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Business News/ Opinion / An ecosystem to cope with corporate defaults
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An ecosystem to cope with corporate defaults

The current system keeps capital frozen in failed enterprises

Illustration: Jayachandran/MintPremium
Illustration: Jayachandran/Mint

The lenders to ailing construction company Gammon India have this week decided to take over control from the promoters after loan defaults. This is the sixth case in recent times where bankers have decided to change company management by using the strategic debt restructuring option that was introduced this year. Such moves are welcome.

The traditional Indian way of dealing with loan defaults has usually let promoters off the hook. Reserve Bank of India governor Raghuram Rajan has often spoken about the problem of freeloaders who do not honour their loan payment commitments, some wilfully while others because of business shocks. We had commented earlier in these columns that the new system that allows banks to take majority stakes in defaulting companies is also a fine example of coordination between the banking and stock market regulators.

Now comes a problem. The banks will have to take over operations of companies even though they have no experience of running corporate operations. And remember that a modern corporate operation also means a complex supply chain.

The Gammon case suggests that the lenders will try to bring in a new investor who can help them run the company. But this could take time. A subsidiary problem is that some investment professionals are wondering how to value bank shares when the lenders end up owning industrial companies after converting debt into equity. Banks may begin to resemble conglomerates.

This newspaper has often argued that the new way of settling bad loans is still only an interim solution—a milestone in the road towards a modern bankruptcy code. India seems to be moving towards such a law. The draft code that is out in the public domain right now for comments is a clear improvement over the current messy system that keeps capital frozen in failed enterprises.

The draft bankruptcy code has proposed that corporate insolvency will be managed by a special class of insolvency professionals who will be regulated by a government agency. India currently does not have such professionals though it is quite likely that new firms will emerge to grab the opportunity. The big question is whether this part of the new insolvency ecosystem will develop fast enough, given the urgent needs to deal with bad loans in the banking system.

What are the alternatives? The former development finance institutions also have convertibility clauses written into their loan agreements, but they rarely ended up with control over company operations. The right of the promoter or existing management group to run the company that had borrowed was rarely questioned.

There was an older alternative as well. The managing agency system emerged in India during colonial times. One reason this system emerged was that there was almost no domestic organizational ability to run the industrial enterprises that came up in the second half of the 19th century. This system too had its own problems—major principal-agent problems being one of them—which led to an eventual ban after independence, a process that began with the Companies Act of 1956.

Yet, it is worth asking whether India needs some similar structure to deal with its corporate insolvency process. Perhaps the proposed insolvency professionals will become like quasi-managing agencies, with two major differences—they will have short-term contracts and they will be regulated entities. Yet, it is still worth throwing the question into the cauldron: Does India need a modern version of the managing agency system to deal with companies in distress?

The new system of dealing with problem loans does well to increase the rights of lenders. But both the strategic debt restructuring process as well as the proposed insolvency code will succeed only if a supporting ecosystem emerges. The insolvency code does well to address these issues, but there may be a need for more institutional innovation before a robust insolvency ecosystem finally emerges in India.

Will the new insolvency ecosystem develop fast enough to deal with the problem of bad loans? Tell us at views@livemint.com

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Published: 26 Nov 2015, 10:17 PM IST
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