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Monday, December 28, 2015

Personal insolvency: Lessons from the UK and Australia

by Renuka Sane.

In India, we have always paid more attention to the restructuring and winding up processes for companies. These include provisions in the I(DR)A Act, 1951, Companies Act (1956 and 2013), the Sick Industrial Companies (Special Provisions) Act, 1985. The 1993 Recovery of Debts Due to Banks and Financial Institutions Act set up Special Tribunals, the DRT, with special powers for adjudication for recovery of loans and enforcement of securities charged with banks and financial institutions. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 was put in place to allow banks and financial institutions (FIs) to take possession of securities and sell them.

In contrast, the legal framework for insolvency of individuals is rooted in very old laws. Individuals are geographically divided across the Presidency Towns Insolvency Act, 1909 (PTIA) for Calcutta, Bombay and Madras, and the Provincial Insolvency Act, 1920 (PIA) for the rest of India. A unified version of the existing laws was submitted to the government by the 26th Law Commission in 1964 but not enacted as law.

Individuals do not have a high share of unsecured borrowing from the banking sector. This seems to have been used as a justification for ignoring the substantive and procedural problems in the law governing individual insolvency. But poor recovery practices may be precisely the reason why there is limited lending to individuals leading to financial exclusion and ultimately inhibiting the emergence and growth of small enterprise in the country.

This is not true of other parts of the world. How have other countries designed their personal insolvency system? What lessons can we learn from them? In a recent paper (Ramann, Sane and Thomas, 2015), we motivate the need for a personal bankruptcy law, and study the existing Indian legal framework and contrast it with the UK and Australian experience. This was part of the research that fed into the Indian bankruptcy reforms.

The UK system

In the UK, the Cork Committee undertook a comprehensive review of the insolvency law, publishing its report in 1982 (the "Cork Report"). This led to the enactment of the UK Insolvency Act 1986 (the "UK Insolvency Act"), an omnibus bill which combined the personal and corporate insolvency regimes. Substantial refinements were again made to the UK's insolvency regime by way of the Enterprise Act 2002 (the "UK Enterprise Act") (which amended the UK Insolvency Act) and the Cross-Border Regulations 2006, which adopted the UNCITRAL Model Law on Cross-Border Insolvency into the UK regime. There are three kinds of relief possible for individuals in the UK law:

  1. Individual Voluntary Agreement (IVA): which is a private negotiation between debtors and creditors so that debtors avoid the stigma of bankruptcy. While negotiations are outside of the court, they are supported by legal provisions embedded in the law.
  2. Court initiated bankruptcy: which is process intensive and governed by the rules of the Court.
  3. Debt Relief Order (DRO): which provides debt relief to low-income households, where the costs of doing an IVA may often be higher than the debts of these households.

In the first two cases debtors in bankruptcy can be subject to Income Payment Orders, requiring payment of all future income beyond ``reasonable domestic needs'', generally for a term of three years. An important feature of the UK process is that the house or dwelling of bankrupt is excluded from estate available for distribution only after 3 years of adjudication of debtor as insolvent by the Court. Discharge in the UK has also become faster. Debtors are now discharged automatically after one year. As a result they can return to professional and financial life (at least legally) in a year.

The recent institutional changes made in the UK law include the Insolvency Practitioner, the Trustee, the supervisor, the nominee all of whom assist the debtor or the Official Receiver in its role as a mediator between debtor and creditors. The specific provisions in the 2007 amendments on time-lines for completion of negotiations strengthened the hands of creditors and also fixed discharge at the end of one year without an adverse credit history bringing relief to debtors.

The Australian system

The Commonwealth legislation, the Bankruptcy Act 1966, covers personal insolvency, including bankruptcy, Part IX (debt agreements) and Part X (personal insolvency agreements) in Australia. Corporate entities are covered by the Corporations Law administered by the Australian Securities and Investments Commission. There are four forms of relief available in Australia:

  1. Declaration of intention (DOI): in which the debtor does not file for either insolvency or bankruptcy. This is just a period of 21 days of relief from unsecured creditor action provided to the debtor to be able to choose the future course of action.
  2. Debt agreement (DA): a binding agreement between debtors and creditors where creditors agree to accept a sum of money that the debtor can afford. This is similar to the negotiation in the IVA in the UK. Only those below certain specified thresholds are eligible for a DA.
  3. Personal insolvency agreement (PIA): is also a binding agreement between debtors and creditors, but is more formal than the DA described above. It allows the debtor to come to an agreement with creditors to settle debts without the stigma of bankruptcy.
  4. Bankruptcy: is a court-led bankruptcy procedure. It may be voluntary (when the debtor presents a petition), or involuntary (when the creditor makes a petition if the debtor fails to pay within 21 days of the creditor serving a notice).

The Australian system departs from the UK in having a separate institution, knows as the Australian Financial Security Authority (AFSA), responsible for the administration and regulation of the personal insolvency system.

Lessons for India

A sound framework for personal insolvency involves an impartial, efficient and expeditious administration. The trend in the UK and Australia, and in other parts of the world as well, is towards placing administrative proceedings outside of the courts. A negotiated settlement outside of court allows more flexibility in the repayment plans, and the time to execute the plans, that can be acceptable to both parties, as opposed to a court procedure which can constrain the possibilities. Thus the lower the intervention of the court, the better. Recourse to courts should only occur after completion of the negotiation or composition process in the event a party is aggrieved by the order. The record in the credit history of a negotiated settlement should differ, and be lighter from that of bankruptcy. This ensures that individuals will be incentivised to agree on a repayment plan with the creditors.

The process of negotiation, and bankruptcy, is carried out more effectively by an intermediary, instead of an officer of the court. The institution of an insolvency professional (IP) is critical if negotitations between debtors and creditors have to take place outside the court. The same intermediaries can also be entrusted with the task of verifying submissions of debtors, and the claims of creditors. This will assume a lot of importance in India as documentation is weak, and disputes on claims may be large, at least in the early years of the system.

It is important to hold the intermediary accountable, and ensure minimum standards. A regulatory body to monitor the performance of IPs and discipline them as necessary is an important element in the system of personal insolvency. The regulator in Australia plays a larger role in the personal bankruptcy framework than the regulator in the UK, and is a model worth considering, given the problems with the judicial system in India.

A DRO equivalent is worth introducing for India for low-income households. An additional reason to consider this mechanism is that it will lead to formalisation of rules for loan waivers done by the state. Debt-relief has to come at some price, in the form of a record in a credit-registry, which may make it difficult for the person to take future loans. This forces individuals to evaluate the trade-off between relief in the present and expensive credit in the future, thus guarding against misuse of the provision.

These considerations have played an important role in the proposals of the Insolvency and Bankruptcy Code submitted by the Bankruptcy Law Reforms Committee (BLRC).


Ramann, S., Renuka Sane and Susan Thomas (2015), Reforming personal insolvency law in India, IGIDR Working Paper.

Renuka Sane is a researcher at the Indian Statistical Institute, New Delhi.

Macroeconomic conditions and outlook

I wrote a pair of columns in the Business Standard.

In A balance sheet recession? (14th December), I argue that we are in an unprecedented moment in India's history, where nominal GDP growth has slipped below the interest rate. This gives adverse debt dynamics. To achieve debt stability, a substantial fiscal correction is required in order to get to the required primary deficit. Firms also have adverse debt dynamics, with top line growth of 2.5% and interest rates of 13% and up. We have a balance sheet recession on our hands.

What will happen in the recovery? (29 December) thinks about how business cycle declines play out in India, where macro and finance policy are impaired and do little for stabilisation. Firms bear the brunt of the adjustment. Some firms exit, some firms get better. Capital and labour slowly move into the better firms. This sets the stage for the next expansion. This is roughly what happened from 1997 to 2002, and set the stage for the great expansion of 2002-2008, and may give us an insight into what comes next.

Friday, December 25, 2015

Building the institution of Insolvency Practitioners in India

by Anirudh Burman.


Some of the time, individuals directly consume goods or services without the requirement of an intermediary. For example, if one wanted to buy a telephone connection, one does not need expert advice on how to buy one, or which telephone connection to buy, and so on. In some other sectors however, there is a need for intermediation. For example, getting treatment for an ailment or a disease requires the expertise of a doctor who stands between the patient and treatments. Similarly, entering into legal transactions and resolving legal disputes requires the expertise of lawyers.

Generally, the need for specialised intermediation increases with the sophistication of a transaction and how critical it is in one's life. Such specialised intermediation gives rise to professions which provide these complex and critical services, such as chartered accountants, doctors, and lawyers.

