apply for the remaining financial firms and for all non-financial firms. The Bankruptcy Legislative Reforms Commission (BLRC), which drafted the Insolvency and Bankruptcy Code (IBC), worked with this scheme. IBC does not cover financial firms, unless the Central Government notifies certain financial firms to be covered under that law. Many types of financial firms, especially firms handling consumer funds and firms that are critical for financial stability, require a specialised resolution mechanism. For firms handling consumer funds (eg. banks, insurance companies), the process under IBC is not suitable, as a large number of small value consumers will find it difficult to invoke that process. The processes of IBC are designed for creditors who are firms, not individuals. For systemically important financial firms (eg. central counterparties, larger banks), a creditor-led resolution process under IBC is not suitable, because what is at stake is not just the interest of creditors but the stability and resilience of the financial system. Hence, for such financial firms a specialised resolution regime is required. The FRDI Bill will create such a specialised resolution regime.

What is resolution?

In the world of financial firms, resolution complements regulation. Regulators and the Corporation are expected to work in tandem, with the regulators focused on maintaining financial health and, when a firm gets into trouble, pushing for its recovery. The Resolution Corporation will take over and resolve a firm after recovery efforts have failed. Although the version of the Bill approved by the Cabinet is not yet in public domain, based on the version that was released for public consultations last year, the framework is divided into four stages.

First, when the financial firm is healthy, the respective regulators will monitor the firm and work to ensure it continues to stay healthy. At this stage, the Resolution Corporation will only get information indirectly through the regulators. Substantive powers to monitor the firm or to take any other action with respect to the firm will not be available to the Corporation.

Second, once the financial firm starts deteriorating, the respective regulator will attempt recovery. At this stage also, only the regulators will continue to have substantial powers over the firm.

Third, if the recovery efforts fail, and as the financial firm get close to failure, the Corporation will get substantial powers to instruct the firm to improve its resolvability and prevent actions that may erode the values of assets available for resolution. At this stage, the role of regulators is restricted.

Finally, when the firm fails, the Corporation will take charge and resolve it. Resolution typically means selling the failed financial firm, as a whole or in parts, to another financial firm via a competitive bidding process. However, resolution could also involve other instruments. For example, the firm could be "bailed-in", which means that the rights of and obligations to creditors may be written down to recapitalise the firm from within. Bail-in typically includes converting some junior debt into equity, but may also include writing down other types of claims. This is the opposite of a bail-out, wherein outside investors rescue a borrower by injecting money to help service a debt. Finally, liquidation may be a tool used for resolution.

There is a certain degree of tension and potential conflict between the Regulators and the Resolution Corporation. This is a healthy check-and-balance. Resolution works as a check on regulatory incompetence and forbearance. Both sides will need to be mature, respect the role of the other, and coordinate.

The idea of a specialised resolution regime for financial firms is well-accepted globally. The US has had a resolution system for banks for more than 80 years. The scope of this system was extended after the financial crisis of 2008. There have been more than 600 bank failures in US since the crisis. In this time, there has been not been even one bank run in the US, because depositors trust the resolution system to work. Why the crisis happened in the first place is another matter, which is beyond the scope of resolution. Resolution comes into play only after regulation fails, and the occurrence of crisis resulted from regulatory failure, among other factors.

Many other countries have put in place comprehensive resolution systems. These include: all European Union member states, Switzerland, Australia, Canada, Japan, Korea, Mexico, and Singapore. Many jurisdictions have ongoing or planned reforms to resolution regimes. These include: Australia, Brazil, Canada, China, Hong Kong, Indonesia, Korea, Russia, Saudi Arabia, Singapore, South Africa, Turkey.

Next steps

We are still a few years away from having a full-fledged resolution regime. Now that the Bill is going to the legislative branch, it remains to be seen what version of the Bill eventually gets enacted. If the essential features of a good resolution regime are diluted in the final version, the chances of success will be low.

Even after the Bill gets enacted, it would still take some time to build an independent and competent Resolution Corporation. Since this capability currently does not exist in the system, it will have to be cobbled together, and then strengthened over a period of time. Consider the example of human resource strategy. There are many models out there. While the Canadian authority works with fewer than 100 employees, the US authority has more than 10,000 employees. The Corporation could choose to run a tight ship, and rely on contractual work to scale up capacity in times of crisis, or it could choose to build a large organisation that is able to, on its own, deal with a crisis. Similarly, given the skill sets required to do this job, the Corporation will have to think innovatively about attracting top talent within the constraints of a government agency.

