“A Race to Collect”: Unravelling the Economic Underpinnings of Conflicting Creditor Interests in the Indian Insolvency Regime
-Aaryan Dhasmana and Avanish Kar
Introduction
Within the Indian Insolvency and Bankruptcy Code (IBC), conflicting interests among creditors have sparked disputes, shaping the insolvency landscape. As debtors face financial distress, various creditors with diverse priorities and objectives vie for their rightful share. Secured, unsecured creditors, as well as operational and financial creditors navigate a complex landscape, each guarding their interests diligently. These conflicts have given rise to intense battles within the insolvency arena, influencing the fate of debtors and the distribution of assets. Through this paper, we untangle the complexities of conflicting creditor interests while shedding light on the legal and economic dynamics that shape the Indian IBC landscape.
This paper incorporates the ideas of Elinor Ostrom’s Common Pool Resource (CPR) framework and Thomas Jackson’s Creditor’s Bargain model to shed light on the fault lines that contribute to certain classes of creditors, particularly secured creditors, favoring liquidation over resolution in the Indian insolvency context. By applying Ostrom’s CPR principles, the paper explores how the limited pool of resources in insolvency cases creates a competitive environment among creditors, leading to a preference for liquidation. Additionally, drawing from Jackson’s Creditor’s Bargain model, the paper examines how the design of the insolvency laws and the imbalance of power between debtors and creditors incentivize secured creditors to opt for liquidation, given the potential for higher recoveries.
Insolvency and the relevance of Common Pool Resource management principles
The concept of Common Pool Resources as goods that are rival and difficult to exclude was given by Elinor Ostrom in her seminal paper “Governing the Commons: The Evolution of Institutions for Collective Action.” Challenging the existing notion of “tragedy of the commons” proposed by Garett Hardin, Ostrom’s model outlines how communities can manage shared resources regulation through cooperation and collective action without resorting to private ownership or government. This conclusion is similar to one of the popularly proposed solutions to John Nash’s classic game theory model of “prisoner’s dilemma”, where the equilibrium point obtained by resorting to a selfish dominant strategy gives lower payoffs to the players when compared to the payoffs at the point obtained through cooperation. Ostrom’s proposals include clearly defining resource boundaries, allowing those affected to participate in decision-making, setting up effective monitoring systems, imposing graduated sanctions for rule violators, offering conflict resolution mechanisms, and organizing in layers of nested enterprises.
While Ostrom had based her model on the basis of empirical case studies of fisheries, pastures, woods, lakes, and groundwater basins, the brilliance of the model is clearly demonstrated by its interdisciplinary applicability. Scholars have applied the self-governance framework to resolve issues ranging from knowledge and information as a shared resource to analysis of the success and failure of institutions for collective action in pre-industrial Europe. In a similar vein, Thomas H. Jackson has applied the principles of CPR Management in the context of insolvency and bankruptcy regulation to develop a “creditor bargaining model”.
The CPR problem in the context of insolvency law, as per Jackson, arises because an insolvent firm’s assets are a shared resource for its creditors. In the absence of relevant law or regulation, a debtor’s insolvency triggers a “grab race” or a “race to collect” in which the creditors rush to claim their shares, leading to an inefficient distribution or use of the firm’s assets, much like the overuse and depletion seen in classic common-pool resource dilemmas. For instance, if individual creditors seize assets separately, the overall value obtained through liquidation may be lower compared to if the debtor’s assets were kept intact and sold as a whole. However, if the creditors collaborate, they can strategically utilize the assets to maximize their value. The predicament arises when the debtor possesses insufficient assets, as cooperating with the group would result in only partial payment for any individual creditor, whereas acting independently and seizing the assets first could secure full payment. Consequently, creditors are motivated to take actions that diminish the overall worth of the asset pool.
Mistrust thus forms the core reason for the formulation of this rat race, similar to why betrayal is the dominant strategy in the prisoner’s dilemma model. Consequently, circumvention of this quandary, as proposed by Jackson, requires co-operation to be imposed upon the creditor in order to get a more efficient outcome. The creditors’ bargain approach, in consonance with Ostrom’s proposals, promotes collective decision-making and a more equitable and efficient distribution of the debtor’s assets. It’s an implicit agreement to cooperatively manage the common resource (the debtor’s assets), rather than every creditor individually pursuing their own interests. This cooperative approach minimizes the risk of the firm’s assets being hastily sold off at fire sale prices, which can destroy value. Instead, assets can be liquidated in an orderly manner, or the business can be reorganized, to maximize the value of the firm’s assets. Bankruptcy laws should thus attempt to create a scenario required for a Coasian bargain, by mimicking the agreement that creditors would collectively reach if transaction costs were not a barrier. In other words, bankruptcy procedures should facilitate a cooperative solution that maximizes the overall value of the debtor’s assets for the benefit of all creditors.