The need for regulation of professions

Market failures can arise in transactions between customers and professionals owing to asymmetric information. Customers of specialised services are often not able to judge the knowledge of a professional and are not able to judge whether services that were promised and paid for were actually delivered. For example, in many cases, a person discovers much later that their doctor or lawyer gave them the wrong advice, or did not exercise adequate dilligence in their case. Under these circumstances, if the law mandates that certain services must be purchased from a professional, this merely creates rents for professionals.

The need to protect consumers then justifies government regulation of such professions. By setting minimum standards and entry requirements, and enforcing penalties against violations, the State can improve outcomes where consumers cannot easily understand ex ante, the quality of a product. This is particularly important where specialised knowledge or skill is involved. As a consequence, we now have many regulated professions in India.

The approach taken by the Indian legislature has, however, turned out to be inadequate. Our regulatory approach has generally been to recognise that such professions are special, and to grant recognition to one national self-regulatory body to set and enforce standards of conduct for all professionals in that sector.

For example, the Bar Council of India is a legally recognised self regulatory organisation that is the only national body setting and enforcing codes of conduct against lawyers. The Medical Council of India is a legally recognised SRO for doctors in India. Both these bodies, among other legally recognised SROs, are widely viewed as having failed in enforcing standards that are of benefit to consumers. There are few, if any disciplinary actions against errant lawyers and doctors that the BCI or MCI take. There is no regular examination or evaluation of professional skills. There is, hence, a need for fresh thinking in how professions should be regulated.

The failures of the existing arrangements is grounded in the weak institutional structure and legal framework surrounding self regulatory organisations. The existing SROs have badly defined incentives to protect consumers. Their incentives are instead, designed towards protecting their members.

A new approach to regulating professions

A new approach towards thinking about SROs is required (Shah, Rajagopal, Roy, 2013). This requires thinking of SROs as mini-states rather than clubs. A state exercises legislative (standard setting), executive (conducting exams, skill building, and investigating complaints), and judicial (imposing penalties) powers. An SRO must be designed so as to function as a mini-state rather than an insulated priesthood accountable to none.

One feature of regulatory design that can improve the working of SROs is competition. A competitive market of SROs would be one where multiple SROs in a sector compete to corner a greater share of consumers on behalf of its members. The relevance of a SRO would then depend on its reputation, and therefore the reputation of its member professionals. The UK for example, has multiple SROs for insolvency professionals, differentiated by the quality of their codes of conduct, their entry barriers, and consequently the quality of their members. The government objective of consumer protection is therefore enhanced by promoting a competitive field of SROs as opposed to the current system where SROs are legally recognised monopolies.

At the same time, if SROs become for profit entities, then there can be tension between the objective of business development for the shareholders as opposed to the regulatory function. In some situations, e.g. exchanges, where there are network effects, this can work fairly badly. The ownership and governance of SROs needs to be regulated to help ensure they are well incentivised to pursue the regulatory functions.

Version 1.1 of the draft Indian Financial Code has a treatment of these issues in the context of the laws governing Financial Market Infrastructure Institutions (FMII) which are mini-states with legislative, executive and quasi-judicial functions. The experiences in India of setting up exchanges, and dealing with the two extremes of an exchange which did not enforce against its own and an exchange which sacrificed regulatory functions in the quest for profits, have given considerable clarity on how to think about for-profit exchanges which are SROs that are mini-states.

SROs of insolvency professionals

In a recent paper (Burman and Roy, 2015), Shubho Roy and I propose design principles for a new regulated profession in India: insolvency professionals. This was part of the research that fed into the Indian bankruptcy reforms.

A good insolvency framework is beneficial for society as it allows for the efficient reorganisation of capital, and creates dynamism in the market. Additionally it enables sick firms and individuals to have a fresh start. Insolvency professionals provide sophisticated services to customers undergoing insolvency, or requiring assistance with regard to insolvency proceedings. Their intermediation is essential for ensuring good outcomes in an insolvency process. Insolvency professionals generally perform the following critical functions in the bankruptcy process:

  1. Nominee or supervisor of a voluntary arrangement.
  2. Interim Receiver.
  3. Trustee in Bankruptcy.
  4. Trustee under a Deed of Arrangement.
  5. Trustee of a Trust Deed for Creditors.
  6. Trustee of the insolvent Estate of a deceased individual.
  7. Administrator.
  8. Administrative receiver.
  9. Liquidator.

Insolvency practitioners need to be regulated because the lack of trust in their services would lead to an erosion of trust of the insolvency process. Secondly, in a bankruptcy process, insolvency practitioners act as agents of the state.

However, direct regulation of insolvency professionals by the government is not feasible in the long run. Like all sophisticated services, this profession will also devise its own norms and codes of conduct that are suited to changing needs of consumers. State intervention can actually retard, if not inhibit this process. Therefore, the creation of SROs of insolvency professionals is essential for the success of an insolvency and bankruptcy regime. This however does not mean that SROs be created with vague objectives and low accountability. Government regulation of SROs can play an important role in shaping the incentives of SROs and their members in order to produce the best possible outcome for consumers.

Government regulation of insolvency professionals must therefore do the following:

  1. Recognise and regulate SROs of insolvency professionals.
  2. Ensure that consumer protection be a key objective of insolvency professionals, that SROs must ensure.
  3. Ensure that SROs clearly define their internal legislative, executive and judicial powers in the best interests of consumers.
  4. Create well defined offences and penalties for errant insolvency professionals.
  5. Ensure a competitive market for SROs.
  6. Leave leeway for SROs of insolvency professionals to compete on parameters such as quality of members, entry requirements, codes of conduct and quality of grievance redress.

The Draft Insolvency and Bankruptcy Code

The Finance Ministry has published the report of the Bankruptcy Law Reforms Commission, which includes a draft law which is a unified framework for insolvency and bankruptcy processes for firms and individuals. It also proposes the creation of insolvency professionals and enables the licensing of multiple SROs of insolvency professionals. The Government has introduced a bill in Parliament, the "Insolvency and Bankruptcy Code, 2015", building on the draft law proposed by the BLRC. This step is welcome. However, some improvements to the proposed framework are essential in order to enable the profession to serve its purpose.

The Bill creates a regulator that will regulate insolvency professionals and IP SROs. The Bill does not mandate minimum governance structures for IP SROs. For example, it does not mandate the separation of legislative, executive and judicial powers. Critically, it does not place any emphasis on the independence and efficacy of the judicial function of disciplining IPs who are members of IP SROs. If consumer trust in IPs is to be developed and maintained, IP SROs have to be mandated to ensure that disciplinary actions against errant members are conducted impartially and efficaciously. Existing professions regulated by SROs face cynicism precisely because of the poor standards of enforcing discipline within the SRO.

An efficient insolvency and bankruptcy regime requires a cadre of insolvency professionals. Their services are both complex, and critical for the economy. The law must be clear in the regulatory objectives behind their regulation, and set certain minimum standards of performance for both IPs and IP SROs.


Anirudh Burman, Shubho Roy. Building the institution of Insolvency Practitioners in India, Working Paper, 2015.

Ajay Shah, Arjun Rajagopal, Shubho Roy. From clubs to States: The future of self-regulating organisations, Ajay Shah's blog, December 19, 2013.

Anirudh Burman is a researcher at the National Institute for Public Finance Policy.

Thursday, December 24, 2015

The regulatory difficulties of NBFCs in India

by Shubho Roy.

The founder of the Shriram Group, R. Thyagarajan, who is one of the most respected people in Indian finance, spoke to Forbes India expressing concerns about the things that are being done with the regulation of NBFCs. This is important food for thought for understanding the problems of Indian finance. He talks about how the NBFC sector is being stifled with regulation and the need for moving it away from the Banking Regulator. He points out that the mind-set and objectives of RBI, in regulating NBFCs in ways that are appropriate for banks, is killing the industry.

Banks and NBFCs are different, pose different problems for financial regulation, and should be regulated differently. RBI is smothering NBFCs by applying banking thinking for them, and is thereby hampering access to credit for the firms who obtain financing from NBFCs. The FSLRC approach offers logical answers to these questions.

What motivates regulation

Regulation must not degenerate into central planning; it must be motivated by the need to correct a precisely stated market failure. We must understand the anatomy of the market failure, and use the coercive power of the State at the precise root cause. Occam's Razor of Regulation implies that we should get the job done with the minimum use of force. The market failures associated with banks and with NBFCs are quite different. For banks, the market failure is consumer protection of unsophisticated depositors. This is the reason why we have detailed banking regulation. If there are no unsophisticated depositors in a lending institution, regulating them like banks is wrong, and harms the economy.

