What Should the Insolvency and Bankruptcy Code for SMEs be Like?

[Guest
post by Rishi A, who is a Legal
Analyst at Spotdraft.com]
The Insolvency and the Bankruptcy Code (“IBC”), 2016 was a much-needed
legislation in India for hastening the process of bankruptcy filing and to
provide for a framework that would incorporate globally recognised standards
for both creditors as well as debtors. However, right from its inception, there
has been some discussionabout the need for a similar legislation better suited
for smaller enterprises. In July, the Government
disclosed
the fact that it is working on a framework (the “new code”) that will focus on small and medium scale enterprises (“SMEs”).
While, a large number of the SMEsare
registered as either a sole-proprietorship or partnership, the rise of
entrepreneurship India has seen growing number of company registrations. Even
the IBC has included entity specific provisions, like allowing only individuals
or partnerships to access the provisions dealing with the fresh start process.[1] To avoid complexities and
ambiguities, the new code must deal with all possible economic forms in a
comprehensive manner, treating partnerships, sole-proprietorships and small
companies alike.
The report of the Bankruptcy Law Reforms
Committee
(“BLRC”),
from which the IBC draws inspiration, highlights the importance of a more
efficient framework for SMEs. The BLRC focuses the reform on two aspects: an
insolvency resolution process, which involves a process of negotiation between
the company and the creditors, and a fresh start process; but, as reflected in the
IBC, it limits the application to just individuals, partnerships or
sole-proprietorships. Thus, expansion of the scope of application of the proposals,
to cover other entities like companies, and an inclusion of a fast track
insolvency process along with the other two aspects would make for an effective
framework for the SME sector.
At the outset, it is useful to note that in
the European Union, experts have stressed on the need to focus on outofcourt
settlements or negotiations in cases of SMEs, instead of dragging them through
an insolvency proceeding. Numerous countries, including
Portugal
and Germany, have encouraged out of court settlements, not just to speed up the
process but also to lessen the courts’ burden. 
Similarly, in India, the Government must
encourage such settlements for SMEs and allow the courts to focus on insolvency
proceedings relating to larger companies. Insolvency professionals must be
allowed to give professional advice to SMEs about the settlements,
restructuring of the business or on the options available to the company or
otherentity. It is important that they perform this function as a third party,
mediating between the entity and the creditors to ensure benefits to both sides.  
To achieve this objective, the Government must
consider broadening the scope of the functions provided to the insolvency
professionals so as to allow them to consult with the entity during out of court
settlements. Even the BLRC has recognised the need for negotiations between the
debtor and the creditor with the resolution professional having a complete
oversight. However, at present, the insolvency professionals’ functions are
restricted to taking over the operations of a company against whom an
insolvency proceeding has been initiated. These functions need to be reconsidered
and the professionals should be allowed to consult with the entity and the
creditors.
Furthermore, the notification of the Insolvency
and Bankruptcy Board of India (Information Utilities) Regulations, 2017

