Insolvency and bankruptcy code, 2016 - A critical analysis

Introduction: This article makes a critical analysis of Insolvency and Bankruptcy Code, 2016 (IBC in short) by highlighting the key parts of the Code and assess its likely impact on the Indian debt market  and what does the new Code contain and how effective will it be in promoting the efficient and timely resolution of insolvent entities?

It's no secret that the Indian banking industry has a rather large number of loans outstanding that have simply gone wrong. With non-performing loans estimated at just over INR 8.3 trillion market.

In this context, the new Insolvency and Bankruptcy Code (the 'Code') passed by Parliament promises to address the structural problems hampering the efficient recycling of capital and rebalance the rights of creditors, giving them much needed recourse to take timely and effective action against defaulting borrowers.

The erstwhile regime

In India, insolvency and bankruptcy are terms that are common with many other jurisdictions. However, they are not synonymous and should not be confused to mean the same thing (they often are).

Insolvency refers to a situation where any person or a body corporate is unable to fulfill its financial obligations (often occurring due to several factors such as a decrease in cash flow, losses and other related issues).

Bankruptcy on the other hand is a situation whereby a court of competent jurisdiction has declared a person or other entity insolvent, having passed appropriate orders to resolve it and protect the rights of the creditors.

To put it otherwise, the difference is that one comes before the other i.e. insolvency is a state of affairs, which triggers the legal process of bankruptcy.

In India, the position is slightly different than in England & Wales, whereby the distinction between insolvency and bankruptcy is determined by whether the entity is a body corporate (governed by the insolvency regime) or an individual (governed by the bankruptcy regime).

The laws governing insolvency and bankruptcy in India were not consolidated. Insolvency of individuals was dealt with under the Presidency Towns Insolvency Act, 1909 (the 'Presidency Act') and the Provincial Insolvency Act, 1920 (the 'Provincial Act').

Insolvency for companies was dealt with under a number of pieces of legislation including the Companies Act, 2013 (the 'Companies Act'); the Sick Industrial Companies Act, 1985 (the 'SICA'), the Recovery of Debt Due to Banks and Financial Institutions Act, 1993 (the 'Recovery Act') and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ('SARFAESI').

As a result of this overlap, several institutions had jurisdiction over the insolvency and bankruptcy process. The Company Law Board, the High Courts, the Debt Recovery Tribunals and the Board of Industrial and Financial Reconstruction dealt with the insolvency of entities they govern, which led to the problem of concurrent jurisdiction, systemic delays and other related complexities.

Providing a coherent and unified structure under a consolidated legal framework to deal with insolvency and bankruptcy in India had long been overdue. To this end, the Rajya Sabha passed the Code on 11th May 2016 and sections 188 to 194 of the Code relating to the constitution of the Insolvency & Bankruptcy Board (the 'Board') came into force on 5 August 2016

The Code seeks to consolidate and amend the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner by creating authorities and agencies that will specifically deal with insolvency processes framed under the Code.

The Code will therefore merge the insolvency related provisions under the Companies Act, SARFAESI, the SICA, and the Recovery Act. Furthermore, the Presidency Act and Provincial Act stand repealed.

The new regime

Through IBC various following new organs of insolvency resolution ecosystem have been created:

• The Insolvency and Bankruptcy Board of India

The Code provides for the constitution of the Board having 10 members including representatives from the Reserve Bank of India and the Central Government to regulate insolvency procedures in India.

It is intended that the Board shall act on the general directions of the Central Government in matters which inter alia include the registration and functioning of Insolvency Professional Agencies, Insolvency Professionals and Information Utilities, making regulations, bye-laws and guidelines on matters relating to bankruptcy and insolvency.

The Code vests in the Board powers of a civil court under the Code of Civil Procedure, 1908 with respect to discovery and the production of books and other related matters.

• Insolvency Professional Agencies and Insolvency Professionals

The Code further provides for the establishment of Insolvency Professional Agencies ('IPAs') who, inter alia shall develop and regulate Insolvency Professionals ('IPs') who shall be a specialized class of professionals, registered with the Board and enrolled with IPAs to deal and manage the Insolvency Resolution Process (the 'IRP').

