09 Chapter 2

CHAPTER 2
THEORETICAL FRAMEWORK AND LITERATURE

REVIEW
2.1 Overview of the chapter
2.2 Concepts and definitions
2.3 Theoretical Paradigm of the Study
2.4 Review of Previous Studies
2.5 Research gap
2.6 Summary of the chapter

AN ANALYSIS OF CORPORATE INSOLVENCY RESOLUTION PROCESS OF INSOLVENCY AND
BANKRUPTCY CODE (IBC)2016: CASE STUDY OF SELECTED COMPANIES
2.1 Overview of the chapter
A good literature survey is very important for any study. It gives a deeper and wider
understanding of the subject and also helps in identifying the gap in earlier studies. The
literature review of the current study has been done mainly on three aspects namely Bankruptcy
laws, Financial Distress and Corporate Insolvency Resolution. This chapter is divided into
three parts. The first part discusses the concept and definition of Financial Distress, Insolvency
and Bankruptcy. The second part of the chapter deals with theoretical base of study and the
third part is the review of literature of most relevant and influential contributions to research in
the fields of Bankruptcy laws, financial distress and Insolvency resolution.
2.2 Concepts and Definitions
Financial Distress, Insolvency and Bankruptcy are generally used synonymously. But all are
different concepts. Financial distress is a short-term financial difficulty. Insolvency is not
being able to pay debts whereas bankruptcy is a court order which decides how the debts will
be paid. It usually involves selling of assets for settlement of dues. Insolvency can lead to
bankruptcy if proper measures are not taken during insolvency period. A firm can be insolvent
without being bankrupt but the vice versa is not possible.
The concept and literature of financial distress has also been discussed in this chapter. It is so
as financial distress is precedent of bankruptcy. The study consists of case studies of insolvent
firms and financial distress was precursor to their insolvency therefore it is desirable to study
about financial distress also.
Financial Bankruptcy
Insolvency
Distress
Fig 2.1: Financial Stages of a Firm
Source: Author’s Own Creation
IMCE, SRMU, LUCKNOW 30

2.2.1 Financial Distress
Financial distress is generally used in a negative sense as it is a situation where cash flow is
insufficient to cover current obligations, these obligations can be unpaid debt to suppliers,
employees. Financial distress is defined as the inability of a firm to pay its financial obligations
as they mature. Beaver [Bea1966] pointed that financial distress can be of different types.
Wruck [Wru1990] had defined financial distress as a stage where a company’s operating cash
flows is less than its obligation and company adopts some measures to correct it. More firms
enter financial distress as a result of poor management than as a result of economic interest
[Whi1999]. Financial distress can be interpreted as an important event where the company’s
financial health and financial illness period can be distinguished and corrective measures are
taken to resolve the issue [And1998; Bal1983; Bro1992]. A business main aim is to generate
profit and maximize shareholders wealth. In the course of operation, however, a firm might
experience financial problems caused by both internal and external factors. The term financial
distress is used to refer bankruptcy in corporate sector in western countries. Baldwin & Mason
[Bal1983] said that when the business of the company comes to a level where it cannot meet
its financial obligations, the firm is said to have entered the state of financial distress. On the
other hand, Pindado [Pin2006] concluded that, if the firm is possessing negative cumulative
earnings over a few consecutive years, simply noted as cumulative losses and weaken
performance, it will be subject to a financially distressed situation. Accordingly, Opler &
Titman [Opl1994] developed Corporate Risk Management theory in the presence of dead
weight losses caused by financially distress. As per their study, Financially Distressed firm
may lose valuable customers, suppliers & key employees.
2.2.1.1 Determinants of Financial Distress
The problem of financial distress has become a worldwide phenomenon and even advanced
countries like America, United Kingdom, Germany and Japan are affected by it. Traditional
views of causes of financial distress, which have over time been partially confirmed by
empirical results. Andrade & Kaplan [And1998], Asquith et al., [Asq1994], Kaplan [
Kap1993], Theodossiou et al., [The1996] Whitaker [Whi1999], provide some evidence that
financial distress arises in many cases from endogenous risk factors, such as mismanagement,
high leverage, and a non-efficient operating structure in place. The general economic climate

and government policies are reported to be the cause for large scale commercial bankruptcies
in Canada [Fis2005]. In addition to these causes, studies have pointed that poor or failure of
management is an important reason for sickness. Bidani &Mitra [Bid1983] have identified that
when there is default on interest payments and erosion of net worth by more than 50%, then it
could be the initial indicators of serious imminent failure. Khandawallah [Kha1981] mentioned
that revival efforts initiated early, when the unit is performing well below its potential, yields
better results than when the unit is officially sick. There are many financial factors which can
land any firm in financial distress. The major financial reasons are high financial leverage, lack
of liquidity due to mismanagement of working capital, high operating leverage due to increased
fixed cost.
Liquidity
The ability of a firm to convert its asset into cash quickly at a low cost is known as liquidity.
The liquidity is measured by ability of firm to pay its short-term obligations as and when they
become due. Early signs of financial distress include low or declining liquidity of the firm
hence liquidity ratios are good indicators of cash flow problems [Git1991]. Many studies have
shown that firms which have low levels of cash flow are prone to face financial distress as they
are prone to exogenous negative shocks to cash [Alt1983].
Leverage
Leverage is the second important determinant of financial leverage. Leverage is that part of
fixed cost that represent the risk of the firm. Operating leverage, a measure of operating risk,
refers to the fixed operating costs found in the firm’s income statement, whereas financial
leverage is a measure of financial risk, refers to financing a portion of the firm’s assets, bearing
fixed financing charges in hopes of increasing the return to the common stockholders. The
higher the financial leverage, the higher the financial risk, and the higher the cost of capital
[Shi1998].
Leverage limits the ability of the firm to withstand negative shocks to cashflow. Increased
leverage ratios are an indicator of financial distress as it shows the high debt of the company.
One of the most important ratios is the debt ratio. It is an important ratio to measure the debt
of the company. The higher the ratio the more financial leverage of company.

Profitability
The profitability ratios are used to measure firms return on its investment [Bre2000]. In a
competitive market firms need to generate sufficient profits for its survival. Firm profitability
has linked to financial distress and bankruptcy in two ways. Firms with poor management will
be driven out of market and ultimately low profits will result in low liquidity which will result
in financial distress.
Size
Other determinant of financial distress is the firm size. The size of total assets is also
responsible for the probability of financial distress [Hot1995].
Efficiency
Firm’s efficiency or turnover ratios measure how productively the firm is using its assets
[Bre2000]. The firm’s efficiency is measured in terms of its asset turnover, average collection
period and average payment period. These components indicate the firm’s viability as well as
speed of turning over its assets within the year, which determines the firm’s financial distress.
An efficient firm has ability to have high earnings before interest, taxes, depreciation and
amortization (EBITDA) and hence will be able to earn more whereas with a low EBITDA the
firm may head towards financial distress. The possible cause of financial distress is efficiency
or turnover, the higher a firm’s total asset turnover; the more efficiently its assets have been
used. This measure is probably of greatest interest to management, because it indicates whether
the firm’s operations have been financially efficient [Bre2000].
Macroeconomic Determinants
Manufacturing companies have a major role in economic activity of every country through
provision of financial services. In addition to banks influence on economic activities,
macroeconomic factors also affect the performance of manufacturing companies in a given
country. Gross Domestic Product (GDP) i.e. economic growth, inflation [Kea2001] are some
of the important macroeconomic conditions.

