by Ajay Shah and Bhargavi Zaveri, ajay shah blog

M. C. Govardhana Rangan and Satish John have an article in the Economic Times where they describe selective default by Amtek Auto to some bondholders but not to others.

We have been aware of this problem for a while now: it appears that when a firm gets into trouble, it undertakes a `soft default’ where powerful investors get paid while less powerful investors are not. Sometimes what firms seem to do is respond to stress by paying out different bond holders with different delays, which is also a form of default.

This undermines the very concept of the securities market

Securities markets are about arms-length investing. The investor looks at public domain information about the issuer, at the rules of the game as articulated in securities law, and makes the decision to buy or sell. The investor should need to have no human relationships into the game, or possess political power or influence.

When the cashflows that emanate from a security depend on who the investor is, this is not arms-length investing; it is not a securities market.

Selective default clouds our databases about default, and makes it more difficult to analyse credit risk in the future. In a well functioning financial system, we should observe a binary event of default or non-default associated with each date of cashflow for a bond. With selective default, the information set becomes enormously complicated: the information set of interest is the list of bondholders who were paid and the date on which the payment was made. None of this is visible in the public domain. Enormous energy is expended by market participants in obtaining gossip about these questions of fact. Ordinarily, bonds are a superior way for society to organize loans for borrowing above a certain size, but the productivity gains are lost when expensive finance practitioners waste their time on information gathering about default.

At a philosophical level, the equal treatment of every security is fundamental to the concept of a securities market, much like the concept of equal treatment in the eyes of the State is essential to liberal democracy (e.g. as is done by Art. 14 of the Constitution of India).