Consumer protection in banking regulation

When you deposit your money in a bank, you can go and withdraw the principal at any time you want. Even for fixed deposits, the principal is protected in the case of premature withdrawal.

How does a bank pay interest on money which you can withdraw at any time? Through loans. However, when a bank gives a loan: the bank gets repaid only as per the loan terms (and not when the bank needs money). If you take a home-loan or a car-loan for five years, the bank cannot come and ask you to repay the entire money before the five years are up (unless you default). The bank can only ask for the regular predefined installments. No bank can come to you (a borrower) and say:

"a lot of people are withdrawing money this month, so please pay up your five year car loan, ahead of time, this month."

Similarly, when you (depositor) go to withdraw the money from a bank the bank cannot say (legally prohibited):

"a lot of people have delayed their loan repayments so you cannot withdraw your money today, come back after a few months."

These types of deposits are technically called deposits callable at par. i.e. Deposits you can withdraw at any time without losing the principal.

Contrast this with a term loan or a bond/debenture. When you buy a five year Tata Motors debenture in the debt market, cannot withdraw it at par before the debenture matures. i.e. If you go with the debenture to the offices of Tata Motors before the five years are up, Tata Motors has no legal obligation to repay the loan amount in the debenture. You can only get your principal and interest payments as per the terms of the debenture and not a minute before that. You may sell your debenture to someone else (secondary market), but that is not the same as getting your principal back from Tata Motors. In the secondary market you have no assurance you will get your principal amount back.

Ensuring that households are able to withdraw their deposits, whenever they need it, is not trivial. Whenever a bank fails do it, eventually, there is a run on the bank. A run happens when you households panic that their life savings will be destroyed and queue up to get withdraw their deposits. Governments know (from the history of bank failures) that you cannot trust banks to pay up to households on time. Therefore, countries create banking law and corresponding banking regulator to check the banks.

Three important components of these regulations are:

  1. Deposit Ratios: This requires the bank to lend out only a part of its deposits, say 80%. The bank has to keep the rest for withdrawals on any given day.
  2. Equity buffers: Banks are required to have a certain minimum equity capital. As an example, in India, the leverage of the banking system is roughly 20 times, which means that for each 20 rupees of total assets there is 1 rupee of equity capital. This acts as a buffer against losses as the shareholders bear the loss.
  3. Loss Recognition: Banks are forced to recognise losses and write them off using equity capital, so as to not subvert the intent of the equity buffer.

Banks have the incentive and capability to cover up bad news about the loans they have made. If banks admit they have bad loans then the banking regulator forces them to raise money from other sources (equity market). Raising money from the equity markets is hard, expensive and, dilutes existing shareholders. Normally, a bank likes to hide and delay the fact that debtor is not repaying as long as possible.

Unlike sophisticated creditors, you and I are unable to really understand the balance sheet of a bank. I cannot judge whether the bank will have enough money to repay a fixed deposit five years from now. Without a financial agency looking over banks every day, it is easy for banks to lend money profligately and end up defaulting to depositors.

The oversight of the financial agency, and the checks imposed by these regulations, are not without benefit to banks. In return for complying with all these regulations, the government encourages the general public, to keep money in banks. The government and the central bank extends a guarantee of safety in bank deposits. The Jan Dhan Yojana does not encourage you to buy corporate bonds but put money in bank deposits. The government runs a deposit insurance program to protect helpless households who have deposits with banks.

NBFC regulation

Non-Banking financial companies should be what their name suggests: non-banks. Sadly, this was not the case for India till about a decade ago. Because, there were few banks, Indian laws allowed NBFCs to also take deposits callable at par. i.e. Take money from depositors (unsophisticated savers) which the depositors could withdraw at any moment (working hours). These were called NBFC-Deposit Taking.

Over the last few years, RBI has gradually removed this category. Today, most NBFCs take money from the bond market or term loans (sophisticated depositors). There are no unsophisticated depositors in most NBFCs today. Since there are no unsophisticated depositors who may need their money immediately on demand, there is no consumer protection angle from deposits.

However, in spite of closing down most deposit-taking NBFCs, RBI continues to regulate NBFCs like banks, requiring them to keep liquid funds (in government securities) and also recognise problematic loans and keep capital against it. This defeats the very purpose why NBFCs are prohibited from taking deposits callable at par from household. If you are not taking deposits callable at par from households, you can go and make risky loans which banks are not going to make. There is no point in recognising and regulating NBFCs, if they are forced to meet banking regulations. We may as well call them banks and allow them to collect deposits callable at par.

The FSLRC approach

FSLRC does not indulge in artificial distinctions between banks and non-banks. It has a clear functional test for designating something as a bank or not:

Are you taking deposits from the public?

If you are; you are a bank; and you will be regulated like a bank; by the banking regulator. If you are not; then you are not a bank and you will not be regulated as a bank.

It takes care of concerns of shadow banking (entities taking deposits callable at par without complying with banking regulation) with a principled based approach. All the regulator has to test is if an entity is taking deposits callable at par. Then whatever be its name, it should be regulated like a bank.

FSLRC recommendations are driven by informed analysis of the need for regulation. Banks have unsophisticated consumers on both sides of the balance sheet and therefore the regulations have to address the consumer protection issues on both sides of the balance sheet. NBFCs on the other hand have unsophisticated consumers only on the side of borrowers. There are no depositors in an NBFC in the same sense as banks.

FSLRC recommended that financial firms which do not do this activity should not be regulated like banks and therefore not be regulated by the banking regulator. FSLRC does not leave NBFCs out of regulation. It concentrates regulation of NBFCs in two areas:

  1. The protection of unsophisticated consumers who borrow from NBFCs, in line with regulation on consumer protection.
  2. Systemic risk regulation, which would be done in a consistent way for all systemically important financial firms, some of which may be NBFCs.

The concerns of systemic risk however is not limited to NBFCs. Systemic risk regulation cross-cuts across all segments of the financial sector and has its own set of instruments/regulations which are not the same as the ones in banking regulation.


Mr. Thyagarajan reminds us that it's broke. We should fix it. He recommends that the central bank should not regulate the NBFC sector. The intellectual framework for regulating banks and NBFCs is so different that the same regulator cannot do it. India has a few large and stable businesses which banks can lend to. However, most of India's growth will come from new businesses which are small and risky. The small entrepreneur who buys a truck will face liquidity shocks (will miss a few of the regular installments). As long as such entrepreneurs are not being funded with household safe savings, there is nothing wrong in that. NBFCs have to be different from banks, they should be more risk taking. And yes, more of them will fail, but it will not harm the unsophisticated savers.

Regulation should be based on some rational requirement to address market failures. Without identifying market failures, regulations are no more than arbitrary injunctions from the powerful which serve no purpose.

Shubho Roy is a researcher at the National Institute for Public Finance and Policy.

Wednesday, December 23, 2015

Foreign investment in Indian pooling vehicles: FEMA gets creatively flexible

by Bhargavi Zaveri.

On November 16, 2015, RBI issued a notification allowing pooling vehicles registered with SEBI to raise funds from non-residents. The notification marks several firsts in the history of FEMA. First, it allows non-residents to subscribe to units of trusts and companies which are engaged only in the business of making downstream investments.1 Second and more importantly, it allows funds which are fully raised abroad to override the framework on capital controls, so long as the sponsor and manager of the fund are Indian owned and controlled. This constitutes an important step forward in capital account liberalisation, within the unsavoury strategy of requiring that money is routed through Indian owned and controlled funds.


From 2012 onwards, SEBI implemented numerous frameworks for registering and regulating funds set up in India. These frameworks classified funds into different categories (such as real estate funds, infrastructure funds, venture capital funds, hedge funds, etc.), depending on the objectives of the fund. Thus, funds meant for investment in real estate were regulated differently from funds meant for investment in infrastructure. Funds other than those investing in real estate and infrastructure were regulated differently. The SEBI-frameworks explicitly enabled these funds to raise money from non-residents 2. However, pending amendments to the relevant FEMA regulations, Indian funds could not directly raise money abroad.

Nearly three years after the implementation of the first of such frameworks, the RBI notification allows non-residents to subscribe to units of funds registered with SEBI.

Regulating downstream investments by funds

While it is easy to propose capital controls in the form of sectoral caps on foreign investment, there is tremendous complexity in writing law and enforcing it. For instance, the rule is that Indian companies, which are owned and controlled by non-residents may invest downstream on the same conditions as the foreign investor herself could have made such investment.3 The idea is that one cannot do indirectly what she could not have done directly. How does one address this problem in the case of pooling vehicles having foreign investment?