2.2.2 Insolvency
Broadly speaking insolvency means inability to pay its creditors. Armour et al., [Arm2015]
have identified six different types of insolvency. Apart from the fact that it has to do with
inability to pay he further distinguishes the concept as ‘balance sheet insolvency’, ‘cash flow
insolvency’ and ‘economic failure which represent the accounting concept of insolvency while
on the other hand he talks about ‘liquidation’, ‘reorganization’ and ‘insolvency proceedings
i.e., bankruptcy’ on the legal aspect of insolvency. When the liabilities exceed the assets, a firm
becomes insolvent. Accordingly, Basel II norms define insolvency as when the scheduled
payments are delayed for more than 90 days. Belcher [Bel1997] has compared the availability
of assets to the payment of liabilities with a focus on cash flow. Balance sheet insolvency is
when the book value of assets of a company is less than those of its liabilities whereas cash
flow insolvency arises when a firm is unable to pay its dues when they fall due. This condition
is also known as financial distress when a company is not able to repay its dues as and when
they fall due. There is a difference between solvency and economic viability [Whi1983].
Insolvency is the relationship between a firm’s asset or cash flows and amount of debt in its
financial structure whereas economic viability is the function of net present value of its
business as a going concern. If a business has a going concern value which is greater than the
value of its asset sold on a break up basis, and also greater than zero, then it is economic value
[Arm2015]. Lack of economic viability is known as ‘economic distress’.
2.2.2.1 Economic Concept of Insolvency
As per the economic concept of insolvency, it is a situation where a company is not able to pay
its dues, dividends to shareholders’ etc. which may or may not lead to a legal remedy. In this
concept if management of company is suspended then it is considered to be a good step towards
resolution. Some authors, as Zopounidis [Zop1995] have defined this concept very elaborately.
According to them, when a company defaults in repayment, it means that it is not able to make
profits, and its capital is not creating any value. The authors also reason that the company
defaults as it is not able to solve social problems like unemployment etc. But this definition is
too broad and it leads to focus on payment problem only. Safe companies can be differentiated
from risky companies on the basis of timely repayment of their dues. The inability to repay
makes companies more risky. This definition is adopted by Ooghe and Van Wymmersch

[Oog1996]. According to these authors, a company, is said to be insolvent when it cannot

anymore reach its economic goals in a socially and legally constrained environment. One
feature of economic concept of insolvency is that it is unable to fulfill its commitment towards
its different stakeholders. The problem of inability to pay must be analyzed and should be done
continuously. The failure starts with small difficulties which are gradually transformed into
more serious problems. Some works, following [Bea1966], thus tried to propose models in
which the non-payment is used like the signal of failure of the company
2.2.2.2 Law & Finance concept of Insolvency
Insolvency from legal point of view is defined on the basis of judicial criteria which has been
laid down in the insolvency act of any country. In most countries, a firm is classified as
bankrupt when the judicial authority decides that the company is not able to pay its dues
[Cab1999]. Insolvent companies always conform to this mix of legal and accounting logic. At
each stage of judicial process, accounting considerations are introduced to strengthen the
rationality of the decision made by the judges. The legal action begins with default in payments
and finishes with a resolution or liquidation plan. If a point of time is to ascertained to tell that
the company is shifting from a sound company to an insolvent company, many scholars are of
the view that it is the moment when a company presents its legal documents to the court for
liquidation or reorganization. The failure is then adjusted to the entry in insolvency proceedings
and filing for petition has to be considered as an extreme situation, i.e., an exit from the market
resulting from the mismatch between the entrepreneurial project and the market conditions
2.2.2.3 Corporate Insolvency
Corporate Insolvency is a situation when a company is no longer able to meet its economic,
financial, and social objectives on a regular basis. Some go even further by considering that
firms enter in periods of decline when they fail to anticipate, recognize, neutralize, or adapt to
external and internal pressures, that threaten their long-term survival. The separation between
the failing companies and the others based on different performance criteria is proposed by
Platt & Platt [Pla2002]. They draw a line between going concerns and distressed firms having
experienced either several years of losses or decreases in the distribution of dividends or a
major restructuring. Beaver [Bea1966] is representative of this approach and defines the failure
as a result of the inability of a company to meet its commitments once they have reached

maturity. The results are quite poor however and become even worse when the purpose is to
discriminate between profitable firms and non-profitable ones because no function properly
separates the two classes. More recently, this approach has also been adopted by Bose and Pal
[Bos2006] who obtained prediction rates ranging between 65% and 75% in their attempt to
separate companies a priori considered as financially healthy from those which are not.
2.2.2.4 Determinants of Insolvency
There is no dearth of literature when we talk about the reasons of Insolvency and most of the
researchers have focused on the non-financial reasons of insolvency [Bau1992; Gre1996;
Swa1996]. These studies have majorly stressed about one factor or one company and have
talked about the failure of one company or a specific types of companies. Size, according to
most of the researchers, as a key discriminant factor.
For a long time, small businesses have been a major concern for the authors involved in this
field. Hall [Hal1992] or more recently Back [Bac2005] is representative of this large set.
However, the changes in characteristics of companies going bankrupt lead some other scholars
to pay attention to the exit of large corporations. Indeed, the bankruptcy of American large
companies in the beginning of year 2000, question the failure of large corporate groups. Among
many reasons and following the controversial paper by Charan & Useem [Cha2002],
managerial errors is often presented as a major one whereas some others, rediscovering Kotler
[Kot1965] and considering that it can be profitable for corporate groups to abandon some
activities, begin to think about bankruptcy as a business strategy. These new directions still
remain rare and, as highlighted by Ooghe & Prejicker [Oog2008] ‘most of these studies declare
management characteristics to be the most critical factors in corporate bankruptcy’, whereas
insolvency should be seen as a process in which different causes intervene at the different
stages.
2.2.3 Bankruptcy
Insolvency and Bankruptcy are often used interchangeably but there is a difference between
the two concepts. Bankruptcy is a legal process by which the firms which are financially

distressed, individuals and sometimes government resolve their debt. The word bankruptcy has
been derived from Italian word banca rotta which means broken bank. Bankruptcy is a legal
process through which the firms which are not able to pay their financial obligations or fail to
pay their creditors seek relief (in part or full). A bankrupt firms net asset value is less than its
liabilities; its net worth is negative; and creditors would not be repaid in full if the firm were to
be liquidated. Bankruptcy filing is a legal recourse. The firm files for bankruptcy in the court
and all the outstanding debts of the company are measured and are paid out from the firm’s
asset. Bankruptcy helps an individual, family, or business discharge its debts either through
liquidation or a payment plan. There can be two needs for filing bankruptcy; first reason
can be liquidation and the second can be of reorganization.
2.2.3.1 Liquidation
Liquidation is a process where the assets of an insolvent firm are redistributed between the
creditors and the owners of firm. It is also referred to as winding up or dissolution of the firm
although dissolution is the last stage of liquidation. Liquidation may either be voluntary or
compulsorily. Voluntary liquidation is when the business owner might choose to discontinue
the company for a variety of reasons. Compulsory liquidation is a situation where the company
is completely unable to make payments to its debts and the director applies direct to the court
to request that the liquidation process is implemented. When a firm file for bankruptcy
liquidation, a trustee is appointed to shut it down and to liquidate its assets. The proceeds net
of transactions costs (or ex post bankruptcy costs) are distributed to creditors in order of
priority. Claims are paid off, so that creditors (except the last) are either paid in full or not paid
at all. Claims due in the future are accelerated to the present at face value. The priority rule in
liquidation is the absolute priority rule (APR). It gives priority first to the transaction’s costs
of the bankruptcy process, second to taxes, rent and wages, third to unsecured creditors (trade
creditors, bondholders and often banks), and last, to equity. One important group is outside the
APR ordering: secured creditors. These creditors have a lien on a specific asset owned by the
firm such as a building, equipment, inventory or accounts receivable. In the event of
liquidation, they can reclaim the asset or its value. Liquidation is desirable when the asset value
of the firm is more as compared to when put for alternative uses.

