Indians can finally go legally broke. With the passage of the Insolvency and Bankruptcy Bill by both Houses of Parliament in May, a set of at least 12 archaic pieces of legislation – some legacies of the colonial era – has been consigned to the history books. “This is a historic legislation,” said minister of state for finance Jayant Sinha. Added M. Venkaiah Naidu, union minister for parliamentary affairs: “History has been created. [This is] one of the big economic reforms and a game changer.”

“The Bankruptcy Act is a much-needed legislation for industry that will greatly help resolve issues pertaining to the speedy winding up of insolvent companies, lowering NPAs (non-performing assets), and redeployment of capital productively,” says Harshavardhan Neotia, president of the industry lobby group FICCI. “It is a transformational financial sector reform,” adds Jayanta Nath Mukhopadhyay, director of the department of management at the J.D. Birla Institute. “The code consolidates the existing framework, doing away with the plethora of legislation, some of them centuries old.”

The smooth passage of the Bankruptcy Code (it becomes law when the President of India signs off on it, which is a formality) has surprised some observers. After all, the biggest “game changer,” the Goods and Services Tax (GST) Bill, which envisages a national value-added tax, has been successfully blocked by the Congress-led opposition. This is odd because the bill was originally moved by the Congress, when it was in power before the advent of the Prime Minister Narendra Modi era. The Modi-led Bharatiya Janata Party (BJP) had stonewalled it then. Now, the Congress is paying back the BJP in its own coin; the bill itself — implementation of the GST is expected to boost GDP growth by 2% — has become a bagatelle for politicians to play with.

So how did the Bankruptcy Code escape a similar fate? There are many reasons. First, Reserve Bank of India (RBI) governor Raghuram Rajan has begun cracking the whip; he has asked banks to clean up their books. For a long time now, banks have making inadequate provisions for NPAs. The quantum of bad debts is threatening to sink several banks unless they are bailed out by the government (read: taxpayers’ money). According to a study by chamber of commerce Assocham, the stressed assets (gross NPAs plus restructured assets) of banks were around Rs. 10 trillion ($150 billion) at the end of fiscal 2015-16. The banks have been belatedly providing for this. (Earlier, some of them used to give the incipient defaulter a fresh loan to pay the next installment to avoid being classified as an NPA.)

Bottom-line Blues

Expectedly, bottom lines have taken a beating. Public sector banks notched up losses of Rs. 120 billion in the last quarter of calendar 2015. Consider Bank of Baroda, which has won several awards as Best Bank of the Year. In January-March 2016, it reported a net loss of Rs. 32 billion. The previous quarter, the loss had been marginally higher at Rs. 33 billion. In the same three months of 2015, the bank had registered a profit of Rs. 5.98 billion. But that was before Rajan insisted that all banks should have spick and span books. “Our intent is to have clean and fully-provisioned bank balance sheets by March 2017,” the RBI governor told a banking conference in Mumbai.

“It’s important not to overstate the effect of bankruptcy on GDP growth, but an effective bankruptcy system can make a significant difference.” –David A. Skeel

A second factor for the relatively unhindered progress of the Bankruptcy Code – the Congress Party had moved more than a dozen amendments but did not press them — is that the Supreme Court has also taken up the issue. In a public interest litigation, it had asked the RBI to file a list of all defaulters with loans from public sector banks above Rs. 5 billion in the past five years. The central bank has since given the court the data, with a request that the names not be made public.

The third factor is the public face of bad loans – Vijay Mallya. A former member of the upper house of parliament (he resigned last week), he had endeared himself to politicians across the board. Now, he is an outsider, because banks have declared him a “willful defaulter” for refusing to pay the Rs. 90 billion his company, Kingfisher Airlines (KFA), borrowed from them. “I’ve been made a poster boy of all bad loans,” Mallya has said.

“Willful defaulters have become the demons in the system,” adds Mukhopadhyay. “Indians have realized that they have to pay high interest rates and higher taxes because of them.”

Encouraging Entrepreneurship

Will the Bankruptcy Code live up to its billing? “It’s important not to overstate the effect of bankruptcy on GDP growth, but an effective bankruptcy system can make a significant difference,” says David A. Skeel, professor of corporate law at the University of Pennsylvania Law School and the author of Debt’s Dominion: A History of Bankruptcy Law in America. “This is true on the consumer side as well. Several studies have found that a robust fresh start for consumers — many of whom have small businesses — is directly correlated with entrepreneurship.” Explains a note by the finance ministry: “The vision of the new law is to encourage entrepreneurship and innovation. Some business ventures will always fail, but they will be handled rapidly and swiftly. Entrepreneurs and lenders will be able to move on, instead of being bogged down with decisions taken in the past.

