Chapter I; of Part II of the Insolvency and Bankruptcy Code, 2016 (Code) provides a fast- track process for the resolution of insolvency of small companies, start-ups, and unlisted companies with total assets below Rupees. one crore. The fast-track insolvency resolution process (fast-track process) essentially provides for the insolvency resolution process of such debtors to be conducted within a period of 90 days (extendable by a further 90 days), instead of one hundred and eighty days (extendable by a further 45 days) allowed under the regular corporate insolvency resolution process (CIRP) under Chapter III of Part II of the Code.
The Bankruptcy Law Reforms Committee (BLRC), which recommended the enactment of the Code, also recommended that a special process be put in place for those entities whose insolvency could be resolved in less than 270 days. Consequently, the fast track process was designed with a view to provide a shorter process for entities that have a less complex structure of liabilities and assets or a smaller size of operations. While the report of the BLRC does not explicitly state that this fast-track process is targeted towards improving the insolvency resolution process for Medium, Small and Micro Enterprises (MSMEs), the World Bank in its Report on the Treatment of MSME Insolvency, categorises the fast track process as a process that shortens timelines to make general insolvency law more suitable for MSMEs. 1 As such, this process has been designed for ‘small corporate debtors’.
Despite the clear objectives underpinning the enactment of the fast track process, and its potential utility in providing a framework for the insolvency resolution of small corporate debtors, the process has had few takers. The Economic Survey of 2017-18 noted that only one fast track process had been initiated under the Code.2
In this background, this essay first analyses the case to have a separate, shorter process for the insolvency resolution of certain entities. Secondly, it examines the reasons due to which the fast-track process has not been implemented successfully in India. Finally, it makes suggestions to redesign the process to enable it to serve its objectives better.
NEED FOR A DIFFERENT PROCESS
CIRP is a 270 day process during which the committee of creditors (CoC), comprising of the financial creditors (FCs) of the corporate debtor (CD), assesses its viability and invites resolution plans for the CD. If the CoC believes the business is viable, it approves a resolution plan. If no resolution plan is approved, the CD goes into liquidation.
However, like most standard insolvency resolution processes for CDs, this process is better suited to larger companies, with more complex capital structures. Where the CD is a small company or a small limited liability partnership, recourse to the CIRP and liquidation processes under the Code may not be suitable since they require an ability to pay for a public and complex process, active creditor participation, an active market for the assets of the debtor and timely detection of distress, to be successful. These factors may not operate in the same manner for small CDs as discussed below.
Ability to Pay for a Public and Complex Process
CIRP is a costly procedure that requires the appointment of an insolvency professional (IP), a detailed and public claims collection process, meetings of creditors and a public marketing exercise of the CD. Further the public nature of the CIRP means that a company has to shoulder the loss of goodwill associated with the initiation of insolvency proceedings against itself.3 The process of liquidation too has various formalities, including obligations to carry out various valuations, prepare various reports and conduct meetings of stakeholders.
This works well, when incurring the costs of these public processes enable a transparent and fair marketing exercise that results in the most value maximising use of the assets of the CD. However, these processes may be ‘too complex, lengthy and expensive for micro and small business debtors, which are characterized by low value, low sophistication and low complexity.‘4 For instance, the utility of a public marketing exercise may not be high in case of small companies where the number of interested buyers are small. In these cases, processes are only likely to reduce recoveries for creditors. In some cases, small companies may not be able to withstand the costs of running this process and there is a high risk that the value of their business would ‘evaporate‘5 on the advent of insolvency proceedings. This is especially likely since small CDs often have a lower proportion of fixed assets, higher turnover on total assets and lower assets per employee those CDs where the proportion of fixed assets are lower, the turnover on total assets is higher, and the total assets per employee are lower.6 This may lead to closing of businesses even when it is not the most commercially desirable outcome.7
Active Creditor Participation
The CoC of the CD (which comprises of their FCs) is expected to take the commercial decisions under the CIRP.8 The key responsibility of the committee is to assess if the CD is viable, and to approve an appropriate resolution plan. In addition to this, however, decisions such as raising of interim finance, sale of assets during the CIRP, related party transactions, change in the terms of appointment of the CD etc. all have to be approved by the CoC.9 The decisions of the CoC, including on how the CD’s assets are to be sold, are also relevant in liquidation. Further, there is now an obligation to form a stakeholder consultation committee comprising of the creditors of the CD, which would provide advice to the liquidator on a multitude of issues. 10
This model works best when creditors believe that collective action would be most value maximising and that the costs of participating in the process will be outweighed by the returns they get from the process. However, in case of small CDs, especially those that house micro and small businesses, secured creditors may prefer individual enforcement of their security interest over the main assets of the company, outside of a collective process. Indeed, the BLRC also noted anecdotal evidence that `banks are too quick to initiate recovery proceedings against MSMEs in the event of a default (irrespective of the viability of the entity)߲, despite guidelines of RBI that incentivise them to consider restructuring debts due from viable enterprises. On the other hand, unsecured creditors may find that the unencumbered assets of the company would not give them enough realisation to outweigh the costs of participating in the process. 12 Thus, there may not be enough incentives for creditors to participate in the CIRP or liquidation processes of such debtors.