2.2.3.2 Reorganisation
Failing firms can file for a reorganization in bankruptcy, but continue operating in essentially
the same form with the same management. Management proposes a settlement with creditors
which specified a cutback in unsecured debt claims. Equity remains intact, but with no
dividends paid until all obligations under the reorganization plan were met. Secured creditors
are prevented by the bankruptcy filing from foreclosing on their lien assets. The plan has to be
approved by majority vote of all unsecured creditors' classes.
2.2.3.3 Efficiency of Bankruptcy Laws
While there is very less consensus about an optimum bankruptcy procedure but there is one
aspect of bankruptcy where all the scholars agree upon. Oliver Hart [Har2000] has stressed that
there is no “one size fits all” about bankruptcy procedure. There is probably less agreement
about what exactly is the best bankruptcy procedure or how well the existing bankruptcy
procedures function around the world. Although researcher across the world have different
view regarding this but they all agree upon the goals of a good bankruptcy law and some
characteristics of efficient bankruptcy law. Efficiency can be evaluated at three stages in the
bankruptcy process-ex ante, interim, and ex post depending upon the information available at
the time. As defined by Holmstrom and Myerson (1983), the ex-ante stage is the time before
individuals are in receipt of any private information; the interim stage is when private
information is received, but not shared; and, finally, the ex-post stage is when all private
information has become common knowledge. One of the general definitions of efficiency is
proposed by Voigt [Voi2016],‘‘Efficiency prevails when a given output is realized with
minimum input, or a maximum output is produced with a given amount of inputs.” In respect
of the bankruptcy law procedures, there is no ultimate approach to the efficiency assessment.
The reference point for efficiency can take the form of market value or market-oriented
procedures [Tho2000], time, cost, and recovery rate of the procedure [Succ2012], ability to
strike a balance between debtors and creditors protection [Fra1994; Lap2008].
Ex- ante efficiency
Ex- ante efficiency is considered before the start of financial distress of the firm, for example
when debt contract is signed i.e. before a firm becomes insolvent. It should ensure that creditors

could effectively control the debtors’ behaviour A bankruptcy law has to decides what to do
with an insolvent firm and how to compensate the creditors. An efficient ex-ante process
should penalise the managers and shareholders adequately to preserve the bonding role of debt.
Oliver Hart [Har1999] discusses that a simple way to penalize shareholders in a bankruptcy
state is to follow absolute priority rule of claims i.e., senior creditors are paid off first then
junior creditors and finally the shareholders. A good bankruptcy procedure protects creditors
interest when the firm is in financial distress and ex- ante efficiency may reduce the overall
cost of borrowing for the firm [Cor1997]. An efficient ex ante insolvency regime prevents
managers and shareholders from taking imprudent loans, and lenders from giving risky loans.
Interim Efficiency
Interim efficiency is that which allows the realization of the assets in the shortest time at the
lowest achievable cost. A good bankruptcy procedure should preserve the absolute priority of
claims
Ex post efficiency
Ex post means that the firm has already become insolvent. There is a strong argument that a
good bankruptcy process should adequately divide the money available to the creditors and
related parties [Har2000]. Considering this as main goal, the bankruptcy procedure should
decide whether to reorganize the insolvent firm, to be sold as a going concern or to liquidate in
piecemeal.
2.2.3.4 Bankruptcy Cost
Bankruptcy costs are the deadweight economic costs of the firm going bankrupt [Whi1983].
Bankruptcy process can incur huge costs on the distressed company in the form of direct and
indirect costs. Direct costs are those costs which are incurred directly in the process of
bankruptcy. One of the most explicit direct costs is the need to employ various outside
professionals to help deal with the situation at hand. Lawyers, accountants, consultants,
investment bankers and many others provide the necessary professional services that are paid
for by the firm. After paying the external professionals, the company incurs internal costs as
various employees now have to spend time in dealing with the bankruptcy process. From senior

management to employees in the legal, accounting and personnel departments, time and energy
are spent in coordinating with the external professionals. Indirect costs are those which are
borne by the company due to the disruption in the working of the firm. Ability to effectively
compete in the marketplace and loss of reputation are biggest indirect cost which a distressed
firm has to bear. Other indirect costs include lost sales, lost profits, and possibly the inability
of the firm to obtain credit or to issue securities except under especially onerous terms. For
direct cost of bankruptcy to arise, it is necessary that there are transaction costs associated with
negotiating disputes between claimholders. But for indirect cost to arise, it depends on the
situation of the market [War1977]. The costs of distress are also dependent on the type of assets
the firm owns. Tangible assets like real estate, or equipment that can be used in various
applications, can pass through bankruptcy with their value relatively intact. Conversely,
intangible assets like brand, human capital and proprietary technology are likely to diminish in
value significantly and as such give rise to higher distress costs.
2.2.4 Distress Risk Assessment Models
The problem of measuring the level of financial distress is having a very long history in the
literature of finance. Many researchers have investigated and developed new approaches for
predicting financial distress and bankruptcy. The prediction can be made from economic,
financial, accounting, statistical and even informational point of view [Out2007]. Most of the
research in this area can be chronologically divided into two parts: before and after the 1990s.
The techniques of distress risk assessment before the 1990s were dominated by static single-
period models which try to find unique characteristics that differentiate between distressed and
non-distressed firms. An extensive review of these classification models can be found in
Altman [Alt1983], Zavgren [Zav1983], Foster [Fos1986], and Jones [Jon1987]. The
examination of distress risk during and after the 1990s has led to the development of dynamic
models which would be able to determine each firms’ distress risk at each point in time. An
extensive review of “new techniques” in comparison to the previous discriminant models can
be found in Mosmann et al. [Mos1998], Cybinski [Cyb2003], Weckbach [Wec2004], and
Altman and Hotchkiss [Alt2006]. Cybinski [Cyb2003] points out that within the recent decades
no new methodology has been introduced. Most extensions of the already existent models
occur when either a new statistical technique or a new database becomes available. In the

absence of theory, extensions to the available techniques concentrate on the analysis of

