Author: Anjali Sharma

Anjali Sharma is a Research Director at TrustBridge.

On this blog:

• An evaluation framework for public procurement processes, 17 July 2024.

• Reducing challenges to arbitration awards: lessons from court data, 26 October 2023.
• Improving judgment enforcement: Let judgment creditors file insolvency resolution applications, 26 October 2023.

• The footprint of union government procurement in India, 20 December 2021
• Litigation in public contracts: some estimates from court data, 26 May 2021

• What ails public procurement: an analysis of tender modifications in the pre-award process, 26 November 2020.
• Judicial triage in the lockdown: evidence from India's largest commercial tribunal, 14 October 2020.
• Measuring court output in the pandemic: evidence from India's largest commercial tribunal, 11 September 2020.
• Holding their breath: Indian firms in an interruption of revenue , 3 April 2020.

• Delays in liquidated and resolved firms: Visualisation of an output measure of the Indian bankruptcy reform , 30 March 2019.

• Watching markets work: Structural change in the Nifty implied volatility, 29 September 2018. 
• An annotated reading list on the Indian bankruptcy reform, 2018, 14 August 2018. 
• Bank recapitalisation: the allocation challenge, 30 January 2018. 

• Understanding the recent IBC (Amendment) Ordinance, 2017, 7 December 2017. 
• Bank recapitalisation: The myth around growth capital, 21 November 2017. 
• Issues with the regulation of Information Utilities, 12 July 2017. 
• The size of personal bank credit in India, 7 March 2017. 
• Protecting retail investors' interest in the bond market, 27 February 2017.

• How will IBC 2016 deal with existing bank NPAs?, 5 December 2016.

• Firm insolvency process: Lessons from a cross-country comparison, 22 December 2015.
• Is India a hospitable environment for India-related finance?, 28 September 2015.
• Regulatory governance problems in the legislative function at RBI and SEBI, 23 September 2015.
• Concerns about Finance SEZs, 15 March 2015.

• NPAs processed by asset reconstruction companies -- where did we go wrong?, 23 August 2014.
• Analysis of recent regulations on currency futures, 24 June 2014.

Ordinances on Commercial Courts and the Arbitration Act: Analysing the process problems of drafting law

by Vrinda Bhandari.

In the midst of the Bihar elections and parliamentary logjam, the fact of the President promulgating two ordinances on 23rd October to amend the Arbitration and Conciliation Act, 1996 ("AC Act") and to enact the Commercial Courts, Commercial Division and Commercial Appellate Division of High Courts Ordinance 2015 has largely gone unnoticed. Aimed at the speedy settlement of commercial disputes, both ordinances derive largely from the draft Bills prepared by the Law Commission of India ("LCI") in its 246th and 253rd Report respectively. Nevertheless, they have had slightly different trajectories - the Arbitration Act amendments received Cabinet clearance in August, although they were not introduced in Parliament; while the Commercial Courts Bill was pending before a Parliamentary panel, which was due to give its report on 30th November (and which is still due).

Recently, an article by Ajay Shah offered 11 principles to improve the processes used in drafting law. In this article, I utilise this as an organising framework to critique the processes used for these two ordinances. Before starting, it is important to provide some context to the two ordinances – the principal motivation behind the AC Act was to reduce excessive judicial interference in the arbitration process, particularly in challenges to appointment of arbitrators and arbitral awards. The Supreme Court’s expansive construction of “public policy” in a challenge under s. 34 of the Act had made arbitrations as costly and time consuming as litigation. This was undermining the objective of speedy dispute resolution, whilst simultaneously introducing uncertainty for those doing business in India. Similarly, the Commercial Courts Ordinance is as an attempt to create a separate track for dealing with commercial disputes to ensure that these disputes are extracted from the otherwise stagnant civil justice system, with its low case disposal rate.

The drafting process

Let's start by describing the drafting process of the two ordinances. In case of the AC Act, the Law Ministry asked the LCI to study its proposed amendments, pursuant to its `Draft Note to the Cabinet'. The LCI constituted an expert committee comprising both Senior Counsels and junior lawyers. It also received written submissions from various lawyers (including government counsel) and organisations such as FICCI, CII and ASSOCHAM and held meetings with former judges (including the author of the previous LCI Report on the AC Act amendments).

For the Commercial Courts Ordinance, the Law Ministry referred a 2009 Bill on the subject to the LCI. Consequently, the LCI issued a "First Discussion Paper" specifying the defects in the Bill and its proposed changes and sent it to an expert committee, comprising sitting judges, Senior Counsels and junior lawyers. Based on their feedback, LCI issued a "Second Discussion Paper" and a draft Bill, which was then circulated to the Bar in Delhi, Madras and Bombay for comments. Subsequently, a small team (including policy specialists) finalised the draft Bill.

