Notes

Why firm death matters as much as firm birth

The concept of creative destruction goes beyond simple business cycles. When weak firms are artificially kept alive, they compete with healthy firms and drive down profit margins across entire sectors. This creates a vicious cycle where successful companies lose the incentive to invest because they cannot earn adequate returns.

Ajay draws on Japan's experience after 1986, where zombie banks propped up zombie firms for three decades. The Ministry of Finance and MITI orchestrated this industrial policy, but it backfired spectacularly. Rather than protecting jobs and economic stability, it strangled economic dynamism for an entire generation.

The airline industry provides a clear example. When Air India or Jet Airways are artificially kept alive through government support or evergreen lending, they sell tickets below market rates. This damages the financial health of well-managed airlines like Vistara, reducing their ability to invest and grow.

Ajay explains the deeper mechanism:

"If healthy firms are not profitable, how will they invest? If zombie firms are present, if an Air India or a Jet Airways is artificially kept alive, it is selling tickets and it is driving down the prices of plane tickets. And it is harming the health of the high quality airlines like Vistara."

The death of firms serves another critical function: it prevents asset stripping by insiders. When promoters know their company is heading toward bankruptcy, they have strong incentives to extract cash illegally while they still control the books. A swift bankruptcy process limits this window of opportunity, protecting creditor value.

The basic architecture of limited liability companies

The fundamental design of corporations, invented in 15th and 16th century Europe, creates a clear hierarchy of control. Shareholders run the company as long as they service their debts to creditors. The moment they default, control automatically transfers to creditors and shareholders typically get wiped out.

This transfer of control is more dramatic than many people realize. It involves completely reconstructing the company's balance sheet under new ownership. If a company has 100 rupees of equity and 100 rupees of debt, and defaults on the debt, the equity holders lose everything. Creditors essentially become the new equity holders of the entire enterprise.

Ajay emphasizes this is not sentimental—it's contractual:

"This is a very dramatic fact about the concept of a limited liability company that shareholders are in charge of the company as long as they are meeting their dues. The day the shareholders fail to pay their dues, they're supposed to get thrown out and replaced by the creditors."

The bankruptcy process extends this basic principle into operational machinery. Courts should only verify two facts: was there a credit relationship, and did a default occur. Everything else—how to restructure, whether to liquidate, who should take control—belongs to commercial negotiation between creditors.

This foundational concept gets obscured in India by excessive sentimentality about founding families and stakeholder rhetoric. The cold commercial logic that makes corporations work requires respecting both creation and destruction as normal business processes.

The committee of creditors and their competing interests

When a firm enters bankruptcy, creditors face complex negotiations about how to maximize recovery. Some creditors hold secured loans backed by specific assets—they can threaten to take their collateral and leave. Others are unsecured creditors who depend on the firm's overall value. Operational creditors (suppliers) have different time horizons than financial creditors (banks).

These different positions create natural conflicts. Secured creditors can use their leverage to demand priority repayment, effectively threatening to torpedo any attempt at keeping the firm as a going concern. They negotiate from strength, telling other creditors: "Pay me first, then figure out what to do with what's left."

The law in India requires a super majority of creditors to agree on any resolution plan—not just 51% but 60-70%. This forces creditors to make complex deals among themselves about priority, timing, and risk sharing.

Ajay describes the sophisticated business judgment required:

"These are all the core questions that some people say, no, this is pointless. Let's just cut it up and sell the pieces. And maybe they have good pieces. Some people say, no, no, no, we should try going concern. Some people argue, you're welcome to try going concern, but I have primacy because I can take away the core assets."

The problem in India is that many financial firms, especially public sector banks, operate more like bureaucracies than commercial enterprises. They lack the business instincts needed for these negotiations. Bank employees worry more about future CBI investigations than maximizing recovery for their institution.

This creates a fundamental mismatch between the sophisticated commercial judgment the law expects and the bureaucratic mindset of key participants.

