[Anushka Garg is a fourth-year B.B.A., LL.B. (Business Law Hons.) student at National Law University, Jodhpur]
In wake of the economic fallout caused by the COVID-19 crisis, India’s Finance Minister Nirmala Sitharaman rolled out several measures to provide relief to companies that face the threat of insolvency. The Insolvency and Bankruptcy Code, 2016 will be modified to bring various important amendments.
First, the Government will amend the Code to bring into force section 10A that will suspend the operation of sections 7, 9 and 10. In effect, it will bar the initiation of fresh insolvency cases for a period of six months that may extend to a year, depending on the prevalent situation. Second, the definition of ‘default’ which is a prerequisite for initiation of proceedings under the Code will be amended to exclude COVID-19 related debts. Lastly, a special insolvency resolution framework is in the making for micro, small and medium enterprises (MSMEs). Earlier, on 24 March 2020, the threshold for default to trigger cases of insolvency was raised from INR 1 lakh to INR 1 crore.
Although the underlying intention behind promulgating such changes in the Code is to mitigate the adverse economic effects that are forcing companies into insolvency, some consequences of the suspension seem rather inadequately evaluated.
Continuance of Other Recovery Laws
Even though the Code will be suspended, the continuance of other recovery laws will pose a problem. In a scenario where a lender holds mortgage over the immovable properties of a debtor, which usually is the case, the lender may initiate a sale process with minimal court intervention and could also take over the management of the debtor company under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”). Until now, there is no indication that the operation of SARFAESI Act will also be suspended. Moreover, the suspension of the Code is limited vis-à-vis companies only. Applications under section 7 (by financial creditors), section 9 (by operational creditors) and section 10 (by the debtor company itself) are barred, whereas there is no suspension of the insolvency process against personal guarantors of the company. Therefore, if the promoters or directors of a company have provided personal guarantees to their lenders, they may still be taken to the insolvency court under part III of the Code that deals with individual insolvency.
Therefore, if other recovery laws continue to operate against the defaulting debtor and its related parties, suspension of the Code would rather deprive the creditors and debtors of several benefits. One of these benefits is the application of moratorium under section 14(1) of the Code. It temporarily bars all recovery actions against a company that will perhaps now be achieved by suspension of the Code. The Code is a significant departure from the earlier laws, wherein the rule of debtor in possession is substituted with creditor in possession and control. However, the same would no longer be applicable and the underlying rationale of the process will be lost.
COVID-19 and Default under the Code
An amendment to exclude COVID-19 related matters from the definition of ‘default’ is pointless in light of the entire Code being suspended for one year. It casts a doubt whether the Government’s intention is to continue the benefit of exclusion of COVID-19 defaults even after suspension on the Code is lifted. If that is so, the suspension of Code can effectively continue beyond a year.
Since the effects of the pandemic have triggered economic collapse in the entire world, other jurisdictions have also taken certain actions. However, no jurisdiction has suspended their insolvency laws in entirety. For example, Germany has amended its insolvency law to stipulate that a company’s default would not be eligible for suspension if: (i) the insolvency is not due to the COVID-19 crisis; (ii) there are no prospects of overcoming the existing cash flow insolvency in the company. However, a rebuttable presumption is established for suspending the insolvency proceedings with regard to the company if it were not cash flow insolvent until December 31, 2019. Moreover, for any creditor’s insolvency application to be successfully accepted, it would have to show that the insolvency of the debtor took place before March 1, 2020.
Restriction of Debtors’ Freedom
One of the most important objectives that the Code seeks to achieve is to ensure debtor companies a hassle free and timely exit from the market. This in turn ensures release of resources from inefficient uses and unlocks growth in the market. Section 10 of the Code allows a debtor to initiate insolvency proceedings, but its suspension denies the very freedom to exit and that is especially when the debtor in its own assessment may believe that it cannot efficiently sustain in the market. Other jurisdictions have also announced several changes in their insolvency laws, in order to combat the distress caused by COVID-19, but none of these jurisdictions has suspended the freedom of debtor companies to submit themselves to insolvency proceedings.
Lenders in Deep Water
These changes also do not take into consideration that some lenders, both financial and operational creditors, may not be able to absorb the fallout of a high magnitude of bad debts. For instance, individual operational creditors may bear the brunt if they are not paid for the goods and services they provide to companies (most of which are organized, large-scale enterprises) in a timely manner. Similarly, many financial institutions are already facing stress on their balance sheets, which they cannot absorb. The absolute denial to lenders for the right to invoke IBC will only prolong their struggle to enforce debt and could exacerbate the stress on the financial system that was already dealing with a large debt before the COVID-19 impacted it.
The changes in the Code are likely to add more debt levels at banks, which are already grappling with stressed assets and slowdown. The suspension of Code may not prove to be a good idea, as a blanket ban may act as a tool in the hands of unscrupulous borrowers to delay and defeat the objects of the Code. Instead, a better option could be to direct banks to form committees that would analyze and decide the need to initiate any legal action under the Code and assess the performance and credentials of the borrower to deduce if the default is attributable to the COVID-19 pandemic.
It is also unclear what would happen in cases that were already doubtful before COVID-19 and the borrower seeks to take an undue advantage of the same. The alternative remedy with the lender in such scenarios is also uncertain. A blanket ban displays a wrong signal on the performance of contractual obligations by parties and the legal protection available to the aggrieved party. Therefore, the absolute denial to lenders for the right to invoke IBC will only prolong their struggle to enforce debt and could upsurge the stress on the financial system that was already dealing with a large debt before COVID-19.
The proposed changes to the Code are an incomplete solution to counter the economic dishevel caused by the pandemic, and the suspension of Code in its entirety without any exceptions or reservation stretches the idea too far and does not achieve the intended succor. It seems to be premised on the notion that insolvency proceedings are debt enforcement proceedings that companies would ordinarily not want to resort to. However, this notion is unfounded. The Code is not only a debt enforcement tool but also the only formal and binding mechanism that a company can resort to, in case it wants to restructure its debts. In fact, as on December 31, 2019, a total of 3,312 cases have been filed so far, proving that provides recourse to companies in salvaging and maximizing the value of their assets. By this approach, the Government banks upon the idea that suspension of sections 7, 9 and 10 of the Code will not lead to any circumstances that will prevent loss of assets when, in reality, no one will actually be in control over them. Therefore, a wise way to go about it could be to include certain restrictions on creditor actions for recovery by providing certain criteria to assess if the default is a result of COVID-19 pandemic or not. Moreover, one must ensure that other recovery laws do not corrode the objective sought to be achieved by the Code.
– Anushka Garg
Very interesting and meaningful article.