Let’s rework incentive structures to boost IBC recovery

Synopsis: IBC is a landmark reform and its efficiency can be further enhanced by adopting incentive structure.

Introduction

Despite value erosion at disbursal due to poor credit discipline, the IBC has yielded impressive recoveries so far. However, the Code has also been criticized on several other grounds, many of which are questionable.

Why IBC ‘s criticism is not justified?

Number of liquidations: The purpose of any resolution mechanism is not to minimize liquidations, but to maximize recovery.

Bankruptcy laws: IBC is not designed to save companies from liquidation, but to maximize value using market mechanisms.

Global comparison: So far, close to half of all cases under the IBC have ended up in liquidation. This is an abnormally large number that implies its failure. However, according to data from US Courts, twice as many US firms file for liquidation than they do for reorganization. Hence, the proportion of liquidations (50%) under the IBC is not a cause for concern or criticism.

Long resolution times under IBC: For a new bankruptcy law, a lead time of 400 days is not unusual. Till 2005, the average duration in the US was 480 days.

What are the issues still pending?

Lack of focus on efficiency: IBC does not adequately address the fact that the ability to reorganize a business during bankruptcy is a vital driver of recovery values. Corporate bankruptcies are an opportunity for businesses to become leaner and more efficient.

In the US, many firms employ bankruptcies strategically and use it to renegotiate contracts and streamline fixed costs.

Management: Unlike the USA where debtors retain management control of the bankrupt firm, firms under IBC are managed by resolution professionals.

Why USA’s debtor in possession model can not work in India?

Debtor-in-possession provisions: Experts have suggested to introduced it to allow the management to retain control of the bankrupt firm and incentivize them to streamline operations and maximize recovery. However, most firms in India are owned and operated by promoter families, hence debtor-in-possession is a recipe for disaster.

This will also substantially increase the duration of bankruptcies, since promoters with management control will have no incentive for a quick resolution.

What is the way forward?

Firstly, incentivize resolution professionals, since they take charge of a bankrupt firm’s management under the IBC. An incentive fee structure based on a percentage of recovery will also attract talented managers, thereby boosting IBC resolution quality.

Secondly, authorities need to take a broader economic approach to incentivizing reorganization for maximizing recovery.

Source: This post is based on the article “Let’s rework incentive structures to boost IBC recovery” published in Livemint on 23rd September 2021.