Based on these draft Bills and the internal deliberations of the Cabinet, the government issued the two ordinances, after making various changes. In this background, this post now considers compliance with the 11 principles and the impact they had on the outcome.

We now work through the 11-fold path to drafting better laws.

1. Be wary of incumbents. "Do not judge your own cause":

The first principle of good drafting is to exclude the incumbent agencies, directly affected by the law, from the drafting process. This prevents the draft law from providing more power and less accountability for the incumbent agency. To some extent this was avoided in the AC Act amendments because the LCI involved commercial organisations, lawyers and judges (with arbitration experience), each with their own vested interests. This helped balancing out incentives, and enabled the introduction of proposals for a new costs regime (adversely affecting lawyers/litigants) and incorporating the International Bar Association's Guidelines on Conflict of Interest (adversely affecting arbitrators' interests).

LCI's extensive consultation during the drafting of the Commercial Courts Bill, and the selection bias in terms of the lawyers who took time to respond, meant that new measures were also introduced against the natural incentive of lawyers/litigants to delay proceedings. Thus, s. 16 provides for amendments to the Code of Civil Procedure (“CPC”) and includes a costs regime, case management hearings, time limits etc.

2. Malleability vs. the agency problem:

Good laws achieve flexibility or “malleability” by leaving procedural details to subordinate legislation, without it empowering the incumbent agency to undermine the objectives of the principal law. This is not as much of an issue here since the current ordinances do not envisage the establishment of a separate agency.

Pertinently, however, malleability is achieved in the case of the Commercial Courts Ordinance by s. 3, which leaves the constitution of the Commercial Courts to the discretion of the State Government, to be exercised in consultation with the concerned High Court. Similarly, the Chief Justice of each High Court having ordinary original civil jurisdiction, i.e. Delhi, Bombay, Madras, Calcutta, and Himachal Pradesh, has the discretion to decide whether to constitute a Commercial Division in that High Court. The Ordinance, therefore, provides the requisite flexibility to the State Governments and the High Courts to decide if, and when, to take advantage of the Ordinance based on their specific local requirements. Thus, the Delhi High Court is the first Court to notify the constitution of Commercial Divisions and Commercial Appellate Divisions as per the Ordinance.

3. The Joint Secretary cannot manage these projects:

It is easier for a dedicated team, as opposed to a Joint Secretary, to put in the time and effort required to draft a new law. As discussed, the process of drafting these two ordinances was substantially different, inasmuch as it involved the LCI's team and not senior government officials. To that extent, these ordinances are a much-needed improvement from status quo.

However, using LCI drafts’ as the basis for ordinances is not a permanent organisational solution, since that makes it contingent on the composition of the LCI, which changes every three years. Interestingly, the 20th LCI, chaired by Justice A.P. Shah was unique in its involvement of external consultants, lawyers, academics and policy specialists and introduced the norm of drafting Bills instead of just giving suggestions to the government.

Moreover, the overall practice of promulgating ordinances should proceed with caution. Ordinances involve no pre-legislative public consultation or parliamentary debate, which help remedy the (inevitable) problems with drafting. Any subsequent change, when the ordinance is finally approved by Parliament, can create further uncertainty in the interpretation of law in the intervening period.

4. Writing law is different from reading it:

The process of writing good laws requires combining specialist knowledge with public administration skills. The current ordinances have been primarily drafted by lawyers with domain knowledge, but no skills in public administration. The modifications to the LCI draft were, however, made by the Law Secretaries/Ministry officials. However, in both cases, the LCI had drafts to work with -- the existing AC Act and the 2009 Commercial Courts Bill. So the LCI did not have to start from scratch. Further, the laws itself were relatively simpler, and thus easier to draft than the two big recent laws, the Indian Financial Code and the Insolvency and Bankruptcy Bill, 2015.

5. No premature coding:

Ajay talks about the importance of the ‘thinking process’ as a necessary preamble to drafting reasoned and well-written laws to prevent `repentance in leisure'. The LCI followed a substantive `thinking process’ with the Arbitration and Commercial Courts Reports taking nearly four and two years respectively, at least on paper. Both draft Bills were supported by a comprehensive report that explained the rationale for the proposed amendments and the reasons for disagreeing with previous suggestions. Further, as explained above, each report was preceded by interim consultation papers, which helped capitalise on specialist domain knowledge. These processes illustrate that there was no premature coding, at least at the LCI’s end.