accuracy of forecasts and the manner of its improvement.
The classification can be done in a chronological manner [Alt2006]. They divide all techniques
of prediction of financial distress in the following groups:
 Qualitative analysis
 Univariate Analysis (Use of accounting-based ratios or market indicators for distress
risk assessment) [Bea1966]
 Multivariate Analysis (including Discriminant, Logit, Probit, Non-linear models Neural
Networks, Recursive Participating Analysis based on the accounting or market
information: Altman’s Z-Score, Ohlson’s O-Score, A Simple Hazard Model of
Shumway)
 Discriminant and Logit Models in Use (Z-Score for manufacturing, ZETA-Score for
Industrials, Private Firm Models – Z-Score, EM (Emerging Markets) Score, etc.)
 Artificial Intelligence Systems (Expert Systems, Neural Networks Credit Model of
S&P) − Contingent Claim Models (KMV Credit Monitor Model, Risk of Ruin)
 Mixed Ratios / Market Value Models (Moody’s Risk Calc, Z-Score / Market Value
Model) [ALT2005].
2.3 Theoretical Paradigm of the Study
Theories provide a base for the practical application. Economic theories and models give us
knowledge to make policy. Academicians provide us knowledge via their theories whereas the
policy makers imbibe these theories into their policies. Thus, academicians and policymakers
work hand in hand to allow market forces to operate freely. In this section of the study theories
of bankruptcy law and financial distress is discussed. Bankruptcy law theories are important as
they give a base for an insolvency and bankruptcy law framed in a country according to their
local economic and social conditions.
2.3.1 Theories of Bankruptcy Law
Bankruptcy theories are based on the problems which are faced during the bankruptcy process.
One of the major problems of bankruptcy law is the distribution of the proceeds among the

various stakeholders i.e the distribution problem. When a firm becomes insolvent various
stakeholders like the creditors, employees, customers and society at large has its own vested
interest in the company. Because the assets in most of the cases are insufficient the claims of
the various stakeholders are always not achieved. Thus, to solve the problem of distribution
various theories are there according to which the proceeds are to be distributed.
2.3.1.1 Maximisation of Social Welfare Theory
The theory of Maximisation of Social Welfare says that social welfare should be maximized
when a firm is liquidated. According to this theory, social welfare is maximized when
economically distressed firms are liquidated and the financially distressed firms are corrected
and allowed to run. When a firm is only financially distressed, the social welfare can be
maximized only when the firm continues to be in existence and makes profit whereas when a
company is put for sale, creditors will try to take all available assets which in the opinion of
Miller [Mil1977] may lead to piecemeal liquidation. All the creditors are required to cooperate
to synchronize their collection efforts.Consequently, reasonable financial equilibria may exist
where piecemeal liquidation of economically distraught entities are, conducted, without
regulation [Mil1977]. Adler [Adl2002] is of the view that inefficiency at the time of liquidation
can be avoided till the time when the government official decides on the future of the firm.
Baird and Rasmussen [Bai2003] are of the view that the liquidator shoud decide whether the
liquidation should be in piecemeal or there should be bulk disposal. Piecemeal liquidation is
more beneficial as the economic value of the firm is maximized. Alternatively, if the firm is
getting a higher value as a going concern, then it should be so disposed of.
2.3.1.2 Absolute Priority Rule
According to the Absolute Priority Rule theory, the value of a firm could be maximized if the
recovered amount is equitably distributed among all the claimants. This type of bankruptcy law
should give full respect to claims priority among different class of claimants. The early scholars
believed that Absolute Priority in distribution of claims should be followed strictly by any
bankruptcy system. The creditors should be paid according to their contractual claims and if
there is no document then the settlement should be done in the order with which contracts of

the equity was created [Agh1998]. As the residual value of the company is worth nothing, the
equity shareholders should be paid at last. The exception can be there if the equity holder has
contributed money to the firm.
There are some exceptions to Absolute Priority Rule. First, that there is some other objective
that has become important. For example, where a court of competent jurisdiction may direct
abrogation of the absolute priority rule in the interest of fairness. The exception to this rule is
however not applicable and cannot be invoked when the estate of a deceased is to be distributed.
2.3.1.3 Creditors Bargain Theory
Jackson gave Creditors’ Bargain Theory in 1982. The theory focusses that welfare can be
maximised if the bargaining is done together in groups. The theory is based on the idea that
bankruptcy law reflects hypothetical creditors bargain that creditor would reach if they were to
bargain before the extension of the credit. This is to say that if both the parties being rational
and willing are able to negotiate and come into ex ante amicable agreement, they would be
better positioned to strategically manage and reduce costs thereby maximizing the outcome. If
there is no such ex- ante agreement then each creditor would run to collect maximum of his
entitlement ahead of other creditors. This situation will create the classic example of “common
pool puzzle.” This theory is based on the principles which have been talked about by the
proceduralist by Baird [Bai1998], including respect for non-bankruptcy entitlements in
bankruptcy except as necessary to solve the collective action problems facing creditors. The
creditors’ bargain theory has also been, criticized by Warren [War1993] on the grounds, that
its explanation and appraisal of the bankruptcy system is not only narrow but is also unrealistic.
She contends that economic value enhancement is only part of the goal of bankruptcy law.
2.3.1.4 Risk Sharing Theory
Risk sharing theory is a modification of creditors bargain theory developed by Jackson and
Scott in 1989. The drawback of the creditors bargain theory was that it assumes that creditors
would agree to change the pre-existing contractual priorities, which seemed very unrealistic.
According to this theory all the investors which are related to the firm should aim at maximising
the general value of the assets and resources of the debtors. To achieve this objective, it seeks
to compel all claimholders to share the risk of the entity especially as relating to possible

business failure. Miles [Mil2011] has identified two types of risks – (i) Common risk – which
include industry specific or government policy risks which are external determined and cannot
be controlled by management and (b) company specific risks relating to internal factors. The
creditors can bargain and choose to bear one or other type of risks.
2.3.1.5 Value-based Theory
The Value based theory was promulgated by Korobkin [Kro1991] in 1991. The theory proposes
that a bankruptcy law should consider the distribution impact of liquidating a company on those
also who are not creditors and who may not have legal rights to the assets of the company. The
assets of the debtor should not be considered only as a pool money which is available only for
sharing. The theory suggests that only financial or economic aspect of bankruptcy should not
be considered but it should take all the important factors into consideration. In other words, a
bankruptcy law should be multidimensional and resolve every issue arising from it. As each
claimant will possess a conflict of interest, the law should provide for each of them to derive
maximum value
2.3.2 Theories of Financial Distress
This section provides a theoretical background to the financial distress of the companies. The
theories seek to explain the effect of financial distress. Three main financial distress theories
are – Wrecker’s theory of financial distress, Agency Cost Theory and Trade off theory.
2.3.2.1 A “Wrecker’s theory”
Campbell, Hilscher and Szilagi [Cam2006] present hypothesis that stocks of distressed firms
perform in a manner which is vastly inferior to stocks of financially healthy firms. The theory
seeks to explain the benefits that may come out of financial distress to the stakeholders. The
firms which are close to bankruptcy, non-cash returns to ownership may be an important form
of payout. In an efficient market situation, the returns of the stock are high. The authors test
this hypothesis against the alternative of inefficient market using the theory of convenience
yields. This may be called Wrecker’s theory of financial distress which according to Campbell,
Hilscher and Szilagi [Cam2006], is “profiting from a ship wreckage”. They paint an illusion of

