A blog on financial markets and their regulation
Creditor versus Creditor and Creditor versus Debtor
November 16, 2015Posted by on
In India, for far too long, bankruptcy has been a battle between creditor and debtor with the dice loaded against the creditor. In its report submitted earlier this month, the Bankruptcy Law Reforms Committee (BLRC) proposes to change all this with a fast track process that puts creditors in charge. It appears to me however that the BLRC ignores the fact that in well functioning bankruptcy regimes, the fight is almost entirely creditor and creditor: it is very much like the familiar scene in the Savannah where cheetahs, lions, hyenas and vultures can be seen fighting over the carcass which has no say in the matter.
The BLRC ignores this inter-creditor conflict completely and treats unsecured financial creditors as a homogeneous group; it believes that everything can be decided by a 75% vote of the Creditors Committee. In practice, this is not the case. Unsecured financial creditors can be senior or junior and multiple levels of subordination are possible. Moreover, the bankruptcy of any large corporate entity involves several levels of holding companies and subsidiary companies which also creates an implicit subordination among different creditors made more complex by inter company guarantees.
Consider for example, the recommendation of the BLRC that:
The evaluation of these proposals come under matters of business. The selection of the best proposal is therefore left to the creditors committee which form the board of the erstwhile entity in liquidation. (p 100)
If the creditors are homogeneous, this makes eminent sense. The creditors are the players with skin in the game and they should take the business decisions. The situation is much more complex and messy with heterogeneous creditors. Suppose for example that a company has 60 of senior debt and 40 of junior debt and that the business is likely to be sold for something in the range of 40-50. In this situation, the junior creditors should not have any vote at all: like the equity shareholders, they too are part of the carcass in the Savannah which others are fighting over. On the other hand, if the expected sale proceeds are 70-80, then the senior creditors should not have a vote at all. The senior creditors have no skin in the game because it matters absolutely nothing to them whether the sale fetches 70 or 80; they get their money in any case. They are like the lion that has had its fill and leaves it to lesser mortals to fight over what is left of the carcass.
The situation is made more complex by the fact that in practice the value of the proposals is not certain, and the variance matters as much as the expected value. A junior creditor’s position is often similar to that of the holder of an out of the money option – it tends to prefer proposals that are highly risky. Much of the upside of a risky sale plan may flow to the junior creditor, while most of the downside may be to the detriment of the senior creditor.
Another recommendation of the BLRC that I am uneasy about is the stipulation that operational creditors should be excluded from the decision making:
The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors. (p 84)
Suppose for example that Volkswagen’s liabilities to its cheated customers were so large as to push it into bankruptcy. Would it make sense not to give these “operational creditors” a seat at the table? What about the bankruptcy of a electric utility whose nuclear reactor has suffered a core meltdown?