Going concern versus liquidation—preserving intangible capital

The central decision in any bankruptcy is whether to preserve the firm as a functioning business or break it into pieces for sale. This depends critically on timing—firms that enter bankruptcy early often retain significant intangible capital that makes them worth more as going concerns.

Intangible capital includes organizational culture, employee relationships, customer connections, supplier networks, and institutional knowledge. These assets have no liquidation value but can be extremely valuable when orchestrated by capable management.

However, once a firm gets into serious trouble, it becomes a "melting ice cube." Key employees leave, suppliers demand cash on delivery, equipment maintenance gets deferred, and customer relationships deteriorate. The longer bankruptcy is delayed, the more intangible capital erodes.

Ajay emphasizes this is purely a business calculation:

"This is not a value judgment. This is not any humanitarian notion that, oh, we should protect the company as a going concern. This is a business judgment. So the firm goes bankrupt, the equity guys are thrown out, the old management is thrown out. The creditors come in, they gain control of the firm."

Creditors must coldly evaluate whether liquidation might yield 40% recovery while selling as a going concern could yield 70%. The higher number should win, regardless of sentimental considerations about preserving jobs or honoring founding families.

The presence of a sophisticated buyer willing to pay good money for the going concern is crucial. Without credible bidders, liquidation becomes the only realistic option, regardless of theoretical going concern value.

India's journey from no bankruptcy law to the IBC

India's bankruptcy infrastructure developed in stages, each addressing specific gaps. Before 2002, creditors had essentially no legal recourse when borrowers defaulted. The SARFAESI Act of 2002 gave secured creditors the right to seize collateral, but this only supported liquidation—there was no mechanism for collective negotiation or keeping firms as going concerns.

The Companies Act of 2013 was supposed to include comprehensive bankruptcy provisions, but the Ministry of Company Affairs failed to deliver despite assurances to then-Deputy Chairman Planning Commission Montek Ahluwalia. This left a crucial gap in India's commercial law infrastructure.

The Financial Sector Legislative Reforms Commission (2011-2015) developed bankruptcy procedures for financial firms with retail claimants, but recognized that somebody needed to tackle the broader corporate bankruptcy problem. When the 2015 budget mentioned bankruptcy provisions for small companies, KP Krishnan suggested to Finance Minister Arun Jaitley that they could be more ambitious.

The Bankruptcy Law Reforms Committee, led by TK Viswanathan with Ajay and Susan Thomas as members, initially had a narrow mandate to amend existing winding-up provisions. It took time to convince stakeholders that India needed a completely new bankruptcy architecture with creditor negotiation mechanisms.

Ajay recalls the evolution of thinking:

"And again, at the beginning of the BLRC, there was a very narrow vision that, oh, we'll do some amendments to the winding up provisions of the Companies Act and it was really a while before people got the point that no, a bankruptcy code is something playing at a different level."

The breakthrough came when Rajiv Mehrishi became secretary of the Department of Economic Affairs and supported the more radical approach of building a full bankruptcy code rather than incremental reforms.

Where the IBC struggles with Indian realities

The Insolvency and Bankruptcy Code represents sophisticated legal architecture, but it performs at a C-grade level because of broader Indian institutional weaknesses. The most fundamental problem is the mismatch between what the law expects from participants and their actual capabilities.

Banks, which are often the largest creditors, have strong incentives to delay and hide bad news rather than move quickly to resolve problems. Banking regulation in India focuses on avoiding the recognition of losses rather than dealing with them efficiently. Banks prefer private renegotiation in darkness to transparent processes in committees of creditors.

The National Company Law Tribunal (NCLT), which serves as the adjudicating forum, suffers from the same delays and inefficiencies that plague other Indian courts. What should take weeks stretches into months and years, allowing the "melting ice cube" effect to destroy firm value.

The Insolvency and Bankruptcy Board of India (IBBI), the regulator for the bankruptcy process, lost the sophisticated governance architecture that was originally designed for it. Instead of 140 sections establishing checks and balances, it received a simple cut-and-paste job from the SEBI Act, importing all of SEBI's governance problems.