allows for a more dynamic assessment of the financial data of an entity. The
information that is stored by the entity can be accessed by not just thepersonstoring
it but also the creditors and the insolvency professionals. Access to this
information can allow parties to make more informed decisions even before an
insolvency proceeding is initiated. Accordingly, the Government must consider
making it mandatory for all entities to store and maintain their financial data
with these Information Utilities.
Also, under the IBC, an insolvency
resolution proposal to be adopted requires the approval of 75% of voting share
of the creditors.[2]
It has been observed that SMEs have a
tendency
of obtaining
a line of credit from an
average of two financial institutions and, in situations where their interests
don’t match, reaching an agreement becomes difficult. Thus, for the sake of
making it easier for companies or creditors to be able to adopt settlement
proposals or restructuring plans, it would be preferable if the Government
considered reducing the percentage of the consent needed.
Secondly, while it is important to ensure
that the discharge period is shortened for SMEs, in the new code a more dynamic
system must also be implemented that not just hastens insolvency proceedings
but also facilitates SMEs to restart their businesses. In other words, it
should provide them with a second chance or a fresh start in cases when they do
fail.
Initiating bankruptcy proceedings against a
company adversely affects the reputation and, consequently, its business
affairs. To ensure that SMEs keep their businesses running,it is important for
the regulations to acknowledge the fact that failure to access capital or
professional advice, or even market fluctuations is usually a bigger cause for
the failure of a small business than misconduct or wilful negligence. The
proprietors of these businesses are generally business run by individuals who
undertake unlimited liabilities to operate a business, and provisions must be
made to ensure that they are not deterred because of an unsuccessful venture. A
second chance policy should create a system of exemptions which would protect a
promoter or entrepreneur from losing his living necessities like his personal
assets or his house. It should simultaneously also protect the licenses and
approvals the promoter or entrepreneur has obtained in relation to his previous
business. Thus, a secondchance policy should ideally aim to limit the consequences
forced upon a promoter or entrepreneur when filing for bankruptcy.
The European Union has adopted a second
chance policy
where, on principle,
businesses that have failed but show credible potential are provided support so
as to not impede entrepreneurship. This step was taken after recognising the
fact that market conditions were a bigger reason for businesses failing when
compared to fraudulent conduct. Thus, a mechanism was proposed to be adopted
which could correctly distinguish between dishonest and honest businesses by
looking at aspects like reckless utilisation of funds, paying family members,
evaporation of assets, etc., and in cases of dishonest businesses, strict
regulations were implemented to deter such practises.
Similarly, as part of a second chance
policy, the IndianGovernment must make provisions for SMEs to be able to access
funds more easily. One of the methods could be to allow companies to utilise
online
platforms for the private placement of securities
.
A deficiency in funds is a critical factor in the failure of a small
enterprise, which is why it is important to allow them access to capital, cash
or credit with lesser restrictions on future trade. Tax breaks are another aspect
that could be considered where a business, which is being restructured, is
allowed a tax relief for a particular number of years. The role played by the
Information Utility, in such situations, could also be crucial. The analysis of
this data stored can give the opportunity to the resolution professionals to
provide sound advice to the entities during the entire process. 
Chapter II of Part III of the IBC, 2016 does
provide for a
fresh
start process
which allows individuals or
partnerships with small debt holdings to discharge their debts and start
afresh. But,the threshold limits that it places on a debtor to be eligible to
avail the benefits of the chapter are too low, like not having a gross annual
income over Rs. 60,000/-; or, net asset value of over Rs. 20,000/-; or, having
a debt above the value of Rs. 35,000/-. These overly restrictive conditions
will barely cover any party with a dire need forthe benefits of these
provisions.
However, the provisions under Part III have
not been notified yet. This allows the Government the opportunity to consider
including provisions for a fresh start in the new code but with less rigid
threshold limits and one that addresses all forms of businesses. Furthermore, if
thereis an issue with disposing of the distressed assets held by the SMEs, then
the Government must also encourage asset reconstruction companies to set up
businesses wherein they specifically target SMEs. A few have already shown
interest to make the shift from
larger
assets to focus on SMEs
.
Finally, while Part III of the IBC provides
for a fresh start to individuals and partnerships, it fails to focus on speedy
resolutions of insolvency proceedings once initiated. Also, the fact that it
mandates a time period of 180 days to complete the proceedings does not help in
fast-track resolution processes.[3] Currently, only Chapter IV
under Part II of the IBC provides for a fast-track insolvency resolution
process. However, this process
can be
availed
of only by a small company as defined
under the Companies Act, 2013, or a start-up, or an unlisted company with total
assets under Rs. 1,00,00,000/-. The
fast-track
process
would shorten the time period of the
proceedings from the usual 180 days down to 90 days and this 90-day period is
extendable by another 45 days upon obtaining approval from the National Company
law Tribunal (“NCLT”).
One must note that this non-uniform
application of processes to different forms of businesses is what needs to be
addressed by the Government in the new code. The Government must consider
replicating this chapter in the new codebut broadening the scope of the
application of the provisions,so that it may include sole-proprietorships and
partnerships, which should be their primary goal.
To conclude, it is important to keep in
mind that
India currently has
more than 48 million SMEs and these SMEs contribute more than 45% of India’s
industrial output, 40% of the country’s total exports and employ close to 40%
of India’s workforce. Hence, for the economic progress of the country, a focused
growth in this sector is absolutely necessary. When small businesses fail
because of problems like operational challenges and inabilityto access credit,
they must be provided with a second chance to allow them to continue their
business operations. Studies across the world show that a flexible and business
friendly bankruptcy law not just helps in the growth of the SME sector and the
country’s economy but also encourages
highly
educated, sector experienced individuals
to
venture into entrepreneurship. 
Thus, in the case of SMEs, amongst other
things the promoters of the company must be allowed to retain control of their
business through the entire process, until and unless it is very clear that the
business is being conducted fraudulently. The new code must allow promoters of
all businesses to play a core role in the resolution of the insolvency
proceeding, to the extent that the resolution may end with the company being
permitted to continue its operations. At present, only an
individual’s
consent
is required for settling an insolvency
proceeding. However, if it has been ascertained that the business has been run
recklessly, the framework must encourage the resolution professionals to take
over the operations of the business. In all, the new code must be built on two
pillars: speed and willingness to give a second chance.
– Rishi A



[1] Part III of the Insolvency and Bankruptcy Code, 2016.
[2]Section 30(4) of the Insolvency and
Bankruptcy Code, 2016.
[3] Section 101 of the Insolvency and Bankruptcy
Code, 2016.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

Add comment

Subscribe to Blog via Email

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Recent Posts

Topics

Recent Comments

Archives

web analytics