Thanks to the bankruptcy code, distressed firms are able to better access short- and long-term debt funds
The Covid-19 pandemic has been driving corporate failures around the world, including in India. In the absence of the much-needed institutional arrangements in many developing countries, following default, a given firm’s management, capital and labour would come to a standstill, pushing it into liquidation.
Creditor rights in India
A credit ecosystem that effectively balances the rights of creditors and debtors is crucial for the development of capital markets and to increase entrepreneurial activities in a country. In the context of India, there was no efficient bankruptcy reform until 2016 and corporate insolvency procedures were contained under different legislation such as the Sick Industries and Companies Act of 1985 (SICA 1985), the Debt Recovery Tribunal Act of 1993 (DRT Act), and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act of 2002 (SARFAESI Act). As resolving insolvency was a challenge in the Indian multi-layered legal framework, the government instituted a new more efficient mechanism called the Insolvency and Bankruptcy Code (IBC) on May 28, 2016.
In the light of the Covid-19 pandemic and business failures globally, it is important that financially distressed companies can still access the credit market thanks to a strong bankruptcy system and survive under stressed scenarios. In this regard, our recent study adds to the evidence that the IBC is a one-stop solution for resolving insolvencies, aiming to protect the interests of small investors and making the process of doing business less cumbersome.
Using a panel of 33,845 non-financial firms for the period of 2008-19 and by exploiting a difference-in-differences analysis, we studied the impact of the IBC policy on the availability of long- and short-term financing for, and the cost of, credit of distressed firms as compared to their non-distressed counterparts.
As in most emerging markets, India’s debt market is dominated by state-owned banks and the domestic credit to private sector by banks (percentage of GDP) is 50 per cent in 2019 compared to a world average of 90.5 per cent (Source: World Development Indicators). Recent statistics from World Bank’s Doing Business Data show the creditor rights index in India improving from 6 in 2014 to 9 in 2019 compared to the world average of 5.67 in 2019. In India, it used to take 4.3 years to resolve insolvency in 2014 which declined to 1.6 years in 2019 compared to the world average of 2.47 years in 2019.
The IBC reform
Under the IBC, companies have to complete the insolvency process within 270 days, whereas for smaller companies (identified as those with an annual turnover of no more than ₹10 million), it should be completed within 90 days (with a potential further 45 day-extension). If debt resolution does not happen within this timeframe, the company heads for liquidation. The resolution process may be initiated either by the debtor or the creditor. More than 3,774 cases have been admitted into the Corporate Insolvency Resolution Processes (CIRPs) under the IBC as of March 31, 2020.
Improving resolution process
According to the Economic Survey released on January 31, 2020, the IBC has improved resolution processes compared to the earlier mechanisms. It has resulted in recovery of 42.5 per cent of the debt amount involved compared to 14.5 per cent under the SARFAESI Act.
In terms of duration, the Survey stated that, under the IBC, it takes 340 days on average compared to 4.3 years in the earlier system.
This outcome suggests that, since the IBC is specifically designed for firms in financial distress, the law aims to prevent corporate failure and has helped maintain creditor rights while limiting hasty liquidation to the debtor’s benefit resulting in increased efficiency only to keep viable firms alive.
Bose et al. (2021) study shows that after the introduction of the IBC reform, the access to long-term debt increased by 6.3 per cent, short-term debt increased by 1.4 per cent, while the cost of borrowing declined for distressed firms. This is the first study that provides evidence on the impact of the IBC policy on the “credit channels” of distressed firms.
The notion “credit channels” is referred to the greater access to long-term and short-term financing and to the lower cost of credit.
We find that, after the IBC reform, distressed firms were able to increase their access to long-term and short-term debt and reduce their cost of financing as opposed to their non-distressed counterparts due to better and faster debt recovery mechanisms under the IBC framework.
Moreover, we suggest that distressed firms that benefit from both increased access to debt and reduced cost of borrowing are further able to improve their performance resulting in higher growth opportunities compared to their non-distressed counterparts.
Furthermore, our evidence shows that the benefits stemming from the implementation of the IBC policy are more prominent for those financially distressed firms that are larger, younger and more collateralised.
We conclude that these results are relevant to the current academic and policy debates on safeguarding and preserving businesses in the midst of the current Covid-19 crisis, which is likely to drive many businesses into bankruptcies.
Given the profound implications of the Covid-19 pandemic, fostering a deep understanding of the provisions is paramount to avoid bankruptcy. A strong bankruptcy system can not only support financially distressed companies to benefit from a quick and long-lasting revival process, but can also give lenders more confidence to lend to enable better credit access by firms under stressed scenarios.
Bose and Filomeni are with the University of Essex and Mallick is with Queen Mary University of London