6. Access control in the drafting or editing process:

The absence of premature coding has to be accompanied with giving control of the editing process only to a small team, steeped in the drafting process. This was completely absent in the present case, since LCI's draft Bills (prepared by a small team after extensive deliberation) were edited/modified by an entirely different team at the government secretariat. In fact, the first draft of the Arbitration Ordinance was never sent to the President for assent, after serious objections were raised to some of its clauses, including a mandatory time limit of 9 months for an arbitrator to decide arbitrations. Consequently, the government consulted Justice Shah and other jurists. Nevertheless, they were not consulted on the second and final draft of the Ordinance. In addition, the original LCI drafting team never saw the changes made by the government, since they were not available to the public, and had no inputs. This has resulted in problems.

For instance, s. 29A introduced by the Arbitration Ordinance fixes a time limit of 12 months (18 months by consent) to make an arbitral award, after which the arbitrator's mandate shall terminate, unless the Court extends the period. This one-size-fits-all approach ignores the possible complexity, volume of material and multitude of parties/contracts before the arbitrator. It marks a return to the pre-1996 stand of increased judicial involvement and even incentivises respondents to delay proceedings.

Conversely, s. 29A(2)'s provision giving additional fees to arbitrators for making the award within 6 months prioritises speed over quality, which is equally dangerous because the grounds for judicial interference to set aside awards are very narrow.

Further, the Arbitration Ordinance omitted the LCI's recommendation to provide for emergency arbitrators in s. 2(d), in line with SIAC Rules and international practice.[1] Further, while accepting the LCI's recommendations to require the disposal of a s. 34 objection petition to a domestic award within one year, the Ordinance ignored similar recommendations for a one-year disposal limit to s. 48's conditions for enforcement of foreign awards. Such significant errors may not have crept up if the same team had drafted and edited the law.

7. The need for continuity and absorption:

The above examples illustrate the drawbacks of not having a continuity of personnel drafting and editing a single law. Good drafting requires continuity so that the team can understand the impact of changes in one section on another section. The advantage of continuity is seen with the speed with which the LCI drafted a Supplementary to Report No. 246 to undo the Supreme Court's wide construction of "fundamental policy" in ONGC v Western Geco, one month after the decision. This amendment was incorporated as an Explanation to ss. 34(2)(b) and 48(2)(b) of the AC Act, displaying the advantages of absorption.

However, to add to Ajay’s principle, it is also important to retain continuity amongst those drafting different laws within the same field. The Delhi High Court (Amendment) Act, 2015, which was passed and notified on 26.10.2015, increased the pecuniary jurisdiction of the High Court from Rs. 20 lakhs to Rs. 2 crore. Merely a month later, the Commercial Courts Ordinance, with its wide definition of 'commercial dispute' was notified in Delhi on 17.11.2015. The cumulative effect of both the Amendment and the Ordinance is that the High Court has jurisdiction over all commercial matters over Rs. 1 crore, while all civil disputes valued less than Rs. 2 crore have been shifted to the trial courts in Delhi. The LCI in its 253^rd Report recommended setting the pecuniary jurisdiction of the Delhi High Court at Rs. 1 crore to prevent such an anomaly. Now, disputes valued between Rs. 1-2 crore will be decided by the trial courts, even though disputes above Rs. 1 crore have been benchmarked as being likely to involve technical issues requiring specialist judges or benches.

The notification of the Amendment and the Ordinance almost simultaneously can be seen either as a means of appeasing the influential High Court lobby (to retain business for the High Court lawyers) or a case of one hand of the government not knowing what the other is doing. In either case, a harmonious interaction between the laws could have been achieved by fixing the pecuniary limit at Rs. 1 crore.

8. Break with our traditional writing style:

Most of our laws introduce uncertainty because they are unnecessarily complex. They are not simple to read and are not to the point. The two ordinances seem better drafted, with the Commercial Courts Ordinance incorporating the LCI's illustration in s. 35 CPC on imposing costs on decree-holders. However, there is still a long way to go till we adopt the British system of drafting simple laws with illustrations, e.g. the IPC in India.

9. Gear up for a detailed law:

Good laws are not simple high-level statements and have sufficient detail to account for different circumstances. Both the current ordinances follow this principle and are detailed codes.

For instance, the Commercial Courts Ordinance has introduced comprehensive amendments to the CPC to deal with the award of costs. These specify what constitutes costs; the circumstances to be considered while awarding costs; and the range of orders that can be made by Courts under the provision. Similarly, the Arbitration Ordinance introduced the Fifth Schedule detailing different circumstances that give rise to justifiable doubts about the independence or impartiality of the arbitrator, with the Sixth Schedule containing the form of the arbitrator’s disclosure. The newly introduced Seventh Schedule lists the categories of relationships between the proposed arbitrator and the parties/counsel/subject matter that would make the person ineligible to be appointed as arbitrator.