The notification addresses the problem by attributing the nationality of the asset manager and sponsor to the nationality of the fund corpus itself. 4 It provides that where the asset manager and sponsor are not Indian owned and controlled, the fund corpus will not be regarded as Indian owned and controlled.

As a natural corollary, where the asset manager and sponsor are Indian owned and controlled, the fund corpus will be regarded as Indian owned and controlled (notwithstanding that the fund is raised abroad). Consequently, the capital controls framework will not apply to the downstream investment made from such fund.5

When is an asset manager or sponsor "Indian owned and controlled"?

This gets us to the question as to when can an asset manager be regarded as Indian owned and controlled. Going by FEMA 6, an asset manager is Indian owned and controlled, if:

  1. More than 50% of its capital is beneficially owned by resident Indian citizens or companies which are ultimately owned and controlled by resident Indian citizens; and
  2. Majority of its directors are appointed by and the management and policy decisions, are made by Indian resident citizens or by companies which are ultimately owned and controlled by resident Indian citizens.

The same principle applies to a sponsor for it to qualify as Indian owned and controlled.

Linking downstream investment to ownership and control of asset manager and sponsor

Attributing the nationality of the asset manager and sponsor to the nationality of the fund means that an asset manager and sponsor which is Indian owned and controlled, may raise the entire fund abroad. But the fund will be regarded as Indian money for the purpose of downstream investment. Such a fund can then be potentially invested in real estate business, in which foreign investment is otherwise prohibited, or even in the insurance sector, where there is a cap on foreign investment.

Presumably, the character of the fund is attributed to the character of the asset manager and sponsor, for ease of administration of the capital controls framework. This is because, one cannot control the transfer of fund units to non-residents.

Simply put, today, if a 100% domestic fund acquires say, more than 49% (the present sectoral cap) in an Indian insurance company, the regulator cannot control the transfer of the units of that fund by domestic investors to non-residents. It will be impossible to alter the downstream portfolio of the fund depending on the ownership of the fund.

Matters get complicated even further where a completely domestic fund has made downstream investments in sectors which have FDI-linked conditions (such as retail or NBFCs). If the domestic investors in such a fund transfer their investment to non-residents, again, the rules regarding FDI-linked conditions would be subverted. Take a 100% domestic fund which invests in retail. Now, FDI in retail is allowed subject to compliance with minimum sourcing and other norms. If the investors in the fund transfer their units to non-residents, then the downstream retail company (in which the fund has invested) will have to begin complying with domestic souring norms, etc. It is impossible to monitor this kind of compliance and also practically not feasible for the downstream company to change their sourcing strategies depending on the ownership of (what may be one of many) investors.

On the other hand, it is easier to monitor the control and ownership of the sponsor and the asset manager. Hence, the fix.

Better than some worse alternatives

This approach is creatively flexible, and is better than some things which could have been done. For instance, another tool that the regulator could have adopted to address the problem of subversion of sectoral caps, is to restrict the transferability of units of funds which have made downstream investments in sectors prohibited for FDI or restricted sectors. This would have left investors worse-off with restricted liquidity. The current approach reflects the progressive attitude of the administration. It potentially dispenses with sectoral caps and FDI-linked performance conditions that FEMA stipulates for various sectors.

The method, however, raises two concerns:

  • The rule creates incentives for a foreigner who wants to set up an asset management company in India to tie up with an Indian entity (and give majority ownership and control to an Indian) to make sure that she is able to raise funds from abroad. Only then will the fund be treated as Indian to enjoy the flexibility of making downstream investments in sectors restricted or otherwise prohibited for downstream investment. The rule, thus, creates a protectionist bias in favour of residents. This would, in general, diminish the quality of fund management services that emerge out of the competitive market for fund management.
  • What will happen to existing downstream investments made by the fund if the Indian asset manager wishes to sell his business to a non-resident? Will the downsteam investment be wound up if they are in a prohibited or restricted sector?

Succumbing to the temptations of FEMA-style policy thinking

In some respects, the notification has, however, yielded to the discretionary framework that pervades FEMA. For instance, the notification allows foreign investors to transfer or redeem the units of such funds on terms and conditions specified by RBI and SEBI. This approach suffers from the following flaws:

  • The pricing of units in a fund is linked to the NAV of the fund. There are no restrictions on the transfer of units of such funds between domestic investors. We must stop imposing different standards for transfer of securities between domestic investors inter-se and non-residents.
  • Today, there are no restrictions on the transfer of units of mutual funds bought by foreign investors. This principle should hold true for all pooling vehicles.
  • Reliance on future directions issued by SEBI and RBI adds to uncertainty and discretion, which has been repeatedly written about here, here and here.

Similarly, it states that since it is difficult to identify whether a LLP is Indian owned and controlled, a LLP cannot act as an asset manager or sponsor of the fund. Now, this is taking the ease of administration argument too far.


While the notification has shown maturity in dealing with the problem of downstream investments by pooling vehicles, it remains to be seen whether the administration will be able to shrug off its long standing bias in favour of sectoral caps, and the mindset of FEMA, and allow this new framework to actually operate.



  1. Hitherto, foreign investment in a purely holding company could be made only under the approval route. Similarly, foreign investment in trusts, except a mutual fund and VCF, was prohibited. If the VCF was structured as a trust, foreign investment was allowed only under the approval route. Back
  2. See Regulation 10(1) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, Regulation 14 of the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations, 2012. Back
  3. See Regulation 14(6) of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back
  4. The notification states: Downstream investment by an Investment Vehicle shall be regarded as foreign investment if neither the Sponsor nor the Manager nor the Investment Manager is Indian `owned and controlled' as defined in Regulation 14 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back
  5. The notification expressly states that the extent of foreign investment in the corpus of the Investment Vehicle will not be a factor to determine as to whether downstream investment of the Investment Vehicle concerned is foreign investment or not. Back
  6. Regulation 14(1) of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back

Bhargavi Zaveri is a researcher at the National Institute for Public Finance and Policy.

Tuesday, December 22, 2015

Author: Bhargavi Zaveri

Bhargavi Zaveri is a researcher at the Indira Gandhi Institute for Development Research.

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Firm insolvency process: Lessons from a cross-country comparison

by Rajeswari Sengupta and Anjali Sharma.

Recent moves in Indian bankruptcy reform have come about as a response to a broken system that has been termed `capitalism without exit'. Table 1 shows estimates on Resolving Insolvency parameters from the World Bank's `Doing business' database in 2015.

Indicator India South Asia OECD
Time (years) 4.3 2.6 1.7
Cost (% of estate) 9.0 10.1 8.8
Recovery rate (%) 25.7 36.2 71.9
Outcome (0=piecemeal sale; 1=going concern) 001
Strength of insolvency framework index (0-16) 6 5.6 12.2
Domestic financial credit to GDP (%) 74.8 69.5 210.8



A comparative law perspective

In a recent paper (Sengupta and Sharma, 2015) we study the corporate insolvency resolution frameworks of the UK and Singapore, compare these with the existing framework in India and draw lessons for Indian bankruptcy reform. This paper was part of the research process that led up to the report of the Bankruptcy Law Reforms Committee (BLRC).

The UK, Singapore and India are all ostensibly common law jurisdictions. However, bankruptcy law has evolved in different ways in each of the three countries, and the outcomes are very divergent. On the Resolving Insolvency indicator of the World Bank's `Doing Business' Report, 2015, the UK ranks at 13, Singapore ranks at 27, and India has a rank of 136.

The size and structure of their credit markets (Table 2) are also very diverse. The Indian credit market is relatively small and bank-dominated. The UK and Singapore have larger credit markets, and bigger bond markets.

Indicator UK Singapore India
Rank 13 27 136
Time (years) 1.0 0.8 4.3
Cost (% of estate) 6.0 3.0 9.0
Outcome (0=piecemeal sale; 1=going concern) 1 1 0
Recovery rate (%) 88.6 89.7 25.7
Domestic financial credit to GDP (%) 171.5 126.3 74.8
Bank credit to GDP (%) 85.3 56.5 93.1

Each country is at a different stage of building its corporate insolvency framework. The UK started out with a reasonably sensible common law system, and has undertaken two rounds of significant reform, in 1986 and in 2002. The Insolvency Law Reform Committee (ILRC) of Singapore, set up in 2010, submitted its recommendations in 2013. India began on this journey in 2014, with the establishment of BLRC by the Ministry of Finance.

