Principles: Economics and related concepts of insolvency and Bankruptcy
The economic analysis of law deals with legal rules, whether made by legal experts or courts, not just as a way of handing out rewards and punishments, but as a system of incentives intended to affect behaviour.
Economic theory is used to predict how rational individuals will respond to such rules and what consequences will be. Economics has made a substantial contribution to our understanding of law, but the law has also contributed to our understanding of economics. Courts routinely deals with reality of such economic abstractions as property and contract. The study of law thus gives economists an opportunity to improve their understanding of some of the concepts underlying economic theory. The most notable example is the work of University of Chicago economist Ronald Coase. Coase received the 1991 Nobel Prize in economics, in part for using ideas based on his study of the law of nuisance to revolutionise the corresponding areas of economics –the theory of externalities.
The economic objectives are similar in corporate and personal bankruptcy. One important objective of bankruptcy is to require sufficient repayment that lenders will be willing to lend – not necessarily to the bankrupt debtor but to other borrowers. Reduced access to credit makes debtors worse off because businesses need to borrow in order to grow and individuals benefit from borrowing to smooth consumption. On the other hand, repaying more to creditors harms debtors by making it more difficult for financially distressed firms to survive and by reducing financially distressed individuals’ incentive to work. Both the optimal size and the division of the pie in bankruptcy are affected by this trade-off. A second important objective of both types of bankruptcy is to prevent creditors from harming debtors by racing to be first to collect. When creditors think that a debtor is in financial distress, they have an incentive to collect their debts quickly, since the debtor will be unable to repay all creditors in full. But aggressive collection efforts by creditors may force debtor firms to shut down even when the best use of their assets is to continue operating, and may cause individual debtors to lose their jobs (if creditors repossess their cars or garnish their wages). A third objective of personal bankruptcy law that has no counterpart in corporate bankruptcy is to provide individual debtors with partial consumption insurance. If consumption falls substantially, long-term harm may occur, including debtors’ children leaving school prematurely in order to work or debtors’ medical conditions going untreated and becoming disabilities. Discharging debt in bankruptcy when debtors’ consumption would otherwise fall reduces these costs. An additional objective that applies only to corporate bankruptcy is to reduce filtering failure. Financially distressed firms may be economically either efficient or inefficient, depending on whether the best use of their assets is the current use or some alternative use. Filtering failure in bankruptcy occurs when efficient but financially distressed firms shut down and when inefficient financially distressed firms reorganize and continue operating. The cost of filtering failure is either that the firm’s assets remain tied up in an inefficient use or that they move to an alternative use when the current one is the most efficient. Many researchers have argued that reorganization in Chapter 11 tends to save economically inefficient firms that should shut down.
Insolvency is when an individual, corporation, or other organization cannot meet its financial obligations for paying debts as they are due. Insolvency can occur when certain things happen, some of which may include: poor cash management, increase in cash expenses, or decrease in cash flow. A finding of insolvency is important, as specific rights are enabled for the creditor to exercise against the insolvent individual or organization. For example, outstanding debts may be paid off by liquidating assets of the insolvent party. Prior to proceedings, it is common for the insolvent entity to meet with the creditor in order to attempt to arrange an alternative payment method. According to some experts, It is possible that a business may be “insolvent” in cash flow, yet still solvent on the balance sheet. These cases may involve illiquid assets, which help the balance sheet’s solvency but not the cash flows. This can also work the other way around with negative net assets (balance sheet insolvency), yet a positive cash flow. In this case, the flow of cash is simply enough to pay off debts, despite the fact that the business has more liabilities than assets. Bankruptcy is not exactly the same as insolvency. Technically, bankruptcy occurs when a court has determined insolvency, and given legal orders for it to be resolved. Bankruptcy is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency. Insolvency describes a situation where the debtor is unable to meet his/her obligations. The main reasons behind insolvency are primarily poor management and financial constraints. This is much more prevalent in smaller companies. Specifically, the reasons are: Market – Company did not recognize the need for change Bad debts – obviously money owed by customers Management – failure to acquire adequate skills, imprudent accounting, lack of information systems Finance – loss of long term finance, over gearing or lack of cash flow Knock on effect – i.e. from other insolvencies Other – for example excessive overheads etc. It is however observed that the larger the company, the better the chance of survival and of receiving remedial treatment and of paying creditors.
