IBC Amendment 2019: Why landmark legislation failed to rescue MSMEs from vicious cycle of indebtedness

Updated: September 24, 2019 6:27 PM

Ease of Doing Business for MSMEs: If MSMEs are expected to contribute more actively to the economic upliftment of India, the IBC must introduce yet another amendment to rescue the MSMEs from their vicious cycle of indebtedness.

IBC, IBBI, Insolvency and Bankruptcy Board of India, financial creditors, Dhir and Dhir Associates, corporate debtorThe core spirit of the IBC is to reduce the mortality rate of enterprises and boost the recovery rate.
  • By R Narayan

Ease of Doing Business for MSMEs: Touted as landmark legislation in heralding a massive transformation in the recovery and resolution process, the Insolvency & Bankruptcy Code of India was amended on 6th August 2019 for the 5th time. First passed in Parliament in May 2016, the Code provides for resolution of insolvencies in a time-bound manner.

The Code consists of two major processes: insolvency procedure and actual liquidation. If during the insolvency procedure, financial creditors find the business unviable to continue, the Committee of Creditors (CoC) proceeds to the liquidation process where the assets are distributed to stakeholders in a cascading manner, called the Waterfall Mechanism, as provided by the IBC.

Hits & Misses of IBC Amendment 2019

The Insolvency and Bankruptcy Code (Amendment) Bill 2019 was introduced to retain the vibrancy of the code and prevent its interpretative ambiguities as was done in the resolution of the recent Essar Insolvency Case. While it amended by means of addition and modification of some clauses, it failed to make any positive impact for the MSME sector.

The amendment has addressed mainly three issues: resolution in a time-bound manner of 330 days, manner of representation of financial creditors on the CoC, and the minimum amount to be paid out to operational creditors in case of Insolvency.

The core spirit of the IBC is to reduce the mortality rate of enterprises and boost the recovery rate which stands at about 43 per cent. Ironically, it is under the same measures that many MSMEs are declared NPAs due to non-payment of dues owed to them owing to lower prioritization in the proceeds of distribution of assets.

A gaping shortfall of the IBC is that it only admits applications against private and public limited companies and Limited Liability Partnerships (LLP) as defaulting corporate debtors. It does not contain provisions for cases where an individual or partnerships may have defaulted, thus excluding the larger chunk of debtors.  

The Impact on MSMEs

A major drawback for the MSME sector is that the amendment has failed to equalize financial and operational creditors. MSMEs are recognised as operational creditors under the IBC, which confers an elevated status to the financial creditors. In the Waterfall Mechanism, financial creditors are placed second while MSMEs are fourth. In case of liquidation of assets, the financial creditors claim the lion’s share of returns, leaving little to trickle down to the operational creditors, which are then declared insolvent/bankrupt themselves. A resolution of this predicament would have rectified the many wrongs against the MSME sector.

Financial creditors can start insolvency proceedings even for disputed debts but operational creditors cannot. Operational creditors are excluded from the CoC who determine the resolution plan. This deprives them of decision making in their interest. Another discrimination against operational creditors is that in case of insolvency, the IBC provides for payment to them of an amount which is higher of the two:

  1. The liquidation value of their debt or 
  2. The amount that would have been received in case of liquidation in accordance with the Waterfall Mechanism.  

These measures are crushing for the recovery of dues of MSMEs since they would recover very little or no amount under either circumstance.

The amendment aspires to reduce the scope of judicial intervention and litigation by clarifying that under the resolution plan, payments made to operational creditors and dissenting financial creditors will be construed as fair and equitable to such creditors. However, by failing to fully explain the concept of fair and equitable distribution of settlement proceeds or the liquidation value, operational creditors have once again been left high and dry.

Recommendations of NCLAT

The NCLAT is the appellate tribunal for hearing appeals against the orders passed by bankruptcy courts. Other than demanding the removal of discrimination amongst financial creditors on the basis of existing priorities or security interest in a resolution plan, they had demanded fairness in resolution plans of bankrupt companies for financial and operational creditors and that they are treated similarly by receiving the same percentage of haircut.

Deriving its authority from the IBC, the CoC can consider the manner of distribution of proceeds of a resolution plan and can take into account the order of priority amongst creditors, including the priority and value of the security interest of a secured creditor. The NCLAT wanted to abrogate this provision since the CoC includes financial creditors who will seek to favour their own vested interests in the resolution, but these suggestions have not been addressed in the latest Amendment Act. This has acted as yet another blow to the MSME sector.

While the Amendment has sought to trim the timelines taken for resolutions, it has failed to bring about any upliftment for the status of MSMEs in the reclamation of debts, thus overruling the NCLAT’s judgement in the Essar Steel Case. 

India will have the largest working-age demographic in 2020 and the MSME sector is expected to provide employment to the teeming masses, which will not be possible if they themselves are cash strapped and sinking. If MSMEs are expected to contribute more actively to the economic upliftment of India, the IBC must introduce yet another amendment to rescue the MSMEs from their vicious cycle of indebtedness and bring them at par with financial creditors. 

Insolvency for Financial Institutions

The NBFC crisis in India brought to light the absence of bankruptcy legislation exclusively for financial institutions since banks, insurance companies, NBFCs and stock exchanges lie outside the scope of the IBC. Section 227 of the IBC empowers the central government to direct a financial service provider to the IBC for resolution of insolvency, however, this means that financial institutions lie at the mercy of the central government to undergo insolvency proceedings, in the absence of which, they will perish faster and be unable to salvage the losses for their stakeholders.

It is essential to consider that financial institutions are custodians of the economy and house public and private funds. While the IBC may provide an interim diagnosis for financial institutions at the behest of the centre, it is absolutely imperative to constitute a separate legislative framework which monitors financial health, anticipates risk, and resolve insolvency of financial institutions.

(R Narayan is the Senior Vice President at FICCI-CMSME and Founder & CEO at Power2SME. Views expressed are the author’s own.)

  • First published on www.financialexpress.com on 22 September 2019

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