Institutional mechanisms

Figure 1 above shows the corporate insolvency procedures of the three countries. In the UK and in Singapore, the formal procedures are contained in a single law (except Scheme of Arrangement in the UK which is contained in the Companies Act), whereas in India they are fragmented across many laws.

Till 1985, in the UK, corporate insolvency was placed in the Companies Act. In 1986, the UK enacted the Insolvency Act, a comprehensive law dealing with insolvency of companies and individuals. In Singapore, the Companies Act is the primary corporate insolvency law, and contains procedures for reorganisation and liquidation.

In India, the Companies Act 1956 and 2013, has (deficient) provisions for liquidation. Reorganisation is available only to certain types of industrial companies, through the Sick Industrial Companies Act (SICA 1985).

In addition, the UK and Singapore laws deal with interaction of the insolvency law with other laws of the land through a combination of judicial interpretation and legislative carve-outs. This appears to work well for them, as they are ultimately getting good outcomes. In India, the interaction between laws is fraught with complexity and this, combined with judicial capacity constraints, has been one of the causes for delays in resolution (Ravi, 2015).

Lesson 1: We require a single, consolidated law with well defined interaction with other laws.

Institutional setting: courts

The judiciary is an integral part of the insolvency resolution process. In the UK and in Singapore, a single adjudicating authority presides over insolvency proceedings. The Chancery Division of the High Court in the UK hears corporate insolvency matters. In Singapore, the High Court, equipped with adequate capacity, exercises significant discretion in dealing with insolvency proceedings.

In India, multiple adjudicating forums deal with liquidation and reorganisation matters. High Courts hear liquidation cases under the Companies Act, while the Board for Financial and Industrial Reconstruction (BIFR) hears reorganisation cases under SICA. High courts are often found reviewing BIFR decisions afresh, causing further delays in proceedings (Ravi, 2015).

Courts in India are challenged by serious capacity constraints. This is reflected in their high levels of pendency. The average pendency of BIFR cases is 4.5 years. Anecdotal evidence suggests that pendency of liquidation cases in High Courts is 9-10 years. Considerable new work is required in order to make courts work (Datta and Shah, 2015).

Lesson 2: We require a single adjudicating authority with adequate capacity to ensure timeliness in adjudication.

Lesson 3: We need to precisely define the role of the adjudicating authority and build capacity at courts commensurate with their role in the process.

Institutional setting: insolvency professionals

Insolvency professionals ("IPs") play a central role in insolvency proceedings. The UK has a private, competitive industry of IPs regulated by the government. Multiple self regulating organisations (SROs) monitor and enforce standards for licensing and practice. These SROs are, in turn, regulated by an executive body of the Ministry of Business, Innovation and Skills.

In Singapore, the Insolvency and Public Trustees Office of the Ministry of Law empanels and regulates a private industry of IPs. The Companies Act defines the qualifications required for becoming an IP.

In India, a public financial institution or a scheduled bank acts as an Operating Agency (OA) in reorgnisation cases under SICA. Official Liquidators (OL) are appointed by the central government and attached to each High Court. The provisions for appointment of OLs are in the Companies Act. Both OAs and OLs face capacity challenges. Their roles and incentives in the insolvency resolution process have been heavily criticised (Eradi, 2000).

Lesson 4: We require a private competitive industry of insolvency professionals.

Lesson 5: We require strong oversight regulation to enforce minimum standards of professional and ethical conduct, and to formulate correct incentives for insolvency professionals.

Comparison of procedures: Reorganisation

Administration in the UK, Judicial Management in Singapore and BIFR filings in India are the formal reorganisation procedures. The main procedural differences across the three countries are:

  • In the UK and in Singapore, th reorganisation procedure can be initiated by both debtor and creditors. In India, the primary onus for initiating the procedure lies with the debtor. Creditors have low power when faced with default. The metaphor employed in India is that of a sick patient who seeks out medical care on his own.

  • In the UK, the process can be triggered on the basis of actual or impending insolvency. In Singapore, evidence of inability to pay debts is required. In both countries, early signs of financial distress can cause the debtor to trigger. In India, erosion of balance sheet networth is required as a trigger for the reorganisation procedure. This disincentivises early triggering by debtors.
  • Both in the UK and in Singapore, the existing management loses control of the company upon trigger. A moratorium on creditor actions and legal suits is enforced for a defined period of time. In India, the existing management retains control during the reorganisation process. They may have greater information, but their objectives may not be aligned with the creditors.

  • Both in the UK and in Singapore, a committee of creditors vote on the reorganisation plan. In India, the BIFR adjudges and approves the plan. Creditors' rights are weak throughout the insolvency proceedings.

  • In the UK, the Administrator is generally appointed by the debtor with consent of creditors. In Singapore, a Judicial Manager is appointed by the court and is monitored by a committee of creditors. In India, the OA under SICA is appointed by and acts under directions of the court. Creditors have no say in matters concerning OAs.

  • The court's role is the least in the UK. The court there mainly acts as a body for dispute resolution and providing guidance to the Administrator. The court in Singapore plays a more active role in the resolution process. In India, BIFR as a subordinate of the High Court plays a critical role in deciding on the rehabilitation plan.

Lesson 6: We require early triggering of the resolution process. We require both the debtor and the creditors to have the ability and the incentives to trigger early.

Lesson 7: We need to ensure that assessmement of viability of a company is done by concerned parties. Courts should merely aid but not adjudicate upon this decision.

Lesson 8: We require a design that would set the correct ex ante incentives for all parties. For example: penalty for fraudulent or frivolous triggers, loss of control by existing management in exchange for a moratorium, and safeguards against abuse of process by debtor, creditors and IP.

Comparison of procedures: Liquidation

In the UK, Singapore and India, liquidation precedes winding up of a company. In the UK, winding up is a remedy available under the Insolvency Act, 1986. In Singapore and in India, it is available under their respective Companies Acts.

The three countries follow similar liquidation procedures. Both creditors and the debtor can trigger liquidation which can be voluntary or court ordered. In the UK and in Singapore, creditors nominate the liquidator, and the court usually accedes to this nomination. In India, an OL is appointed by the High court for liquidation proceedings.

The major difference lies in the time taken for liquidation proceedings to be completed. In both the UK and Singapore, liquidation proceeding may get completed within 1-2 years. In India, liquidation proceedings continue for 9-10 years on an average, and up to 25 years in some cases.

Liquidation should act as a credible threat that keeps the debtor and creditors on the negotiation table during insolvency procedings. Delays of the type witnessed in India reduce confidence in the formal resolution framework.

In addition, secured creditors need to know that they will receive priority in liquidation payments to the extent of their security. The rights of unsecured creditors need to be protected as well, to promote diverse credit sources in the economy. In the UK for example, the Crown gave up its priority on tax dues in exchange for a defined amount of payment to unsecured creditors. A well defined priority of distribution of liquidation proceeds is also needed to provide all creditors with the ability to estimate their loss-given-default.

In India, secured creditors prefer to use individual enforcement under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI 2002) over the formal framework for insolvency resolution. This is because in the latter, their rights are pari passu with workers. This creates a bias against selling a firm as a going concern, and thus reduces the recovery rate.

Lesson 9: We require timely and effective liquidation.

Lesson 10: We require a well defined priority of distribution of liquidation proceeds. This sets ex ante incentives for development of credit markets as well as for use of the formal resolution framework by various classes of creditors.


An analysis of laws and procedures of the three countries yields important lessons for corporate bankruptcy reform in India. These have been incorporated in the BLRC Report:

  1. A single, consolidated Code.
  2. A single adjudicating authority supported by a court administrative unit.
  3. A regulated but private and competitive industry of insolvency professionals.
  4. A collective, time bound process to assess viability of the company.
  5. Assessment of viability during a calm period by concerned parties.
  6. Moratorium on claims, balanced by transfer of control of the company from debtor to IP.
  7. Creditors' rights to trigger insolvency proceedings and vote on a resolution plan.
  8. A timely liquidation process and well defined waterfall of priorities.

Enacting a draft bill containing these provisions is only part of the reform process. Effective insolvency resolution will depend to a large extent on the manner in which these provisions are implemented and the enabling infrastructure is set up. What works in Singapore and the UK is not just the de jure status, but the State capacity in the institutional machinery through which the law is enforced. In absence of a proper implementation plan, the entire reform process may become an exercise in 'isomorphic mimicry'.


Eradi, V. B. (2000),"Report of the Committee on Law relating to Insolvency of Companies".

Datta, Pratik and Shah, Ajay, How to make courts work?, Ajay Shah's blog, 22 February 2015.

