In a strange case of irony, Vijay Mallya may have done more to bring India into the modern world of finance than anybody else. His flight to the UK and his continued stay there in exile sparked a national uproar which ultimately led to the President of India signing a new bankruptcy law about a year ago, a law that ushered in much needed bankruptcy reform.
In March last year, I had argued in these columns that India badly needs new bankruptcy laws. I made several key points, some of which deserve repeating: Just because a company fails, it does not mean that those at its helm did something wilfully wrong. Companies go down for a variety of legitimate business reasons and, like people, they often need second, perhaps even third, chances. As motivational speaker Robert Kiyosaki says, “Losers quit when they fail. Winners fail until they succeed.” This principle is at the heart of India’s new bankruptcy law.
Bankruptcy code
Under India’s new bankruptcy code, two national authorities have been set up. The National Company Law Tribunal will adjudicate cases for companies and partnerships. The Debt Recovery Tribunal will do the same for individuals. These authorities take on the role of bankruptcy judges in the US and other western countries.
India’s judicial process is modelled after British law and is inherently slow. Smart lawyers know how to keep cases from ever coming to trial by clogging the wheels of justice with endless motions and legal manoeuvres. There’s such a backlog of civil cases in India’s courts that the age old adage, “Justice delayed is justice denied”, applies to India like no other country in the world.
India’s bankruptcy law recognises this fact and requires that the tribunals dispose of cases within 180 days of first appeal. By Indian standards, this is justice at warp speed. Because decisions issued by the tribunals are final and cannot be appealed, even to the supreme court, the New York Times reported that foreign investors are excited about the prospect of investing in India’s bad debt.
Banks’ bad debt problem
Why is this so important?
Currently almost all of India’s bad debt is held by banks — about $105 billion. Unlike in western countries, India’s companies, when they need money to borrow to expand or for working capital, go to banks rather than issue corporate bonds. When companies fail to make interest payments or pay back principal, banks become severely stressed. This has a domino effect on the rest of the economy. Banks make up for their bad debt problems by raising revenue through other means, such as when SBI recently raised retail fees on practically every banking transaction.
Meanwhile, the defaulting company continues to default on its payments, other banks are unwilling to lend to a habitual defaulter, the bank that made the bad loans sits doing nothing meaningful while the debt multiplies, and the bad movie progressively gets worse.
The new bankruptcy law allows a free market solution to the problem by stemming the rot. It offers companies in bad debt situations a chance at redemption by inviting them to declare bankruptcy (banks can bring cases of insolvency against defaulting companies too). Once in bankruptcy, the tribunal considers the claims of all parties to whom the company owes money — banks, employees, vendors and other stakeholders. It then makes a decision to award each player a percentage of what they are owed — by divvying up the company’s assets and current cash flow, including receivables. True, this means that everyone takes a forced ‘haircut’, but the goal is to get companies to quickly emerge from bankruptcy having ‘legally’ shed their debt, so that they become healthy, going concerns again.
As the whole process is legal, investors (both domestic and foreign) who are willing to make bets on companies’ bad debt, could provide a crucial lift to the stalled structured assets industry. Banks have little incentive to deal with defaulters other than to insist on full payment. But investors who have bought into companies’ bad debt have an incentive to deal, recover their investment and make a quick profit — all possible because of the legal powers vested in the tribunal.
Buying a company’s debt
Suppose a company owes $1 billion to a bank but it has run into hard times and is unable to pay back the loan. A foreign investor offers to buy the bank’s bad debt for 15 cents on the dollar, in this case, $150 million. The bank could wait for the tribunal’s proceedings by forcing the company into insolvency and on the hope that it will get a higher return, say 20 per cent. But, it has no idea if the tribunal will even admit the bank’s plea, far less on how much it will get following the ‘haircut’ process. For example, there’s a risk that it may be awarded only 12 per cent, a loss of $30 million compared to the foreign investor’s offer. The bank, previously inclined to write off the entire $1 billion gratefully accepts the investor’s offer of $150 million and walks away from the tribunal’s deliberations altogether.
Having bought the bad debt, the foreign investor is legally entitled to force the defaulting company into insolvency, that is, into bankruptcy. It is hungrier than the bank to collect on its investment, so it uses high-powered lawyers to do just that and, once in bankruptcy, extract as much as it can from the tribunal during the haircut process. If it gets lucky, the tribunal could award it 25 cents on the dollar — $250 million. That would mean a return of $100 million over a period of 180 days on an investment of $150 million, a stupendous profit. Of course, it may get unlucky and get lower than 15 cents on the dollar. That is the risk of being in business and the investor takes such losses in stride.
A second way is through private equity. The tribunal’s only job is to maximise the result of the division of the company’s spoils to various creditors. Suppose the tribunal has established through rigorous accounting that the total cash value of a company is $300 million, and this amount would be distributed to various claimants according to some formula. Enter an angel investor who is willing to pay $320 million for the whole company. The tribunal is pleased and legally formalises the sale.
A new industry
The private equity investor then puts in aggressive management to help turn the company around and keep it as a going concern. It could also choose to sell it all off for a huge profit after the turnaround; or sell the company’s assets in pieces where the sum of the parts amounts to more than the whole.
The most important outcome, by far, is that bankruptcy laws will allow companies to issue their own paper to raise funds, bypassing banks altogether. Ordinary investors, including mutual funds, could start buying these funds, injecting cash into companies’ coffers. The cost of borrowing for companies will fall because banks’ overpriced loan rates are no longer of concern to borrowers. True, some of these bonds will fail and some retail investors will get hurt, but because of the protections provided by the tribunal, more retail investors are willing to play the game. India has been a laggard in corporate bonds, so this industry could take off, creating jobs and opportunities for thousands of people.
MBA types have unique capabilities to exploit India’s new structured assets industry. After all, foreign investors are not the only vultures looking to play. Many Indian firms, who know local business conditions well, are being sought out by foreign investors to partner with them. This is because, in the bad debt business, the chance to increase your return by just a few additional cents on the dollar could mean dramatic pay-offs to all concerned.