Need Restructuring, not Bankruptcy

Context: In India, we tend to think of debt that performs vs. debt that goes into the bankruptcy process. 

Case Study for Negotiated Restructuring of distressed firms: Suppose there is debt with a net present value (NPV) of Rs 100 and the firm gets into trouble and this debt is unlikely to be repaid. 

• Limitations of Insolvency and Bankruptcy Code (IBC): The lenders will eject the shareholders, and get whatever is the residual value of the company. Suppose this residual value is Rs 40. 

• But it is not in the best commercial interests of the lenders to always rely on the bankruptcy code; When they get Rs 40 through the IBC, they still have a loss of Rs 60. 
• A case for Restructuring of Debts: A good solution is the combination of a write-down of debt by the lenders, coupled with a rights issue. 
• Cuts the losses: Suppose an agreement is reached where the lenders will get Rs 75 on an NPV basis. This cuts their loss from Rs 60 to Rs 25. 
• Importance of shareholders maintained: Alongside this, the shareholders do a rights issue, through which they bring in Rs 20. It serves two purposes - 
• The shareholders show their commitment to the lenders, and they signal their belief that the business is truly sound and can be salvaged. 
• They contribute to making the firm financially healthy and increase the chances that the promised Rs 75 of repayment will work out. 
• Reduced the bankruptcy costs: In this example, the lenders got to a loss of Rs 25 through restructuring while the IBC process would have generated a loss of Rs 60. The difference (Rs 35) is the bankruptcy cost. 

Issues with the Bankruptcy in India:

• Bankruptcy process is a disruption on the firm: The bankruptcy process ejects the shareholders (who know a lot about the company) and imposes a disruption on the firm.

• Banking regulation hampers both restructuring and the IBC: 

• Sound banking regulation would force banks to aggressively write down stressed debt. 

• The bankruptcy process ejects the shareholders (who know a lot about the company) and imposes a disruption on the firm.

• Bankruptcy costs: It involves paying a lot of money to lawyers, accountants, and consultants.

• Hard for financial firms to get their employees aligned towards the profit objectives of their organisations: Individuals in financial firms veer towards inaction, covering up, and corruption.