The Task Force on Establishment of the Resolution Corporation, led by M. Damodaran, has done considerable work that lays the groundwork for constructing the agency. The implementation of their project planning needs to commence immediately, so that the delay between enacting the law and enforcing it can be minimised.

It will also take our governance system some time to get used to this kind of a system of taking over and resolving a failed financial firm in a decisive and quick manner, as opposed to the present approach of allowing things to linger on. If things do go right, there are many potential benefits of this reform.

 

The author is a researcher at NIPFP.

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.

The regulatory difficulties of NBFCs in India

by Shubho Roy.

The founder of the Shriram Group, R. Thyagarajan, who is one of the most respected people in Indian finance, spoke to Forbes India expressing concerns about the things that are being done with the regulation of NBFCs. This is important food for thought for understanding the problems of Indian finance. He talks about how the NBFC sector is being stifled with regulation and the need for moving it away from the Banking Regulator. He points out that the mind-set and objectives of RBI, in regulating NBFCs in ways that are appropriate for banks, is killing the industry.

Banks and NBFCs are different, pose different problems for financial regulation, and should be regulated differently. RBI is smothering NBFCs by applying banking thinking for them, and is thereby hampering access to credit for the firms who obtain financing from NBFCs. The FSLRC approach offers logical answers to these questions.

What motivates regulation

Regulation must not degenerate into central planning; it must be motivated by the need to correct a precisely stated market failure. We must understand the anatomy of the market failure, and use the coercive power of the State at the precise root cause. Occam's Razor of Regulation implies that we should get the job done with the minimum use of force. The market failures associated with banks and with NBFCs are quite different. For banks, the market failure is consumer protection of unsophisticated depositors. This is the reason why we have detailed banking regulation. If there are no unsophisticated depositors in a lending institution, regulating them like banks is wrong, and harms the economy.

Consumer protection in banking regulation

When you deposit your money in a bank, you can go and withdraw the principal at any time you want. Even for fixed deposits, the principal is protected in the case of premature withdrawal.

How does a bank pay interest on money which you can withdraw at any time? Through loans. However, when a bank gives a loan: the bank gets repaid only as per the loan terms (and not when the bank needs money). If you take a home-loan or a car-loan for five years, the bank cannot come and ask you to repay the entire money before the five years are up (unless you default). The bank can only ask for the regular predefined installments. No bank can come to you (a borrower) and say:

"a lot of people are withdrawing money this month, so please pay up your five year car loan, ahead of time, this month."

Similarly, when you (depositor) go to withdraw the money from a bank the bank cannot say (legally prohibited):

"a lot of people have delayed their loan repayments so you cannot withdraw your money today, come back after a few months."

These types of deposits are technically called deposits callable at par. i.e. Deposits you can withdraw at any time without losing the principal.

Contrast this with a term loan or a bond/debenture. When you buy a five year Tata Motors debenture in the debt market, cannot withdraw it at par before the debenture matures. i.e. If you go with the debenture to the offices of Tata Motors before the five years are up, Tata Motors has no legal obligation to repay the loan amount in the debenture. You can only get your principal and interest payments as per the terms of the debenture and not a minute before that. You may sell your debenture to someone else (secondary market), but that is not the same as getting your principal back from Tata Motors. In the secondary market you have no assurance you will get your principal amount back.

Ensuring that households are able to withdraw their deposits, whenever they need it, is not trivial. Whenever a bank fails do it, eventually, there is a run on the bank. A run happens when you households panic that their life savings will be destroyed and queue up to get withdraw their deposits. Governments know (from the history of bank failures) that you cannot trust banks to pay up to households on time. Therefore, countries create banking law and corresponding banking regulator to check the banks.

Three important components of these regulations are:

1. Deposit Ratios: This requires the bank to lend out only a part of its deposits, say 80%. The bank has to keep the rest for withdrawals on any given day.
   
2. Equity buffers: Banks are required to have a certain minimum equity capital. As an example, in India, the leverage of the banking system is roughly 20 times, which means that for each 20 rupees of total assets there is 1 rupee of equity capital. This acts as a buffer against losses as the shareholders bear the loss.
   
3. Loss Recognition: Banks are forced to recognise losses and write them off using equity capital, so as to not subvert the intent of the equity buffer.
   