Bankruptcy is the legal process whereby financially distressed firms, individuals, and occasionally governments resolve their debts. The bankruptcy process for firms plays a central role in economics, because competition tends to drive inefficient firms out of business, thereby raising the average efficiency level of those remaining. Bankruptcy also has an important economic function for individual debtors, since it provides them with partial consumption insurance and supplements the government-provided safety net. This article discusses the economic objectives of bankruptcy and surveys theoretical and empirical research on corporate and personal bankruptcy Bankruptcy law
For both corporate and individual debtors, bankruptcy law provides a collective framework for simultaneously resolving all debts when debtors’ assets are less valuable than their liabilities. This includes both rules for determining which of the debtor’s assets must be used to repay debt and rules for dividing the assets among creditors. Thus bankruptcy is concerned with both the size of the pie – the total amount paid to creditors – and how the pie is divided.
An important difference between personal and corporate bankruptcy law is that, while corporations may either liquidate or reorganize in bankruptcy, individuals can only reorganize (even though the most commonly used personal bankruptcy procedure in the United States is called liquidation). This is because part of individual debtors’ wealth is their human capital, and the only way to liquidate human capital is to sell debtors into slavery – as the Romans did. Since slavery is no longer used as a penalty for bankruptcy, all personal bankruptcy procedures are forms of reorganization in which individual debtors keep their human capital and the right to decide whether to use it.
Corporate bankruptcy Theory
A central theoretical question in corporate bankruptcy is how priority rules affect the efficiency of decisions made by managers (who are assumed to represent the interests of equity), particularly whether the firm invests in safe or risky projects and whether and when it files for bankruptcy. Inefficient investment decisions lower the firm’s return, and inefficient bankruptcy decisions result in filtering failure. Both reduce creditors’ returns and cause them to raise interest rates or to reduce the amount they are willing to lending.
According to the some economists, during the first six months of its operationalization in India, most of the cases were triggered by creditors. Of these, most were filed by unsecured operational creditors. This indicates that operational creditors, who hitherto had weak enforcement rights, have taken recourse to the IBC to enforce their claims. There may be multiple reasons for the relatively low number of financial creditors taking recourse to the IBC during the first six months. Some researchers also point out that firm debtors default to financial creditors the last. Financial creditors may largely be secured creditors who may choose to enforce their claim by realizing their security. There was lack of regulatory certainty on provisioning norms for banks and the apprehension of scrutiny by the anti-corruption investigative agencies among bank management. It is important to note that the rights of secured creditors have been modified by the Insolvency & Bankruptcy Code (IBC), 2016.
Secured credit for productive purposes drives the economy and creates wealth, generates employment and encourages entrepreneurship. If a secured creditor’s rights to priority over other claims and taxation dues are recognised under the secured transactions law as well as insolvency law, it will result in increased secured lending and better growth and development. Under the Insolvency & Bankruptcy Code, a secured creditor’s claims are given priority only if the secured assets are surrendered to the liquidator. It is for this reason that the SARFAESI Act is also proposed to be amended to strengthen secured creditor rights and extend priority to secured creditors even outside insolvency proceedings.
The intention of the Code is to do away with the modify the existing laws covering aspects of insolvency and bankruptcy. Given that many corporate transactions and businesses involve an international element, the Code attempts to address this by including provisions for cross border insolvency. The Code provides that the Central Government can enter into agreements with any country outside India for enforcing provisions of the Code and notify applicability of the same from time to time. Further, assets of the debtor located outside India (in countries with whom India has reciprocal arrangements) may also be included for the purpose of the insolvency resolution process and/or liquidation before the Adjudicating Authority.
The Code according to some experts is a landmark piece of legislation establishing a robust legal framework which brings about a much overdue reform that is aimed at creating necessary procedures for swift resolution of insolvency and bankruptcy in India. It attempts at bringing the Indian statutory regime at par with some of the most legally advanced jurisdictions of the world.
NCLT, National Company Law Tribunal
Ministry of Company Affairs, Government of India
The author is Prof.M.Guruprasad, UNIVERSAL BUSINESS SCHOOL