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Commercially Sustainable Bankruptcy

The law must provide a framework in which entrepreneurs can either revive their failing businesses or seamlessly exit them and take another shot at commercial success
By Ranjeev C. Dubey | Print Edition: June 19, 2016
Photo: Ajay Thakuri

Ranjeev C. Dubey
Here is another of those Incredible India Ironies. We want you to 'Make in India', but if your business model fails, we want you flogged, crucified, drawn and quartered. From the purely entrepreneurial standpoint, India is a harsh medieval society where there exists no practical distinction between business bankruptcy, personal bankruptcy and social banishment. If you get a punt wrong, even the Supreme Court will ask you to submit a list of your wife's and children's assets so that creditors demands may be met. If you want Indians to 'Make in India', the law must provide a framework in which entrepreneurs can either revive their failing businesses or seamlessly exit them and take another shot at commercial success. The government hopes the newly-passed Insolvency and Bankruptcy law will do the trick. Is this new law quite the biggest thing since Narasimha Rao's 1992 'liberalisation' that the government is cranking it up to be?

I have my doubts. My apprehensions are best understood in the context of the practical reality that hit entrepreneurs of failing businesses. At the top of the heap is the plethora of laws that makes criminals out of them. Here's a small sampler. If a factory owner fails to pay excise duty or CENVAT to the government because he runs out of money, he risks going to jail for seven years. It's no better in the services business. If a service provider can't deposit the Service Tax he has collected, he also goes to jail for seven years. It's not just personal liberty that a businessman risks losing either. If a man has not deposited VAT under, say, the Delhi VAT Act, 2004, the Commissioner can recover the money by attaching and selling his moveable and immoveable properties.

It's not just the king's share of your revenue that creates a problem. It's labour, too. For instance, the law prescribes a jail term of one to three years for every employer who fails to deposit any provident fund contribution that has been deducted from a salary. Bear in mind that every business is a cash flow management game. A deduction is only a paper entry. A provident fund contribution may be shown as 'cut' from a salary, but the employer doesn't physically cut anything. Every manager has a 'pay by' date for everything. Failure to deposit a provident fund contribution is only proof that the employer ran out of money before it was time to deposit the contribution.

This same flawed logic informed a variety of other labour laws. The Employees State Insurance Act, 1948 prescribes imprisonment of between one and three years to every employer who fails to pay any contribution that he has deducted from the wages of the employee. The Factories Act 1948 has a variety of rules that every employer must comply with. It includes stuff like the state of the walls of the workers' canteen. When the employer runs out of money, he can't whitewash the walls anymore. That results in potential imprisonment up to two years. It's the same with the Industrial Disputes Act. A bankrupt business can't pay wages and that is a breach of a wage settlement. That can result in six months in jail. That can also happen if an employer fails to honour his financial obligations to labour under the Payment of Bonus Act 1965, Payment of Gratuity Act 1972, Payment of Wages Act 1936, Minimum Wages Act 1948, and so forth. Before parting with this subject, allow me to add that every failed business has issued cheques that are subsequently dishonoured because the money runs out. Each of these is potentially a two-year prison term. In sum, shorn of the rhetorical flourish, Indian law sends entrepreneurs to jail for between three and seven years simply because they run out of cash.

What you get on the other side of the cash crunch is extortion at the hands of those who are capable of entrapping promoters in a myriad variety of criminal cases. They want the entrepreneur to give them a reason to go easy on them. This is one of the primary reasons promoters defalcate funds in the dying moments of their imploding businesses.

What does our new law purport to do on this critical item? Section 14 allows the adjudicating authority overseeing the bankruptcy proceedings to declare a moratorium, which means that this section prohibits "the institution of suits or continuation of pending suits or proceedings against the corporate debtor including execution of any judgement, decree or order in any court of law, tribunal, arbitration panel or other authority". This is fine so far as it goes, but it says nothing about the criminal prosecutions the promoter must contend with.

