While the Indian Bankruptcy Code (IBC) has been critical of low recoveries, my previous column has shown that despite the value erosion in disbursements due to poor credit discipline, when compared to alternative resolution mechanisms and Chapter 11 bankruptcies in the US, the IBC Has yielded impressive recovery so far. However, the Code has also been criticized on several other grounds, many of which are questionable.
One big thing that has been ruthlessly thrown at IBC is that it leads to a disproportionate number of liquidations. This is an absurd argument. The economic objective of any resolution mechanism is not to minimize liquidation, but to maximize recovery. If liquidation can be maximized by liquidation, the liquidation is a desired outcome of the process. Bankruptcy law is not designed to protect companies from liquidation, but to maximize value using market mechanisms. Still, delving deeper into the numbers shows that this is not a fatal failure typical of the IBC, as critics are telling it. So far, about half of all cases under the IBC have ended in liquidation. For skeptics, this is an unusually large number that means its failure. However, a further comparison with US bankruptcy law shows that this is not true. According to data from US Courts (bit.ly/39mb0lh), out of 22,780 business filings for bankruptcy in 2019, only 7,020 were under Chapter 11 for reorganization, while the rest were under Chapter 7 for liquidation. This ratio has remained almost the same in the last five years. Thus, in light of the fact that many US companies file for liquidation for restructuring, the proportion of liquidations (50%) under the IBC is not a cause for concern or criticism.
Finally, many have criticized the long resolution time under the IBC. Currently, the IBC process takes between 400 and 500 days, during which the firm is likely to lose significant value. However, as long as it may seem, for a new bankruptcy law, a lead time of 400 days is not uncommon. Foteni Teloni (‘Chapter 11 Duration, Preplanned Cases, and Refilling Rates: An Empirical Analysis in the Post-Dad Era’) shows that as of 2005, the average duration of Chapter 11 bankruptcy in the US was 480 days. This was significantly reduced to 261 days after 2005 with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act, which promoted pre-packaged bankruptcy with less time. Thus, while resolution times under the IBC are longer, they are similar to those in the US before the widespread spread of pre-pack, and thus likely to decrease with greater adoption of pre-pack resolutions, which are now complemented.
Despite the achievements of IBC, it is a work in progress and some shortcomings need to be addressed. Primarily, it does not adequately address the fact that the ability to reorganize a business during bankruptcy is an important driver of recovery values. Corporate bankruptcy is an opportunity for businesses to become leaner and more efficient. In the US, many firms employ bankruptcy strategically and use independence under Chapter 11 to renegotiate contracts and streamline fixed costs. This is less visible under IBCs because, unlike Chapter 11, where debtors retain management control of the insolvent firm, firms under IBCs are managed by resolution professionals. Therefore, some think-tanks have suggested that Chapter 11-style debtor-in-possession provisions be introduced in the IBC, to allow management to retain control of the insolvent firm and allow them to streamline operations and recoveries. be encouraged to maximize
However, given the poor state of our judicial and enforcement agencies and the fact that most firms in India are owned and operated by promoter families, who often have little understanding of the difference between individual and company resources, debtors Capture is a recipe for disaster. This would encourage promoters to use their control retention over the firm’s management by siphoning off assets funded by banks, declaring bankruptcy and then forcing creditors to accept small recoveries. This would also substantially increase the period of insolvency, as promoters with management control would have no incentive for speedy resolution. This model of asset-stripping has been widely documented in several Chapter 11 bankruptcies, such as Caesar Entertainment and J.Crew, where private equity owners took foreign assets valuable intellectual and physical assets beyond the reach of creditors before declaring bankruptcy. transferred to the courts.
A better way to further improve recovery and promote restructuring of insolvent firms is to encourage resolution professionals, as they take charge of the management of an insolvent firm under the IBC. While many IBC cases have used a ‘success fee’ model to induce restructuring, the Insolvency and Bankruptcy Board of India’s recommendations of a “fair and reasonable” fee have been disappointing. Restructuring and turning over an insolvent firm is a specialized skill and unless resolution professionals are adequately encouraged, they are unlikely to do the best job. In addition, an incentive fee structure based on percentage of recovery will also attract talented managers to their pool, thereby promoting IBC resolution quality.
Finally, while the IBC has made tremendous progress in a short period of time, its effectiveness can be greatly accelerated if our officials take a macroeconomic approach to encourage restructuring to maximize recovery.
Diva Jain is a director at Arjav and is a ‘probabilist’ who researches and writes on behavioral finance and economics. His twitter handle @Divajain2 . Is
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