10. Given enough eyeballs, all bugs are shallow:

Good drafting requires an elaborate process of peer review and public consultation to identify flaws beforehand. While the Bills prepared by the LCI were peer-reviewed, the current ordinances were not open for public comment or expert review. This is especially problematic in the case of the Commercial Courts Ordinance, which was promulgated even while the Bill was pending with the Parliamentary Standing Committee on Law and Personnel till 30.11.2015. Considering the history of the Bill in 2009, the importance of the Select Committee's input, and the eventual withdrawal in face of Rajya Sabha opposition, the government should have tried passing the law through Parliament rather than taking the ordinance route. Any amendment now will create even more confusion about the law's applicability.

11. Code re-use - but in the future:

Good drafting requires starting with `clean building blocks’ rather than replicating the existing defective landscape. These new laws can then provide opportunities for reuse in the future. The 253^rd Report rejected the 2009 Draft Bill’s core proposal of vesting original jurisdiction in Commercial Divisions in High Courts and transferring all such disputes to the High Court. It considered the proposal problematic. Instead, it introduced the idea of separate Commercial Courts at the district level and Commercial Division and Commercial Appellate Division of High Courts. This was incorporated in the Commercial Courts Ordinance.

The Ordinance also introduces novel `building blocks', from the insertion of a new Order XV-A, CPC laying out a complete code for case management hearings; to the requirements under s. 17 for the Court to collect and disclose statistical data; and training and continuous education stipulation under s. 20. These can hopefully act as opportunities for code reuse in the future, especially for the eventual amendment to the CPC.

Conclusion

While the process followed in drafting the Arbitration and Commercial Courts Ordinances is a big improvement on the prevailing drafting process, the process was not ideal. As has been shown, drafting changes made by the government to LCI's draft without stating any clear rationale has created legal issues in both the ordinances. Legal drafting is a technical skill which the government as of now lacks. Policy makers should seriously think about how to improve State capacity in this regard.

As stated above, the Ordinances were urgently required to remedy the problems of costly and time-consuming commercial dispute resolution in India. While they suffer from various drafting flaws, in comparison with the status quo they undoubtedly represent an improvement of the litigation landscape here. For instance, the amendments made in the AC Act have reduced the scope of judicial interference in the arbitration process. Similarly, the Commercial Courts Ordinance has ensured that the ordinary processes of the CPC no longer apply and has simultaneously introduced novel principles of case management. Thus, improved processes have resulted in improved outcomes in this case. In turn, it is hoped that these Ordinances will reduce the transaction cost of doing business in India by resolving disputes expeditiously, fairly and in a cost-effective manner. If the 11 steps towards better drafting had been properly applied, the results would have been even better, and would have helped design more effective laws.

Disclosure and acknowledgement

The author was involved in drafting the 253rd LCI Report.

The author thanks Pratik Datta for useful discussions.

Footnotes

[1] The LCI proposed to amend s. 2(d) defining "arbitral tribunal" to means a sole arbitrator or a panel of arbitrators "and, in the case of an arbitration conducted under the rules of an institution providing for appointment of an emergency arbitrator, includes such emergency arbitrator". Its appended Note reads, "NOTE: This amendment is to ensure that institutional rules such as the SIAC Arbitration Rules which provide for an emergency arbitrator are given statutory recognition in India."




Vrinda Bhandari is a practicing advocate in Delhi. She was involved in the Law Commission of India's 253rd Report on Commercial Courts.

Looking beyond the label `algorithmic trading'

by Ajay Shah.

At the EMF 2015 conference, I attended a talk by Pradeep Yadav, where he presented a paper: Raman, Robe, Yadav, 2015. This paper analyses algorithmic traders ("AT") and manual traders ("MT") on one of the world's largest electronic limit order book exchanges, the National Stock Exchange ("NSE").

NSE is an ideal laboratory for studying these questions, as it is a simple plain limit order book market, without the confusion caused by market makers. In addition, the overall equity market structure is simple, with two exchanges (NSE and BSE) where NSE has dominant market share. The complexities of the fragmented order flow and multiple trading venues, of the US, is not present. At NSE, both spot and futures trade in the same time zone, with orders emanating from the same co-location facility, which also facilitates research. NSE data has thus shaped up to be a very nice foundation for understanding markets, in recent years, with some of the cleanest microstructure work getting done here.

The puzzle

Pradeep Yadav and his coauthors find that under conditions of market stress, ATs withdraw from the market. This immediately lends itself to a pejorative interpretation: "ATs are good for liquidity under good times, but are quick to withdraw when the going gets difficult, and this is creating a new set of problems".