a firm being hit by a series of negative events which lead to financial distress. With higher
leverage, volatility of share prices increases with respect to private information; the ultimate
fate of the firm depends on issues unknown to the general public.
With information asymmetry becoming more important, uninformed investors will leave very
soon, equity will be owned by insiders – market participants who have a specific advantage in
obtaining and interpreting information related to the company in question. Two groups come
to mind: managers themselves and competing firms. A third possibility might be private equity
or funds, working on a restructuring [Cam2006]. It is this group of well-informed insiders that
can draw returns on their investment in other ways than receiving a cash dividend payout. With
managers, this is obvious: there is a large body of literature on corporate governance which
shows how difficult it is to prevent managers from taking undue advantage of the firm. If the
firm is distressed, it would not be wise for managers to realize hidden reserves generating a
cash flow, as this cash presumably would go to the creditors [Cam2006].
2.3.2.2 Agency Cost Theory
Agency cost theory was formulated by Jenson & Meckling [Jen1976] and it says that agency
cost arises from the conflict of interest between debt and equity holder. Generally, the managers
are part of the owners and in case of financial distress of the firm the equity holder persuade
managers to pass decisions which in effect extract the wealth from debt holders to equity
holders [But2005].
2.3.2.3 Trade off theory
The Trade-off theory says that firms have optimal debt-equity ratios, which they determine by
trading off the benefits of debt with the costs. In traditional trade-off models, the chief benefit
of debt is the tax advantage of interest deductibility [Mod1963]. The goal is to maximize the
firm value for that reason debt and equity are used as substitutes. According to this theory,
higher profitability decreases the expected costs of distress and let firms increase their tax
benefits by raising leverage; therefore, firms should prefer debt financing because of the tax
benefit. As per this theory firms can borrow up to the point where the tax benefit from an extra
dollar in debt is exactly equal to the cost that comes from the increased probability of financial
distress [Ros2002].

Based on the Trade-off theory, financial distress has gained consideration as an important
determinant of a firm’s optimal capital structure [Opl1994]. The trade-off theory suggests that
a firm can capitalize on advantages from increasing its debt level through tax benefits (i.e.,
interest expense is tax deductible).
However, as a firm exceeds the debt level above a certain point, the firm’s degree of financial
distress begins to increase and costs associated with debt begin to overshadow benefits.
Therefore, the firm attempts to maintain its capital structure at a balanced and optimal level to
avoid the greater costs of debt compared to the benefits of debt [Jen1976] and extends the
[Mod1963] theorem by including the possibility of financial distress costs. Thus, the idea of
the trade-off theory is that an optimal capital structure at which the firm maximizes its value
and minimizes its cost of capital; it can be attained when the benefits and costs of debt exactly
offsets [Mil1977].
Miller [Mil1977], however, argues that bankruptcy costs are too small to affect optimal capital
structure; he also argues that taxes are irrelevant to the firms’ debt to equity choice.
2.4 Review of Previous Studies
The review of previous literature is divided into three parts
1. Bankruptcy Laws
2. Financial Distress
3. Insolvency and Bankruptcy Code
2.4.1 Studies on Bankruptcy Laws
Bankruptcy laws are considered to be an essential requirement for the growth of capital market
and entrepreneurship [Agh1994]. They provide a framework of rules and regulation through
which a creditor can take the possession of the firm’s assets and can also affect the decision of
liquidation. The main aim of a bankruptcy law should be to protect the creditors, ensure
financial discipline and free assets from inefficient use [Lam2003] Bankruptcy law should aim
at enforcing debt contracts and this can affect the cost of capital [(Har2000; Sti2001]. When
lawmakers design a bankruptcy law that is best for their economy they cannot stick to existing

theories in economics, corporate finance or law as the countries differ in their economic
environment and these theories do not capture such cross-country differences Berkovitch et al.,
[Ber1998]. However, there is no agreement on an optimal bankruptcy procedure. Bankruptcy
procedures differ substantially along many dimensions such as allocation of control rights,
priority rules or the role of judges and court
[Agh1994] have talked about the choice of bankruptcy law in their working paper. According
to them generally economists and lawyers in the west recognize that bankruptcy law has an
important place in the timely resolution of the problems of an insolvent firm and a socially
efficient disposition of firm’s assets. Yet both practitioners and academicians are dissatisfied
with the procedures which they consider favor piece meal approach or as being administratively
very inefficient and costly. In their paper they have proposed a new bankruptcy procedure
which they believed removed some discrepancies of the earlier procedure. In their model they
proposed where non cash bids are also allowed which reduces or even eliminates the risk of
financing problems. The reason being that a bidder who is cash constrained or does not want
to bear the risk of holding a large fraction of the company shares himself even in short term
can offer shares (and/or bonds) in the new company directly to the old claimants. This proposal
was criticized that the lack of finance in the firms makes it impossible for the shareholders to
exercise their options thus making the implementation of the scheme very difficult.
According to Berkowitch et al., [Ber1998] there exists a cross country differences in economic
environment and law makers cannot assign an optimum bankruptcy law according to the
theories of economics, corporate finance or law. In their research paper they provided a theory
that demonstrates how optimal bankruptcy laws depend on the specific structure of the
economy and propose bankruptcy laws for various economic systems based on their specific
characteristics. They gave a normative theory which depended on the information structure of
the economy. According to them an optimal bankruptcy law always includes a creditor chapter
that enables the creditor to liquidate the firm and obtain the entire cash flows from liquidation
if the manager is not able to convince them to continue. In contrast, the debtor chapter is only
efficient when the manager does not have an information advantage. Their proposed
bankruptcy law for various economies is divided into three parts (i) for developed countries
with bank-based economy like Germany where information technology is fully developed and
most of the finance is done through banks a creditor chapter should be adopted (ii) for

developed countries with a market based economy like United States where information
technology is fully developed and financing is done through the markets both creditor chapter
and a debtor chapter should be included (iii) for underdeveloped systems with poor information
technology and concentrated financing includes both a creditor chapter and a debtor chapter.
The debtor chapter gives the manager more protection in comparison to market-based creditor
chapter.
Hart [Har1999] has discussed about the goals of the bankruptcy laws and some characteristics
of an efficient bankruptcy procedure. He stressed that it is very unlikely that “one size fits all”
i.e. a country should adopt that procedure which depends on the country’s internal factors i.e.
institutional structures and legal traditions. The author is of the view that it is very difficult to
have an optimal bankruptcy law but a good bankruptcy law should have three important goals.
The first goal is that a good bankruptcy law should bring an ex- post efficient outcome. It
should maximize the total monetary value, should be divided between the between all class of
claimants. The second goal of a good bankruptcy law concerns ex- ante efficiency. A good
bankruptcy procedure should preserve the bonding role of debt by penalizing managers and
shareholders adequately in bankruptcy states. The author discusses that a simple way to
penalize shareholders in a bankruptcy state is to follow absolute priority rule of claims i.e senior
creditors are paid off first then junior creditors and finally the shareholders. The third goal of a
good bankruptcy procedure should be to preserve the absolute priority of claims except that
some portion of value should possibly be reserved for shareholders.
Baird [Bai2006] has talked about two propositions on which the bankruptcy law should be
based. Traditionalist and Proceduralists. The traditionalists basic approach stems from a
conviction that bankruptcy law plays an important role in our legal system and advance
substantive goals that are both important and distinctive. The proceduralist focusses on belief
that a coherent bankruptcy law must recognize how it fits into both the rest of the legal system
and a vibrant market economy. The traditionalists and proceduralists have a different set of
beliefs that emerge from the divergent ways in which they answer three sets of question. The
first question is that what role should a bankruptcy law play in keeping a firm intact as a going
concern. Second, to what extent can one consider bankruptcy a closed or an open system and
thirdly once a society settles on a substantive policy how does it implement that policy.
According to the author the traditional bankruptcy expert believe that the preservation of the

