• PAGE ONE
• INDEX
• HOME

Cleaning up the insolvency system

Pratap Ravindran

THE WIDESPREAD abuse of Sections 22(1) and 22(5) of the Sick Industrial Companies (Special Provisions) Act, 1985 has, in recent months, emerged as a subject of debate in diverse fora all of which, whatever be their other differences, are unanimous that t hese sections should either be scrapped or modified significantly if thousands of crores of rupees worth of assets are to be restored to productive deployment.

Ever since the formal adoption of the ideology of economic liberalisation in the early 1990s, successive governments have sought to bring about radical changes in the legislative environment in which commercial enterprises function. However, these change s, for the most part, have been effected with regard to nascent or established businesses with very little attention being paid to the liberation, rehabilitation and management of the value locked up in insolvent concerns. This lack of adequate attention may be genuine oversight of the legislators and administrators. On the other hand, it may not -- because there are very strong interests entrenched against any reform in the insolvency systems.

Firms take on debt for a variety of reasons. In certain cases, they prove unable to pay their debts. These firms then become bankrupt.

Consider a situation in which bankruptcy laws do not exist and the creditor(s) and debtor(s) are pretty much left to themselves to sort out problems arising from bankruptcy. It is obvious that two alternatives will be available to creditors:

In the case of secured loans, they can seize the collateralised assets. In the case of unsecured loans, the creditors can call upon a third party or an arbitrator to sell some of the debtor's assets.

But what happens if the creditors are numerous and the debtor's assets do not cover all the liabilities. In such cases, the creditors will scramble to dismantle and dispose of the debtor's assets, inevitably resulting in a sharp deterioration in the valu e of these assets and a consequent loss to the creditors.

It must be understood here that bankruptcy affects the interests of groups other than the creditors (including suppliers of goods and services, banks, financial institutions, and so on): Employees, customers, shareholders and guarantors, to name a few.

The impact of insolvency can be -- and often is -- wider still in scope. Thus, for instance, insolvency can impinge on the interests of a society as a whole which is why it is necessary to have in place codified systems to provide insulation a gainst economic damage (loss of direct and indirect jobs, by way of illustration), facilitate reallocation of resources to retain their productive potential, make possible the rehabilitation of honest debtors, minimise the risk of systemic failu res and bolster confidence in the fairness and efficiency of the market.

It is, thus, manifest that changes in the insolvency systems must be dictated by efficiency, equity and transparency in substantive and procedural terms.

In his paper on `Different Approaches to Bankruptcy,' Dr. Oliver Hart of Harvard University points out that it is extremely unlikely that a ``one size fits all'' approach will work in putting together appropriate bankruptcy procedures. That is, although some bankruptcy procedures can probably be rejected as being manifestly bad, there is a class of procedures that satisfy the main criteria of efficiency.

Further, according to Dr. Hart, it is important to recognise that bankruptcy reform should not be seen in isolation: It may be necessary to combine it with legal and other reforms -- training of judges, improvements in corporate governance, stren gthening of investor rights, and so on.

Dr. Hart, in his paper, makes the interesting observation that, in principle, individuals could arrange bankruptcy procedures themselves. That is, a debtor could specify as part of a debt contract what should happen in a default state. Writing such a con tract may, however, be difficult given that the debtor may acquire new assets and creditors as time passes.

``Moreover, the empirical evidence -- both the fact that firms rarely write such contracts and that almost all countries have at least a primitive state-provided bankruptcy procedure -- suggests that firms cannot rely on such `private' s olutions in practice. In other words, there seems to be a clear case for the government at least to provide an `off-the-shelf' bankruptcy procedure, that is, one that parties can use in the event that they do not write their own.''

The paper goes on to assert that it is difficult to derive an optimal bankruptcy procedure from first principles as economists do not, at this point, have a satisfactory theory of why parties cannot design their own bankruptcy procedures (that is, why co ntracts are incomplete).

However, economic theory does prove useful in pinpointing the characteristics of a good bankruptcy procedure.

Dr. Hart sets out three goals for a bankruptcy procedure:

* Ceteris parabus, a good bankruptcy procedure should deliver an ex post efficient outcome. That is, it should maximise the total value (computed in money terms) available to be divided among the creditors and possibly other interest ed parties -- workers, for instance. In specific terms, a firm should be reorganised, sold for cash as a going concern, or closed down and liquidated piecemeal according to which of these steps generates the greatest total value.

* A good bankruptcy procedure should preserve the bonding role of debt by penalising managers and shareholders equally. In short, the procedure must have ex ante efficiency. The most important reason why a firm raises funds by borrowing money rather than, say, issuing shares is to commit itself to pay out future cash flows. For such a commitment to have any force, there has to be some punishment if the commitment is not met. This punishment can take various forms: Shareholders can be punish ed by having their claims wiped out while managers can be punished by making it unlikely that they hold on to their jobs.