In my view, the establishment of a number of IPAs as opposed to a single IPA for regulating the functioning of IPs and other matters may lead to further complexities, delays and conflict of interest.

• Information Utilities

Information Utilities established under the Code shall be required to perform functions relating to storing financial information in an accessible format, publish statistical information.

 It is unclear as to whether the jurisdiction of the Information Utilities will extend over both public and private companies and to what extent that information will be made public, potentially raising key confidentiality issues.

Will there be just one Information Utility or will there be several? Again, the risks of duplication and co-ordination will arise in the event that there are several Information Utilities.

• The Insolvency Resolution Process

Broadly, the insolvency resolution process under the Code envisages:

(a) a fresh start process;
(b) individual IRP;
(c) corporate IRP;
(d) individual bankruptcy process; and
(e) the liquidation of a corporate debtor firm.

Individuals and Partnership Firms

In case of individuals and partnership firms, the Code provides for the below mentioned methods for resolving disputes.

• Fresh Start Process for Individual debtor

Pursuant to the fresh start process, a debtor who is unable to pay off his or her debts may apply personally or through an IP to the adjudicating authority for a discharge from its qualifying debts (i.e. debts which are liquidated, unsecured and not excluded debts and up to INR 35000).

However, such discharge is permitted only if the debtor qualifies under certain thresholds, demonstrating:

• that his or her gross annual income does not exceed INR 60000,
• that the aggregate value of the assets of the debtor does not exceed INR 20000, and
• that the debtor does not own a house.

Where the application under section 80 of the Code is filed by the debtor himself and not through an IP, the adjudicating authority shall direct the Board to nominate an IP for the fresh start process. When a debtor files an application, an interim moratorium shall commence on the date of filing of the application.

Further, the IP shall within 10 days of his appointment submit a report to the adjudicating authority either recommending acceptance or rejection of the application with reasons.

The Adjudicating Authority shall within a period of 14 days from the date of submission of the report by the IP, pass an order admitting or rejecting the application. If such application is accepted, then on such date, the moratorium period shall commence for all the debts and shall cease to have effect at the end of 180 days beginning from the date of the admission of the order.

A creditor mentioned in the order is given a chance to raise objection once he receives such order on several grounds, such as the inclusion of the debt as a qualifying debt, incorrectness of details of the debt and other grounds.

In assessing the validity of creditor objections, the IP shall be required to prepare and draw up a final list of qualifying debts within specified time periods. A debtor or creditor who is aggrieved by such action of the IP may file an application to the adjudicating authority challenging such action. The Code provides the interested parties with an option to replace the IP.

To obtain a discharge order, the IP is required to prepare a final list of all qualifying debts and submit the list to the adjudicating authority at least seven days before the moratorium comes to an end.

On the expiry of this period, the adjudicating authority will pass an order on discharging of the debtor from the qualifying debts and give an opportunity to the debtor to start afresh

• Insolvency Resolution Process for Individual

In the event of an individual IRP, the debtor or creditors may initiate an IRP by submitting an application through an IP to the adjudicating authority. Similar to the fresh start process, an interim-moratorium shall commence on the date of the application in relation to all debts and shall cease to have effects on the date of admission of the application.

Further, the IP shall within 10 days of his appointment submit a report to the adjudicating authority, either recommending acceptance or rejection of the application with reasons.

When the application is admitted, a moratorium shall commence in relation to all the debts and shall cease to have effect at the end of the period of 180 days beginning with the date of admission of the application. Furthermore, the adjudicating authority may issue instructions for conducting negotiations between the debtor and its creditors with a view to arriving at a repayment plan.

If however, the application is rejected by the adjudicating authority on grounds of mala fide intention on part of the debtor, then such order may record that the creditor is entitled to file for bankruptcy. On admitting the application, the adjudicating authority shall issue a notice inviting claims from creditors. Pursuant to such claims, the debtor shall prepare a repayment plan in consultation with the IP and submit such plan to the adjudicating authority. This process will be followed by a meeting of the creditors to vote in respect to the repayment plan.

The repayment plan or any modification needs to be approved by 75% of the creditors present in person (or through proxy) and voting on the resolution. The IP is responsible to provide the adjudicating authority a copy of the report of the meeting and then the adjudicating authority shall either approve or reject the plan.