I wondered how this squares with a powerful result from Aggarwal & Thomas, 2014. This is a modern causal econometrics paper, and in this they find that the incidence of mini flash crashes goes down when there is more AT. They look for mini flash crashes defined as 2%, 5% and 10% declines of the price within a five minute window (see Table 6, page 28). All three coefficients are negative; more AT gives fewer flash crashes. For the 2% and 10% case, the differences are not statistically significant, but for the case of a 5% drop of prices in 5 minutes, bigger AT gives a statistically and economically significant decline in the incidence of flash crashes.

Both papers seem to have persuasive empirical strategies. How do we square the results? How is it that ATs are more likely to step away in difficult times (Raman, Robe, Yadav) but at the same time how it is that when there is more AT, mini flash crashes are less frequent (Aggarwal, Thomas)?

A better classification system

In order to figure out what's going on, I think we should break with the classification AT vs. MT. Instead, it's better to think in terms of simple, mechanistic trading strategies vs. complex strategies that involve human judgment. For the purpose of argument, let's call these "SI" for simple vs. "CO" for complex strategies.

Let's start with the old world, before algorithmic trading. In that world, we very much had many humans running SI strategies and many humans running CO strategies. `Technical analysis', and other trend following mechanistic strategies, were around well before algorithmic trading came along!

As Friedman, 1953, reminded us, there is a Darwinian process at work where speculators who lose money tend to exit the market. Because markets are competitive, the dumb adherence to a SI strategy would induce losses, and the people who did this would exit the market. Hence, the only sensible approach for a trader who uses a SI strategy is to either stop some times (i.e. have a "kill switch") or switch to a CO strategy at certain times.

In the good old days, SI speculators had "kill switches". When the market got weird, they would just stop trading. Nobody expected a simple trend following speculator to behave unchanged when volatility changed or when big news broke. We had trading floors where a boss would shut down some strategies from time to time. This was akin to a "kill switch" applied to a large number of SI strategies.

All that has happened with algorithmic trading is that we now have powerful clerks, i.e. computers, who are the foot soldiers implementing SI strategies. Nothing else has changed. Humans are still in charge!

Some human traders keep a swarm of SI strategies under leash, and when market conditions get difficult, they hit the kill switch. Some of them switch to CO strategies when the going gets difficult, and because CO strategies are much harder to program, they may well do this trading by hand. Some bosses of trading floors yank hundreds of SI strategies when the going gets weird.

Resolving the puzzle

There were always SI strategies and CO strategies. These have been around ever since organised financial trading began. In the older data, we are not able to disentangle the two.

In recent years, the SI strategies have gotten automated. We have reduced the use of humans in mechanistic tasks, and got computers to do this clerical work. For the first time in human history, we are now seeing a flag on orders where orders from SI strategies are now called "AT" orders. The CO strategies continue to be mostly done by hand, as it's quite hard doing this programming.

There is nothing wrong or unusual in SI strategies backing out of the market when conditions become confusing. SI strategies can only work in peaceful times. A trader who ran SI strategies all the time would exit the market as his wealth would run out (Friedman, 1953).

SI strategies done through AT give us more eyeballs looking at the millions of traded products in the modern exchange environment. When there's a dislocation in a market (e.g. a crash in the futures price), immediately, hundreds of traders come through with a mechanistic response (reverse cash and carry arbitrage), which stabilises the price. In contrast, in the manual world, the field of view of each human was limited, and when a little crash got started, there were fewer people available to interfere with it. This gave more mini flash crashes in the pre-AT world. This is how both statements are correct:

1. In times of market stress, the AT orders shy away (Raman, Robe, Yadav, 2015)
2. Greater AT intensity reduces the incidence of mini flash crashes (Aggarwal & Thomas, 2014).

References

Nidhi Aggarwal, Susan Thomas. The causal impact of algorithmic trading on market quality, Working Paper, 2014.

Milton Friedman. The case for flexible exchange rates. In Essays in Positive Economics, The University of Chicago Press, 1953.

Vikas Raman, Michel A. Robe, Pradeep K. Yadav. Man vs. Machine: Liquidity Provision and Market Fragility, Working Paper, 2015.

Insolvency and Bankruptcy Bill was tabled in Parliament today

The Insolvency and Bankruptcy Bill, 2015, was tabled in Parliament today. I have yet to see how this draft has evolved compared with the version submitted by the Committee.

This is an important step forward.

The glass is half full. From here, the work required is:

• Refining the law from the viewpoint of coping with future litigation and from the viewpoint of creating sound institutional infrastructure. The level of polishing and perfection that's found with version 1.1 of the Indian Financial Code is not yet here.
• Establishing a `Task Force' process to build the four pillars of institutional infrastructure required for enforcing the law: adjudication, regulator, insolvency professionals, information utilities.
• Navigating it through Parliament.

