Beware moral policing. Which is pretty much what the Ordinance on the amendment to the Insolvency and Bankruptcy Code (IBC) by GoI amounts to. It practically bars promoters of insolvent companies from bidding for these companies.

The preamble to the Insolvency and Bankruptcy Code (IBC) states that its objectives are to maximise the value of assets of insolvent corporate entities, promote entrepreneurship and availability of credit, and balance the interests of all stakeholders. Now, the value of an insolvent entity depreciates with time. It then faces difficulty in raising funds from banks as well as the capital market. Since there is no organised junk bond market in India to finance an insolvent company, its value is best preserved by resolving the insolvency at the earliest.

Resolution could be through restructuring or sale where bidders would compete on the degree of support brought in for the resolution. The efficiency of the resolution process, it stands to reason, increases with the number of serious players competing. Any restraint put on bidders junks this very reason. The promotion of entrepreneurship and availability of credit is a broader objective of the IBC. This is expected to be achieved through establishing an atmosphere of fair and competitive resolution of insolvencies. The Ordinance goes against this objective as well.

The IBC is also supposed to balance the interests of all stakeholders, which requires a fair appreciation of the dynamics between them. Consider the case of an insolvent company defaulting to a creditor. The company owes .`X to the creditor. When the creditor invites bids for its dues from the company, and accepts the best bid to sell the dues at .`Y, the difference of .`X-.`Y is a loss for the creditor. The latter’s immediate objective should be to minimise this difference.

For this purpose, the creditor should be indifferent to the identity of the bidders — as long as they are serious and legally tenable, of course.

At the same time, a significant majority of the losses are currently being borne by public sector banks (PSBs) and, thereby, GoI. It makes sense that GoI, as a profit-maximising shareholder of PSBs, would like to accept the highest bid, even if it is from the promoter of the insolvent company.

On the other hand, GoI also plays the role of a policymaker. An important policymaking objective of the insolvency framework is to devise and implement suitable incentives for fair and contract-abiding market players. There should be strong disincentives against such players who may be adopting insolvency as an unfair strategy against creditors for making undue gains.

In the past, the reluctance of banks to declare their defaulting borrowers as non-performing assets (NPAs) provided an incentive to the latter to default and push the banks towards refinancing them.

This issue has now been largely addressed through a mix of regulatory actions, as well as the promise (through the IBC) of a better pay-off to the banks in case they declare the defaulting companies as NPAs.

Also, there was no distinction between the bidders for the auction of insolvent companies (or assets) in the secondary market. In other words, the promoters of defaulting companies did not suffer any handicap. The proper approach to solve this issue should have been the use, by the banks, of a multi-parameter evaluation model, with one of the parameters assigned to the track record of the bidder (promoter). This approach would have had the desired benefits of penalising only wilful defaulters, and not killing the entrepreneurial spirit of promoters who have failed for reasons beyond their control.

This would have been a far better approach than the latest Ordinance, even as it would have required some hard work on the part of the banks and the regulators. Errors in the discriminant model of both wrongly rejecting a defaulting, but genuine, promoter and wrongly accepting a defaulting, and wilful, promoter would have needed balancing.

The current Ordinance is a dangerous shortcut. It relieves the banks from judging the promoters, and guides them towards a faster — even if financially less-attractive resolution — in many cases. In terms of the policy objectives, GoI has clearly moved towards minimising a wilful defaulter from entering the fray. But this move would have been justified if the virtue of keeping a defaulter at bay was far higher than the genuine ‘sin’ of driving away a defaulting but genuine promoter.

The Ordinance is not just throwing away the baby with the bathwater, but making the process seem virtuous by sprinkling it with holy water.

(The writer is associate professor, SP Jain Institute of Management and Research, Mumbai)