IBC And MSME Insolvency

The government is in the process of finalizing

regulations for fast-track resolution under the

Insolvency and Bankruptcy Code 2016 (IBC).

The draft regulations placed in the public domain

propose that the fast-track process of insolvency

resolution under IBC comprising 90 days will be available

to small companies with paid-up capital not exceeding

INR 50 lakh or such higher amount as may be prescribed

not exceeding INR 5 crore; or with turnover not exceeding

INR 2 crore or such higher amount as may be prescribed

but not exceeding INR 20 crore. A holding company or a

subsidiary company will not be able to avail the benefits

of the fast-track process. The benefits of fast-track will

also be available to start-ups up to five years from the date

of incorporation if their turnover does not exceed INR 20

crore in any financial year, and they are working towards

innovation, development, deployment or commercialization

of new products, processes or services driven by technology

or intellectual property.

While making the fast-track resolution process available to

small companies and start-ups is a welcome move, the Indian

micro, small and medium enterprises (MSMEs) sector will

not benefit from these regulations. While the IBC and fast

track regulations apply only to limited liability companies

and limited liability partnerships, over 97 per cent Indian

MSMEs are proprietorships or partnerships. Proprietorship

is the most commonly adopted ownership structure (94.5 per

cent of all MSMEs), primarily because this structure requires

lower legal overheads. The other ownership structures

adopted by enterprises include partnership and cooperative

(1.2 per cent), private and public limited company (0.8

per cent) and other forms (3.5 per cent). Mature small,

medium and new knowledge-based enterprises in the sector

are mostly structured as private limited or public limited

companies. But that number is nearly insignificant. In 2009-

10, the Indian MSME sector was estimated to include 29.8

million enterprises, out of which 28 million are unregistered

and only 1.8 million registered.

MSMEs form the foundation of the Indian economy. They

represent the majority of businesses and are key drivers of

employment, economic growth, and entrepreneurship. The

MSME sector is an important pillar of the Indian economy

as it contributes greatly to growth of the Indian economy

with a vast network of around 30 million units, creating

employment for about 70 million, manufacturing more than

6,000 products, contributing about 45% to manufacturing

output and about 40% of exports, directly and indirectly. This

sector assumes even greater importance now as the country

moves towards a faster and inclusive growth agenda.

Moreover, it is the MSME sector, which can help realize the

target of proposed Indian National Manufacturing Policy of

raising the share of the manufacturing sector in GDP from

around 16% at present to 25% by the end of 2022.

MSMEs vary in size and nature. The term "MSME"

encompasses a wide-ranging spectrum of businesses. Most

MSMEs fall into the "micro" category, which usually includes

sole proprietorships and single-employee businesses. Small

enterprises may have more than one owner and multiple

employees but may have an informal business structure.

Firms at the other end – labeled as "medium" enterprises

– may be starkly different from their micro and small

counterparts and have hundreds of employees. Yet they may

not be corporatized. MSMEs, for a variety of reasons, forgo

formal registration of their enterprise and operate without

limited liability. This practice is seen around the world, but it

is particularly common in developing economies. However,

for many entrepreneurs and shareholders, the difference

between an informal and formal corporate structure is

limited – in many cases, MSME lenders require personal

guarantees to secure loans, meaning the main advantage

of a limited liability corporate structure is significantly

reduced.

Although MSMEs contribute significantly to overall

economy of the country, they face certain disadvantages, some of the credit-related issues being: availability of

adequate and timely credit; high cost of credit; collateral

requirements; access to equity capital; and rehabilitation

of distressed enterprises. MSMEs are exposed to acute

difficulty of weathering macroeconomic and financial

shocks. Furthermore, they may lack the sophistication or

knowledge to properly address complex processes with

limited resources. The combination of challenges that

MSMEs face makes them prone to insolvency. Just as there

are large numbers of MSMEs, there are large numbers of

MSME insolvencies. But MSME insolvencies cannot be

treated on par with corporate resolution. There remains

a question of whether broad parameters for corporate

insolvency systems, as reflected in international standards,

can effectively respond to the needs of MSMEs. Nor do

they typically fall under the rules of insolvency of natural

persons.

MSME insolvency faces unique challenges and issues.

Complex insolvency systems deter MSMEs from resorting

to formal procedures to tackle financial distress.

Unsophisticated MSMEs struggle to understand this

complexity; thus discouraging timely use of insolvency by

MSMEs. Creditors have few incentives to deal with MSME

debtors through legal processes. Creditor passivity often

arises when creditors weigh the amount they estimate they

will receive from participating in the insolvency process

against the amount of time and money this effort requires.

If the costs outweigh the return, then creditors make the

rational decision to not get involved. Secured creditors

typically focus on enforcement of security at the first sign

of financial distress and thus efficiencies may be lost.

MSME debtors may lack good records and reliable financial

information. This makes it harder to assess the viability of

the MSME debtor and erodes creditor trust in the MSME

debtor and the effectiveness of insolvency processes. Postinsolvency

financing is hardly available. MSMEs rely on

family and friends for help. MSMEs often lack the resources

to cover the costs and fees for a formal insolvency procedure.