Active Market for the Assets of the Debtor
CIRP displaces the management of the CD, and requires that a public marketing exercise be conducted for the assets of the debtor. While the Code originally provided that any person may propose a resolution plan for the CD, section 29A of the Code added vide an amendment in 2018, effectively bars a promoter from applying as a resolution applicant in the CIRP or purchasing the assets of the debtor in liquidation. This means that initiation of proceedings under the Code effectively results in the control of the CD being wrested from the hands of the promoters permanently.
While section 240A of the Code exempts the application of certain provisions of section 29A on MSMEs, the definition of MSMEs is likely to be too restrictive 13 and may not cover all instances where the best chance of the small company’s rescue would be to keep it in the hands of the existing promoter. Similarly, while section 230 of the Companies Act, 2013 enables the promoters to enter into a compromise with the creditors of the CD in liquidation, and regain control of their enterprise, the use of schemes may prove extremely cumbersome and costly for small debtors. Thus, the chance of the promoter regaining control of the CD is minimal.
This may be useful in building a market for corporate control of strategic/large assets, especially since Indian corporates are typically closely held. However, in cases of small CDs, such a market may not exist for multiple reasons. First, in many cases, smaller companies suffer from poor record keeping. Such information asymmetry is likely to make it harder for a third party to purchase the business of the company. Secondly, smaller companies are likely to have fewer fixed assets, and may be heavily dependent on the promoter-manager and his employees, which may not be so easily transferred. Consequently, the best likelihood of resolving insolvency maybe to keep the business in the hands of the existing promoters/managers.
Timely Detection of Distress
CIRP can be initiated by an operational creditor (OC), FC or the CD itself on a ‘default’ in payment of a debt due to a FC or OC. The test of ‘default’ was chosen to ensure the timely detection of distress and recourse to a rescue procedure.
However, in case of smaller companies where the nexus between promoters and the management is likely to be more, 14 the fact that the promoter is likely to lose control on the initiation of the CIRP, and is unlikely to be able to bid for the CD, means that promoters are less likely to initiate the CIRP promptly. 15 In addition to this, the provisions of the Code dealing with personal insolvency have not been implemented yet, which means that in those cases where the promoter has given personal guarantees, which is likely to be common in case of small companies, the promoter is unlikely to be guaranteed a discharge. This further disincentivises promoters from initiating proceedings under the Code.
Further, the promoter-managers of such companies are more likely to act recklessly in the wake of insolvency to preserve their business, especially since they are less concerned about getting into the job market again. 16 It may be harder to suitably apply provisions such as those preventing wrongful trading or fraudulent trading, in the context of small CDs since it would be difficult to judge ‘what the correct behavior of the director should have been retrospectively. This may lead to prolonged litigation that creditors may be less interested in funding due to the limited assets of the promoter-managers of such debtors, which would further reduce the efficacy of such provisions. 18
If creditors of such a company are also passive, as may be the case as discussed above, they are also unlikely to identify distress sufficiently early, and trigger the CIRP. This means that such companies do not enter the CIRP till an advanced stage of distress.
Given these fundamental mismatches between the corporate insolvency resolution regime and the needs of small CDs (that may have less complex balance sheets, fewer creditors, small scale of operations, or high ‘evaporation risk’), there is a need to have a different insolvency resolution process for such debtors.
