1. Column: Bankruptcy reform for India

Column: Bankruptcy reform for India

A pro-rehabilitation bias, along with conflicting legislation and parallel legal processes, has often led to delays

By: | Published: November 20, 2015 12:19 AM

India’s economic situation has an inexorable logic. It has a bulge in the working-age population. These people need to be given skills and decent jobs. The government has neither the fiscal resources nor the organizational capabilities to make this happen directly. Hence, the private sector has to play a major role in both skilling and job creation. The private sector has to have an institutional environment in which this is easier to do than is currently the case. One crucial aspect of creating new businesses that provide jobs is having the ability to move on quickly from failure. This is where bankruptcy reform comes in as a crucial piece of the jigsaw puzzle of India’s future growth story.

A major initiative on this front came with the current government’s creation, in August 2014, of a Bankruptcy Legislative Reforms Commission (BLRC). This was done along the lines of the recent Financial Sector Legislative Reforms Commission (FSLRC). The BLRC submitted its report earlier this month, and it promises to improve matters significantly for business exit and restructuring in India, and thereby contribute to making entry easier. This effect occurs because prospective investors face lower costs of, and quicker recovery from failure.

Earlier attempts at reforming the legal processes governing business distress and failure included the Sick Industrial Companies Act (SICA) of 1985, the Recovery of Debt due to Banks and Financial Institutions (RDDBFI) Act of 1993, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act of 2002, and portions of the Companies Act of 2013. These previous attempts have been somewhat piecemeal. The latest effort is in the spirit of the FSLRC, striving for more comprehensive reform based on detailed application of analytical principles from modern economics. These developments are noteworthy in that they are indicative of a new intellectual phase in the Indian economic reform process, though its roots can be found as early as two decades ago in the work of Project LARGE (Legal Adjustments and Reforms for Globalising the Economy), which was headed by Bibek Debroy.

Financial distress and bankruptcy are inherently difficult and contentious processes, involving competing interests in situations where the market does not provide clear signals of property rights, valuations, and decision-making options with respect to significant accumulations of financial and non-financial assets. India’s judicial institutions are notoriously slow and sometimes capricious, and the lack of clear legal frameworks that prescribe efficacious procedures has been a major handicap to business dynamism for decades.

A recent analysis by Kristin Van Zwieten (Corporate Rescue in India: The Influence of the Courts) of Indian high court judgments under SICA found evidence that judges tended to try too hard [my terminology] to rehabilitate flailing companies, increasing delays and financial costs unnecessarily. Aparna Ravi, a member of the BLRC, extended the evidence and analysis to look at more cases under several of the different laws and institutional channels for resolution of financial distress. Her work found a similar pro-rehabilitation bias, exacerbating delays, as the previous analysis. As well, Ravi found that conflicting laws and options for parallel legal processes also led to delays and compounded conflicts in already-difficult situations.

The BLRC report and draft bill seek to streamline processes, but it is not clear whether other existing laws will be repealed or amended sufficiently to remove opportunities for conflicting resolution procedures. Further, bankruptcy law is inherently complex and will always include opportunities for judicial discretion. Even advanced economies with relatively good bankruptcy procedures, such as the US and UK, will have situations where judges act in ways that might seem arbitrary or one-sided. It will be important not only to have enough structure in the new legislation to control discretion (firm time limits in the draft legislation are just one example) within any single channel, but also removal of options for “forum shopping,” as Ravi describes it. Furthermore, judges will need to be educated on the underlying principles, which is a delicate but necessary aspect of judicial reform in India more broadly.

The potential gains from this particular reform cannot be overstated. Banks with non-performing assets that are tied up in lengthy liquidation or restructuring proceedings are unwilling to make new loans. Firms that are in limbo as a result of such proceedings contribute to payment delays that spill over to upstream suppliers and lock up the flow of finance throughout the value chain. There are numerous pain points in the Indian economy. Sometimes, dealing with them causes grief elsewhere and leads to political gridlock. Bankruptcy reform is probably as close as one can get to a win-win situation, with only a few economic actors benefiting from the current situation at huge cost to the rest of the economy. Bankruptcy reform is not a panacea for all the ills that plague the Indian economy, but it surely deserves to be labeled “low-hanging fruit,” and the BLRC has provided a good instruction manual for how to pick that fruit.

The author is professor of economics, University of California, Santa Cruz

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