company and the jobs of workers should be the priority of any bankruptcy law; contemplation
of rights and need of the parties before the court matters more than the effects on incentive
before the fat that bankruptcy judges should enjoy broad discretion to implement bankruptcy
substantive policies. The proceduralists on the other hand believe that the preservation of firms
is not an independent good in itself; ex- ante effects are important and the judge must allow the
parties to make their own decisions and thereby choosing their own identities.
Cornelli & Felli [Cor1997] have focused that there is a great variety of bankruptcy laws in
different countries. Scholars do not agree upon which procedure is best but they all agree upon
certain goals which good bankruptcy law procedure should have. According to authors one
such obvious goals is to maximize social surplus i.e to make best possible use of the firm. The
second goal is about ex-ante efficiency i.e., the effect of a good bankruptcy law on the
incentives of the involved parties before the firm goes into bankruptcy. There is, firstly a
bankruptcy procedure punishing managers or entrepreneurs of the insolvent firm may be seen
as providing them with right incentives to manage the firm so as to avoid ending up in financial
distress. Secondly a bankruptcy procedure, by protecting the creditors interest when the firm is
in financial distress, may reduce the overall cost of borrowing for the firm. The paper has talked
about the alternative aspect of ex-ante efficiency; the protection of the creditors’ claims. They
took the protection of the creditors claim to consist in both the attempt to maximize the
proceeds of creditors from the reorganizations (revenue efficiency) and respect of the relative
seniority of their claims (absolute priority rule)
Piotr & Sylvia [Pio2019] have investigated the efficiency of creditor protection in insolvency.
They approached efficiency in three dimensions; ex- ante, ex-post and interim. The paper
presents the difference between Polish and Spanish ex- ante efficiency, the factors influencing
the interim recovery rate and efficiency and the differences between ex-ante and ex-post
efficiency in Polish proceedings and they reached the conclusion that polish insolvency
proceedings are inefficient. The duration of the proceedings from filing until resolution takes
an average of 853 days. The results have policy implications, as creditor protection is a major
aspect in attracting investment for net foreign debtors.
Franks & Loranth [Fra2014] in their research paper have studied how the allocation of rights
in bankruptcy influences outcomes. Using a unique dataset of distressed and bankrupt firms

from Hungary, they related particular provisions of the bankruptcy code. They examined three
features of bankruptcy code (i) lack of control by secured creditors over the proceedings, (ii)
the compensation scheme for the court appointed trustee and (iii) the potential advantages
derived by trade creditors from supplying the firm when it is maintained as a going concern in
bankruptcy. The article used a sample of 120 bankruptcies to measure the cost of immediate
closures and going concern bankruptcies and the recovery rate of different creditor classes.
They found out that for Hungary going concern results in higher bankruptcy cost than
immediate closures. These higher costs are not associated with larger revenues for assets sold
in bankruptcies hence, loss given default (LGDs) are higher for pre bankruptcy creditors in
going concern bankruptcies. They also found that costs and LGDs are significantly affected by
the choice of trustee. When the trustee is from a state-owned firm, the going concern is less
likely to deplete creditors claim than when the trustee is from private firm. At the same time,
they observe higher cost and lower recoveries for pre bankruptcy creditor when the initiator is
a junior creditor.
The literature on Law and Finance has investigated the difference between legal origins
particularly the difference between the common law countries and civil law countries and their
impact on economic performance.
La porta et al., [Lap1998)] have studied empirically the impact of different bankruptcy laws
in financial markets. They had collected a data set of 49 countries and examined the laws
governing investor protection, the quality of enforcement of these laws and ownership
concentration in these countries around the world. The study suggested three broad conclusions
(i) laws differ significantly around the world and common law countries tend to protect
investors considerably as compared to French civil law countries. The German civil law and
the Scandinavian countries take a middle approach in investor protection. (ii) German civil law
and Scandinavian countries have the best quality of law enforcement. Law enforcement is
strong in common law countries as well whereas it is weakest in French civil law countries.
(iii) the data suggested that countries develop substitute mechanisms for poor investor. Some
of these mechanisms are statutory as in the case of remedial rules such as mandatory dividends
or legal reserve requirement.

Classens & Klapper [Cla2005] in their paper have reported about how often bankruptcy is
being used in countries around the world and investigated which legal and other country
characteristics affect the likelihood that formal bankruptcy procedures are used to resolve
financial distress. They used a panel of 35 countries and investigated that how bankruptcy use
relates to countries’ creditor rights and judicial efficiency. They created a unique data set on
the number of commercial bankruptcy filings in 35 countries where they included all legal
proceedings designed either to liquidate or rehabilitate an insolvent firm. They found out that
bankruptcies are more frequent in countries with better functioning judicial systems. They
found out that only presence of creditor rights alone is not associated with more use of
bankruptcy but in combination with greater judicial efficiency leads to more bankruptcy use.
Another important finding was that the occurrence of bankruptcy varies with specific creditor
rights. The presence of a “no automatic stay on assets” provision leads to fewer bankruptcies
independently of the efficiency of the judicial systems.
2.4.2 Studies on Financial Distress
Gilson, John & Lang [Gil1990] have investigated the incentives of financially distressed firms
to restructure their debt privately rather than through formal bankruptcy. Study examines that
firms had to choose between private negotiation and Chapter 11. They evaluated the
involvement of 169 publicly traded companies that experienced severe financial distress during
1978 – 1987. They concluded that in fifty percent of the cases the financially distressed firms
resolved their debts outside chapter 11. Financial distress is more likely to be resolved through
private renegotiations when more firm’s asset is tangible and relatively more debt is owed to
banks; private reorganization is less likely to succeed when there are more distinct cases of
debt outstanding.
Gilbert & Schwartz [Gil1990)] analyzed that in most bankruptcy studies models are developed
using samples containing equal proportions of bankrupt and non-bankrupt firms. This
procedure results in an overall sample with a much higher representation of bankrupt firms
than actually exist in the world. They say that though the results under these models are
impressive but all they are able to influence the bankers and other resource suppliers who has
to assess the likelihood of bankruptcy for problem companies. The paper demonstrated that a
bankruptcy model developed using a bankruptcy random estimation sample is unable to

distinguish firms that fail from financially distressed firms. Further, it is demonstrated that a
financial ratio-based bankruptcy model estimated from a sample comprised of distressed firms
also perform poorly, suggesting that the resolution of distress is influenced by other perhaps
non-financial factors.
Opler & Titman [Opl1994] in their paper have investigated the link between financial distress
and corporate performance by listing whether firms with high leverage are more likely to
experience performance losses in industry downturns than other firms. The authors have used
firm level data from the 1992 Standard & Poors Compustat Pst fc and research files. These
files contain 105074 firm years of data on income statement and balance sheet items from 1972
to 1991 period. They excluded firms in financial sector which were in financial distress due to
difference in accounting treatment of revenues. They also excluded the firms that were in
industries which are unable to provide reasonable benchmark for industry adjustment and also
the firms that list two or more industry segments in their annual reports since including these
firms would make industry adjustments problematic and firms for which data required in the
analysis were unavailable and firms in industries with insufficient cross-sectional availability
in leverage. After applying these selection criteria, they retained 46799 firm- years of data for
the empirical analysis. The results indicated that there is a positive relationship between
financial condition and industry downturn. During the downturn more highly, leveraged firms
tend to lose market share and experience lower operating profits than their competitor. The
relation between leverage and performance tends to be more visible when the firms which have
significant R&D expenditures and for those in non-concentrated industries.
Asquith, Gertner & Scharfstein [Asq1994] have tried to analyze the ways by which financially
distressed firms try to avoid bankruptcy through public and private debt restructurings, asset
sales, mergers and capital expenditure reduction. The paper tried to put these elements together
in a more comprehensive study of how firms respond to financial distress. Their study is based
on a sample of 102 companies that issued high yield “junk” bonds during the 1970s and 1980s
and subsequently got into financial trouble. Of these 102 companies, 76 took viable steps to
restructure the companies in response to distress
Andrade & Kaplan [And1998] analyzed that the starting point of a financial distress situation
is shortage of cash flow and highly leveraged transactions. The authors found out that there are