A good collection of research and commentary on Indian bankruptcy reform is at this page.

6th Emerging Markets Finance Conference, 2015

The 6^th edition of Emerging Markets Finance Conference, organised by the Finance Research Group, IGIDR is starting tomorrow. The conference agenda is up on the website.

Drafting hall of shame #1: Criminal sanctions for a new concept of exchange control violations

by Pratik Datta.

In recent years, curbing the menace of black money has been at the political forefront. Finally, the Finance Minister, Mr. Arun Jaitley, in his budget speech [at paragraph 103(9)] said:

"The Foreign Exchange Management Act, 1999 (FEMA) is also being amended to the effect that if any foreign exchange, foreign security or any immovable property situated outside India is held in contravention of the provisions of this Act, then action may be taken for seizure and eventual confiscation of assets of equivalent value situated in India. These contraventions are also being made liable for levy of penalty and prosecution with punishment of imprisonment up to five years."

However, the legal change brought in by the Finance Act, 2015, has now created a completely new offence which may detrimentally impact genuine foreign exchange transactions.

Consequences for businesses: A hypothetical example

The new amendment empowers the Central Government to prescribe a pecuniary threshold. Let's assume that the Central Government prescribes Rs. 1 crore as the threhold. Now, X Ltd, an Indian company, takes a foreign currency loan of GBP Y from a foreign lender in London in compliance with RBI's ECB regulations. If the loan of GBP Y > Rs. 1 crore (prescribed threshold amount), the Indian borrower X Ltd. would be guilty of committing an offence which is punishable with up to 5 years of imprisonment! This effectively constitutes a new layer of capital controls, with criminal sanctions.

But why is this an offence?

Because of an error in legal drafting. The new section 13(1C) of FEMA says that acquisition of foreign exchange exceeding the threshold prescribed is an offence -- even if such acquisition is otherwise in compliance with RBI's capital controls framework.

Section 4 of FEMA states:

Save as otherwise provided in this Act, no person resident in India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India.

Following the budget announcement, sections 13(1C) and 37A(1) were inserted in FEMA.

Section 13(1C) reads:

If any person is found to have acquired any foreign exchange, foreign security or immovable property, situated outside India, of the aggregate value exceeding the threshold prescribed under the proviso to sub-section (1) of section 37A, he shall be, in addition to the penalty imposed under sub-section (1A), punishable with imprisonment for a term which may extend to five years and with fine.

Section 37A(1) reads:

Upon receipt of any information or otherwise, if the Authorised Officer prescribed by the Central Government has reason to believe that any foreign exchange, foreign security, or any immovable property, situated outside India, is suspected to have been held in contravention of section 4, he may after recording the reasons in writing, by an order, seize value equivalent, situated within India, of such foreign exchange, foreign security or immovable property:

Provided that no such seizure shall be made in case where the aggregate value of such foreign exchange, foreign security or any immovable property, situated outside India, is less than the value as may be prescribed.

Note, if any foreign exchange, foreign security or immovable property outside India is held in contravention of section 4, then only the power of seizure under section 37A can be triggered. So far, so good.

However, section 13(1C) creates an offence which does not even require any violation of section 4 of FEMA. Note, section 13(1C) does not refer to any contravention of section 4. It only states that acquisition of foreign exchange exceeding the threshold prescribed under section 37A(1) proviso is now an offence. Under FEMA, only Central Government can prescribe. Therefore, the proviso to section 37A(1) empowers the Central Government to prescribe the value of the threshold. And section 13(1C) makes it an offence to acquire foreign exchange, foreign security or immovable property abroad beyond the value prescribed by the Central Government -- even if no other provision of the existing FEMA is violated.

How to remedy the situation?

FEMA needs to be amended to address this mistake. The words `in contravention of section 4' should be inserted into section 13(1C) and it should read like this:

If any person is found to have acquired, in contravention of section 4, any foreign exchange, foreign security or immovable property, situated outside India, of the aggregate value exceeding the threshold prescribed under the proviso to sub-section (1) of section 37A, he shall be, in addition to the penalty imposed under sub-section (1A), punishable with imprisonment for a term which may extend to five years and with fine.

Pratik Datta is a researcher at the National Institute for Public Finance Policy.

Treatment of individual credit in the draft Insolvency and Bankruptcy Code

by Shreya Garg and Renuka Sane.

