Resolving Municipal Distress In India

In recent years, municipal bodies in India have been increasingly accessing the public debt markets. In the four-year period beginning 2017 to August 2021, nine municipal corporations made bond issuances aggregating to Rs 3,000 crore. In contrast, in the immediately preceding two decades, ten municipal bodies had issued bonds aggregating to less than half this amount. This is generally a positive development. Tapping financial markets expands the resources available to cities for critical services and development. Like firms that access the public markets, municipal bodies that subject themselves to market discipline are held up to higher standards of transparency and local governance. A key missing element in this story, however, is the lack of clarity about municipal creditors' rights in the event of a default by a borrowing municipal body. In a chapter published in the 2021 annual publication of the Insolvency and Bankruptcy Board of India titled Quinquennial of Insolvency and Bankruptcy Code, 2016, we argue that the time is ripe for policymakers in India to develop a reorganisation framework for financially distressed municipal bodies. We evaluate the potential of a formal bankruptcy regime as the model for such a framework.

The Case For A Municipal Reorganisation Framework

We make three arguments. We begin by demonstrating the weak state of municipal finances in India. For example, in the decade beginning 2007-08, municipal revenues stagnated at 1% of the GDP, significantly lower than comparable countries. Municipal bodies (urban local bodies or ULBs) are disproportionately reliant on state governments for grants-in-aid and loans. They are shown to have consistently under-invested in capital infrastructure. The pandemic has exacerbated the weak state of municipal finances in India. The size of the municipal debt market is, therefore, likely to grow as municipalities seek additional resources.

Second, we argue that the current legal regime in India provides neither opportunities for collective action against municipal debt default nor clarity on the treatment of creditors (bondholders, banks and financial institutions, state lending agencies, employees and vendors) in the event of the borrowing municipal body's insolvency.

At one end of the spectrum, this creates the possibility of aggressive sale of public assets, owned and operated by the ULB for the benefit of the public, by 'powerful' creditors of the ULB. On the other end of the spectrum, this deprives the system of the benefits of early recognition of financial distress in ULBs. It minimises the possibility of salvaging a ULB's operations through a mutually negotiated and court-supervised reorganisation exercise. The growing levels of municipal borrowing from the public markets and the impact of the Covid-19 pandemic reinforce these concerns.

Third, the standard reorganisation framework applicable to private borrowers does not apply to ULBs as they provide public goods, and most of their assets are presumably for public use. Several countries have enacted differently designed reorganisation frameworks for resolving distressed municipal bodies. We highlight the key features of one such framework, namely, Chapter 9 of the U.S. Bankruptcy Code. To be sure, Chapter 9 has its critics. However, with more than 100 municipal entities having used Chapter 9 for their resolution, it has proven to be a viable municipal bankruptcy regime. It is a rule-bound process, but one that is flexible enough to be able to address the complex problems of government financial distress, which inevitably combine important commercial concerns with essential necessities of social well-being. At the least, it helps frame a number of threshold and critical questions that should be part of any discussion on the reorganisation of distressed municipal entities.

Key Legal And Institutional Challenges

We conclude by underscoring some key legal and institutional challenges to the idea of a municipal bankruptcy law in India.

First, while bankruptcy and insolvency are in the concurrent list of the Constitution, municipal governance is an intrinsically State subject. A union municipal bankruptcy legislation will raise complex questions of federalism and will require provisions that allow states to retain their autonomy in applying a union legislated bankruptcy law to their ULBs. What might be the institutional tools for preserving such autonomy?

Second, experience from the U.S. suggests a pro-active role for courts in administering a municipal bankruptcy.

If so, this would be a fundamental departure from the design of the Insolvency and Bankruptcy Code, 2016, which seeks to minimise court intervention in the insolvency proceedings and provides for the appointment of Insolvency Professionals for running the debtor's operations. Similarly, the scope of relief that the process can legitimately provide in a ULB's bankruptcy proceeding will need to be considered. Can a resolution plan for a ULB contemplate an increase in taxes? Can it provide for the sale of the ULB-owned public property? How can it do so without impinging upon decisions that are the prerogative of a city-level legislature or the state's power?

Enacting a municipal bankruptcy law will require the resolution of these questions and prolonged negotiations with states much like the enactment of the GST framework. However, this should not deter policymakers from beginning the process. The gains of a clear municipal bankruptcy framework, in the face of the severe impacts of the Covid-19 pandemic and the deteriorating state of India's cities, should provide a motivation for doing so. The fact that municipal bonds are set to become an important asset held by Indian households adds an additional imperative and responsibility to ensure that there is a framework in place for addressing municipal financial distress in India.

This article was originally published as ‘Resolving Municipal Distress In India’, by Adam Feibelman and Bhargavi Zaveri-Shah, The Leap Blog, October 24, 2021.

Adam Feibelman is a Professor of Law and Director of the Center on Law and the Economy at Tulane Law School. Bhargavi Zaveri-Shah is a doctoral candidate at the National University of Singapore.

The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.