The legal system should trust the process of the IBC. Permitting exceptions on a case by case basis is a dangerous path to go down
The Indian Bankruptcy Code (IBC) helps to create and maintain a well-functioning market mechanism to deal with insolvent corporations. In recent months, there have been attempts by market participants to modify the process laid down in the Code. If they succeed, the market for insolvent corporate assets may very easily break down.
Alvin Roth and Lloyd Shapley won the 2012 Nobel Prize in Economic Science for their work on market design. Roth has written extensively about three basic requirements needed for any market to run well. These are that the market needs to be thick, safe and free of congestion.
‘Thickness’ means that there should be enough buyers and sellers in a market that participants will be satisfied with a transaction. ‘Safety’ means the rules of a marketplace should allow parties to reveal and act upon the information they possess, without fear that some other participant would gain an unfair advantage. Freedom from ‘congestion’ means that as a market gets thick, it should not get so slow or cumbersome that transactions take long to close.
Illustration: Binay Sinha
The IBC lays down the Corporate Insolvency Resolution Process (CIRP) to be followed in handling corporate insolvency. It attempts to quickly and efficiently resolve insolvency through a market-led process. In particular, the CIRP cannot last longer than 270 days. Within this period, resolution plans must be received and evaluated by a Committee of Creditors. This Committee may collectively choose one plan by a 75 per cent majority vote. If no choice is made within 270 days, the company is declared bankrupt and its assets liquidated.
The CIRP of the Code helps ensure that we have thick, safe markets that are free from congestion. The attempts to subvert this process have come in many forms.
Parties have tried to make their own arrangements outside the rules that the CIRP lays down. This has been both by refusing to participate in the formal process as well as by failing to honour their commitment to the process. This undermines the benefit of a market process. As more participants are able to opt out, the market will unravel and lose its thickness.
Parties to a CIRP have also attempted to make offers after all other bids have been considered and made public. Some have argued that if a new offer is better than any preceding offers, this is good for creditors and should therefore be entertained. This argument is faulty for two reasons.
First, it assumes that higher bids are ‘better’ bids. The IBC is silent on how to identify ‘the best’ resolution plan. Implicit in the 75 per cent majority rule is the idea that the law and the legal system should not sit in judgment over what is ‘best’ for creditors, debtors and other stakeholders.
Rather, the choice of a resolution plan is a commercial decision between the parties against whom the debtor has defaulted. These decisions do not admit simplistic solutions such as choosing the highest bid in monetary terms. For example, they may take into account the likelihood that a resolution plan will be honoured, the complexity of the restructuring plan or the relationship that a bidder has with other stakeholders.
Second, it does not consider the unfair advantage that it gives parties that make offers after the bids are revealed. Markets need to both efficiently move information between parties and at the same time, allow participants to protect their private information. A party’s offer may rest on private information that other participants could use to refine their own bids. Safety in the marketplace demands that a bidder is not penalised for revealing her preference. If parties to the process are not incentivised to reveal their true preferences, the process will yield suboptimal outcomes.
To see this, consider the example of an antique clock that is being auctioned off, where all the bidders want to resell the clock for profit. The value of the clock is uncertain and each bidder must guess its true value. Suppose that one bidder somehow learns another’s valuation of the clock. This knowledge will probably change her own valuation and possibly her bid.
Imagine further that after all the bids have come in, the seller approaches the highest bidder and says that she will sell only if the bidder pays slightly more than she bid. Economic theory tells us that bidders usually bid slightly below their true valuations. In such a case, the winner bidder will agree to pay a bit more as it may still be at a price lower than her valuation. While the seller will get more money in that particular auction, there will be a loss of faith in this seller’s desire to stick to the rules of the game. In the long run, this will mean that fewer bidders will participate in future auctions with less money received by the seller.
The commercial world is full of transactions where the exact value of an asset is uncertain. Despite that, buyers and sellers transact business every day because they commit to a particular way of transacting. When that commitment breaks down, or the process becomes uncertain, the market can unravel.
A system of rules makes it safe for someone to participate in the market as simply as possible as opposed to transacting outside of the marketplace or engaging in strategic behaviour that reduces overall welfare. When people do not play by the rules, parties will resort to the legal system for remedies. This prolongs the process and leads to congestion in the market.
To limit this congestion, the legal system should trust the process of the IBC. Permitting exceptions on a case by case basis is a dangerous path to go down.
As the outcomes of different CIRPs are successfully challenged in court, belief in the insolvency process could begin to wither away. At the end of the day, it does not matter how well the insolvency process has been designed, how innovative is its approach, or how quickly and efficiently it could resolve insolvency. If parties no longer have faith in the marketplace, they will simply choose not to enter.
Vakil is a partner at AZB & Partners; Krishnan is an economist at True North Managers LLP