Such repayment plan shall be binding in nature.

• Bankruptcy order for Individuals and Firm

Formal bankruptcy of an individual or partnership can only be initiated following the failure of the Insolvency Resolution Process (IRP) in the following circumstances:

• When an application for IRP has been rejected by the adjudicating authority for reasons such as the plan not being approved by 75% of the creditors; or
• When the repayment plan has been rejected by the adjudicating authority; or
• When the adjudicating authority passes an order that the repayment plan has not been completely implemented.

The Code states that either a debtor or a creditor can file an application for bankruptcy within 3 months from the date of the order passed by the adjudicating authority.

When debtors or creditors file such an application, an interim-moratorium will commence on all actions against the property of the debtor. The Code further states that the IP may be proposed as a bankruptcy trustee and the estate of the bankrupt shall vest in the bankruptcy trustee immediately after his appointment. Under the Code, the bankruptcy order passed by the adjudicating authority shall have effect until the debtor is discharged.

When debtors or creditors file such an application, an interim-moratorium will commence on all actions against the property of the debtor.

The Code lays down the following priority in which all debts will be paid off:

1. Costs and expenses incurred by the bankruptcy trustee;
2. Workmen's dues for the period of twenty-four months preceding the bankruptcy commencement date;
3. Debts owed to secured creditors (ranking equally with workmen's dues);
4. Wages and any unpaid dues owed to employees, other than workmen, of the bankrupt for the period of twelve months preceding the bankruptcy commencement date;
5. Any amount due to the Central Government and the State Government; and
6. All other debts and dues owed by the bankrupt including unsecured debts.

• Companies and Limited Liability Entities

Corporate Insolvency Resolution Process (CIRP)

The Code provides an exhaustive, unambiguous insolvency regime and speedy process for revival of companies and limited liability entities and a corporate debtor or creditors can initiate the IRP.

Under the Code, in case of insolvency and liquidation of corporate entities, a minimum default of INR 1 (one) lakh should have occurred.

It is felt be some people that this threshold is low and it will be the duty of the adjudicating authorities to firmly distinguish vexatious claims from the legitimate claims of creditors.

With respect to creditors, the Code lays down different procedures to be followed by operational creditors and financial creditors to initiate the IRP. Financial creditors refer to any person to whom a financial debt is owed and an operational creditor refers to any person to who a debt with respect to goods or services is owed.

It is likely that financial creditors will initiate the insolvency process, since they normally have access to the debtor's financial records and will be able to assess whether an insolvency scenario is just around the corner.

In case of companies, the Code prescribes a limit of 180 days from the date of admission of the application by NCLT (extendable for a period of 90 days with approval of 75% of the creditors) within which the IRP should be completed. On admission of the application by the adjudicating authority it shall declare a moratorium on specified activities, call for the submission of claims and appoint an interim IP.

In case of corporate entities, on the first meeting of creditors by a majority vote of 75%, an IP shall be appointed who shall conduct the entire Insolvency Resolution Process(IRP).

Such IP shall be responsible for preparing an information memorandum in a manner specified by the Board for formulating a resolution plan.

An resolution applicant may also submit such resolution plan to the IP on the basis of such information memorandum.

The Code states that the IP shall be responsible for examining the plan to ensure that it provides for management of the affairs of the corporate debtor and does not contravene any provision of the law (amongst other things).

Such plan shall be presented to a committee of creditors, who may approve it with the consent of not less than 75% of the creditors.

If the adjudicating authority is satisfied with such resolution plan, then it may by order approve the plan, which will then be binding on the corporate debtor.

However, the adjudicating authority may also reject the plan.

Where the adjudicating authority rejects the plan because the requisite creditors have not approved it, he shall pass an order of liquidation. The Code further makes provision for a fast track insolvency process for companies with smaller operations.  The process will have to be completed within 90 days unless extended with the approval of 75% of creditors.

The liquidation process

The adjudicating authority can initiate the liquidating process in the following circumstances:

• On the expiry of maximum period permitted for completion of IRP;
• When the adjudicating authority rejects the resolution plan;
• Where the committee of creditors, before the confirmation of the resolution plan, notifies the adjudicating authority of its decision to liquidate the corporate debtor; or
• Where the corporate debtor contravenes the resolution plan, approved by the adjudicating authority.
• Where the adjudicating authority passes a liquidation order, the IP shall act as the liquidator and   the assets of debtor may be sold to repay its creditors.