MSMEs are often financed with a mixture of corporate debt

and personal debt taken on by the entrepreneur (including

potentially personal guarantees being granted). The failure

of the MSME may thus have severe consequences for the

entrepreneur and his/her family including social stigma.

Prior to entering an insolvency proceeding, many MSMEs

are disadvantaged because they lack the sophistication to

identify and react to financial distress. This may result in

MSMEs waiting too long before initiating the insolvency

process. This problem is particularly acute for MSMEs given

the limited incentives they have for starting a complex and

burdensome proceeding, often without an effective business

rescue framework, as is the case in many of the insolvency

processes around the world. Also, the social barriers and

reputational stigma associated with the insolvency system

may discourage MSME representatives from resorting to

formal insolvency proceedings.

The insolvency process itself can be difficult for MSMEs. Of

particular concern is the complexity and length of typical insolvency processes. Smaller MSMEs may lack funds

to cover the expenses of an insolvency process or fail to

generate an expectation for unsecured creditors to receive

any returns. Therefore, while insolvency laws require

that creditors prove their claims, monitor the company

either individually or via a creditors' committee, vote

on restructuring proposals, etc., there are very limited

incentives for creditors to actively participate in the process.

Finally, as mentioned earlier, MSMEs usually have more

acute issues in obtaining finance during restructuring even

if it is viable.

Another particular issue that arises for MSME insolvency is

the overlap and conflicts between regimes for insolvency of

businesses and regimes for insolvency of natural persons.

Whereas one of the main purposes of a business insolvency

regime is to ensure the orderly resolution of debt and

distribution of value to creditors whenever the business

is unviable (frequently involving the dissolution of the

debtor company), the purpose of a personal insolvency

regime is to couple, and also balance the distribution of

value to creditors with a basis for the debtor to continue

his/her economic life (since, once the insolvency process for

a natural person is concluded, the debtor will usually still

be in existence). The nature of many MSMEs, particularly

micro-businesses, is such that a clear distinction between

the business and the persons operating it does not always

exist and it is not clear which insolvency regime (business or

personal) is better suited to apply to MSMEs. A MSME may

be incorporated as a corporate entity or unincorporated;

from a legal standpoint, this has several consequences for

the limitation of liability and applicability of a personal or

corporate insolvency law regime to the business, depending

on each country's legislation.

Countries have adopted different approaches toward the

issue of MSME insolvency. Many countries treat MSME

insolvency with the same general procedures applicable

to large corporations or conversely, natural persons.

Some other countries have tried to address the needs of

MSME insolvency by tailoring their insolvency laws. They

have done this by shortening timelines for MSMEs, or

eliminating certain formalities from "standard" insolvency

law. Other countries have implemented tailored procedures

that are specific to MSMEs, or provided some degree

of procedural unification for personal guarantors and

companies undergoing connected insolvencies. What these

country experiences show is that there are typically two

ways in which MSME insolvency is being addressed – either

by making slight modifications or allowing exemptions

from certain requirements to the existing provisions in

the insolvency legislation, or by drafting entirely new

provisions that target MSMEs, such as in the cases of Japan

and Korea.

Effective insolvency regimes, if properly implemented, may

mitigate many of the challenges facing MSMEs. They are

amongst the most powerful engines of growth of the Indian

economy. MSMEs are also effective vehicles for employment

generation. India's cities have been experiencing the burden of a consistently growing population, comprising an everincreasing

proportion of migrants in search of employment

and livelihood. City infrastructure is already stretched,

and policy makers are seeking solutions to mitigate issues

arising from migrant population growth. Rural MSMEs

and those based outside of large cities, offer a viable

alternative for employment to local labor, hence presenting

an opportunity for people to participate in productive, nonfarm

activities, without needing to migrate to urban areas.

With adequate financial and non-financial resources, as

well as capacity building, the MSME sector can grow and

contribute to economic development considerably higher

than it is doing currently. It is important to support them

by providing a simpler mechanism for their resolution and

liquidation in the event of distress. Having an efficient,

expeditious insolvency system in place that rescues MSMEs

or swiftly reallocates their productive assets to more

efficient activities is paramount.

However, this does not suggest that a separate law is

needed for them. A separate set of regulations to deal

with insolvency of MSMEs is needed. In its Report on

the Treatment of MSME Insolvency released recently,

the World Bank recommends that due to the lack of

sophistication on the part of MSMEs, they need out-ofcourt

assistance such as mediation, debt counseling,

financial education, or the appointment of a trustee.

Since the majority of MSMEs facing insolvency are

more likely to liquidate and not go into reorganization/

restructuring (by virtue of their size), frameworks should

not only focus on reorganization/restructuring, but also

on expeditious liquidation mechanisms. The Indian

government should develop regulations that are at the

intersection of personal insolvency frameworks and

corporate insolvency.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.