AN ASSESSMENT OF THE FAST-TRACK PROCESS
As discussed above, there is a need to have a different insolvency resolution process for small CDs, which the fast-track process could have served. However, first, the fast track process barely differs from the CIRP. It primarily reduces the time period within which the insolvency of the debtor may be resolved to ninety days, extendable by another 45 days. Other than reducing the timelines, the fast-track process only recommends a variation in the number of valuers to be appointed. As such, the fast-track process, which was meant to provide an alternate framework for the insolvency resolution of small CDs offers no significant deviation from the CIRP.
Secondly, the fast-track process applies only to the ‘resolution’ stage. However, in many cases, it may be hard to rescue small CDs. In such cases, they would have to undergo the liquidation process, which could be value destructive in a disproportionate manner due to the extensive formalities and costs of the process. Given this, there is a need to have a simplified and low-cost liquidation process as well, which the fast-track process does not cover. Considering that the fast-track process does not factually simplify the process for small CDs, even the Insolvency Law Committee recommended the repeal of the fast-track process in 2018.20
Thus, the Code does not offer the most effective regime for the insolvency resolution of smaller CDs. This is particularly damaging since MSMEs ߱form the foundation of the Indian economy, and are key drivers of employment, production, economic growth, entrepreneurship and financial inclusion21߲ As such, the lack of a suitable insolvency resolution and liquidation process is likely to affect credit availability to and entrepreneurial activity for this sector, and undermine the objectives of the Code.
Accordingly, there is a need to reconceptualise the fast track insolvency resolution process framework to enable maximisation of value for all stakeholders of such special types of debtors.
REDESIGNING THE PROCESS
To redesign the fast-track process one of two approaches can be followed. First, the CIRP and Liquidation Process can be applied to small CDs with additional modifications. Secondly, an entirely new scheme, which is significantly different from the current process may be integrated into the Code.
CIRP and Liquidation Processes can be applied with additional modifications
Most jurisdictions treat the insolvency of small CDs by making certain modifications to their insolvency resolution process. For instance, the UK makes certain exemptions, including exemptions from holding physical meetings, exemptions from providing proof of small debts and deemed approval of routine decisions of creditors.22Argentina, on the other hand, provides for lower documentation requirements, and removes the requirement to mandatorily constitute a creditors’ committee.23 The Organization for the Harmonization of Business Laws in Africa’s uniform insolvency law also provides for a simplified reorganisation and liquidation process. The simplified reorganisation process has lower documentation requirements, and allows for the preparation of a simpler reorganisation plan. The simplified liquidation process provides for sale of properties through private agreements.24
Similarly, in India too, the fast-track process could be redesigned to include a further simplified CIRP and liquidation process. The CIRP and liquidation processes could be simplified for this purpose by:
A New Scheme can Replace the Fast-Track Process
Alternatively, the fast-track process could be redesigned to include a new scheme for resolution and liquidation, whose fundamental features would be different from those of the CIRP and liquidation under the Code. A new scheme for resolution could include:
Example of such procedures include:
Company Voluntary Arrangements (CVAs), United Kingdom:In a CVA, the directors may propose a voluntary debt arrangement, which needs to be agreed to by the creditors of the company. Where the directors of the company propose a CVA, they must approach an insolvency professional to act as a nominee, whose role is to opine if the proposal has a reasonable prospect of being approved and implemented. After this, the proposal is put for approval of the creditors. If at least 75 per cent of the unsecured creditors of the company approve of the CVA, broadly, the company and its unsecured creditors are bound. Secured creditors are bound only if they approve of the CVA. However, creditors may apply to the court if the CVA’s terms are unfairly prejudicial or if there was some material irregularity in the procedure leading up to its approval.29 The CVA scheme itself has had ‘very little take up and is subject to criticism since it doesn’t provide an automatic moratorium, except in case of small companies, and doesn’t bind secured creditors unless they consent. Further, in many cases, the terms of the CVA are not met by the debtor. 31 Despite this, it is estimated that the average value that would be foregone if the CVA was not available, and all debtors had to resort to the administration procedure would amount to £167, 500 per case.32
Small Business Rehabilitation Procedure, Korea: Other jurisdictions such as Korea also have a special procedure for Small Businesses. In this procedure, the CD retains management of the business. However, an examiner is to be appointed to assess the debtor’s financial condition using a simplified accounting method. Further the requirements for approval of a resolution plan are also simplified in this case to ensure that one major creditor is unable to block the approval of the resolution plan.33 This process is common for small companies as well as unincorporated entities.