The focus of thinking on bankruptcy and insolvency in India has primarily been upon defaults by firms. However, defaults by individuals are equally important for the economy. Most small firms obtain debt financing through the vehicle of personal borrowing of the entrepreneur. Households require credit for reducing the volatility of consumption. In this article, we sketch the treatment of individual insolvency in the draft Insolvency and Bankruptcy Code, and compare and contrast this against the treatment of firms.

The design of a sound insolvency process for individuals

In India, at present, we lack a well functioning market for personal credit, in part because of poor consumer protection, and the absence of well-functioning insolvency framework for enforcing repayment of loans. A key element of a credit contract is predictability around what happens if the borrower cannot repay. Creditors need mechanisms to enforce repayment, or alternatively, restructure obligations. At the same time, coercive collection mechanisms need to be blocked. Creditors need information on whether potential debtors have failed to repay in the past. Debtors need the assurance that if they fail to repay once, there is the possibility of starting all over again. Both creditors and debtors need to know that decisions will be taken swiftly. The following elements are thus important in the design of the insolvency process:

1. Participation of both the creditors and debtor: When the debtor is facing financial difficulties, it may in the interest of both the creditors and the debtor to re-negotiate the terms of repayment, and come to a new agreement. Voluntary decisions by both sides are best in terms of obtaining flexibility and maximising the recovery rate. This allows the debtor to reorganise payments in line with expected cashflows. A good insolvency process should aim to bring together all the creditors with the distressed debtor, and facilitate this re-negotiation.
   
   
2. Fair, orderly and timely: The process of re-negotiation needs to be fair and orderly for everyone to participate. It has to be timely as delays can be costly. If the re-negotiation fails, then there has to clarity on what follows, and in what time period the actions follow.
   
   
3. Release from financial liabilities: The debtor will only meaningfully participate in the process if there is the certainty that participation in the process will lead to a clean slate and the possibility of starting all over again. If the process allows the debtor to keep certain crucial assets such as tools of trade, then the debtor has a better chance at a restart.
   
   
4. Ex-ante incentives: The participants in the process will naturally want to maximise their own value first. In this process it is likely that either the creditors or the debtor will game the system to their own advantage at the cost of the others. This can skew incentives and lead to a poor credit market. For example, if the debtor knows that debt forgiveness can be had easily, it will encourage the debtor to be reckless with credit, while discourage creditors from lending. The outcome will be credit constraints.
   
   
5. Care about frictions: The institutional design needs to be mindful that for most individuals, as with most small firms, the magnitude of the debt at stake does not justify substantial expenditures on negotiation, payments for insolvency professionals, and processes at a judicial forum.
   
   

Individual insolvency in the IBC

These design principles are at the foundation of the report and the draft Insolvency and Bankruptcy Code submitted by the Bankruptcy Law Reforms Committee (BLRC). The draft Bill proposes three processes:

Insolvency Resolution Process

The Insolvency Resolution Process (IRP) is the process through which all creditors and the debtor agree on a negotiated repayment plan. This process is core to the IBC. Only on the failure of the IRP would a bankruptcy process be triggered. Individuals are required to attempt a resolution of their insolvency, as this provides debtors a chance to renegotiate and not be divested of their estate through bankruptcy, and thereby avoid the tag of being "bankrupt". The IRP can be initiated by the debtor or the creditor.
Establishing the validity of the claim of default is a bigger problem in the case of individuals than firms. If the debt is registered with an `information utility', the class of infrastructure providers envisaged by the IBC for recordkeeping, then the debtor would be precluded from contesting the validity of the debt. The absence of this electronic information would lead to delays.
Once the IRP has been triggered, a moratorium of six months would commence on all collection actions. Debtors and creditors would be required to agree on a repayment plan within this moratorium period under the supervision of a resolution professional. Once approved by the creditors and sanctioned by the adjudicating authority, the plan would be binding on the debtor and all the creditors mentioned in the plan. The debts would have to be repaid by the debtor under the terms of the repayment plan including the dates envisaged.
A certain class of assets of the debtor would remain outside the purview of this process: e.g. unencumbered assets like his dwelling house upto a certain value, life insurance policy, household items, items necessary for personal use and employment. Compared with the existing law, the ambit of excluded assets under the IBC has been expanded.
The negotiated plan would determine when the debtor is discharged from all debts. It is possible that the debtor is granted a discharge even before all dues are paid. The regulator, which has been named `Insolvency & Bankruptcy Board of India' would keep a record of the default by the debtor for a time period as may be prescribed by regulations and such information would be publicly available.

