For most stressed firms, the path should be restructuring and not bankruptcy

Business Standard, 5 October 2020

In India, we tend to think of debt that performs vs. debt that goes into the bankruptcy process. However, when there is stress in repayment, the first port of call should be a negotiation that leads to debt restructuring. Restructuring (under the shadow of the IBC) is the best of all worlds, and only a few irreconcilable situations should slip into the bankruptcy code. Many features of the Indian institutional landscape come in the way.

Suppose there is debt with an NPV of 100. Suppose the firm gets into trouble and this debt is likely to not be repaid. One vision of the world emphasises IBC. If you can't pay on your debts, the lenders will eject the shareholders, and get whatever is the residual value of the company. Suppose this residual value is Rs.40. It is absolutely essential, in building the institutional apparatus of a market economy, for lenders to have this power.

But it is not in the best commercial interest of the lenders to always rely on the bankruptcy code. When they get Rs.40 through the IBC, they still have a loss of Rs.60. Is there the possibility of doing better? On one extreme is the number Rs.100 -- which the shareholders refuse to pay. At the other extreme is the number Rs.40 that the IBC process can generate -- which is a big loss for the lenders. Is there a deal to be found, in between? This is the question of restructuring.

The bankruptcy process ejects shareholders (who know a lot about the company) and imposes a disruption upon the firm. It involves paying a lot of money to lawyers, accountants and consultants. All this induces `bankruptcy costs'. If the shareholders and lenders can find a negotiated solution, these bankruptcy costs are eliminated.

Roughly speaking, a good solution is the combination of a writedown of debt by lenders coupled with a rights issue. Suppose an agreement is reached where the lenders will get Rs.75 on an NPV basis. This cuts down their loss from Rs.60 to Rs.25. This is a much better deal -- on paper. There is still risk in the picture, as the lenders are not sure that the restructured debt will actually perform. Alongside this, the shareholders do a rights issue where they bring in Rs.20. This serves two purposes. First, the shareholders show their commitment to the lenders, they signal their belief that the business is truly sound and can be salvaged. Second, they contribute to making the firm financially healthy and increase the chances that the promised Rs.75 of repayments will actually work out. For shareholders, they get to retain control of the company they know well, for a price of Rs.20, as opposed to being forced out by the IBC.

This is the rough depiction of a good deal in debt restructuring. If the incumbent shareholders don't believe in the company, then IBC is the best answer. If they believe they can make it work, then they should prove their commitment by doing a rights issue. The lenders should accept a writedown. The two moves (debt reduction plus equity infusion) will add up to a healthier firm and a fresh start for the company as a going concern. This negotiation avoids the legal complexities of the IBC but it can only take place under the shadow of the IBC. In some sense, the very purpose of the IBC machinery is to create the threat through which the shareholders are brought to the table for such a negotiation.

In this example, the lenders got to a loss of Rs.25 through restructuring while the IBC process would have generated a loss of Rs.60. The difference (Rs.35) is the bankruptcy cost. It represents the needless value destruction that is imposed by an inflexible society that is not able to negotiate and find good deals.

In India, we often think that finance can be reduced into a bureaucracy, that decisions can be made through fixed formulas or central plans made by regulators. The essence of finance, however, is imprecise information, speculative forecasts based on incomplete information, judgement and risk-taking. There are no objective formulae that can determine the numerical values of this article for any specific real world situation. Discovering these numbers requires organisational capital. These values unfold through staff working in complex financial firms that know how to obtain information, do research, exercise judgement, engage in negotiation, and make deals. There is no role for the judiciary, legislature, executive or regulator in any of this.

In a sensible arrangement, most stressed lenders should go into restructuring, and the role of the IBC is to create conditions for the negotiation and to mop up the cases where the negotiation fails. Many features of the Indian institutional landscape come in the way. Banking regulation hampers both restructuring and the IBC. Sound banking regulation would force banks to aggressively write down stressed debt. In our example, the bank should be forced to write the debt down to a low value like Rs.25. Once this is done, the bank would have the right incentives to fight for the bankruptcy process (which gets to Rs.40, i.e. a profit of Rs.15) or the restructuring (which gets to Rs.75, i.e. a profit of Rs.50). If banking regulation collaborates with banks to portray stressed assets as being worth Rs.100, banks are reduced to approving loans and hoping for the best.

The second problem is the alignment of employees of lenders with the profit objectives of their organisations. It is truly hard for financial firms to get their employees to work for the organisation. The individuals inside financial firms veer towards inaction, covering up and corruption. The threat of investigations by agencies and regulators, and their lack of rule of law procedures, creates a climate of fear and interferes with the negotiation.

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