Distribution of assets

The Code lists the order of priority distribution of the proceeds from the sale of the liquidation assets, set out below.

1. IRP costs and the liquidation costs paid in full;
2. workmen's dues for the period of twenty-four months preceding the commencement of liquidation;
3. debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in the Code;

(Note that the debts specified in (2) and (3) shall rank equally between and among themselves).

The Code intends to rationalize the processes and procedures for bankruptcy and insolvency, improve the recovery rates of debt and increase creditor confidence in India, and it should hopefully go some way to address the rights of lenders to enforce security in a distress situation, potentially bringing down the rate of non-performing loans.

Under the new regime, it's the creditors who will be able to kick off the process (and not the High Court or the NCLT), which is a welcome change.

Unsecured creditors will get a seat on the creditors committee, getting to vote on the resolution plan on par with secured creditors.

However, the provisions for appeals and the lack of clarity on issues such as payments to creditors on liquidation could prove to be a setback for the effective implementation of a scheme for insolvency disputes.

With avenues for appeals and disputes, it remains to be seen to what extent IPs can essentially take control over distressed assets and sideline promoters of companies in default scenarios and it needs to be watched  the developing jurisprudence before the adjudicating authorities with interest.

Ultimately, the risk is that the bark of the new Code isn't followed through with an effective snap at the heels of the borrower and its promoters and a bite.

In that context, it's important that the new regime successfully demonstrates teeth with a resolution in favor of creditors within a six-month time frame.

 It's only when lenders see an effective and efficient recycling of capital, we will see confidence returning to the debt markets and future lending at lower rates.

• The adjudicating authority

The Code vests powers in the Debt Recovery Tribunal (the 'DRT') to act as the adjudicating authority in relation to insolvency matters for individuals and firms. All appeals from the DRT shall be submitted before the Debt Recovery Appellate Tribunal (the 'DRAT').

The adjudicating authority with respect to insolvency matters of companies and limited liability entities shall be the National Company Law Tribunal (the 'NCLT'). Appeals from any order of the NCLT shall be submitted before the National Company Law Appellate Tribunal (the 'NCLAT'). An appeal from the order of the DRAT or the NCLAT may be filed before the Supreme Court of India.

• Penalties

In an attempt to curb fraudulent and corrupt practices by any IPE, IP or Information Utility, in the event that they contravene any provision of the Code, a penalty equivalent to three times the loss incurred or three times the amount of unlawful gain (whichever is higher) shall be applicable.

The Code specifies that the penalty shall not exceed INR 1 (One) Crore.

Limiting the threshold may destroy the purpose of the provision in cases where such IP, IPE or Information Utility has received an unlawful gain more than the threshold specified.

The Code also penalizes any person who has made an unlawful gain or loss with an amount equivalent to such loss or gain. The Code further provides penalties for corporate entities that do not declare assets owned by it or, otherwise fraudulently conceal such assets.

In such cases, officer of the corporate debtor shall be punished with imprisonment of up to five years, with a fine of up to INR One (1) Crore. The Code also penalizes individuals for providing incorrect information. The punishment in this case will be imprisonment for a term, which may extend to one year, or with a fine, which may extend to INR Five (5) Lakhs or both.

However, punishments may vary depending on the offences committed by individuals and officers of the company.

CONCLUSION:

The Code intends to rationalize the processes and procedures for bankruptcy and insolvency, improve the recovery rates of debt and increase creditor confidence in India, and it should hopefully go some way to address the rights of lenders to enforce security in a distress situation, potentially bringing down the rate of non-performing loans.

The author is a practicing CA based in Delhi and is registered Insolvency Professional. He can also be reached at cavinodchaurasia@gmail.com

Disclaimer: The views expressed in this article are strictly personal. The content of this document are solely for informational purpose. It doesn't constitute professional advice or recommendation. The Author does not accept any liabilities for any loss or damage of any kind arising out of information in this article and for any actions taken in reliance thereon.