by Ajay Shah.
Promoters and bankruptcy in a good world
We should not see default in a moralistic way. People enter into debt/equity relationships, and sometimes equity is not able to pay, in which case equityholders are pushed out of the way, and debt takes over the company. After that, the Committee of Creditors looks for the person who offers the best price to buy the company. This can be the erstwhile shareholder.
Hence, we should be fine with promoters tossing in a bid into the insolvency resolution process. They may have good knowledge of precisely what went wrong, they help increase competition in the IRP, and may often be the highest bidder. By this logic, having the promoter in the IRP helps increase recovery rates. The recent Ordinance, which amended the IBC to block all defaulters from all IBC activities, has been widely criticised for being out of touch with commercial sense. Two recent articles by
Fiebelman & Sane and
Sengupta & Sharma explore these issues and the recent Ordinance.
We are furious about theft by promoters of assets from within the
company. This does not justify debarring promoters from the bankruptcy
process: it justifies S.69 of the IBC, 2016, which initiates a process
of identifying and punishing such theft. Debarring promoters from the
bankruptcy process would actually increase their incentive to steal in
this fashion.
Improvised Explosive Devices (IEDs) tucked away inside many Indian firms
There are some unique features of most firms in India which alter this thinking. Most firms in India do not have a clean structure of legal contracts. There are a large number of unwritten arrangements which keep the firm aloft. Examples of these include:
- Oral contracts.
- Legal contracts which are incomplete contracts, where the counterparty is friends/family to the promoter.
- Ongoing litigation.
- Loopholes in land title.
- Elements of tax evasion or violation of law, and the repeated game with politicians/officials that sustain them.
- Arrangements with labour unions which keep the peace.
- The elements of the business where cashflow is stolen by the controlling team.
Each of these hampers the extent to which the business can be taken over by a new person without the cooperation of the promoter. For the new person, things won't work like they used to when the promoter was around, unless the promoter has done a lot by way of handing over.
The phrase `poison pills' is used to describe these booby traps hidden in most firms, but as Harsh Vardhan correctly emphasises, poison pills are formal legal structures that can be uncovered in the due diligence. These are more like IEDs that won't be detected in the diligence.
How will this influence bidding in the Insolvency Resolution Process?
The Akerlof `lemons model' teaches us that when faced with this kind of asymmetric information, bidders will shade their bids down. On paper, you think the firm is worth 30 paisa to the rupee; you suspect there are IEDs embedded within; to be safe you bid 15 paisa to the rupee.
The promoter has better information and hence bids 30 paisa to the rupee. He wins.
Imagine that this process gets repeated many times.
The professional buyers, that we so badly require to make the Indian bankruptcy process work, will lose heart. What we need most, for the maturation of the Indian bankruptcy process, is for them to develop organisational and financial capital. Instead, after they lose a few bids, they will exit the business. This will harm competitive conditions in the IRP. When competition is weakened, recovery rates will be harmed.
We will get trapped in the wrong equilibrium, where in most cases, promoters bid and win at particularly low recovery rates.
In the limit, if promoters know that if arms length investors bid low prices, then there can be moral hazard as follows. A promoter can initiate default, knowing that in the IRP he will be able to buy 100% of the equity of the firm at (say) 70% of the value of the debt.
At this stage, of course, this is deductive reasoning, as the database of experience under IBC has not yet built up. We should be suitably cautious in our thinking, knowing that we do not know.
What is the way out?
We should not be moralistic about firm failure. But we should recognise that the equilibrium outcome described above is a bad one. We should cautiously consider using the coercive power of the State to exclude promoters from the IRP (in a narrow way: for the company that has defaulted only).
If the promoter is comprehensively excluded from any connection to the IRP, bidders will shade their bids down as they do not know where the IEDs are buried. The solution lies in encouraging side contracts where bidders pay promoters for information about IEDs.
Promoters would then negotiate with various bidders and agree to a side transaction, where they are paid cash in return for full information about the IEDs. Apart from that, they would not be bidders.