From a game theory perspective, the goal of bankruptcy law, as envisioned in Jackson’s creditors’ bargain model, thus becomes shifting of the Nash Equilibrium from a non-cooperative outcome to a cooperative one. It does this by enforcing rules that suspend individual collection efforts and provide for an orderly distribution of the debtor’s assets, thereby aligning individual incentives with the collective good. This is where Nash equilibrium optimization comes in. By enforcing cooperative behaviour, bankruptcy law effectively changes the “payoff” structure of the game. Instead of a prisoner’s dilemma, where the dominant strategy for each player (creditor) is to defect (grab), it becomes a game where the dominant strategy for each player is to cooperate, leading to a Nash Equilibrium that also represents the optimal collective outcome.
The Indian Context
While Jackson proposed his model in the US context, the principles underlying the Indian regulation certainly draw inspiration from the creditor bargaining model. This is especially true for the notion of creditor-in-control model lying at the basis of the Indian Insolvency & Bankruptcy Code, 2016 (IBC) and its overt manifestation, i.e., Committee of Creditors (CoC). This, in terms of the collective bargaining model, can be seen as the Indian attempt to emulate “coerced cooperation”. The CoC brings together the financial creditors to collectively decide on the resolution plan in concurrence with Jackson’s emphasis on the need for all the stakeholders to negotiate and decide the best course of action rather than acting solely on the basis of their own self interests. Furthermore, the IBC requires a 66% majority of the CoC by value for approving a resolution plan. This voting mechanism approximates the kind of agreement that creditors would likely reach in a costless bargaining situation, according to Jackson’s model.
Jackson’s reiteration of the significance of cooperation and the role it plays in increasing the payoffs for creditors can also be seen in the Indian insolvency law’s emphasis on preference of “resolution over liquidation”. While obviously not exactly the same as a scenario where there are no insolvency laws and creditors are getting their dues on a first come first serve basis, liquidation can, in a way, be seen akin to a ‘tragedy of the commons’. Though the waterfall mechanism under Section 53 of the IBC proposes a hierarchy in which the priority of creditors is to be determined, if a company is liquidated, all its assets are sold off. This may bring immediate benefits to some stakeholders (mainly creditors), but in the long term, the value generated by the ongoing business operations is lost. This can lead to suboptimal outcomes for stakeholders. In Ostrom’s terms, overuse and depletion of the resource, which in this case is the company, takes place, leading to its destruction. Resolution, on the other hand, aligns more closely with Ostrom’s principles for managing CPRs effectively. The company is viewed as a shared resource that needs collective stewardship. The aim here is to resolve the issues causing financial distress while keeping the company’s operations ongoing, which can lead to better long-term outcomes for all stakeholders. Thus, the Indian insolvency law jurisprudence favours resolution and holds that a company cannot mechanically go into liquidation on insolvency even if the value recuperated from the latter is more than the value of the assets realised through the resolution plan.
The shifting of the Nash equilibrium through the introduction of cooperation is clearly visible in the Insolvency statistics in India. As per the March 2021 IBBI report, the realizable amount through the Corporate Insolvency Resolution Process was about 45% of the total claim amount, much higher than the 3% average recovery in liquidation cases. Moreover, out of the 2,108 cases resulting in liquidation by March 2021, 1,349 were defunct companies with no business operations, which meant that they offered little to no value for creditors. Liquidation, therefore, often resulted in considerably lower recovery rates compared to resolution, as the business was either inoperative or the assets were sold at low, distress-sale prices. On the other hand, resolution allowed for business continuity, employment preservation, and potentially higher returns for creditors. It often enabled companies to emerge from the insolvency process as going concerns, which was generally more beneficial for all stakeholders in the long term. Further, resolution also aligns with the broader socio-economic goals, such as job preservation, maintaining supply chains, and preventing the erosion of economic value.
