Literature Review
History of Bankruptcy Law in India Prior to IBC
In the early years post-independence in 1947, in order to protect a nascent and vulnerable
economy and develop an eventually competitive industrial base, India adopted a series of
policies around the policies of protectionism, import substitution and limited private-
ownership (Kang and Nayar, 2004). In order to maximize credit creation, the nationalized
banking industry further incentivized borrowings by providing financing at highly subsidized
interest rates, without the usual degree of monitoring on credit quality and collection. As a
result, the need for legislation regarding insolvency and bankruptcy was not required, and
cases regarding the same were handled by courts, where they came under the purview of
archaic law inherited from the British Raj, such as the Presidency Towns Insolvency Act,
1909 and the Provincial Insolvency Act, 1920 (Pandey, 2016).
This changed with the introduction of the Companies Act, 1956, which clearly defined the
procedure for voluntary and involuntary dissolution of companies by creditors and courts
respectively (Rajoria, 2018). However, there were no provisions dealing with bankruptcy
specifically, and the same was left in the purview of the courts, which were advised by
appointed liquidators, creating significant inefficiencies in the process.
By the 1980s, the effects of this system were beginning to be felt: NPAs of sick industrial
units were mounting, which seriously concerned the Reserve Bank of India – since, NPAs
present problems on both the microeconomic and as well as macreconomic level. At the
micro level, NPAs impact the lending capacity and eventual profitability of the bank where
they accumulate. At the macro level, they also threaten the ability of the central bank to
direct monetary policy in the country by creating gaps in the transmission, and impair
economic growth (Bernanke and Gertler, 1989; Soedarmono et al, 2018, Ghosh 2023).
In order to address these concerns, the Sick Industrial Companies Act, 1985 (SIC Act) was
enacted based on the recommendations of the Tiwari Committee. Following the BOP crisis
of 1991, the Government further passed the Recovery of Debts Due to Banks and Financial
Institutions Act 1993 (DRT Act) and Securitisation of Assets and Reconstruction of Financial
Assets and Enforcement of Security Interests Act 2002 (SARFAESI Act 2002) in order to
invite foreign direct investments into a newly liberalized economy.
However, the absence of a single, comprehensive law covering insolvency and bankruptcy
cases, and instead, requiring the involvement multiple agencies – the High Courts, the
Company Law Board, the Board for Industrial and Financial Reconstruction, and the Debt
Recovery Tribunals – all of which had overlapping jurisdictions, created an “outdated and
inefficient” process for resolving creditors’ woes (Batra, 2007). As a result, the time taken on
average to resolve insolvency processes and the debt recovered through liquidation in India
were on average worse than both the regional and the OECD averages, as can be seen in
the figures below:
Time Taken (in years) Recovery Rate
OECD Average:
72.1%
Regional Average:
5.2 years
39.9%
35.6%
24.5% 24.9%
OECD Average:
1.7 years 13.0% Regional Average:
21.4%
10 5 4 2.8 2.2
India Nepal Bangladesh Pakistan Sri Lanka India Nepal Bangladesh Pakistan Sri Lanka
Source: Doing Business 2005, World Bank data, OECD data
It was in this context that the Bankruptcy Law Reform Committee was constituted in 2014 in
order to provide recommendations and create a comprehensive draft of a unified law for
insolvency and bankruptcy legislation. The result of this was the passage of the Insolvency
and Bankruptcy Code, 2016, a unified and comprehensive framework that governs such
proceedings for companies, partnership firms, and individuals.
Economic Effects of the Introduction of Bankruptcy Law
From a theoretical perspective, we see that the cost of financing, which can be broken down
into origination, monitoring and probability of default, should be borne by the borrower, since
in a purely competitive market, the lender has the option to invest the same quantum of
money into assets that don’t have any associated transaction costs (Scott, 1977; Smith,
1980). Therefore, if, for example, banks needed to conduct more extensive credit analysis in
order to protect themselves from the probability of default, this would directly go to
increasing the cost of financing for the borrower (Scott & Smith, 1985).
However, the introduction of bankruptcy laws ensures better creditor rights protection in the
event of default, and thus makes financiers more willing to invest in riskier firms (Houston et
al, 2010; Cho et al, 2014). Bankruptcy reform therefore creates a virtuous cycle whereby
cost of borrowings go down, recovery rates go up and credit supply in the economy expands
(Beck et al, 2004).
Araujo et al. (2012) have undertaken a study to assess the impact of a bankruptcy reform on
credit markets using empirical evidence for Latin American countries. In this study, the
authors have conducted a diff-in-diff study to observe if the implementation of the bankruptcy
reforms in Brazil has significantly changed the debt variables when compared to the average
trend in other Latin American countries (i.e. Argentina, Mexico and Chile). At the national
level, the authors found that the implementation of the bankruptcy reform has on average led
to an increase in the proportion of credit for Brazilian firms. On the firm level, the authors
have found that the new bankruptcy law has positively impacted both the overall amount of
debt and the amount of long-term debt in Brazil. On the other hand, the amount of short term
debt has remained stable, and there has been a significant decline in trade credit, since the
improved availability of debt financing reduced the need to trade credit. According to the
authors, the above results were in line with theoretical literature on credit, i.e. since creditors
have a higher chance of recovering their debt when the firm goes insolvent, they lower what
the firm must pay them when it is solvent (Aghion and Bolton, 1992; Hart and Moore, 1994,
1998; Scott, 1977; Townsend, 1979, as cited in Araujo et al., 2012). The increase in long
term debt occurs since firms that would otherwise extend only short term debt as a
mechanism of discipline would now not need to do so.