This can be achieved by a narrow IBC amendment that requires that the post-IRP equity structure for a company cannot contain shareholding by the erstwhile promoters of that company.
IEDs, resolvability, credit risk assessment
A firm that borrows Rs.100 is expected to repay $100(1+r)^T$, but with probability $p$, it goes into default that yields the recovery rate $R$.
Estimating $R$ is about grappling with resolvability. A clean, transparent, simple business can easily be put through the IRP and yield a good $R$. A messy business is one with numerous IEDs. In a messy business, the IRP will involve complex negotiations for bidders with the promoter and there will be greater fear, thus yielding a lower $R$.
Most credit risk analysis in India today focuses on estimating $p$. We should think about $R$ also. Modelling resolvability and recovery rates is as important as modelling the probability of failure. When the credit market works in an intelligent way on these questions, transferable businesses will get debt at a lower cost. Clean firms will obtain a lower cost of capital and gain market share.
Complex firms and a supportive institutional environment
It should be noted that the market for control transactions also desires a clean, transparent, simple business where control can be transferred. If you were going to put in a bid for a company in a hostile takeover, you will pay more for a transparent firm. If you were building a firm with the aim of selling it in a control transaction at a future date, you would increase transparency. If you plan to borrow, then greater simplicity will yield better pricing from a rational credit market.
However, complexity is important to many large firms. At the level of the economy, high productivity firms are large complex firms. Economies of scope and economies of scale inevitably lead to business complexity. Firm internationalisation is correlated with firm productivity, and internationalised firms must engage in the complexities of multinational corporate finance which requires much complexity of contracts, holding company structures, tax havens, etc. Recovery rates are lower for complex multinational firms.
As a thumb rule in India, I think that if the managers desire it, it is possible to build a Rs.10 billion company in many industries that is easily transferable. But by the time you get to a Rs.100 billion company, considerable complexity is likely. This harms the cost of debt capital and deters certain control transactions. This induces diseconomies of scope and scale.
To say this differently, when the governance environment cleans up, complex companies will become more viable, and this will permit the economy to better nurture the largest firms which are able to harness economies of scope and scale in order to achieve the highest productivity.
Conclusion
- Credit default is not sin. We should not be moralistic in policy thinking. In a limited liability corporation, the liability of shareholders should be limited to losing the equity capital that they put in. We should not create a new notion of harm to a promoter when his company defaults, well beyond his loss of equity capital.
- Most Indian firms are peppered with IEDs. The promoter has a unique informational advantage as she knows where the IEDs are buried.
- Arms length buyers will shade their bids down, reflecting fears of the IEDs. They will not be able to compete with the promoter. This will shrivel the buy side of the bankruptcy process. Barring promoters from the IRP is a way to restore competitive conditions in the IRP and enhance recovery rates.
- But the promoters know something unique which can improve recovery rates. We should not waste this knowledge. The best arrangement is one where the promoters sell this information to bidders.
- The recent ordinance debars such side transactions, which is inefficient.
- Estimating the loss given default is one important element of estimating the fair price of corporate credit. Lenders need to think about resolvability. A clean business, with a structure of complete legal contracts and no IEDs, will be the easiest to carry through the IRP and will get the highest recovery rates. These firms will get the cheapest debt from a rational debt market.
- The most productive firms are the largest and internationalised firms, which have harnessed economies of scope and scale. But these firms are inevitably complicated, with layered holding structures, multinational corporate finance, use of tax havens, and so on. Under present Indian governance arrangements, these largest firms will tend to have low transferability. This hampers their cost of capital. This is a channel for diseconomies of scale, scope and internationalisation. Improvements in the governance environment are required to remove this handcap in going from a firm size of Rs.$10^{10}$ to Rs.$10^{11}$.
I thank Harsh Vardhan, Bhargavi Zaveri, Josh Felman, Anjali Sharma, Adam Fiebelman, M. S. Sahoo, Susan Thomas, Renuka Sane, and Rajeswari Sengupta for useful discussions on these questions.