Limitations of the creditor bargaining model – Problems in the Indian insolvency regime
Thus, as has been highlighted in the previous section, the Indian insolvency regime reflects the principles of Jackson’s collective bargaining model and aims to coerce creditors into a cooperative position. Consequently, it is natural that the insolvency regime would also suffer from the limitations that the creditors’ bargaining model is subject to.
One of the primary assumptions of Jackson’s model is the presupposition that all creditors would agree on the best course of action in a costless bargaining scenario. However, in practice, creditors often have diverse interests. This conflict of interest is especially visible between secured and unsecured with respect to the choice between resolution and liquidation. The liquidation waterfall mechanism, envisaged under the IBC, is especially empowering for the secured creditors. Section 52 of the IBC gives them the option to choose between retaining their security interest and foregoing the same and moving up the liquidation waterfall prior to the initiation of the liquidation process. In the resolution process, however, the fate of the secured creditor is determined by the resolution plan, which in turn should be approved by 66% of the CoC, and the voting share in the same is not reflective of the security interest of the secured creditor. Thus, secured creditors have an incentive to choose the liquidation process over resolution given that the former offers them greater autonomy. Unsecured creditors, however, knowing that liquidation puts them on a lower pedestal, would favour resolution and revival of the company in the hope of a better recovery in the long run.
Secured creditor are thus incentivised to challenge the resolution plan and attempt to disrupt the resolution process so that the corporate debtor ends up getting liquidated. This can lead to conflicts in the CoC and delays in the process. Such delays militate against the very notion of asset maximisation as they can reduce the value of the debtor’s assets and make the resolution less beneficial for creditors. Thus, instead of properly solving the common pool problem, the existence of two separate mechanisms, namely resolution and liquidation, privileging two separate set of creditors, unsecured and secured respectively, creates a conflict of interests leading non actualisation of the goals of the IBC.
Streamlining the interests
As highlighted in the previous section, the presence of conflicting interests of the secured and unsecured creditors remains one of the fundamental issues plaguing the Indian insolvency regime. Streamlining of these interests is necessary in order to prevent the aforementioned delays and realise the maximum value of the corporate debtor and its assets. This streamlining would essentially involve creating incentives for the secured creditors so that it becomes rational for them to opt for resolution over liquidation.
As the secured creditor chooses the liquidation process as it prioritises them over unsecured creditors, such a prioritisation should also be incorporated in the voting mechanism of the CoC. This would involve revision of the voting mechanism of the CoC so that it reflects not just the share of a creditor in the entire debt pool of the corporate debtor but also the security interest that any such creditor may have. This would also be in tandem with Jackson’s proposition that the priority of claims established before the advent of insolvency proceedings must be respected in the creditor bargaining model. Incorporation of such would make the creditor reconsider his/her cost benefit analysis given that they have a greater say right from the start of the resolution process. Given that challenging the resolution plan through litigation is a tedious and time-consuming task, in addition to being extremely costly, the knowledge that a secured creditor would have a greater say in the resolution process might be lucrative enough to disincentive him/her from making the trade-off. Moreover, incorporation of this voting based on security interest in addition to the share of a creditor in the entire debt pool would also provide clarity on the hierarchy of claims which would help in managing expectations and reducing conflicts. The weight that needs to be given to the security interest is however an empirical question and beyond the scope of this paper.
Conclusion
In conclusion, the application of Elinor Ostrom’s Common Pool Resource management principles to insolvency law and bankruptcy regulations, as proposed by Thomas H. Jackson’s creditor’s bargain model, offers valuable insights. It underlines the importance of cooperation amongst creditors, in line with Ostrom’s principles of collective action, to effectively manage the insolvent debtor’s assets as a shared resource, thereby avoiding a destructive race to claim these resources and maximizing their value.
Furthermore, in addition to highlighting the principles underlying the Indian insolvency CPR analysis also helps one realise the current obstacles in the path to the realisation of these principles. The challenge arising from the conflicting interests of secured and unsecured creditors is one such obstacle which can lead to delays in the resolution process and the devaluation of the debtor’s assets. Streamlining the interests of these diverse stakeholders is critical for improving the effectiveness of the insolvency regime. This might involve revising the voting mechanism within the Committee of Creditors to take into account not just the share of a creditor in the total debt pool, but also their security interests.
Aaryan Dhasmana and Avanish Kar are students of The National Academy of Legal Studies and Research (NALSAR).