Bankruptcy Process

The IBC envisages three grounds for failure of the IRP which can lead to bankruptcy proceedings: (a) If the application to the IRP is not accepted due to failure to provide requisite information, (b) If creditors and the debtor cannot agree on a repayment plan, and (c) If the debtor fails to implement the repayment plan within the period prescribed for such implementation in the plan.
The bankruptcy proceeding will not start automatically: the creditor or the debtor would have to make an application to trigger it. On the admission of the application for bankruptcy, a bankruptcy order will be passed by the adjudicating authority.
It will have the effect of declaring the debtor as 'bankrupt' and vesting a subset of the estate of the bankrupt with a resolution professional. A moratorium will begin, on all collection actions of unsecured creditors. Secured creditors will have the option to participate in the process or enforce their security outside the process. On the vesting of the estate of the bankrupt, the resolution professional will declare the amount to be distributed amongst the creditors of the bankrupt, in the order of priority encapsulated in the IBC. The record will be kept by the Board for a time period to be prescribed by regulations. Such information will be publicly available.

Fresh start

An IRP makes sense only when there is a possibility of a repayment plan. In the case of low-income, low-asset debtors, transaction costs in the process of resolution or bankruptcy may exceed the debt at stake. There is also the danger in India that politically motivated loan-waivers destroy the credit culture. A smooth process of dealing with insolvent poor people, which works every day, could potentially de-politicise the problem.
The IBC, therefore, proposes a concept of a Fresh Start, aimed at providing debt relief to the poorest. A debtor with gross annual income of less than Rs.60,000, assets less than Rs.20,000, debts less than Rs.35,000, and no home-ownership, will be eligible to get a complete waiver of debts. These thresholds have been designed using the SECC, 2011, Deprivation Index as well as the Key Indicators of Debt and Investment in India for 2013 and will need to get revised over time.
Only the debtor can trigger this process and on submission of the requisite information, the adjudicating authority may grant him a discharge order. A moratorium will become applicable on all the creditors of the applicant for a period of six months, to provide a conducive environment for the process to go through. The Board will keep a record of the default by the debtor for a time period as may be prescribed and such information is publicly available. Facts about fresh start would stay on the record of the individual and be available to future creditors, thus containing moral hazard.

How does this process differ from corporate insolvency?

While the individual insolvency provisions mirror the corporate insolvency provisions, there are a few differences.

1. In individual insolvency, an interim moratorium starts from the date of the application, unlike corporate insolvency. This is to prevent coercive debt recovery action.
   
   
2. The corporate insolvency framework divides creditors into financial and operational creditors. This distinction is not made in respect of individuals. This is because it is expected that the debt structure of an individual or a partnership firm is likely to be less complex and it should be possible for both sets of creditors to be included in the negotiations on repayment.
   
   
3. In individual insolvency, secured creditors are permitted to stay out of IRP entirely by enforcing their security interest, unlike corporate insolvency. One reason for this is that SARFAESI has seen the greatest success in situations where the lender has extended a single loan to a single individual borrower and it was considered worthwhile to retain SARFAESI rights to individual lenders. It may also be easier for an individual or partnership to rebuild the value destroyed on account of security enforcement.
   
   
4. In corporate insolvency, the fast track IRP makes it possible for the firm to go into liquidation directly. In the case of individuals, there is no such provision. Only when the possibility of a repayment plan is completely ruled out, will the debtor be taken to bankruptcy proceedings. The thrust of the IBC is thus to resolve insolvency through re-negotiation.
   
   
5. In corporate insolvency, failure of the IRP directly triggers the liquidation proceedings. In the case of individuals, a failure of the IRP only entitles the debtor or the creditors to make an application for triggering the bankruptcy proceedings. The trigger is not automatic. The rationale for the distinction lies in the higher stigma attached to an individual's bankrupt status.
   
   
6. Corporate insolvency does not have an option of a fresh start process, as this process has been conceptualised specifically to provide debt relief to poor individuals, for whom the recovery procedure is likely to be more expensive than the amount recovered.
   
   
7. Adjudication for firms will take place at NCLT, while individual insolvency cases will go to DRTs. Over time, individuals from all corners of the country will want to access the DRTs. In terms of organisational capabilities, DRTs as presently structured are not modern courts. A tremendous effort will be required, on the lines of the work that has begun for constructing the Financial Sector Appellate Tribunal, in order to make NCLT and DRT deliver what is required for IBC.
   
   

Conclusion

The draft IBC is the first attempt at a comprehensive law for insolvency by individuals. If the code is implemented, and if the infrastructure in the form of resolution professionals, the information utilities, and the adjudication infrastructure falls into place, this could yield a sea change in the working of the market for individual credit.

Acknowledgments

We thank Richa Roy for useful comments.


Shreya Garg is a researcher at Vidhi Centre for Legal Policy. Renuka Sane is an academic at the Indian Statistical Institute, New Delhi.