15 Mar 2016 15:21 IST

Need of the hour: bankruptcy laws

The Vijay Mallya saga brings to light yet again why India must have watertight bankruptcy laws

The ‘Vijay Mallya’ genre of movies has been seen before, although no one knows how this latest movie will end. Banks eager to curry favour with a charismatic businessman make loans which go bad, and then extend additional loans in the hopes that all loans will be repaid with interest.

The businessman makes a few cursory changes to his business model to prove that he is trying to repay the money, but the entire world knows that his intent is to drive a hard bargain, if at all. Mallya now is reported to owe over ₹9,000 crore to the banking system — and characteristic of the drama in a Bollywood movie, has fled the country.

And the Oscar goes to…

If Oscars were to be given out under this category (of bankruptcy), Donald Trump would earn a lifetime achievement award. Trump’s casinos and other businesses have gone under, four times — a record.

But in the US, the movie script is tightly controlled by strict bankruptcy laws so that borrowers share in the pain too. As was noted in an article in CNN Money, Trump’s first bankruptcy, for the Taj Mahal, was probably the most painful for him, personally.

Why? Because, to come up with the funds he needed to pay his creditors, under orders of a bankruptcy judge, he sold a 282-foot yacht, as well as Trump Shuttle, the airline he operated at the time that flew between Washington, DC, New York and Boston. He also had to give up half of his ownership stake in the Trump Taj Mahal.

Bankruptcy protection

Each day, companies around the world file for bankruptcy protection with the intent to reorganise. The US has some of the world’s most well defined laws for bankruptcy. In the 12-month period ending December 31, 2013, nearly 9,000 cases were filed in US bankruptcy courts. These are 9,000 companies that found the going to be so tough that they couldn’t continue to operate.

But companies, like people, 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 bankruptcy law.

Just because a company fails does not mean that those at its helm did something wilfully wrong. Companies can go down for a variety of legitimate business reasons. For example, insurance companies can face unexpected losses when Mother Nature turns against them. During the recent Chennai floods, these companies were exposed to hundreds of crores of claims that they never anticipated the day prior.

Poor vision

But a majority of corporate failures can be traced to poor vision, followed by poorer execution. Businesses do not see the warning signs early enough and continue to borrow in the hopes that things will turn around. They are not unlike the fan at a racetrack, betting all on that next horse to wipe out his previous debt, make a fortune and live happily ever after. Except that in life, there is no such horse and everyone related to the fan ends up getting hurt.

In a bankruptcy filing, the claims of all creditors, employees, vendors and other stakeholders are heard by an apolitical and neutral bankruptcy judge, who 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. The process is long and arduous, but the idea is that everyone involved takes a painful haircut.

A central tenet of bankruptcy law is that the judge’s decision is binding and cannot be appealed. The goal is to get companies to quickly emerge from bankruptcy, having “legally” shed their debt, so that they become healthy, ongoing concerns again.

The Mallya case

This is what stings in the Mallya case. Customers and investors in the large public sector banks had no idea that their bank manager was making these exorbitant loans to Mallya. Had they known, they probably would have shot down the idea. Because taxpayers own these banks, the noose is now on them to write off ₹9,000 crore in bad loans.

Mallya, who had no experience running an airline, kicked off his troubles by launching Kingfisher Airlines. But running an airline is not easy. Airplanes need fuel, the price of which is set by global, volatile oil markets. Hedging is expensive and can work against you in a time of falling oil prices.

The capital-expenditure ratio is one of the highest amongst service industries, as airlines have to borrow billions of dollars to buy planes. Labour costs are high and every aspect of an airline’s operations is overseen by some government agency, raising compliance costs.

Governments regard airlines as cash cows and hit them for landing fees and ticket taxes. Insurance is expensive. An airline seat is a perishable inventory — if a seat is not sold by the time an aircraft’s door is closed, revenue from that seat is lost forever. And competition is high.

These problems were best summarised by Robert Crandall, the former legendary CEO of American Airlines, who brought to the world frequent flier miles. In a CNBC TV interview in 2006, Crandall said, “I’ve never invested in any airline. I’m an airline manager. I don’t invest in airlines. And I always said to the employees of American, ‘This is not an appropriate investment. It’s a great place to work and it’s a great company that does important work. But airlines are not an investment’.”

That Mallya — and worse, the banks that were competing with one another to loan him money — did not see these issues is a travesty. They should have known that airlines are particularly vulnerable to failures.

Of the top 10 US air carriers, eight have declared bankruptcy, some multiple times. In reorganising after bankruptcy, they have often merged to come out stronger. Delta merged with Northwest; US Airways with American Airlines, and Continental with United Airlines.

Without bankruptcy laws, Kingfisher was left to rot, creating significant collateral damage to all stakeholders — and now, to Indian taxpayers.

Bankrupt territories

It is not that profit-making companies alone fail. Municipalities (Detroit) and entire territories (Puerto Rico) can get into serious financial trouble.

In fact, when the city of Detroit declared bankruptcy, it settled with bondholder BlackRock, the large investment management firm, for 34 cents on the dollar. Surely, the firm would not have been happy to receive such a paltry return on its principal. But a fundamental rule in a market-based economy is that rewards are directly proportional to risk.

The investment firm took the risk of loaning money to Detroit because the promised returns were much higher. If it had wanted a 100 per cent guarantee that its principal be repaid in full, it would have invested in risk-free securities — such as US Government debt. But in this case, the returns would have been significantly lower as well.

India is one of a handful of countries that does not have an organised framework to deal with sick companies. The BJP government should immediately pass strong bankruptcy laws and set up a system where troubled companies can reorganise and come out ahead. The country simply cannot afford to see another unscripted movie of this genre.

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