four sources which are responsible for onset of financial distress: poor industry performance
as a result of economic shock, poor company performance, firm’s leverage and changes in the
short-term interest rates. The empirical investigation found that leverage is the strongest reason
for financial distress. They also made an observation concerning the correlation between the
source and the severity of financial distress.
Whitaker [Whi1999] examines the early stage of financial distress and the causes of firms entry
into financial distress suggest that firms performance may decline because of economic
distress, a decline in industry operating income, poor management, or a decline in firm
performance relative to industry. The author says that more firms are financially distressed due
to poor than as a result of economic distress. Management actions are significant determinant
of recovery and improvement in the industry. The proxy of cash flows for financial distress is
not sufficient as a firm can have a temporary cash storage which can be eliminated by utilizing
other sources of coverage in the face of temporary lack of liquidity.
Turetsky & McEven [Tur2001] depicted financial distress as a series of financial events that
reflect varied stages of corporate adversity. According to the authors each stage of financial
distress has a distress point and continues until the next distress point is reached. They posit
that a volatile decrease in cash flows from continuing operations is one signal of the start of
financial distress and that subsequent distress stages may be characterized by a reduction of
dividend payments, technical or loan default or troubled debt restructuring. They concluded
that the event of default has a significant positive association with business failure.
Platt & Platt [Pla2002] have brought out the fact to the light that there is a lack of a consistent
definition when a company enters financial distress and they try to summarize different
operational definitions of financial distress in case of selection mechanism. According to the
authors firms were classified as financially distressed if they reported several years of negative
net operating income, suspended their dividends or were clients of a turnaround consulting firm
that specializes in the automotive supplier industry. The study also concluded that earning
warning system model need to include all firms within a population; other wise choice-based
sample bias could result. It was evidenced that choice-based sample bias increases as the
proportion of financially distressed to healthy firm within a sample increase.

Natalia [Out2007] found out that financial distress is the result of many factors which include
the general performance of the market. When the economy is in boom, distressed stocks attract
investors’ as they see an opportunity to enjoy good returns after a turnaround. But in the period
of recession investors are risk averse.
Purnanandan [Pur2005] developed a model of corporate risk management by taking in financial

distress cost. According to the author financial distress is an intermediary situation between
solvency and insolvency. The transformation from a solvent to an insolvent state happens only
on the date of maturity if the terminal value of the company’s assets is lower than the face value
of the debt.
Tan [Tan2012] studied financial distress and financial performance with a special emphasis on
the Asian Financial Crisis of 1997- 1998. The sample consisted of 277 entities and found that
the crisis had caused an exogenous shock which led the management to look into the internal
issues such as financial performance and leverage. The findings of the study was that entities
with low financial leverage outperformed those with high financial leverage and they were
better placed to withstand external shocks.
2.4.3. Studies on Insolvency and Bankruptcy Code (IBC) 2016
Deepak and Neelam Tandon [Tan2019] were of the opinion that due to insufficient resolution
framework of Non-Performing Assets (NPA) the banking industry is plagued with asset quality
deterioration. This has resulted into substantial loss for the Indian economy. The rising problem
of NPAs have doubted the sustainability of banking sector in India. The researchers have
attributed the increase in NPA of the banks to lapses on part of banking operations, majorly
non adherence to standard operating procedures. They concluded that despite the initiatives
taken by the Reserve Bank of India (RBI) like Prompt Corrective Action (PCA) to improve the
asset quality the results are not satisfactory and are at a very slow speed,
Srijan Anant and Ayushi Mishra [Ana2019] are of the opinion that the Insolvency and
Bankruptcy Code (IBC) is one of the most important reforms brought about in India. According
to the authors due to IBC India has got a global recognition in the field of bankruptcy laws.

The author opines that the code consolidates the existing multiple laws relating to bankruptcy
into a single law. The author analyses the effect of the IBC on the macro environment of India.
Renuka Sane [San2019] in her study opined that the though IBC has only notified the corporate
Insolvency part and not the personal insolvency. He opined that the Indian credit market calls
for the need of personal insolvency law. The author makes suggestions on the questions of the
policy which needs to be addressed prior to the successful implementation of the law as well
as the evolution of the institutional infrastructure. The researcher in her paper provides a brief
overview of the legal provisions of the law. As per the researcher the prime motivation in
drafting of the law was its potential impact on the credit market. The researcher is of the opinion
that the success of IBC depends on the design of the subordinate legislation as well as the
evolution of the institutional infrastructure.
Nisith Desai Associates [Des2019] analysed the impact of the IBC on the Indian debt market.
The researcher has studied the several judgements during the year and is of the view that
resolution of bad debts of the banks under IBC is very promising for Indian Economy. He has
opined that along with constructive interpretation and effective amendments in the code have
helped in eliminating the challenging issues of the code. The author has said that the Insolvency
and Bankruptcy Board of India (IBBI) is doing a very commendable job in proactively
spreading the awareness. The researcher has mainly focused on impact of IBC on creditors and
investors, Statutory and Regulatory Developments of the IBC and the Judicial Developments.
Manoranjan Ayilyath [Ayi2019] has examined the various issues under the IBC which have
led to the slow progress of the code. The author is of the view that IBC is not able to perform
well as the code related to Personal Insolvency resolution code and Partnership code is not
operational. The author opined that the IBC prevents the erosion in the enterprise value and
provides a time bound solution. The author has analysed the various factors and opined that it
has to be rectified as an ongoing process.
Akshay Kamalnath [Kam2019] is of the view that IBC was introduced with an aim of quick
resolution of insolvent companies. He also said that IBC has created some very efficient
infrastructure like dedicated law tribunals, a regulator and a strict timeline. He further analysed
during the implementation period of last two years, the code has encountered some problems.
He has talked about the initiation problem under IBC. Initiation problem is that where directors