Personal Insolvency under the Code: Closer home, this process appears to be similar to the insolvency resolution process for unincorporated entities in the Code as well, in which the debtor remains in possession of the business assets, and proposes a repayment plan which the creditors may approve in their meetings. While this process has not yet been implemented and does not comprehensively contain all the elements discussed above, some elements from this process could potentially be looked to while designing the framework for small CDs.
The new scheme for resolution could also be redesigned to allow for a cost-effective business sale, which may even be concluded to existing parties. Examples of such a procedure could include:
Pre-packaged sales of the business (including to connected parties), United Kingdom: A prepackaged sale in jurisdictions such as the United Kingdom involves the ‘pre-negotiated sale of the debtor’s assets which is executed soon after’ the initiation of formal insolvency proceedings, and without requiring prior statutory approval of creditors. 34 Since the negotiation of the sale takes place before formal insolvency processes are initiated, the indirect costs of insolvency and the direct costs of following a statutory procedure are not incurred by firms that take resort to these procedures. Further, since the negotiation of the sale takes place when the management is still in control, (although insolvency professionals advise while the deal is negotiated) and even connected parties may purchase the business, management is incentivized to take recourse to this simple restructuring procedure. Moreover, evidence suggests that such sales result in better job preservation and recoveries for both secured and unsecured creditors when they are employed in those cases where there is high evaporation risk, which applies to small CDs described above, even when the sale is made to connected parties. 35
Voluntary auctions, Sweden: In jurisdictions such as Sweden, an auction process can be availed of on the instance of the debtor or individual creditor. This auction is conducted by the court-appointed trustee on the basis of a cash-only deal, where payments are made on the basis of the priority of creditors. The BLRC, in its Interim Report, also recommended that ‘a small business seeking rescue protection could be subjected to voluntary auction of the entire business… Auctions, either as pre-packs or in bankruptcy, have been utilized under the Swedish bankruptcy system with success- they have been found to be a speedy, low-cost bankruptcy procedure.‘36 While this does not provide for the debtor-in-possession, these firms may also be repurchased by the original owner in these auction processes. Indeed, ‘firms sold as going concerns are repurchased by the original owner in 54% of the cases.37 Additionally, the auction may also take place in a pre-packaged deal, meaning that incentives may continue to exist for promoter-managers to initiate such proceedings.
In addition to the new scheme for resolution, a new scheme for liquidation may be provided. The new scheme could make liquidation more speedy and less costly by:
There is therefore, a suite of options to choose from while redesigning the fast-track process. Policy-makers may choose one or a mix of any of these options in the interests of a value maximising insolvency resolution of small CDs, based on a detailed analysis of the costs and benefits of each of these options.
This essay argues that the current fast-track process which was meant to provide a scheme for insolvency resolution of small CDs is not designed to optimally resolve their insolvency since, like the CIRP, it is premised on active creditor participation, an active market for distressed enterprises, timely detection of distress and an ability to pay for a complicated and public process. Instead, the fast-track process should be redesigned more comprehensively, to either provide exemptions from the extensive requirements of the CIRP and liquidation, or to provide an entirely different scheme.
1 World Bank Group, Report on the Treatment of MSME Insolvency (Insolvency & Creditor/ Debtor Regimes Task Force, 2017). (hereafter “World Bank Group”)
2Economic Survey, Ministry of Finance, Government of India, 2017-18, pp. 50.
3Armour, J. (2012). The Rise of the ‘Pre-Pack’: Corporate Restructuring in the UK and Proposals for Reform’, published in Austin, R.P. and JG Aoun, Fady. (eds.), Restructuring Companies in Troubled Times: Director and Creditor Perspectives, 43-78. (Sydney: Ross Parsons Centre of Commercial, Corporate and Taxation Law, 2012) p. 43.
4United Nations Commission on International Trade Law (UNCITRAL), Insolvency of Micro, Small and Medium-sized enterprises: Draft text on a Simplified Insolvency Regime. Working Group V, (V.19-01938 (E), 2019), Para 24. (hereafter ‘Working Group V’)
5 Polo, Andrea. (2012). Secured Creditor Control in Bankruptcy: Costs and Conflict (Job Market Paper) Said Business School, p. 20. https://pdfs.semanticscholar.org/8731/1f37705f153b10cdb9bf02a72e6139985e21.pdf.