“In India, the legal and institutional machinery for dealing with debt default has not been in line with global standards,” continues the note. “The essential idea of the new law is that when a firm defaults on its debt, control shifts from the shareholders and promoters to a committee of creditors, who have 180 days in which to evaluate proposals from various players about resuscitating the company or taking it into liquidation.” India has clambered on the startup bus only recently; the Bankruptcy Code will go a long way to introduce an appetite for risk.

How much time will it take to have an impact? “The 1978 Code in the U.S. took a couple of years to get going, but it quickly had a major effect on U.S. bankruptcy practice,” says Skeel. “Although major changes have been relatively infrequent, U.S. bankruptcy law is regularly updated, usually in response to problems or unexpected developments that have arisen. The last major changes were in 2005, in response to concerns — primarily pushed by credit card companies — about the high number of consumer filings. But the changes addressed perceived problems with business bankruptcy as well.”

Two Achievements of U.S. Law

“U.S. bankruptcy law has been successful because it accomplishes two purposes well,” says Douglas G. Baird, professor of law at the University of Chicago Law School and the author of Elements of Bankruptcy. “In the case of honest, but unfortunate flesh-and-blood individuals who cannot repay their creditors, it offers them a fresh start. Among other things, this safety net ensures that people are willing to take entrepreneurial risks in the first place. When they fail, they will be able to get back on their feet again. Without bankruptcy law, fewer would start enterprises. Bankruptcy law in this sense is good both for the entrepreneurs who fail and also for those who succeed, but who would never have taken the chance without it.”

“Without bankruptcy law, fewer would start enterprises. Bankruptcy law is good both for entrepreneurs who fail and those who succeed.” –Douglas G. Baird

He continues: “A second and quite different purpose is that American bankruptcy law helps financially distressed corporations to obtain a new capital structure and remain in business. This prevents fire sales and inefficient shutdown of firms. Many firms in the U.S. — General Motors, Macy’s, Bloomingdales, United Airlines — are in business today thanks in large part to our bankruptcy laws. It does not matter whether a country has a law that is denominated a “bankruptcy” law or that it takes the same shape as the law in the U.S. What matters is that the legal system facilitates these two objectives.”

The Bankruptcy Code had acquired a certain urgency for the government because of Modi’s promise that in three years India would break into the list of the top 50 countries based on the ease of doing business. In the World Bank’s 2016 report, India was ranked 130 out of 189 countries — up 12 spots since the previous year. “The Code will play a key role in improving the ease of doing business in India,” observes Japanese financial major Nomura in a research note.

“The Bankruptcy Code will structurally strengthen both identification as well as resolution of insolvencies and will significantly improve India’s ease-of-doing-business ranking,” says Krishnan Sitaraman, senior director of Crisil Ratings, a Standard & Poor’s company. “Lenders and ARCs (asset reconstruction companies) will be immediate beneficiaries. Going forward, the Code will improve investor confidence and can deepen the corporate bond market. The Code can potentially kindle investor interest in lower-rated — below AA category — corporate bonds.”

Crisil’s analysis shows recoveries by ARCs have been low — around 36% — with the average resolution taking about five years. That is in line with a World Bank study which says it takes more than four years to wind up a sick company in India, or twice the time taken in China, with recovery at just around 25%, which is among the lowest in emerging economies. But, in the long run, the code will structurally hasten the resolution of the problem of weak assets (currently forecast at around Rs. 8 trillion by March 31, 2017).

Despite the large numbers being tossed around – and the big bad debt lurking like a wolf on the sidelines — Rajan is confident his preemptive measures will be adequate. “There is absolutely no chance of a Lehman moment in India,” he told journalists in London recently. “A firewall is being created to safeguard the economy from external shocks.” The chairman of the newly-formed Bank Board Bureau, former comptroller and auditor general Vinod Rai says that NPAs are troublesome but not alarming. “Banks will come out of this.”

But Sitaraman strikes a note of warning. “The Bankruptcy Code is unlikely to cure the current asset-quality problems of banks anytime soon,” he says. “These are a result of disproportionate exposure to large corporates. These corporates could continue to take legal recourse to delay recovery proceedings, which would challenge effective resolution within the proposed timeline of 180 days.”

“In the U.S., the system works because of strict enforcement,” says Mukhopadhyay. “If the legal procedures continue to take time here, we will be back at square one. Instead of Chapter 11 (which gives protection from creditors of a U.S. company in financial difficulties), it will be Chapter 100001. We will all be asleep by the time anything is decided.”