## Friday, November 13, 2015

### Bankruptcy reforms: It's not the ranking that matters

by Rajeswari Sengupta.

India lacks a single, comprehensive law that addresses all aspects of insolvency of an enterprise. The current system of corporate insolvency resolution is characterised by a fragmented legal framework, and weak institutions. The absence of a well-functioning resolution mechanism results in poor outcomes in terms of timeliness of resolution, recovery rate, as well as costs associated with insolvency proceedings. These problems have also contributed to the ongoing balance sheet crisis of banks and their borrowers. In response to these problems, in 2014, the Ministry of Finance set up the Bankruptcy Legislative Reforms Committee' (BLRC), to recommend a consolidated insolvency and bankruptcy resolution code that would be applicable to all non-financial enterprises and would replace existing laws and resolution guidelines. The report and draft bill of BLRC were released on 4 November 2015.

In recent times, the Indian government has taken great interest in addressing the problems of doing business in India and improving India's rank in the World Bank's Doing Business' report. One of the parameters evaluated in this report is Resolving Insolvency'. India's current rank in the ease of Resolving Insolvency' is 136 in the world, which is roughly the same as the overall rank for India, which is 130. Reform of the corporate insolvency resolution framework is therefore an important element in the overall agenda of improving India's ease of doing business ranking.

In this article we ask the question: What would the legislative reform proposed by the BLRC do, for India's score in Resolving Insolvency' in the Doing Business' rankings?

The draft bill lays out a formal resolution process that is a significant improvement on the procedures currently in place. It provides for collective making decision by creditors, aims to lower information asymmetry in decisions through the use of information utilities, gives the right to initiate insolvency proceedings to both debtor and creditors, clarifies the role of the adjudicating authority, facilitates the conduct of insolvency proceedings by professionals, creates a calm period when a moratorium is imposed and negotiations can take place, specifies well defined penalties for fraud, and provides for a linear flow of events from viability assessment to resolution. In terms of the insolvency resolution process, the proposed law looks good on paper. If enacted, it will result in the ancillary benefit of improving India's score in the Resolving Insolvency' parameter in the Doing Business' report.

It is important to emphasise  that the World Bank's Doing Business' rankings reflect a de jure approach of evaluating what should happen under the stated law, as opposed to what does happen in practice. If a bill, which meets certain criteria, is enacted, the ranking of a country in ease of Resolving Insolvency' will improve even if the working of the insolvency resolution process, on the ground, diverges from what is intended in the law.

### Impact of BLRC proposals on India's Strength of Insolvency Framework Index' score

The overall Resolving Insolvency' parameter consists of two indicators: recovery rate' and strength of insolvency framework index'. In this article, we focus on the second: the strength of insolvency framework index'. This indicator analyses the strength of the legal framework applicable to insolvency proceedings and tests whether a country has adopted internationally recognised good practices in the area of insolvency resolution. We analyse the change that could come about for India's score in this indicator if the draft bill is passed by the Parliament.

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

IndicatorPresent scenario (DB 2016)Under the new bill
Strength of insolvency framework (0-16) 6.012.0
A. Commencement of proceedings (0-3) 2.02.5
Procedures available to debtor Liquidation only (0.5)Reorganisation & Liquidation (1.0)
Creditor filing for debtor's insolvency Yes, Liquidation only (0.5)Yes, Reorganisation Only (0.5)
Basis for insolvency commencement Inability to pay debts (1.0)Inability to pay debts (1.0)
B. Management of debtor's assets (0-6) 3.05.5
Continuation of contracts supplying essential goods & services No (0.0)Yes (1.0)
Debtor's rejection of overly burdensome contracts Yes (1.0)Yes (1.0)
Avoidance of preferential transactions Yes (1.0)Yes (1.0)
Avoidance of undervalued transactions Yes (1.0)Yes (1.0)
Debtor obtaining credit post commencement No (0.0)Yes (1.0)
Priority to post commencement credit No (0.0)Yes, over all creditors (0.5)
C. Reorganisation proceedings (0-3) 0.01.0
Creditors voting on proposed reorganisation plan No (0.0)Yes (1.0)
Dissenting creditors receive at least as much as in liquidation No (0.0)No (0.0)
Creditor class-based voting & equal treatment No (0.0)No (0.0)
D. Creditor participation (0-4) 1.03.0
Creditor approval for selection/appointment of IP No (0.0)Yes (1.0)
Creditor approval for sale of debtor's assets No (0.0)Yes (1.0)
Creditor right to request information from insolvency representative No (0.0)No (0.0)
Creditor right to object to decisions accepting/rejecting claims No (0.0)Yes (1.0)

By this calculation, the enactment of the draft insolvency bill would improve India's strength of insolvency framework' index from 6.0 to 12.0. This would place India ahead of developed economies such as Canada, France, Hong Kong, New Zealand, Netherlands, Norway, Singapore, and United Kingdom; emerging economies such as China, Colombia, Indonesia, Malaysia, Mexico, Peru, Russia, Thailand, Turkey, and Vietnam, and at par with Australia, and Sweden.

Similar analysis is required for the other element, the recovery rate', so as to fully assess how the present proposals for bankruptcy reform would change the overall Resolving Insolvency' score for India in the Doing Business' rankings.

### Limitations of this thinking

Many times, in economic measurement, we are able to observe the de jure status, but what really matters is the de facto outcome. This distinction is an important one when using the World Bank's Doing Business' scoring.

On a de jure basis, the draft bill will improve India's score in the ease of Resolving Insolvency' parameter, and there may be some merit in this as a first step. However, while we would like to have an improved Doing Business' score, we in India should primarily focus on de facto outcomes about recovery rates, and not be satisfied with de jure improvements alone. If the latter were the sole objective, cosmetic changes to the Companies Act 2013 is all that is required.

In a recent paper, Hallward-Driemeier and Pritchett, 2015 show that there is practically no correlation between the findings recorded in the Doing Business' report and the ground realities of doing business. This derives from the large gaps that often exist between laws and regulations on paper, and the manner in which these are enforced in reality, especially true of developing countries.

For instance, one of questions asked in the World Bank questionnaire is: Does the insolvency framework allow a creditor to file for insolvency of the debtor? While the answer to this would be Yes' if the draft bill proposed by BLRC is enacted, in reality the filing process might be too cumbersome in the absence of good enabling infrastructure. This, in turn, would affect the timeliness of resolution and might also distort incentives for creditors to trigger insolvency proceedings to begin with. But these issues are ignored owing to the way in which the question is designed.

The BLRC report has emphasised the substantial scale of institution building, and State capacity construction, that is required in order for the insolvency and bankruptcy processes to work well. Effective implementation of the draft insolvency bill requires building four institutional pillars:

1. A private competitive industry of information utilities
2. A private competitive industry of insolvency professionals
4. A well-functioning regulator

There are several concerns about the draft bill on these four areas. Much more work is required on these fronts, in terms of strengthening the draft bill and implementing it.

Focusing on improving India's ranking in the ease of doing business report is thus problematic. There is a danger of engaging in isomorphic mimicry' where the reform process gains legitimacy by adopting international best practices' in the drafting of the bill without actually obtain the desired outcome. We need to devote energy and resources to a full implementation plan that involves perfecting the law, creating good institutions and building adequate State capacity. The outcomes that matter are recovery rates, equal treatment of unsecured creditors, treatment of bond holders, etc. -- not the Doing Business ranking.

Please note: LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.