It isn’t enough to focus on Doing Business rankings

Mint, October 12, 2016

The Indian government has taken great interest in addressing the problems of doing business in the country and improving India’s rank in the World Bank’s “Doing Business” report. One parameter evaluated in this report is “resolving insolvency”. India ranks 136 in the world in the ease of “resolving insolvency” and 130 overall. The enactment of the Insolvency and Bankruptcy Code (IBC), 2016 is likely to change this. The formal resolution process laid out in IBC is a significant improvement on current procedures. Passing the law is a big step forward. It will result in the ancillary benefit of improving India’s score in the Doing Business report but in and of itself, it will not create a framework for effective insolvency resolution in India. The key now is implementation and this will require time, planning and building adequate State capacity.

The “Doing Business” rankings reflect a de jure approach of evaluating what should happen under the stated law, as opposed to what happens in practice. The “resolving insolvency” parameter in the report consists of two indicators: the “recovery rate” and “strength of insolvency framework index”. The “strength of insolvency framework index” is calculated based on the provisions of the law. It analyses the strength of the legal framework applicable to insolvency proceedings and tests whether a country has adopted internationally recognized good practices in the area of insolvency resolution.

The “strength of insolvency framework index” is the sum of four component indices. Each component index in turn consists of sub-components ranked on a scale of 0-1. The overall index is measured on a scale of 0-16, with cumulative scores across 16 sub-components.

A simple calculation based on the provisions of IBC shows that the enactment of the law can improve India’s “strength of insolvency framework” index from 6 to 12 (see table). The corresponding score for OECD (Organisation for Economic Cooperation and Development) high-income countries is 12.1. This will place India ahead of developed economies such as Canada, France, Hong Kong, New Zealand, Netherlands, Norway, Singapore, and the UK, emerging economies such as China, Colombia, Indonesia, Malaysia, Mexico, Peru, Russia, Thailand, Turkey and Vietnam, and on a par with Australia and Sweden. This improvement will come about merely because the law has been passed, even though it has not been implemented yet.

The other element of the “resolving insolvency” parameter is “recovery rate”. This is assessed through questionnaires filled out by insolvency professionals. The questions are based on a case study such as insolvency resolution of a limited liability company in a big city. It will be interesting to see how India’s estimated “recovery rate” changes now that IBC has been enacted, given that the industry of insolvency professionals is yet to take off. Any case study should not take into account a law that has not yet been implemented.

Many times in economic measurement, we can observe the de jure status, but what really matters is the de facto outcome. This distinction is important when using the “Doing Business” scoring. In a recent paper (2015), Mary Hallward-Driemeier and Lant Pritchett, show that there is no correlation between the findings recorded in the “Doing Business” report and the ground realities of doing business. Large gaps often exist between laws and regulations on paper, and the manner in which these are enforced, especially true of developing countries.

For instance, one of the questions asked in the World Bank questionnaire is: Does the insolvency framework allow a creditor to file for the insolvency of the debtor? The answer to this is “Yes” based on the IBC provisions. In reality, the filing process may be cumbersome in the absence of a good enabling infrastructure. This may distort creditors’ incentives to trigger insolvency proceedings. These issues are ignored because of the way the question is designed.

Successful implementation of IBC is contingent upon four institutional pillars: a private competitive industry of information utilities, a private competitive industry of insolvency professionals, effective adjudication infrastructure and a well-functioning regulator. While the law has proposed setting up this infrastructure, the related provisions lack clarity and are often inadequate. For example, one strength of IBC is that it specifies finite timelines for completing various stages of the resolution process. This needs an efficient judicial infrastructure. But the law itself is silent on what is needed to set up this institutional pillar.

Excessive focus on a de jure ranking may divert attention from what is needed now, which is proper implementation of the law. Energy and resources need to be devoted to a full-fledged implementation plan that involves creating good institutions and building adequate State capacity. If getting a higher rank on the “Doing Business” report were the sole objective, cosmetic changes to the Companies Act, 2013 would have sufficed.

The success of the bankruptcy reforms should be measured by well-defined outcomes in the context of credit market development. The specific outcomes to look out for are higher values of leverage, financial debt share in total debt, non-bank debt share in financial debt and share of unsecured borrowing in total debt. These are the metrics against which the success of IBC should be assessed—not the “Doing Business” ranking.

Clear the air before enforcing Bankruptcy Code

Business Standard, October 9, 2016 (with Anirudh Burman)

The Insolvency and Bankruptcy Code (IBC), 2016 proposes to set up new institutional pillars to support the insolvency resolution and liquidation processes. One such pillar is the industry of insolvency professionals. Insolvency professionals (IP) are expected to play a critical role in the timely and efficient insolvency resolution of firms and individuals. Two specific provisions pertaining to IPs in the new law have gone largely unnoticed: (i) not just individuals but firms can also get licensed as IPs (ii) those residing outside India can practise as IPs on Indian corporate and individual insolvency-related matters. Both these provisions can have important implications for the regulatory structure of the IP industry once the law is implemented.