It seems to me self-evident that no business friendly bankruptcy law can work unless it provides a promoter an opportunity to restructure the business, or an easy exit, leaving him free to pursue new opportunities after he has cleaned out his house through the bankruptcy process. This is how it works in advanced economies, of which Silicon Valley is frequently quoted as a prime example. When businesses begin to become financially unsustainable, promoters rush to declare bankruptcy. Chapter 11 is designed to 'protect' the business and its employees, not its creditors. America believes its government must help a promoter escape financial ruin, rather than persecute him for his errors. No stigma attaches to a bankruptcy. Donald Trump has declared four business bankruptcies in 1991, 1992, 2004 and 2009, yet expects to become the president of the United States. He is not fighting extradition proceedings, his passport revoked, while he hides in a country home in UK. When a bankruptcy law operates on the flawed ideological assumption that every promoter must pay for his sins, and then allows such criminal cases to commence or continue, it forces the promoter to fight the bankruptcy action in order only to avoid the impending extortion and criminal prosecutions. The law defeats its own purpose.

That takes us to the peculiar problem of bankers' claims. Lenders are subordinate divinity in India because they are seen as trustees of 'public money', whatever that means. I don't have the space to argue that that there is nothing public about their revenue streams but that apart, the real problem is that if a business goes bad, the bankers will demand that you pay the principle amount due, all interest on it, and all penal interest charged at extortionist rates on the interest you did not pay when it was due. This is also not how it works with Chapter 11. Americans make no ideological assumption that bankers are doe-eyed babies in need of cuddling. The process will happily write off debts to bankers, employees and even suppliers if that is what it takes to revive the business.

This is not to say that I blame Indian bankers. Anyone who lets an industrialist off the hook in India gets accused of corruption. Why should the banker submit himself to this fate? The problem is attitudinal. We are a cynical, suspicious, distrustful society, very quick to make and believe all manner of incredible allegations without the slimmest basis. This is not a problem any law can fix and the new bankruptcy law does not presume to do so. What it does try and do is promote a consensus culture. It creates a committee of bankers, 75 per cent of whom drive the fate of the bankrupcy business. That's an awful lot of people to corrupt: hopefully, that makes it possible to take a sensible collective decision that may not be seen to be corrupt! Still, this measure does not resolve the real problem facing bankrupt businessmen. So long as bankers continue to insist that personal guarantees be offered by every promoter, business bankruptcy will continue to mean personal ruin and the new law will not achieve its purpose. Tragically, dispensing with personal guarantees is not something we can legislate.

This brings up the hardest question of them all: if a business fails, who controls the business while its final fate is being determined? It seems to me that businesses fail for a variety of reasons. External risk factors are as likely to be the culprit as entrepreneurial blunders. Unless you are dealing with a crooked businessman, no one understands the business better than the current management. If a business can be revived, why not let the current management continue? Chapter 11 proceedings will move quickly to protect the business, leaving it entirely in the hands of the current management. Very rarely will you see a third party manager step in. We have decided instead to go with third party industry professionals and specialists. I suppose this comes from the mind-set that you cannot leave the business in the hands of a promoter who has manifestly shown great skill at running it into the ground. I understand where this comes from. Cricketers who lose matches are physically attacked for the same reason. This logic is flawed for at least two reasons. First, every business has a hidden value that does not appear in the books (and I am not only talking about the value of land under a factory that can only be recovered in 'black'). If every promoter of a dying business knows that he will compulsorily lose control over his business, and thereby its hidden salvage value, he will fight bankruptcy rather than embrace it. The law then defeats itself.

There is, too, a second reason. The ecosystem of third-party turnaround and liquidation professionals doesn't exist at this stage in India, but even if they did, why do you expect that their actions will differ from those of the Official Liquidators who have long done the same job under our Company law? Bankruptcy laws in advance economies exist to protect, promote and revive businesses, they don't exist to shut them down. I have dwelled much on the antics of these Official Liquidators in my latest book "Legal Confidential" (Penguin 2015) so I will spare you a repetition. Suffice for me to say that when it comes to a choice between reviving and shutting down a business, the promoter who has learnt from his mistakes knows what needs doing to revive it. He has an imbedded self interest in reviving a business if he is to salvage its true value. Conversely, a third-party professional with no great expertise in specifically the business he is managing through a court order is inherently incentivised to shut it down and appropriate the hidden salvage value. In that view of the matter, a law that automatically hands over failing businesses to strangers does not encourage entrepreneurs to 'Make in India'; it promotes a culture of 'junk and sack-off in India'. That's pretty oxymoronic for a government that wants to promote business in India.

The author is Managing Partner of the Gurgaon-based corporate law firm N South

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