Ravi, Aparna (2015), "Indian Insolvency Regime in Practice: An Analysis of Insolvency and Debt Recovery Proceedings", Economic and Political Weekly, Volume 1, No. 51.

Sengupta, Rajeswari and Sharma, Anjali (2015), "Corporate insolvency resolution in India: Lessons from a cross-country comparison", IGIDR Working Paper 2015-29, December.

The authors are researchers at the Indira Gandhi Institute for Development Research, Bombay.

Author: Anjali Sharma

Anjali Sharma is a researcher at the Indira Gandhi Institute for Development Research.

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Ordinances on Commercial Courts and the Arbitration Act: Analysing the process problems of drafting law

by Vrinda Bhandari.

In the midst of the Bihar elections and parliamentary logjam, the fact of the President promulgating two ordinances on 23rd October to amend the Arbitration and Conciliation Act, 1996 ("AC Act") and to enact the Commercial Courts, Commercial Division and Commercial Appellate Division of High Courts Ordinance 2015 has largely gone unnoticed. Aimed at the speedy settlement of commercial disputes, both ordinances derive largely from the draft Bills prepared by the Law Commission of India ("LCI") in its 246th and 253rd Report respectively. Nevertheless, they have had slightly different trajectories - the Arbitration Act amendments received Cabinet clearance in August, although they were not introduced in Parliament; while the Commercial Courts Bill was pending before a Parliamentary panel, which was due to give its report on 30th November (and which is still due).

Recently, an article by Ajay Shah offered 11 principles to improve the processes used in drafting law. In this article, I utilise this as an organising framework to critique the processes used for these two ordinances. Before starting, it is important to provide some context to the two ordinances – the principal motivation behind the AC Act was to reduce excessive judicial interference in the arbitration process, particularly in challenges to appointment of arbitrators and arbitral awards. The Supreme Court’s expansive construction of “public policy” in a challenge under s. 34 of the Act had made arbitrations as costly and time consuming as litigation. This was undermining the objective of speedy dispute resolution, whilst simultaneously introducing uncertainty for those doing business in India. Similarly, the Commercial Courts Ordinance is as an attempt to create a separate track for dealing with commercial disputes to ensure that these disputes are extracted from the otherwise stagnant civil justice system, with its low case disposal rate.

The drafting process

Let's start by describing the drafting process of the two ordinances. In case of the AC Act, the Law Ministry asked the LCI to study its proposed amendments, pursuant to its `Draft Note to the Cabinet'. The LCI constituted an expert committee comprising both Senior Counsels and junior lawyers. It also received written submissions from various lawyers (including government counsel) and organisations such as FICCI, CII and ASSOCHAM and held meetings with former judges (including the author of the previous LCI Report on the AC Act amendments).

For the Commercial Courts Ordinance, the Law Ministry referred a 2009 Bill on the subject to the LCI. Consequently, the LCI issued a "First Discussion Paper" specifying the defects in the Bill and its proposed changes and sent it to an expert committee, comprising sitting judges, Senior Counsels and junior lawyers. Based on their feedback, LCI issued a "Second Discussion Paper" and a draft Bill, which was then circulated to the Bar in Delhi, Madras and Bombay for comments. Subsequently, a small team (including policy specialists) finalised the draft Bill.

Based on these draft Bills and the internal deliberations of the Cabinet, the government issued the two ordinances, after making various changes. In this background, this post now considers compliance with the 11 principles and the impact they had on the outcome.

We now work through the 11-fold path to drafting better laws.

1. Be wary of incumbents. "Do not judge your own cause":

The first principle of good drafting is to exclude the incumbent agencies, directly affected by the law, from the drafting process. This prevents the draft law from providing more power and less accountability for the incumbent agency. To some extent this was avoided in the AC Act amendments because the LCI involved commercial organisations, lawyers and judges (with arbitration experience), each with their own vested interests. This helped balancing out incentives, and enabled the introduction of proposals for a new costs regime (adversely affecting lawyers/litigants) and incorporating the International Bar Association's Guidelines on Conflict of Interest (adversely affecting arbitrators' interests).

LCI's extensive consultation during the drafting of the Commercial Courts Bill, and the selection bias in terms of the lawyers who took time to respond, meant that new measures were also introduced against the natural incentive of lawyers/litigants to delay proceedings. Thus, s. 16 provides for amendments to the Code of Civil Procedure (“CPC”) and includes a costs regime, case management hearings, time limits etc.

2. Malleability vs. the agency problem:

Good laws achieve flexibility or “malleability” by leaving procedural details to subordinate legislation, without it empowering the incumbent agency to undermine the objectives of the principal law. This is not as much of an issue here since the current ordinances do not envisage the establishment of a separate agency.

Pertinently, however, malleability is achieved in the case of the Commercial Courts Ordinance by s. 3, which leaves the constitution of the Commercial Courts to the discretion of the State Government, to be exercised in consultation with the concerned High Court. Similarly, the Chief Justice of each High Court having ordinary original civil jurisdiction, i.e. Delhi, Bombay, Madras, Calcutta, and Himachal Pradesh, has the discretion to decide whether to constitute a Commercial Division in that High Court. The Ordinance, therefore, provides the requisite flexibility to the State Governments and the High Courts to decide if, and when, to take advantage of the Ordinance based on their specific local requirements. Thus, the Delhi High Court is the first Court to notify the constitution of Commercial Divisions and Commercial Appellate Divisions as per the Ordinance.

3. The Joint Secretary cannot manage these projects:

It is easier for a dedicated team, as opposed to a Joint Secretary, to put in the time and effort required to draft a new law. As discussed, the process of drafting these two ordinances was substantially different, inasmuch as it involved the LCI's team and not senior government officials. To that extent, these ordinances are a much-needed improvement from status quo.

However, using LCI drafts’ as the basis for ordinances is not a permanent organisational solution, since that makes it contingent on the composition of the LCI, which changes every three years. Interestingly, the 20th LCI, chaired by Justice A.P. Shah was unique in its involvement of external consultants, lawyers, academics and policy specialists and introduced the norm of drafting Bills instead of just giving suggestions to the government.

Moreover, the overall practice of promulgating ordinances should proceed with caution. Ordinances involve no pre-legislative public consultation or parliamentary debate, which help remedy the (inevitable) problems with drafting. Any subsequent change, when the ordinance is finally approved by Parliament, can create further uncertainty in the interpretation of law in the intervening period.

4. Writing law is different from reading it:

The process of writing good laws requires combining specialist knowledge with public administration skills. The current ordinances have been primarily drafted by lawyers with domain knowledge, but no skills in public administration. The modifications to the LCI draft were, however, made by the Law Secretaries/Ministry officials. However, in both cases, the LCI had drafts to work with -- the existing AC Act and the 2009 Commercial Courts Bill. So the LCI did not have to start from scratch. Further, the laws itself were relatively simpler, and thus easier to draft than the two big recent laws, the Indian Financial Code and the Insolvency and Bankruptcy Bill, 2015.

5. No premature coding:

Ajay talks about the importance of the ‘thinking process’ as a necessary preamble to drafting reasoned and well-written laws to prevent `repentance in leisure'. The LCI followed a substantive `thinking process’ with the Arbitration and Commercial Courts Reports taking nearly four and two years respectively, at least on paper. Both draft Bills were supported by a comprehensive report that explained the rationale for the proposed amendments and the reasons for disagreeing with previous suggestions. Further, as explained above, each report was preceded by interim consultation papers, which helped capitalise on specialist domain knowledge. These processes illustrate that there was no premature coding, at least at the LCI’s end.

6. Access control in the drafting or editing process:

The absence of premature coding has to be accompanied with giving control of the editing process only to a small team, steeped in the drafting process. This was completely absent in the present case, since LCI's draft Bills (prepared by a small team after extensive deliberation) were edited/modified by an entirely different team at the government secretariat. In fact, the first draft of the Arbitration Ordinance was never sent to the President for assent, after serious objections were raised to some of its clauses, including a mandatory time limit of 9 months for an arbitrator to decide arbitrations. Consequently, the government consulted Justice Shah and other jurists. Nevertheless, they were not consulted on the second and final draft of the Ordinance. In addition, the original LCI drafting team never saw the changes made by the government, since they were not available to the public, and had no inputs. This has resulted in problems.

For instance, s. 29A introduced by the Arbitration Ordinance fixes a time limit of 12 months (18 months by consent) to make an arbitral award, after which the arbitrator's mandate shall terminate, unless the Court extends the period. This one-size-fits-all approach ignores the possible complexity, volume of material and multitude of parties/contracts before the arbitrator. It marks a return to the pre-1996 stand of increased judicial involvement and even incentivises respondents to delay proceedings.

