The proper purpose of insolvency law

Mint, May 6, 2018, (with Pratik Datta)

When a company becomes insolvent, numerous issues arise. Insolvency law is meant to address some of them, but not all. For the others, the solution must be found in non-insolvency laws. This distinction has been overlooked by Indian policymakers in their attempts to reform the Insolvency and Bankruptcy Code, 2016 (IBC). The recently submitted report of the insolvency law committee (ILC) also reflects this oversight. This may hamper the desired outcomes of the IBC.

The ‘proper’ purpose

In the absence of an insolvency law, if a company defaults on a loan to a creditor (i.e. becomes cash flow insolvent), every claimant would have to race to grab its share of the company’s assets. This fight among its claimants could push the company into liquidation even if it has an otherwise sound business model. This would lead to unnecessary destruction of the company’s organisational value and cause job losses.

From the creditors’ perspective, the winner-grabs-it-all situation would make the business of extending credit more risky. Moreover, a company’s shareholders are the residual claimants with limited liability. When the company approaches insolvency, they have every incentive to engage in high-risk strategies. If the strategy works, they gain from the upside. If the strategy fails, it is the creditors who lose. Shareholders could also engage in asset siphoning and related party transactions. These risks would be aggravated if the incentives of shareholders and managers are aligned. Creditors would price in all these risks ex ante and lend at higher interest rates, hurting borrowers. Overall, the economy would be worse off.

A well-defined insolvency law helps avoid these problems. Therefore, the "proper" purpose of such a law would be to provide:

1. a collective procedure for insolvency resolution, and
2. rules to control the opportunistic behaviour of shareholders and managers in the vicinity of insolvency.

Examined from this perspective, the recent changes made to the IBC as well as some of the recommendations of the ILC report go far beyond the proper purpose of insolvency law. They are an attempt to solve the problems surrounding IBC stakeholders that are better solved outside the IBC.

Promoter disqualification

Let us consider the question of who should be disqualified from controlling an insolvent company. This is an important issue which should be addressed through corporate law and not through insolvency law. A person who is disqualified from controlling an insolvent company, should also be disqualified from controlling a solvent company. There is no reason to have a different disqualification regime for insolvent companies.

To illustrate, currently, under section 29A of the IBC, a person who is declared a wilful defaulter by the Reserve Bank of India (RBI) or is prohibited from trading by the Securities and Exchange Board of India is not eligible to bid for an insolvent company. Yet, the same person is qualified to be a director of companies under section 164 of the Companies Act, 2013. In other words, a person who cannot be trusted with the control of an insolvent company is trusted with the control of a healthy company. This is an anomaly.

If policymakers want to keep undesirable persons out of the boardrooms of companies, they should upgrade the directors’ disqualification regime under the Companies Act. For instance, if a company is declared a wilful defaulter by the RBI, the directors of such a company should be disqualified from being company directors under the Companies Act. This would ensure that a wilful defaulter cannot directly or indirectly control any company, including the insolvent business. This being a corporate law issue, there was no need to create a complex promoter disqualification mechanism for insolvent companies under the IBC.

Homebuyers as ‘financial creditors’

A time-honoured principle in insolvency law is that it should respect non-insolvency entitlements such as security interests. Put differently, the job of an insolvency law is to maximise the size of the pie, not to distort the distribution of the pie under non-insolvency laws. The ILC’s suggestion that homebuyers are "financial creditors" violates this fundamental principle.

To illustrate, secured creditors have higher entitlements than unsecured creditors (like homebuyers) in non-insolvency law. If the insolvency law prejudices such entitlements of secured creditors, they would engage in strategic behaviour to opt out of collective insolvency proceedings. They could realise the collateral earlier than would be collectively optimal, so as to beat unsecured creditors in the race to grab assets. Even if the law successfully curbs any such strategic behaviour by secured creditors, they will adjust and increase the interest rate of secured credit. Either way, this will defeat the ultimate objective of the insolvency law, which is to reduce the cost of borrowing.

Homebuyers’ rights need to be protected but there are good and bad ways of doing do. Using the IBC to protect their interests is the bad way. They could have been better protected through non-insolvency laws. For example, the UK Law Commission, in a 2016 report, suggested a range of non-insolvency law mechanisms (like trusts, insurance, digital payment laws) to protect consumer prepayments on retailer insolvency. In contrast, the ILC assumed that since the homebuyers’ problem arose during insolvency, the solution to it must lie in the insolvency law.

Indian policymakers need to recognise the proper purpose of the insolvency law. The IBC must be used only to address those purposes. For all other purposes, the solution must be found in non-insolvency laws.