Singh et al. (2021) have investigated the impact of the implementation of the IBC on the
financial policy of Indian Firms. They have studied the impact on leverage, debt maturity and
debt heterogeneity using the IBC as an external policy shock. Their results indicate that
improving creditors’ rights has an overall negative impact on the leverage of Indian firms,
and a positive impact on the long-term debt maturity structure. Their results also show that
firms with higher bankruptcy risks are much more sensitive to financial reforms as compared
to firms with lower bankruptcy risks. Another important implication of the results is that
investors (especially international investors) should consider the possibility of reforms in a
given economy before making their investiments, since the value of the investment would
change in response to financial reforms.
Spaliara (2009) brings in an angle of macroeconomics by analysing how capital-labour (K/L)
ratios are affected by cash flow, leverage, and collateral. The author has studied the impact
in the context of how financing constraints affect the sensitivity of the K/L ratios to the
financial factors. The author has reasoned that while there are individual studies that look at
the impact of financial variables on Capital (Investment Decisions) and Labour (Hiring
Decisions), those studies are not entirely accurate till the time both factors are used in the
production process with some degree of substitutability between them. The paper found
evidence that the capital-labour ratio is impacted by the balance sheet characteristics of
firms. The capital-labour ratio shows significant association with cash flow, leverage,
collateral and interest burden. The authors also found that the capital-labour ratios for firms
that faced financial constraints were more sensitive to the balance sheet characteristics
when compared to unconstrainted firms.
Agarwal & Singhvi (2022) have used the implementation of the IBC in India to examine the
impact of supplier’s right to initate their customer’s insolvency proceedings on the trade
credit. Their study was driven by their observation that suppliers’ are able to enforce
repayments using informal means, thereby prompting the authors to believe that formal
rights may not of any use to suppliers. However, contrary to their belief, the authors found
that suppliers provide significantly more trade credit after they were given rights. This
increase in trade credit isn’t seen uniformly across firm types. Firms with weak bargaining
power, and high sales volatility saw a higher increase when compared to firms with strong
bargaining power, and low sales volatility. The authors construe these results to imply that
the rights provide suppliers with limited capabilities of using informal channels of debt
recovery with a way to enforce debt repayment. Thus, their results suggest that the
suppliers’ right to initiate insolvency proceedings complements the existing informal ways of
debt recovery.
Krishna & M (2022) have undertaken a Difference-in-Difference study to evaluate if the
introduction of the IBC has helped reduce the bankruptcy risk of Indian firms. They have
complemented existing literature by looking at actual defaults rather than proxies used by
existing literature. The authors have estimated default risk using a logistic regression with
explanatory variables across financial, governance and geographical variables. They have
found that IBC has reduced the
References:
Kang, N. & Nayar, N. (2004). The Evolution of Corporate Bankruptcy Law in India. ICRA
Bulletin Money and Finance. 3.
Pandey, A. (2016). The Indian insolvency and bankruptcy bill: Sixty years in the making. 8.
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Gupta, A. (2019). Insolvency and Bankruptcy Code, 2016: A Paradigm Shift within
Insolvency Laws in India. The Copenhagen Journal of Asian Studies. 36. 75.
10.22439/cjas.v36i2.5650.
Rajoria, K. (2018). INSOLVENCY AND BANKRUPTCY CODE OF INDIA: THE PAST, THE
PRESENT AND THE FUTURE.
Batra, S. (2007). “Insolvency Laws In South Asia: Recent Trends And Developments”. Legal
and Institutional Reforms of Asian Insolvency Systems.
Bernanke, B.S. and Gertler, M. (1989), “Agency costs, net worth, and business fluctuations”,
American Economic Review, Vol. 79, pp. 14-31.
Soedarmono, W., Tarazi, A., Agusman, A., Monroe, G. and Gasbarro, D. (2018), “Loan loss
provisions and bank lending behaviour: do information sharing, strength of legal rights and
bank size matter?”, SSRN Paper No. 2782707
Ghosh, S. (2023), "Credit quality determinants of banks: how important are bankruptcy
reforms?", Journal of Economic Studies.
Araujo, A. P., Ferreira, R. V. X., & Funchal, B. (2012). The Brazilian bankruptcy law
experience. Journal of Corporate Finance, 18(4), 994-1004.
Scott, J. A., & Smith, T. C. (1986). The effect of the Bankruptcy Reform Act of 1978 on small
business loan pricing. Journal of Financial Economics, 16(1), 119-140.
Houston, J. F., Lin, C., Lin, P., & Ma, Y. (2010). Creditor rights, information sharing, and
bank risk taking. Journal of Financial Economics, 96(3), 485-512.
Jose, J., Herwadkar, S. S., Bilantu, P., & Razak, S. A. (2020). Does Greater Creditor
Protection Affect Firm Borrowings? Evidence from IBC. Margin: The Journal of Applied
Economic Research, 14(2), 212–225.
Bose, U., Filomeni, S., & Mallick, S. (2021). Does bankruptcy law improve the fate of
distressed firms? The role of credit channels. Journal of Corporate Finance, 68, 101836.
Scott, James H., Jr. (1977). Bankruptcy, secured debt, and optimal capital structure, Journal
of Finance 32, 1-19.
Smith, Clifford W., Jr. (1980). On the theory of financial contracting: The personal loan
market, Journal of Monetary Economics 6, 333-358.
Cho, S.-S., El Ghoul, S., Guedhami, O., & Suh, J. (2014). Creditor rights and capital
structure: Evidence from international data. Journal of Corporate Finance, 25, 40-60.
Beck, T., Demirgüç-Kunt, A., & Levine, R. (2004). Law and firms’ access to finance (NBER
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