Govt proposes individual bankruptcy law: Will India follow US model?

After a bankruptcy law for corporates, the government is now planning to come up with a similar law for individuals.

This means in case of a financial crisis in life, you and I will also be able to claim bankruptcy and get rid of the debt that is beyond our means to repay.

The law, once enacted, would help the Indian financial sector turn more professional, helping individuals live a peaceful life even if some of their financial decisions go wrong.

At the moment, defaulting on a loan means public humiliation by the financial institutions, which may get extended to unofficial threats by goons hired by lenders.

How will the the law function?

While there is no clarity yet on how the government will frame the rules for personal bankruptcy, to understand its potential direction, one could look at the similar law used in the United States.

1. Keep your property

Currently, in India, if an individual is unable to service his/her monthly EMI for a home or a car loan, he/she stands to lose the property to the creditor.

However, in the US, a bankrupt person can use Chapter 13 of the bankruptcy law, which allows re-organisation of bankruptcy. This clause allows a debtor to keep his/her property, and the loan repayment is restructured by reducing “principal to the market value of the collateral, and lowering payments by extending the repayment period to 60 months”. So far, the facility to restructure loans was available to only corporate houses.

2. Chapter 7

While some people need time to recover the assets attached to their loans, there are others who just want their loans written off completely. For such people, there exists 'Chapter 7 bankruptcy', which allows on individual to get rid of all liabilities to repay his/her loans.

However, filing bankruptcy under Chapter 7 means the debtor is agreeing to allow a bankruptcy trustee to take any property that is not exempt from collection and sell it to repay the creditors.

Filing under this chapter leaves a lasting impression on an individual's credit history. According to hrg.org legal resources, the bankruptcy stays on the credit history for 10 years.

Challenges in implementation

Even though India is among the fastest growing major economies in the world, and attracts highest foreign direct investments, the financial sector in the country, especially for individuals, remains largely informal.

A large number of people take loans from local lenders, who can use force and intimidation in case of a loan default to recover their dues.

While providing a bankruptcy law to individuals is the right step, the government must follow the international best practices, and should also look at ways to bring the informal financial sector under the proposed law.