Ajay suggests an unorthodox solution:

"One of my unorthodox ways, which is going to be very hard to persuade people about is that until banking regulation figures out its act. The voting power of banks in the committee of creditors should be reduced."

The broader environment of weak rule of law creates additional problems. Corruption pressures can influence insolvency professionals, promoters can engage in asset stripping with limited consequences, and various actors optimize for looking good in future investigations rather than maximizing commercial outcomes.

The shadow of the law and commercial culture

The true measure of bankruptcy reform is not how many cases go through the formal process, but how it changes everyday commercial behavior. In advanced economies, most credit disputes get resolved through private negotiation "in the shadow of the law"—both parties know what would happen in bankruptcy court, so they negotiate settlements without going there.

This behavioral change is the real prize. When borrowers know that default leads to swift bankruptcy proceedings where they lose control, they work harder to avoid default. When lenders know they have effective recourse, they are more willing to lend. The overall level of leverage in the economy should increase as credit markets become more efficient.

However, this outcome requires that all market participants believe the bankruptcy process will work as intended. If promoters think they can game the system, if banks believe they can hide problems through evergreening, if courts are expected to delay rather than decide quickly, then the shadow effect disappears.

Ajay emphasizes this broader impact:

"In advanced economies, most transactions are privately negotiated between the creditors and the shareholders under the threat of the law. So the term used is in the shadow of the law. Only a few cases go to court because you're not able to find the correct negotiation."

The challenge is that building this commercial culture requires many institutional pieces working together. Banking regulation must push for swift recognition of problems. Courts must process cases quickly and predictably. Regulators must focus on their core functions rather than seeking expanded roles. Knowledge ecosystems must provide ongoing research and criticism to drive improvements.

Lessons for policy reform in India

The bankruptcy reform experience illustrates broader challenges in Indian policy implementation. Good laws perform poorly without supporting institutional infrastructure. The distinction between inputs (laws, institutions), outputs (processed cases), and outcomes (changed commercial culture) is crucial for understanding why reforms often disappoint.

Successful reform requires sustained knowledge ecosystems with researchers producing data, analysis, and criticism. The bankruptcy field had such an ecosystem briefly, but it dissipated as the initial reform energy faded. Without ongoing intellectual engagement, there is no mechanism for identifying problems and driving iterative improvements.

The theory of change for policy reform requires multiple projects moving simultaneously. The 1991-2011 reform period succeeded because capital market liberalization, telecom deregulation, software industry development, and other initiatives reinforced each other. Isolated reforms in hostile environments struggle to achieve their potential.

Ajay reflects on the broader lesson:

"The basic story is the same as what we told in our theory of change episode. In all issues in public policy, the theory of change is that there is a pipeline where there is data, there is research, there are multiple rival public policy proposals happening in the public domain."

Some reforms are more fundamental than others. Instead of spreading limited state capability and reform energy across all possible areas, India should focus on "zero-based" priorities: what institutional foundations are absolutely essential for civilization and market economy to function? Criminal justice, commercial law, financial regulation, and similar foundations deserve priority over more complex sectoral interventions.

This suggests that bankruptcy reform, despite its current limitations, was correctly prioritized as part of the essential institutional infrastructure for a market economy. But it also highlights why such reforms struggle when attempted in isolation from broader improvements in rule of law, state capability, and commercial culture.

Supplementary Resources

• Report of the Bankruptcy Law Reforms Committee, Volume I: Rationale and Design by Bankruptcy Law Reforms Committee (Committee Report)
• The Insolvency and Bankruptcy Bill, 2015 by Bankruptcy Law Reforms Committee (Draft Legislative Bill)
• Insolvency and Bankruptcy Reforms in India edited by Susan Thomas (Book)
• The Corporate Bankruptcy Decision by Michelle J. White (Journal Article)
• Evolution of the Insolvency Framework for Non-financial Firms in India by Rajeswari Sengupta, Anjali Sharma, and Susan Thomas (Book Chapter)
• Building the Insolvency and Bankruptcy Board of India by Working Group on Building IBBI (Working Group Report)

The complete transcript file is available to download below.