Countries that include all creditors in the voting process often do so through elaborate mechanisms of committee representation, claims processing, and debt trading. These mechanisms come at a cost, and the reality is that they often provide little protection. For example, in the US, despite robust mechanisms for unsecured creditors to participate in the decision process, those creditors often recover little or nothing.
Second, operational creditors tend to have a strong anti-liquidation bias, making their vote – when actually coordinated – a threat to efficient decision making. Operational creditors recover near the bottom of the liquidation waterfall and have little to gain in liquidation. At the same time, any project that might produce a future payout – no matter how risky – can increase their payout and continue their valuable relationship with the debtor. This reinforces their bias towards an overall sub-optimal resolution.
What might be the costs of excluding operational creditors? Theoretically, financial creditors, especially secured creditors, may be biased toward liquidation as it offers them a chance to keep their security outside the debtor's estate, and the lack of voice for operational creditors in the process might reduce their recovery rates in bankruptcy.
Reduced recoveries could, in turn, lead to higher costs of trade credit for firms nearing distress as vendors charge higher fees or require advance payments at the earliest signs of distress. Reduced recovery could also lead to the collapse of a vital vendor, speeding up the deterioration of the financial health of the distressed debtor.
Every insolvency system in the world struggles to balance these competing forces.
Notably, though, the balance is difficult only if operational creditors actually get a raw deal when they are excluded from the voting process. And there is reason to think that this is not the case. For example, operational creditors seem to favour the IBC
over other alternatives. They are now the most common group to initiate a resolution process under the IBC.
Out of the roughly 1,800 resolution processes that we have seen so far, a little more than half have been initiated at the behest of operational creditors. And, the available data suggests that from January 2017 to March 2019, the number of processes initiated by operational creditors has been increasing by an average of 109 per cent every quarter. The corresponding average for the number of processes initiated by financial creditors is 75 per cent.
Even more tellingly, the Insolvency and Bankruptcy Board of India’s (IBBI’s) affidavit filed with the National Company Law Appellate Tribunal suggests that recoveries for operational creditors are marginally more than those for financial creditors. The IBBI’s published data on recovery rates for 66 completed resolution processes as in December 2018 shows that on an average, operational creditors have recovered 47.45 per cent of their admitted claims. The corresponding number for financial creditors is 45.83 per cent. And, these rates do not take into account the benefit that most operational creditors realise by maintaining their ongoing relationships with reorganised debtors. This further weakens claims of operational creditors being treated unfairly in the resolution process.
These strong recoveries are not as surprising as one might initially think. Financial creditors have strong incentives to treat operational creditors fairly. The best path for financial creditors to maximise recovery is often a reorganisation that keeps the firm alive as a going concern. That requires that the firm’s operations run smoothly, which is not possible without ongoing relationships with operational creditors such as vendors, employees, and clients.
Finally, to truly assess the merits of the IBC’s voting structure, we have to ask how outcomes would differ under alternate regimes where operational creditors are given a vote. Again, there is reason to think that the IBC
is no worse for operational creditors than the alternatives. Even with voting rights, the operational creditors still face coordination problems. And in many cases, it is unlikely that they would have an effective vote in the decision-making processes. Given the current 66 per cent threshold and the structure of the debt market in India, their vote would likely hold little or no sway in most cases.
For operational creditors’ vote to really matter, voting rules would likely have to introduce class voting and costly coordination mechanisms. Class voting then requires even more expensive processes for dealing with hold-out classes, such as the cram-down mechanism in the US. And for all the added costs in those systems, the practical results are often the same where the votes of unsecured creditors have no practical effect on the outcome.
In the end, there is much uncertainty. To assess whether the concerns — and the responses to them — are valid, we must first evaluate potential costs and benefits of excluding operational creditors from the decision-making process of the creditors’ committee. Any decision to change the system should be based on developed theory and firm evidence. As it stands, the theory and available evidence point in favour of the current system and against popular claims of unfairness towards operational creditors.
Casey is a bankruptcy professor at the University of Chicago School of Law and Zaveri is a researcher at the Finance Research Group, IGIDR