6 Ministry of Micro, Small and Medium Enterprises, Annual Report (2017-18), Para 1.1 https://msme.gov.in/sites/default/files/MSME-AR-2017-18-Eng.pdf.
7 Zweiten, K. Van. Principles of Corporate Insolvency Law (5th edn., 2018), p. 495.
8 K. Sashidhar v. Indian Overseas Bank & Ors., 2019 (3) SCALE 6
9 Section 28 of the Code.
10 Regulation 31A, Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2019.
11 Bankruptcy Law Reforms Committee, Interim Report of the Bankruptcy Law Reforms Committee, (2015), pp. 31
12 Working Group V. supra note 4 at Para 17.
13Radhika Merwin. (April 18, 2019). Why leeway under IBC eludes many MSMEs. Hindu Business Line
14World Bank Group. supra note 1 at p. 11
15 Gilson, Stuart C. Managing default- Some evidence of how firms choose between workouts and Chapter 11. in Bhandari, Jagdeep S., Weiss, Lawrence A., & Posner, Richard A. Corporate Bankruptcy: Economic and Legal Perspectives (Cambridge University Press, 1996)
16 World Bank Group. supra note 1 at Pg 11
17Davis et al, The Modular Approach to Micro, Small, and Medium Enterprise Insolvency (July 2016), p. 82.
18 Williams, Richard. (2015). What Can We Expect to Gain from Reforming the Insolvent Trading Remedy? Modern Law Review 78(1), 55.
19Davis et al. supra note 17 at p. 24.
20 Insolvency Law Committee, Report of the Insolvency Law Committee. (2018). Para 22.3. http://www.mca.gov.in/Ministry/pdf/
21Id. at Paras 22.1-22.3.
22Small Business, Enterprise and Employment Act, 2015 (UK). (August 2019) http://www.legislation.gov.uk/ukpga/2015/26/
23World Bank Group. supra note 1 at p. 23.
24World Bank Group. supra note 1 at p. 26-27.
25 Davis et al. supra note 17 at p. 47.
26Davis et al. supra note 17 at p. 47, 64.
27 ‘Poor corporate governance and insufficiently trained and skilled directors, a rather widespread phenomenon in the MSME context, might require a clear-cut, and even easier to apprehend rule on which to base the liability of directors. Indeed, the insufficiency and inadequacy of accounting information, particularly common in the context of MSME, makes it difficult to judge retrospectively and when it should have been executed. Judges in jurisdictions with little practice of holding directors liable for misbehaviour, again, a not uncommon situation, could find it difficult to conduct an assessment, on the merits, of the actions of the debtor’s management on the eve of insolvency. While more rigid, the duty to file constitutes a somewhat clearer rule that works as a stricter ex ante corporate governance incentive, although the experience in systems that subscribe to the duty to file regime (e.g. Germany) show that uncertainty still exists with regard to the point in time when the duty arises. When opting for one system or the other, the legislator would do well to take all considerations into account.’ World Bank Group, supra note 1 at p. 82.
28Working Group V. supra note 4. See also: European Commission, Commission Staff Working Document Impact Assessment: Accompanying the document Commission Recommendation on a New Approach to Business Failure and Insolvency, [C (2014) 1500 final, 2014]. https://ec.europa.eu/smart-regulation/impact/iaDcarriedDout/docs/iaD2014/swdD2014D0061Den.pdf
29Olivares-Caminal, Debt Restructuring (Oxford University Press, 1 st edn., 2011) pp.136-137.
31R3 Association of Business Recovery Professionals, Company Voluntary Arrangements: Evaluating Success and Failure. (2018).
32Supra note 28 (European Commission).
33World Bank Group. supra note 1 at p. 31.
34Kastrinou, A., & Vullings, S. No Evil is Without Good’: A Comparative Analysis of Pre-pack Sales in the UK and the Netherlands, p. 2.
35Supra note 5.
36 Bankruptcy Law Reforms Committee. supra note 11 at pp.129-130.
37Thorburn, Karin. (2000) Bankruptcy auctions: costs, debt recovery and firm survival,Journal of Financial Economics 58, 337, p. 344.
38Davis et al. supra note 17 at pp. 64-65..
*(Ms. Shreya Prakash is the Coordinator, Vidhi Bankruptcy Research Programme, Vidhi Centre for Legal Policy.)