The regulation of professions in India has been a failure. Self-regulatory organisations in professions such as medicine (Medical Council of India), law (Bar Council of India) and accountancy (The Institute of Chartered Accountants of India) have consistently failed to enforce good standards. This hurts the interests of consumers availing the services of the professionals. IBC has stepped away from this status quo. IBC has proposed a system of multiple, private self-regulatory organisations called IP agencies or IPAs that will regulate the insolvency professionals. The IPAs will compete with each other on entry barriers, codes of conduct and supervisory framework. Imagine that instead of the current monopoly, there are two Bar Councils of India competing with each other to prove that they have the better lawyers as their members.

The proposed IP regulatory structure is largely similar to that of stock market brokers - perhaps the only success story in India in regulation of professions. The brokers are members of the exchanges, BSE and NSE who in turn are regulated by the Securities and Exchange Board of India. In case of IBC, the IPs will be registered members of the IPAs. The IPAs will have regulatory and supervisory powers over their member IPs. The Insolvency and Bankruptcy Board of India (IBBI) will watch over the IPAs as well as the IPs.

In this framework, the regulatory burden on the IPAs (and also on the IBBI) will be significantly higher when the IPs are firms instead of individuals. Given the critical role played by IPs throughout the insolvency resolution and liquidation processes, they must be held accountable for their conduct and performance. Holding an individual accountable is easier than holding a corporate body accountable. Every IPA will need to have adequate capacity to regularly monitor, inspect and supervise the firms licensed as IPs. This will also have an impact on the business model of IPAs.

Canada is one of the few countries that allows firms well as individuals to be licensed as IPs. They do so by placing different entry and compliance requirements on firms compared to individual IPs. The insolvency regulator in Canada has issued clear and detailed directives on the eligibility criteria for licensing corporate IPs (or trustees in their case) and individual IPs, and on the organisational structure of firms applying for an IP licence. For instance, a majority of the directors and a majority of officers of the corporate trustee must also be individually licensed as trustees.

This raises several open questions with regard to this specific provision in IBC. What will be the corporate structure of a firm licensed as an IP under the new law? Unlike other Indian laws on professionals, the IBC mandates a qualification exam for IPs. Will all the employees of a corporate IP need to pass the exam or will it suffice if the directors or partners of the firm alone are licensed IPs? When an insolvency resolution case is given to an IP from such a firm, will the name of the IP go in the records or the name of the firm? This also relates to the accountability question. Who will be held accountable for a particular case-the individual IP dealing with the case or the firm she belongs to?

The other provision of IBC that deserves attention is that persons resident outside India can get licensed as IPs and can also form an IP agency. No other Indian law explicitly treats foreign professionals at par with Indian ones. The manner in which this provision is implemented will signal India's willingness to display its maturity as a global market.

This provision raises several questions pertaining to the regulation of the foreign nationals. In the United Kingdom for example, the insolvency profession is very well developed. Does an individual or a firm, who is already licensed as an insolvency practitioner in the UK, need to take the Indian IP exam again? Or is it just a specific portion of the exam focused on the Indian landscape that will be relevant for her? How will the IBBI regulate an IP, or for that matter an IP agency, who is already under the supervision of the UK insolvency regulator? Does the foreign IP need to become a member of an Indian IPA in addition to her membership of a recognised professional body in the UK? Can an IP agency registered in the UK open an office in India and regulate Indian IPs? How can a level playing field be created for foreign IPAs and Indian IPAs to compete with each other? Are there related laws that need to be amended or repealed to allow foreign IPs to practise and to be regulated in India?

The implementation of this provision requires careful balancing. On one side is the need for expertise and experience to implement the IBC and to give Indian debtors and creditors access to the best possible IP services available globally. This is especially important since India does not currently have a developed IP industry. On the other hand, the IBBI needs to ensure that foreign IPs and IPAs are properly regulated such that they can be held accountable for their conduct and for liabilities arising out of their work in India.

IPs are central to the success of IBC. Poor regulation of the IP industry will lead to poor bankruptcy outcomes. Through the enactment of these provisions, Parliament has taken unprecedented and bold but welcome steps towards creating a new paradigm of regulation in India. Now that IBC is about to be implemented, the IBBI and the IPAs need to issue clear and detailed regulations and by-laws addressing the questions arising from these provisions before the IP industry becomes operational.