Any sudden penalty imposed on the Sahara group can force pre-mature liquidation of long-term assets and turn this possibly solvent firm insolvent

It appears that there have been irregularities in the Sahara Group. However, any penalty imposed suddenly can force pre-mature liquidation of long-term assets and turn a solvent firm insolvent. There can also be externalities. All this can be avoided with an alternative plan to punish.

Sahara The Sahara case – Punish The Guilty But Not The Others

The Sahara Group has raised huge amounts of money over a long period of time. The investments have, it seems, been profitable and the group has grown very fast over time. SEBI and the Supreme Court have, however, found irregularities in the way the Sahara group has raised funds over the years. The regulators and the judiciary are the best people to judge this. So, we will not get into this issue at all. The issue addressed here is only the form of penalty and the time frame in which to impose the penalty. The objective is to avoid or minimize losses to stakeholders other than those who have committed the irregularities even while a suitable punishment is meted out to those who are responsible.

In what follows, we will take it for granted that there has indeed been a serious irregularity. We will also assume that there is a need to impose a penalty the size of which is again best left to the regulators and judges. But punish how?

It will help to provide a perspective first. Assets of firms, banks and non-bank financial intermediaries tend to be long-term in nature. Any quick liquidation of assets can bring about large losses. Even if an entity is solvent, it can quickly become insolvent by the sheer process of quick liquidation. Assets like specialized machinery, equipment, patent rights, etc. tend to be illiquid. This means that there is loss of value if sold at short notice. But even where assets are supposedly liquid and there exists a market in which these assets can be disposed off quickly, there is still a problem – equally serious if not more serious. Immediate sales can lead to a crash in the market prices of assets sold. At a short notice, buyers may not have ready cash with which to buy. So they would only offer a small price. This is true even if there is a competitive market so long as buyers face liquidity constraints at short notice. Even if they have the funds, they may not have the time to evaluate the assets being sold. This is particularly true in case of real estate where there is an added complexity. The legal titles need to be verified and the rules and regulations and prospective policies need to be studied in order to see the possible potential value in future. In the absence of all this, the offered price can be low to cover the possible risk for the buyers. Then the sellers will face losses if they must sell quickly. In the extreme case where such losses are large, the firm can become bankrupt. There is loss of organizational capital and jobs apart from the loss to promoters and other shareholders. Why damage or kill the large firm as a whole in the process of punishing the few who are guilty?

There can be another effect of fire sales of assets. There can be externalities for the asset markets in general. Any fire sales of assets can lower prices for assets for other firms as well. These other firms can be law abiding firms but if they hold such assets or similar assets and need to sell these for whatever reasons, there can be financial stress and in some cases bankruptcies for other firms as well. Why punish others outside the firm?

In the light of the above background, let us now come to the case of the Sahara Group. As mentioned already, it is assumed here that there is a case for a harsh penalty. That is not in question. We are only suggesting how the penalty should be imposed in overall social interest. First, the funds raised in the past are due for repayment according to a time scheduled fixed in the past. The suggestion here is let this schedule stay unchanged. However, as and when the funds are due for repayment, these must be repaid or there can be a roll-over of funds provided the financing method is not the same old method. It is instead different, appropriate and approved by the regulators. This way, there will be far less need for fire sales of long-term assets, and losses for stakeholders will be kept to the minimum. At the same time, the investors’ funds are safe. Second, some new directors/managers may be appointed inside the firm by the regulators. This is as a matter of caution to ensure that there is no actual or perceived ‘tunnelling of funds’ from the group. Third, senior management personnel may be required to pay a penalty in their personal capacity for the irregularities committed though they may be given the leeway to pay over a long period of time. Fourth, if the authorities have required the companies involved to pay a penalty, then this can be collected over time such that the discounted presented value of the penalty is exactly equal to the on-time penalty decided already. Financially, the amount is the same for the authorities but the social loss is reduced as pre-mature liquidation of assets is reduced, if not avoided altogether.

There is considerable academic work in Economics that supports the view outlined above. There is in particular work to show illiquidity as a cause of insolvency. The policy lesson is immediate. There is a need to keep in mind liquidity issues even while irregularities are sought to be punished and prevented in future.  Though the academic literature comes primarily from the advanced countries, the view expressed here would apply to any country whether it is a developed country like the US or it is an emerging economy like India.

There is a need to punish the guilty but in an appropriate manner.

By Gurbachan Singh

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