This brief is part of the Insights @ Center for Emerging Markets, a publication focused on cutting edge ideas and advice for global leaders about emerging markets.
By Radhakrishnan Gopalan (Washington University in St. Louis), Xiumin Martin (Washington University in St. Louis) and Kandarp Srinivasan (Northeastern University)
Models of Insolvency in Developed Markets
Accounting rules play an important role in how firms can use bankruptcy protections in different countries. In creditor-friendly countries like the United Kingdom, if a company's assets are less than its liabilities, then the directors of that company can be sued for compensation or disqualification. Therefore, declaring bankruptcy is often an undesirable outcome for managers. In addition, secured creditors can veto court-administered insolvency processes and enforce default provisions from their debt contracts. Similarly, in the United States, 70 percent of CEOs are fired in Chapter 11 reorganizations. Clearly, when creditor protection is strong, and clear accounting rules determine bankruptcy eligibility, there is an incentive for managers to overstate a firm's financial position to avoid insolvency.
Given that most academic research on bankruptcy focuses on countries with robust legal institutions, recent work seeks to advance our understanding of the conditions that foster opportunistic bankruptcy behaviors by examining how a country with weak creditor rights impacted local managers' economic incentives. The authors acknowledge that this type of inquiry is challenging because bankruptcy data is scarce in countries with weak creditor protections, particularly in emerging markets.
Creditor Rights in India
India was chosen for its history of weak creditor protections and the authors' ability to obtain robust data on 1,700 Indian companies that filed for bankruptcy between 1990-2013, of which 706 were publicly listed. Moreover, because India recently passed laws that increased creditor rights, this research examines the changes in bankruptcy behavior before and after the new law was implemented. It shows that, especially before the passing of this market reforms, company insiders deliberately managed earnings downward to game the courts and gain eligibility for bankruptcy protection. Weak creditor rights perverted economic trade-offs, giving rise to opportunistic behavior that allowed insiders to extract private benefits at the expense of creditors and outside shareholders.
This research also shows that Indian firms would see their net worth drop considerably in the year before bankruptcy. In many cases, these results were driven by selling assets to insiders. Part of the reason for the selling was to push firms into negative net worth in order to qualify for bankruptcy protection, often defrauding creditors in the process. The insiders were usually relatives of those who controlled the company. This self-dealing behavior did not occur in solvent companies and those that restructured outside of the Indian court system. Importantly, this work also acknowledges that some companies have good reasons to engage in transactions with relatives. When they find themselves in legitimate financial trouble, suppliers may not want to extend credit that is necessary for the firm's survival. Instead, they might turn to family members to extend credit or help in other ways.
Reducing Bankruptcy Incentives
Although the race towards bankruptcy appears counterintuitive, policymakers have long complained about the failures of India's weak creditor protections. When the Indian government passed the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act of 2002, it gave powers to secured creditors to override automatic stay provisions and seize assets of bankrupt firms. By increasing creditor rights, the law resulted in a significant decline in the number of firms filing for bankruptcy protection. When creditors have additional powers over delinquent borrowers, bankruptcy filing becomes less attractive for insiders.
By strengthening creditor rights, SARFAESI increased incentives for upward earnings management among insiders to avoid bankruptcy filings, similar to what one normally sees in countries with stronger creditor rights. It also gave powers to secured creditors to seize assets of a firm that has defaulted on its debt obligations. SARFAESI was mandatory, and firms did not have opt-out provisions.
Policy Implications
- An important takeaway from this research for policy makers in emerging markets is that designing insolvency law requires a balancing act between competing priorities of debtors and creditors. If the balance tilts too far in the direction of being debtor-friendly, the consequences can be detrimental to the economy.
Original Article
Gopalan, R., Martin X. & Srinivasan, K. Regulatory Protection and Opportunistic Bankruptcy. Contemporary Accounting Research, Forthcoming.
Contact
If you are interested in learning more about this work, contact Professor Srinivasan.