of an insolvent company are reluctant to initiate the resolution process. The author has talked
about ‘Modified Revlon Duty’ which will incentivise the promoters in reviving the company
and avoid retaining the control of company till liquidation.
Adam Feibelman & Renuka Sane [Ada2018] are of the view that Insolvency and Bankruptcy
Board of India is responsible for collection and dissemination of all relevant data about
Insolvency and Bankruptcy Code (IBC). As the code is new the responsibility is increased more
to design a system of gathering data. As per authors, many researches have been done on the
US bankruptcy systems which tells us about the importance of the data and which will improve
the functioning of insolvency law. The researcher gives importance to the fact that data on
insolvency is an important source of much broader information on macro-economic
vulnerabilities and business failures. The researcher is of the view that the Board and
adjudicating authorities should try to generate maximum data. Also, the various challenges in
gathering and percolating data has been stressed upon.
Krati Rajoria [Raj2018] has analysed IBC and has suggested that the focus should be on
implementing the law rather than speedy operation of the process. The author has studied the
evolution of bankruptcy reforms in India and found out the challenges which are existing in
the current code while implementing. The researcher pointed out that there are number of ways
by which the debt can be recovered and the new IBC is one of them. The researcher concludes
that the Code will give an opportunity to the creditors to take essential steps or actions before
the situation becomes uncontrollable and pre-empt such emergencies in the future. According
to the researcher the IB Code has a lot of significance in the current scenario. The researcher
finds that new law will bring certainty and predictability to corporate transactions which will
help improve India’s ranking in World Bank’s ‘‘Doing Business’’ report.
Srilekhya Eduri et al [Edu2018] have laid down the basic framework of the Insolvency and
Bankruptcy Code. They analysed that IBC was introduced in 2015 and came into
implementation in 2016 with an aim to maximize the value and provide a timebound resolution.
The authors stressed that introduction of the new code is a constructive initiative and it is a
forward step in resolution laws. The authors are of the view that the code is having some
challenges and difficulties and the paper examined the impact and the shortcomings of IBC
and suggested measures as to how improve the implementation of the code.

Sreyan Chatterjee et al., [Cha2017] have analysed 110 cases of NCLT, the appellate tribunal
to understand the economic effect of IBC and the performance of judiciary. The parameters
involved were the initiators of the insolvency proceedings, types of evidences used to support
claims, the average time span required and results of the proceedings. The findings of the study
were that 75% of the cases were filed by the creditors while the rest cases were filed by the
debtors which was against the expectation that the creditors will initiate the insolvency process.
Nakul Sharma & Rahul Vyas [Sha2017] have studied the Insolvency Professional Agency as
an important pillar of the IBC in terms of procedural ambit. The authors comment that IBC is
a landmark development which will provide a time bound resolution, will promote
entrepreneurship and will improve credit availability in the country.
Josiah Wamwere [Wam2017] have compared IBC with the bankruptcy law of UK and are of
the view that IBC is more efficient and promising than UK and France bankruptcy laws. They
have used different indices. He was of the view that a good bankruptcy law is that which caters
to the need of both the creditors as well as the debtors. According to him the bankruptcy process
in India is very expensive which deters the relevant stakeholders from initiating the procedure.
The author concluded by saying that IBC is flexible to preserve the solution of liquidation and
continuation.
2.5 Research gap
The Insolvency and Bankruptcy Code (IBC), 2016 is a very significant reform in the history of
our country. The law is still in its evolving phase as it has been recently introduced. There is a
lack of literature on this code. There exists a gap on various aspects of the law. Most of the
literature pertains about the objectives of the code. As the code is new there is lack of data
because of which exact studies are not there which will evaluate whether the objectives of the
code are being achieved or not. After going through the Insolvency and Bankruptcy laws of
different countries and causes of financial distress and the literature available on the new
Insolvency and Bankruptcy Code (IBC) 2016, the researcher observed that there remain some
unaddressed issues which have not been studied or properly taken care of in a systematic and
wholesome manner. Some of the gaps which have been identified can be summarized as below:

There is dearth of research on the new Insolvency and Bankruptcy Code 2016 as it has been
recently introduced. There are few studies on the legal aspect of the code. There are many
aspects of the code which needs to be studied to make the new code perform efficiently.
As the code is in its evolution phase, study about the code becomes pertinent especially the
Corporate Insolvency Resolution Process which needs a lot of improvement for an efficient
working. There is a gap on the literature which pertains to the Corporate Insolvency Resolution
Process (CIRP) of the code.
The researchers have explored the financial distress of Indian industries that resulted into bad
corporate debt and their resolution. The researches in area of evaluating the financial impact
on banking sector in Indian context are limited.
The studies which compare whether liquidation is beneficial or resolution is required, are very
negligent. This needs to be studied as maximization of valuation of the asset is a very important
factor in determining any bankruptcy law.
2.6 Summary of the chapter
The chapter discussed about the concept and definition of aspects of financial distress,
Insolvency and Bankruptcy. After this the theories which form a base for the financial distress
and bankruptcy laws were discussed. Thereafter the dimension of financial distress and
bankruptcy were discussed. The later part of the chapter gave an overview of the studies done
on financial distress, bankruptcy laws, Insolvency and Bankruptcy Code (IBC). Lastly the
research gap was found out which were in consonance with the review of the studies done.

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CHAPTER 2

THEORETICAL FRAMEWORK AND LITERATURE

2.1 Overview of the chapter

2.2 Concepts and definitions

2.3 Theoretical Paradigm of the Study

2.4 Review of Previous Studies

2.5 Research gap

2.6 Summary of the chapter

2.1 Overview of the chapter

2.2 Concepts and Definitions

Fig 2.1: Financial Stages of a Firm

Source: Author’s Own Creation

IMCE, SRMU, LUCKNOW 30

2.2.1 Financial Distress

2.2.1.1 Determinants of Financial Distress

IMCE, SRMU, LUCKNOW 31

IMCE, SRMU, LUCKNOW 32

IMCE, SRMU, LUCKNOW 33

2.2.2.1 Economic Concept of Insolvency

IMCE, SRMU, LUCKNOW 34

[Oog1996]. According to these authors, a company, is said to be insolvent when it cannot

2.2.2.2 Law & Finance concept of Insolvency

2.2.2.3 Corporate Insolvency

IMCE, SRMU, LUCKNOW 35

2.2.2.4 Determinants of Insolvency

IMCE, SRMU, LUCKNOW 36

IMCE, SRMU, LUCKNOW 37

2.2.3.3 Efficiency of Bankruptcy Laws

Ex- ante efficiency

IMCE, SRMU, LUCKNOW 38

2.2.3.4 Bankruptcy Cost

IMCE, SRMU, LUCKNOW 39

2.2.4 Distress Risk Assessment Models

IMCE, SRMU, LUCKNOW 40

absence of theory, extensions to the available techniques concentrate on the analysis of

2.3 Theoretical Paradigm of the Study

2.3.1 Theories of Bankruptcy Law

IMCE, SRMU, LUCKNOW 41

2.3.1.1 Maximisation of Social Welfare Theory

2.3.1.2 Absolute Priority Rule

IMCE, SRMU, LUCKNOW 42

2.3.1.3 Creditors Bargain Theory

2.3.1.4 Risk Sharing Theory

IMCE, SRMU, LUCKNOW 43

2.3.1.5 Value-based Theory

2.3.2 Theories of Financial Distress

2.3.2.1 A “Wrecker’s theory”

IMCE, SRMU, LUCKNOW 44

2.3.2.2 Agency Cost Theory

2.3.2.3 Trade off theory

IMCE, SRMU, LUCKNOW 45

2.4 Review of Previous Studies

The review of previous literature is divided into three parts

2.4.1 Studies on Bankruptcy Laws

IMCE, SRMU, LUCKNOW 46

IMCE, SRMU, LUCKNOW 47

IMCE, SRMU, LUCKNOW 48

IMCE, SRMU, LUCKNOW 49

IMCE, SRMU, LUCKNOW 50

2.4.2 Studies on Financial Distress