Essays on regulatory aspects in indian financial market

Thesis Advisory Committee
Prof. Prof. Naman Desai & Prof. Ajay Pandey (Chair Person)
Prof. Prof. Diptesh Ghosh (Member)

Country-level legal and regulatory institutions play a crucial role in the overall economic development of the country by facilitating the raising of external financial capital, and the flow of foreign investments among others (Cumming et al., 2017). In addition, successful financial regulations in place promote macroeconomic stability and prevent market failure. In this thesis, with three essays, I examine two specific country-level national laws —the Insolvency and Bankruptcy Code (IBC) 2016 of India; and Section(11) of the Security and Exchange Board of India (SEBI’s) Act 1992 and their interplay with the Indian financial market. A combined brief summary of all these three essays have been given below

In the first essay, the trading of exchange-listed stocks which have already entered for insolvency proceedings has been examined. The essay highlights two important questions:—(a) are market participants incorporating information related to the bankruptcy event and (b) is there a lack of availability of the information in the financial market?

The second essay brings another dimension of bankrupt firms. Here, the earnings management of the listed firms in their pre-bankruptcy period has been examined. This question is of special significance as earlier studies have mostly been carried out in a country where the insolvency regime is “pro-debtor” whereas the IBC of India is a leading example of a “pro-creditor” insolvency regime. Cumming and Johan (2019) argue that to properly analyse the impact of securities market regulations, an understanding of computer surveillance is a must.

The third essay, thus, aims to make an additional contribution to the literature falling at the intersection of law and finance, by examining one of the surveillance actions implemented by the Indian Stock Exchanges. A separate summary of each of the three essays is provided below:
Essay 1: Trading of exchange-listed stocks during the course of insolvency proceedings
Previous laws related to corporate insolvency resolution in India neither aided in “credit recoveries” by the lenders nor in the “reorganization of firms”. The Insolvency and Bankruptcy Code 2016, thus is considered as a major structural reform as it restrained managerial opportunism by making the incumbent management relinquish control over the company’s affairs, once the firm is admitted to insolvency proceedings. As a result, the impact of this pro-creditor insolvency law on the financial market is of special importance given significant amount of trading witnessed in some of these bankrupt firms.

Using a simple mathematical model, this essay shows that even to recover the initial invested amount in such stocks, it would take a significant amount of time to recover the original money. In this study, the concept of “insolvency tub” has also been introduced indicating a clear difference between the “true price” and “market price” of the firm resulting from information asymmetry among the market participants. Thus, this essay poses a crucial policy question—How reasonable it is for the regulators to allow continued trading in such stocks, given the confidential treatment of the resolution plan would lead to information asymmetry in the market? The findings from this study does not only contribute to the literature on the trading of stocks of bankrupt firms but also alerts policymakers and regulators about market inefficiency at the time of insolvency proceedings.

Essay 2: Examining earnings management of firms filing for insolvency: Empirical evidence from a pro-creditor insolvency regime
A recent report by Economic-Survey (2021-22) suggests that the Insolvency and Bankruptcy Code, IBC 2016, resulted in a behavioural change in the corporate debtor (EconomicSurvey,
2022). This is driven by the fact that the corporate debtor (firm) needs to change hands i.e. from the incumbent management to the resolution professional when the firm enters bankruptcy. Later, a reorganization plan is invited from a third party. This is in sharp contrast to the country where there is a pro-debtor insolvency regime like that of the US where the management has exclusive rights to file a reorganization plan for the firm. This provides a requisite motivation to study if countries where the insolvency regime is pro-creditor, would the firm’s management try to protect it by showing a better financial position of the firm when it is not in actual. Thus, preventing the firm from entering bankruptcy. Using a sample of Indian firms which filed for bankruptcy under IBC 2016, I have examined their earnings management in prior years before they were admitted for bankruptcy proceedings. The result suggests differently showing that management engages in income-decreasing accruals (a sign of reversal in earnings management) two years before their bankruptcy filings to avoid further litigation. The results found in this study are representative of those countries where insolvency laws follow a pro-creditor regime.

Essay 3: Surveillance action: Examining its efficacy and its relationship with Earnings Management and Corporate Governance
As per Section (11) of the Securities and Exchange Board of India “it shall be the duty of the Board to protect the interests of investors in securities and to promote the development of, and to regulate the securities market, by such measures as it thinks fit”. Thus, the third essay is motivated by a need for protecting the retail investor by examining one of the surveillance actions implemented by the exchange. Surveillance actions are tools used by stock-exchange to detect instances of fraudulent trading practices and thereby alert investors. This surveillance action (notices for clarification by the exchange) is invoked when an abnormal increase in price or volume in intraday trading activity is found. It also has been found that some of the firms come under repeated surveillance action and this is not commensurate with their financial health. I examine the efficacy of this surveillance action, (a notice is sent to a firm for whom a sudden spurt in price or volume is observed) implemented by the National Stock Exchange. The result suggests that there is partial effectiveness of surveillance activities in the short term. Further, the results suggest that there is a direct relationship between surveillance action and earnings management while an inverse relationship exists between surveillance action with the corporate governance of the firm.

This thesis has significant managerial and policy implications which have been enumerated below:
1. In the first essay, the impact of the insolvency regime, Insolvency and Bankruptcy Code (IBC) 2016, on the financial market has been examined. This study examines the significance of various bankruptcy-related events. It further discusses a crucial policy question of the confidential treatment of certain information under (section 36(4) of IBBI) (IBBI, 2016) during the insolvency proceedings and at the same time allowing the continued trading of the stocks of bankrupt firms in the stock market. The other significant implications of this study are:
(a) The study draws a comparison between the trading in the stocks of bankrupt firms in the US with that of India. In the case of the US, the trading can be considered as ”informed trading” while in the latter case, it is more likely to be uninformed.
(b) The study proposes a mathematical model which is helpful for investors to determine how rational it is for them to invest in the stock of bankrupt firms.
(c) The concept of ”insolvency tub” introduced here highlights the existence of information asymmetry as the market price does not reflect the true price of the firm.
2. The second essay, provides empirical evidence that in the face of imminent bankruptcy, the management engages in income-decreasing accruals at least two years prior to the bankruptcy. The study reports that the management wants to avoid future litigation. The finding significantly contributes to the earnings management literature of bankrupt firms in their pre-bankruptcy filing period.

3. The third essay examines the efficacy of one of the surveillance actions implemented by the exchanges. The findings contribute to the debate on excessive surveillance action adopted by the regulatory bodies or the exchange. The other implications of this essay are:

(a) The study suggests that the firms that come under surveillance action repeatedly have a positive association with the earnings management in their immediate previous years. Such firms have been found to have poor corporate governance. The result shows that the presence of institutional ownership can reduce the likelihood of facing surveillance action by 20%. The textbook account of corporate governance would suggest that a firm should have institutional ownership.