Banks have the incentive and capability to cover up bad news about the loans they have made. If banks admit they have bad loans then the banking regulator forces them to raise money from other sources (equity market). Raising money from the equity markets is hard, expensive and, dilutes existing shareholders. Normally, a bank likes to hide and delay the fact that debtor is not repaying as long as possible.

Unlike sophisticated creditors, you and I are unable to really understand the balance sheet of a bank. I cannot judge whether the bank will have enough money to repay a fixed deposit five years from now. Without a financial agency looking over banks every day, it is easy for banks to lend money profligately and end up defaulting to depositors.

The oversight of the financial agency, and the checks imposed by these regulations, are not without benefit to banks. In return for complying with all these regulations, the government encourages the general public, to keep money in banks. The government and the central bank extends a guarantee of safety in bank deposits. The Jan Dhan Yojana does not encourage you to buy corporate bonds but put money in bank deposits. The government runs a deposit insurance program to protect helpless households who have deposits with banks.

NBFC regulation

Non-Banking financial companies should be what their name suggests: non-banks. Sadly, this was not the case for India till about a decade ago. Because, there were few banks, Indian laws allowed NBFCs to also take deposits callable at par. i.e. Take money from depositors (unsophisticated savers) which the depositors could withdraw at any moment (working hours). These were called NBFC-Deposit Taking.

Over the last few years, RBI has gradually removed this category. Today, most NBFCs take money from the bond market or term loans (sophisticated depositors). There are no unsophisticated depositors in most NBFCs today. Since there are no unsophisticated depositors who may need their money immediately on demand, there is no consumer protection angle from deposits.

However, in spite of closing down most deposit-taking NBFCs, RBI continues to regulate NBFCs like banks, requiring them to keep liquid funds (in government securities) and also recognise problematic loans and keep capital against it. This defeats the very purpose why NBFCs are prohibited from taking deposits callable at par from household. If you are not taking deposits callable at par from households, you can go and make risky loans which banks are not going to make. There is no point in recognising and regulating NBFCs, if they are forced to meet banking regulations. We may as well call them banks and allow them to collect deposits callable at par.

The FSLRC approach

FSLRC does not indulge in artificial distinctions between banks and non-banks. It has a clear functional test for designating something as a bank or not:

Are you taking deposits from the public?

If you are; you are a bank; and you will be regulated like a bank; by the banking regulator. If you are not; then you are not a bank and you will not be regulated as a bank.

It takes care of concerns of shadow banking (entities taking deposits callable at par without complying with banking regulation) with a principled based approach. All the regulator has to test is if an entity is taking deposits callable at par. Then whatever be its name, it should be regulated like a bank.

FSLRC recommendations are driven by informed analysis of the need for regulation. Banks have unsophisticated consumers on both sides of the balance sheet and therefore the regulations have to address the consumer protection issues on both sides of the balance sheet. NBFCs on the other hand have unsophisticated consumers only on the side of borrowers. There are no depositors in an NBFC in the same sense as banks.

FSLRC recommended that financial firms which do not do this activity should not be regulated like banks and therefore not be regulated by the banking regulator. FSLRC does not leave NBFCs out of regulation. It concentrates regulation of NBFCs in two areas:

1. The protection of unsophisticated consumers who borrow from NBFCs, in line with regulation on consumer protection.
   
2. Systemic risk regulation, which would be done in a consistent way for all systemically important financial firms, some of which may be NBFCs.
   

The concerns of systemic risk however is not limited to NBFCs. Systemic risk regulation cross-cuts across all segments of the financial sector and has its own set of instruments/regulations which are not the same as the ones in banking regulation.

Conclusion

Mr. Thyagarajan reminds us that it's broke. We should fix it. He recommends that the central bank should not regulate the NBFC sector. The intellectual framework for regulating banks and NBFCs is so different that the same regulator cannot do it. India has a few large and stable businesses which banks can lend to. However, most of India's growth will come from new businesses which are small and risky. The small entrepreneur who buys a truck will face liquidity shocks (will miss a few of the regular installments). As long as such entrepreneurs are not being funded with household safe savings, there is nothing wrong in that. NBFCs have to be different from banks, they should be more risk taking. And yes, more of them will fail, but it will not harm the unsophisticated savers.

Regulation should be based on some rational requirement to address market failures. Without identifying market failures, regulations are no more than arbitrary injunctions from the powerful which serve no purpose.


Shubho Roy is a researcher at the National Institute for Public Finance and Policy.