Insights into Editorial: A greater market role in bankruptcy process
Summary:
Experts say that if the country fails to revive private investments, it could hurt not just employment generation and economic equality but could also lead to social unrest.
What’s the concern now?
An IMF paper notes that Gross Capital Formation in the country over the last five years averaged only 3.5%, compared to 12% per year over the decade ending 2011-12.
Reasons behind this?
- A major cause of investment slowdown is the rise in financial leverage of firms. This is especially true for firms whose earnings are insufficient to service their debt.
- Higher leverage not only cripples the ability of firms to undertake new investments, but also impedes the completion of ongoing projects. As a result, these firms continue to suffer from low productivity.
What’s the way out?
In such situations, a strong exit mechanism goes a long way in ensuring an efficient reallocation of both capital and labour to productive businesses, thereby contributing to higher output.
Long term solution:
Since the much-hyped Bankruptcy and Insolvency code has failed to deliver the expected results, experts have proposed a radical, market-friendly approach to the resolution of the bankruptcy process. This approach was originally intended to help the developing countries of Eastern Europe, which had just witnessed the demise of socialism. These countries had underdeveloped capital markets and inefficient judicial systems.
- The new solution encourages decentralization, reduces the role of courts or insolvency professionals, and allows for a greater role for the markets. According to this proposal, the entire debt of the distressed firm would be converted into one common security called “Reorganisation Rights” (RR).
- Then, two auctions would be held. An “inside” auction would allow the claimants to purchase RRs at a preferential price, one that would reflect the seniority of the claims. Subsequently, a “public” auction would allow external investors to make cash bids for these RRs.
- These external bids in public auctions would allow claimants, including those who were unable to participate in the inside auction owing to financial constraints, to be repaid in cash.
- A reasonable reserve price would be set high enough so as to avert the risk of RRs being acquired at throwaway prices. Once the RRs are acquired, the new RR holders would then vote on the reorganization plan and decide the future course of the firm.
Advantages of this approach:
- The new approach is robust and market-friendly. It would help reduce the economic and financial costs of bankruptcy.
- Since the courts would only have a supervisory role in this approach, this would do away with the need to establish and maintain specialized bankruptcy courts, insolvency professional agencies, or even experts for operating the firm.
- It would also remove the scope for discretionary decisions by IPs. Since the ownership of the firm is homogenized, owners would take all decisions through a vote.
Conclusion:
For India to improve its rankings in the doing business index, it is not enough to simply have a bankruptcy code in place. The code must be robust, decentralized, less costly, inclusive and speedy. This would help businesses exit sooner and capital to be redeployed faster to productive firms, thereby improving economic output and employment.