Conversely, s. 29A(2)'s provision giving additional fees to arbitrators for making the award within 6 months prioritises speed over quality, which is equally dangerous because the grounds for judicial interference to set aside awards are very narrow.

Further, the Arbitration Ordinance omitted the LCI's recommendation to provide for emergency arbitrators in s. 2(d), in line with SIAC Rules and international practice.[1] Further, while accepting the LCI's recommendations to require the disposal of a s. 34 objection petition to a domestic award within one year, the Ordinance ignored similar recommendations for a one-year disposal limit to s. 48's conditions for enforcement of foreign awards. Such significant errors may not have crept up if the same team had drafted and edited the law.

7. The need for continuity and absorption:

The above examples illustrate the drawbacks of not having a continuity of personnel drafting and editing a single law. Good drafting requires continuity so that the team can understand the impact of changes in one section on another section. The advantage of continuity is seen with the speed with which the LCI drafted a Supplementary to Report No. 246 to undo the Supreme Court's wide construction of "fundamental policy" in ONGC v Western Geco, one month after the decision. This amendment was incorporated as an Explanation to ss. 34(2)(b) and 48(2)(b) of the AC Act, displaying the advantages of absorption.

However, to add to Ajay’s principle, it is also important to retain continuity amongst those drafting different laws within the same field. The Delhi High Court (Amendment) Act, 2015, which was passed and notified on 26.10.2015, increased the pecuniary jurisdiction of the High Court from Rs. 20 lakhs to Rs. 2 crore. Merely a month later, the Commercial Courts Ordinance, with its wide definition of 'commercial dispute' was notified in Delhi on 17.11.2015. The cumulative effect of both the Amendment and the Ordinance is that the High Court has jurisdiction over all commercial matters over Rs. 1 crore, while all civil disputes valued less than Rs. 2 crore have been shifted to the trial courts in Delhi. The LCI in its 253rd Report recommended setting the pecuniary jurisdiction of the Delhi High Court at Rs. 1 crore to prevent such an anomaly. Now, disputes valued between Rs. 1-2 crore will be decided by the trial courts, even though disputes above Rs. 1 crore have been benchmarked as being likely to involve technical issues requiring specialist judges or benches.

The notification of the Amendment and the Ordinance almost simultaneously can be seen either as a means of appeasing the influential High Court lobby (to retain business for the High Court lawyers) or a case of one hand of the government not knowing what the other is doing. In either case, a harmonious interaction between the laws could have been achieved by fixing the pecuniary limit at Rs. 1 crore.

8. Break with our traditional writing style:

Most of our laws introduce uncertainty because they are unnecessarily complex. They are not simple to read and are not to the point. The two ordinances seem better drafted, with the Commercial Courts Ordinance incorporating the LCI's illustration in s. 35 CPC on imposing costs on decree-holders. However, there is still a long way to go till we adopt the British system of drafting simple laws with illustrations, e.g. the IPC in India.

9. Gear up for a detailed law:

Good laws are not simple high-level statements and have sufficient detail to account for different circumstances. Both the current ordinances follow this principle and are detailed codes.

For instance, the Commercial Courts Ordinance has introduced comprehensive amendments to the CPC to deal with the award of costs. These specify what constitutes costs; the circumstances to be considered while awarding costs; and the range of orders that can be made by Courts under the provision. Similarly, the Arbitration Ordinance introduced the Fifth Schedule detailing different circumstances that give rise to justifiable doubts about the independence or impartiality of the arbitrator, with the Sixth Schedule containing the form of the arbitrator’s disclosure. The newly introduced Seventh Schedule lists the categories of relationships between the proposed arbitrator and the parties/counsel/subject matter that would make the person ineligible to be appointed as arbitrator.

10. Given enough eyeballs, all bugs are shallow:

Good drafting requires an elaborate process of peer review and public consultation to identify flaws beforehand. While the Bills prepared by the LCI were peer-reviewed, the current ordinances were not open for public comment or expert review. This is especially problematic in the case of the Commercial Courts Ordinance, which was promulgated even while the Bill was pending with the Parliamentary Standing Committee on Law and Personnel till 30.11.2015. Considering the history of the Bill in 2009, the importance of the Select Committee's input, and the eventual withdrawal in face of Rajya Sabha opposition, the government should have tried passing the law through Parliament rather than taking the ordinance route. Any amendment now will create even more confusion about the law's applicability.

11. Code re-use - but in the future:

Good drafting requires starting with `clean building blocks’ rather than replicating the existing defective landscape. These new laws can then provide opportunities for reuse in the future. The 253rd Report rejected the 2009 Draft Bill’s core proposal of vesting original jurisdiction in Commercial Divisions in High Courts and transferring all such disputes to the High Court. It considered the proposal problematic. Instead, it introduced the idea of separate Commercial Courts at the district level and Commercial Division and Commercial Appellate Division of High Courts. This was incorporated in the Commercial Courts Ordinance.

The Ordinance also introduces novel `building blocks', from the insertion of a new Order XV-A, CPC laying out a complete code for case management hearings; to the requirements under s. 17 for the Court to collect and disclose statistical data; and training and continuous education stipulation under s. 20. These can hopefully act as opportunities for code reuse in the future, especially for the eventual amendment to the CPC.


While the process followed in drafting the Arbitration and Commercial Courts Ordinances is a big improvement on the prevailing drafting process, the process was not ideal. As has been shown, drafting changes made by the government to LCI's draft without stating any clear rationale has created legal issues in both the ordinances. Legal drafting is a technical skill which the government as of now lacks. Policy makers should seriously think about how to improve State capacity in this regard.

As stated above, the Ordinances were urgently required to remedy the problems of costly and time-consuming commercial dispute resolution in India. While they suffer from various drafting flaws, in comparison with the status quo they undoubtedly represent an improvement of the litigation landscape here. For instance, the amendments made in the AC Act have reduced the scope of judicial interference in the arbitration process. Similarly, the Commercial Courts Ordinance has ensured that the ordinary processes of the CPC no longer apply and has simultaneously introduced novel principles of case management. Thus, improved processes have resulted in improved outcomes in this case. In turn, it is hoped that these Ordinances will reduce the transaction cost of doing business in India by resolving disputes expeditiously, fairly and in a cost-effective manner. If the 11 steps towards better drafting had been properly applied, the results would have been even better, and would have helped design more effective laws.

Disclosure and acknowledgement

The author was involved in drafting the 253rd LCI Report.

The author thanks Pratik Datta for useful discussions.


[1] The LCI proposed to amend s. 2(d) defining "arbitral tribunal" to means a sole arbitrator or a panel of arbitrators "and, in the case of an arbitration conducted under the rules of an institution providing for appointment of an emergency arbitrator, includes such emergency arbitrator". Its appended Note reads, "NOTE: This amendment is to ensure that institutional rules such as the SIAC Arbitration Rules which provide for an emergency arbitrator are given statutory recognition in India."

Vrinda Bhandari is a practicing advocate in Delhi. She was involved in the Law Commission of India's 253rd Report on Commercial Courts.

Looking beyond the label `algorithmic trading'

At the EMF 2015 conference, I attended a talk by Pradeep Yadav, where he presented a paper: Raman, Robe, Yadav, 2015. This paper analyses algorithmic traders ("AT") and manual traders ("MT") on one of the world's largest electronic limit order book exchanges, the National Stock Exchange ("NSE").

NSE is an ideal laboratory for studying these questions, as it is a simple plain limit order book market, without the confusion caused by market makers. In addition, the overall equity market structure is simple, with two exchanges (NSE and BSE) where NSE has dominant market share. The complexities of the fragmented order flow and multiple trading venues, of the US, is not present. At NSE, both spot and futures trade in the same time zone, with orders emanating from the same co-location facility, which also facilitates research. NSE data has thus shaped up to be a very nice foundation for understanding markets, in recent years, with some of the cleanest microstructure work getting done here.

The puzzle

Pradeep Yadav and his coauthors find that under conditions of market stress, ATs withdraw from the market. This immediately lends itself to a pejorative interpretation: "ATs are good for liquidity under good times, but are quick to withdraw when the going gets difficult, and this is creating a new set of problems".

I wondered how this squares with a powerful result from Aggarwal & Thomas, 2014. This is a modern causal econometrics paper, and in this they find that the incidence of mini flash crashes goes down when there is more AT. They look for mini flash crashes defined as 2%, 5% and 10% declines of the price within a five minute window (see Table 6, page 28). All three coefficients are negative; more AT gives fewer flash crashes. For the 2% and 10% case, the differences are not statistically significant, but for the case of a 5% drop of prices in 5 minutes, bigger AT gives a statistically and economically significant decline in the incidence of flash crashes.