* A good bankruptcy procedure should preserve the absolute priority of claims, except that some portion of value should possibly be reserved for shareholders. In fact, says Dr. Hart, the simplest way to penalise shareholders in bankruptcy would be to respect the absolute priority of claims -- senior creditors should be paid off first, then junior creditors and finally shareholders. This system has various advantages. First, it helps to ensure that creditors receive a reasonable return in bankruptcy states which encourages them to lend. Second, it means that bankruptcy and non-bankruptcy states are not treated as fundamentally different, that is, contractual obligations entered into outside bankruptcy are respected to the extent possible inside bankruptcy.

Let us set aside individual bankruptcy for the time being and examine corporate bankruptcy more closely.

It is evident that substantive law on corporate bankruptcy must rest on the answers thrown up by any given society to certain fundamental questions: For instance, should bankruptcy laws weed out the inefficient and the incompetent, or should they be so s tructured that risk-taking is not discouraged? And then again, should the laws be debtor- or creditor-friendly?

Whatever the answers to these and related questions, Mr. Philip R. Wood of Allen & Overy (London) points out in his paper on `Insolvency Law and the Legal Framework' that nearly all jurisdictions have a liquidation law -- and that most of them go furthe r in that they have an alternative procedure designed to save businesses rather than to guillotine them.

The traditional procedures took forms such as voluntary compositions, preventive compositions, moratoriums (long and short), arrangements with creditors, judicial management, accords and creditor compositions.

``These older versions of the modern rehabilitation proceedings were often quite grudging and fearful of abuse. So they often tended to impose high thresholds for entry or impracticable requirements for guaranteed initial payments or other restrictions.' '

``As a result, they have not been much used. Creditors, it seems, preferred either to work out privately or, if there was no further hope, to call in the liquidator.''

Recent years have witnessed the introduction of ``low entry'' rehabilitation proceedings intended to rescue businesses or at least to enable them to wind down more sedately. They are low entry for two reasons: i) because the management can initiate them by showing insolvency (or sometimes just potential insolvency) with some chance of survival, without having to assure creditors of, say, a 25-40 per cent immediate payment typical of many of the traditional compositions, and ii) because their stay on cre ditors is often more extensive than liquidation in the interest of preserving the business and selling it as a going concern.

Mr. Wood points out that there is general agreement that modern rehabilitation procedures are useful. However, that said, few practitioners would disagree that the best way of saving a business is the private workout -- if it can be achieved. A fter all, this option is less costly and usually involves only sophisticated creditors, with banks often being the largest participants (though the process can get complicated if there are bondholders involved who have different attitudes and ar e more difficult to organise).

But a private workout cannot succeed if there are bondholders and the law prevents a dissentient minority from being overridden by the majority, or if there is a hold-out creditor who refuses to agree until it is too late, or if there is a real emergency and no time to work out an agreement or to find out exactly what the situation is (as in the case of Barings), or if the insolvency is so bad that an agreed stay by the banks is not enough.

Mr. Wood writes: ``So the issue is not so much whether there should be a rehabilitation procedure, but what its impact should be. It is necessary that there should be i) a stay on creditor judicial execution and attachments, and ii) a stay on final liqui dation petitions. Virtually all the statutes contemplate a timetable and do not permit an indefinite freeze: the parties are encouraged to resolve the matter expeditiously rather than to allow it to drift. But, beyond that, agreement ends. In particular, there is little consensus on what the attitude should be to the following issues:

i) The position of secured and title finance creditors;

ii) The position of counter-parties with the ability to cancel their contracts with the insolvent; and

iii) The position of creditors with a set-off.''

A World Bank group meeting (September 14-15, 1999) in Washington saw the formation of a working group on rehabilitation comprising Mr. Ron Harmer, Counsel, Blake, Dawson & Waldron, London; Mr. Manfred Balz, General Counsel, Deutesche Telekom AG, Bonn; an d Mr. Carlos Sanchez-Mejorada, Partner, Sanchez-Mejoraday Associados, SC, which came up with some excellent guidelines for rescue law, may prove of interest to our reformists.

The working group stated that rescue, to be commercially and economically effective, requires a law which:

* permits quick and easy access to the process;

* provides sufficient protection for all those involved in the process;

* provides a structure which permits the negotiation of a commercial plan;

* enables a majority of creditors in favour of a plan or other course of action to bind all other creditors by the democratic exercise of voting rights; and

* provides for judicial and other supervision to ensure that the process is not subject to unfair manipulation or abuse.

Dealing with the application of the law, the working group proposed that a formal rescue process should apply to all forms of corporation, excepting possibly only financial institutions and insurance corporations which should be dealt with either through a special law or by special provisions in the insolvency law. Further, state-owned corporations may require some special, perhaps administrative, treatment where their reconstruction is part of an overall change in economic policy. Otherwise, they shoul d be subject to the same insolvency law that applies to private corporations.

As for access to the law, the working group suggested that the preferred policy should be to make access easy for a debtor by requiring simple threshold proof of the basic criteria (insolvency or financial difficulty). A declaration to that effect may be conveniently provided by the debtor through its directors or board of management.

``There should be sanctions for false declarants.''

For a creditor, there should be a requirement to establish threshold proof of insolvency by raising a `presumption' of insolvency on the part of the corporate debtor. Clear evidence of the failure of a corporate debtor to pay a matured debt is all that s hould be required to trigger that presumption.