Both papers seem to have persuasive empirical strategies. How do we square the results? How is it that ATs are more likely to step away in difficult times (Raman, Robe, Yadav) but at the same time how it is that when there is more AT, mini flash crashes are less frequent (Aggarwal, Thomas)?

A better classification system

In order to figure out what's going on, I think we should break with the classification AT vs. MT. Instead, it's better to think in terms of simple, mechanistic trading strategies vs. complex strategies that involve human judgment. For the purpose of argument, let's call these "SI" for simple vs. "CO" for complex strategies.

Let's start with the old world, before algorithmic trading. In that world, we very much had many humans running SI strategies and many humans running CO strategies. `Technical analysis', and other trend following mechanistic strategies, were around well before algorithmic trading came along!

As Friedman, 1953, reminded us, there is a Darwinian process at work where speculators who lose money tend to exit the market. Because markets are competitive, the dumb adherence to a SI strategy would induce losses, and the people who did this would exit the market. Hence, the only sensible approach for a trader who uses a SI strategy is to either stop some times (i.e. have a "kill switch") or switch to a CO strategy at certain times.

In the good old days, SI speculators had "kill switches". When the market got weird, they would just stop trading. Nobody expected a simple trend following speculator to behave unchanged when volatility changed or when big news broke. We had trading floors where a boss would shut down some strategies from time to time. This was akin to a "kill switch" applied to a large number of SI strategies.

All that has happened with algorithmic trading is that we now have powerful clerks, i.e. computers, who are the foot soldiers implementing SI strategies. Nothing else has changed. Humans are still in charge!

Some human traders keep a swarm of SI strategies under leash, and when market conditions get difficult, they hit the kill switch. Some of them switch to CO strategies when the going gets difficult, and because CO strategies are much harder to program, they may well do this trading by hand. Some bosses of trading floors yank hundreds of SI strategies when the going gets weird.

Resolving the puzzle

There were always SI strategies and CO strategies. These have been around ever since organised financial trading began. In the older data, we are not able to disentangle the two.

In recent years, the SI strategies have gotten automated. We have reduced the use of humans in mechanistic tasks, and got computers to do this clerical work. For the first time in human history, we are now seeing a flag on orders where orders from SI strategies are now called "AT" orders. The CO strategies continue to be mostly done by hand, as it's quite hard doing this programming.

There is nothing wrong or unusual in SI strategies backing out of the market when conditions become confusing. SI strategies can only work in peaceful times. A trader who ran SI strategies all the time would exit the market as his wealth would run out (Friedman, 1953).

SI strategies done through AT give us more eyeballs looking at the millions of traded products in the modern exchange environment. When there's a dislocation in a market (e.g. a crash in the futures price), immediately, hundreds of traders come through with a mechanistic response (reverse cash and carry arbitrage), which stabilises the price. In contrast, in the manual world, the field of view of each human was limited, and when a little crash got started, there were fewer people available to interfere with it. This gave more mini flash crashes in the pre-AT world. This is how both statements are correct:

  1. In times of market stress, the AT orders shy away (Raman, Robe, Yadav, 2015)
  2. Greater AT intensity reduces the incidence of mini flash crashes (Aggarwal & Thomas, 2014).


Nidhi Aggarwal, Susan Thomas. The causal impact of algorithmic trading on market quality, Working Paper, 2014.

Milton Friedman. The case for flexible exchange rates. In Essays in Positive Economics, The University of Chicago Press, 1953.

Vikas Raman, Michel A. Robe, Pradeep K. Yadav. Man vs. Machine: Liquidity Provision and Market Fragility, Working Paper, 2015.

Monday, December 21, 2015

Insolvency and Bankruptcy Bill was tabled in Parliament today

The Insolvency and Bankruptcy Bill, 2015, was tabled in Parliament today. I have yet to see how this draft has evolved compared with the version submitted by the Committee.

This is an important step forward.

The glass is half full. From here, the work required is:

  • Refining the law from the viewpoint of coping with future litigation and from the viewpoint of creating sound institutional infrastructure. The level of polishing and perfection that's found with version 1.1 of the Indian Financial Code is not yet here.
  • Establishing a `Task Force' process to build the four pillars of institutional infrastructure required for enforcing the law: adjudication, regulator, insolvency professionals, information utilities.
  • Navigating it through Parliament.

A good collection of research and commentary on Indian bankruptcy reform is at this page.

Wednesday, December 16, 2015

Friday, December 11, 2015

Drafting hall of shame #1: Criminal sanctions for a new concept of exchange control violations

by Pratik Datta.

In recent years, curbing the menace of black money has been at the political forefront. Finally, the Finance Minister, Mr. Arun Jaitley, in his budget speech [at paragraph 103(9)] said:

"The Foreign Exchange Management Act, 1999 (FEMA) is also being amended to the effect that if any foreign exchange, foreign security or any immovable property situated outside India is held in contravention of the provisions of this Act, then action may be taken for seizure and eventual confiscation of assets of equivalent value situated in India. These contraventions are also being made liable for levy of penalty and prosecution with punishment of imprisonment up to five years."

However, the legal change brought in by the Finance Act, 2015, has now created a completely new offence which may detrimentally impact genuine foreign exchange transactions.

Consequences for businesses: A hypothetical example

The new amendment empowers the Central Government to prescribe a pecuniary threshold. Let's assume that the Central Government prescribes Rs. 1 crore as the threhold. Now, X Ltd, an Indian company, takes a foreign currency loan of GBP Y from a foreign lender in London in compliance with RBI's ECB regulations. If the loan of GBP Y > Rs. 1 crore (prescribed threshold amount), the Indian borrower X Ltd. would be guilty of committing an offence which is punishable with up to 5 years of imprisonment! This effectively constitutes a new layer of capital controls, with criminal sanctions.

But why is this an offence?

Because of an error in legal drafting. The new section 13(1C) of FEMA says that acquisition of foreign exchange exceeding the threshold prescribed is an offence -- even if such acquisition is otherwise in compliance with RBI's capital controls framework.

Section 4 of FEMA states:

Save as otherwise provided in this Act, no person resident in India shall acquire, hold, own, possess or transfer any foreign exchange, foreign security or any immovable property situated outside India.

Following the budget announcement, sections 13(1C) and 37A(1) were inserted in FEMA.

Section 13(1C) reads:

If any person is found to have acquired any foreign exchange, foreign security or immovable property, situated outside India, of the aggregate value exceeding the threshold prescribed under the proviso to sub-section (1) of section 37A, he shall be, in addition to the penalty imposed under sub-section (1A), punishable with imprisonment for a term which may extend to five years and with fine.

Section 37A(1) reads:

Upon receipt of any information or otherwise, if the Authorised Officer prescribed by the Central Government has reason to believe that any foreign exchange, foreign security, or any immovable property, situated outside India, is suspected to have been held in contravention of section 4, he may after recording the reasons in writing, by an order, seize value equivalent, situated within India, of such foreign exchange, foreign security or immovable property:

Provided that no such seizure shall be made in case where the aggregate value of such foreign exchange, foreign security or any immovable property, situated outside India, is less than the value as may be prescribed.

Note, if any foreign exchange, foreign security or immovable property outside India is held in contravention of section 4, then only the power of seizure under section 37A can be triggered. So far, so good.

However, section 13(1C) creates an offence which does not even require any violation of section 4 of FEMA. Note, section 13(1C) does not refer to any contravention of section 4. It only states that acquisition of foreign exchange exceeding the threshold prescribed under section 37A(1) proviso is now an offence. Under FEMA, only Central Government can prescribe. Therefore, the proviso to section 37A(1) empowers the Central Government to prescribe the value of the threshold. And section 13(1C) makes it an offence to acquire foreign exchange, foreign security or immovable property abroad beyond the value prescribed by the Central Government -- even if no other provision of the existing FEMA is violated.

How to remedy the situation?

FEMA needs to be amended to address this mistake. The words `in contravention of section 4' should be inserted into section 13(1C) and it should read like this:

If any person is found to have acquired, in contravention of section 4, any foreign exchange, foreign security or immovable property, situated outside India, of the aggregate value exceeding the threshold prescribed under the proviso to sub-section (1) of section 37A, he shall be, in addition to the penalty imposed under sub-section (1A), punishable with imprisonment for a term which may extend to five years and with fine.

Pratik Datta is a researcher at the National Institute for Public Finance Policy.