India’s new insolvency code – is it a game changer or a run-of-the-mill reform?

Background – The need for a new law

The Indian legal framework for insolvency resolution, debt recovery and restructuring of stressed assets was ineffective in ensuring satisfactory repair of credit default mainly due to the fact that insolvency and debt recovery were governed by different overlapping statutes having conflicting objectives.

The laws governing debt recovery have been scattered across: (i) the Indian Contract Act, 1872 (for unsecured creditors); (ii) the Recovery of Debt Due to Banks and Financial Institutions Act, 1993 (the “RDDBFI Act”) (for banks, financial institutions and foreign banks having a branch or subsidiary in India, whether secured or unsecured creditors); and (iii) the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (the “SARFAESI Act”) (for banks, financial institutions and foreign banks having a branch or subsidiary in India, being secured creditors).

The Presidency-towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920 dealt with insolvency resolution for individuals.

Company winding-up was covered under the Companies Act, 1956 (the “1956 Act”), and the Limited Liability Partnership Act, 2008, provided for the winding-up of limited liability partnerships (“LLPs”).

Additionally, the law governing rehabilitation and revival of sick industrial companies was embodied in The Sick Industrial Companies (Special Provisions) Act, 1985 (the “SICA”), which although was going to be repealed in 2004, continues to operate.

Various complications arose from this multiplicity of laws.

Each statute aided its own target group.  The RDDBFI Act was formulated to assist banks and financial institutions, whereas the SARFAESI Act was enacted to enable secured creditors to sell their security interests without litigating.  In contrast to the RDDBFI Act and the SARFAESI Act, winding-up under the Companies Act was collective in nature and enabled different stakeholders to take recourse under it.  On the other hand, the SICA served the debtor’s interest by focusing on ways to rehabilitate and revive a sick industrial company.  On account of the entity-centric approach adopted by the various statutes, stakeholders were naturally inclined to opt for the mechanism that best suited their interests.

In many cases, the same debtor was subjected to parallel proceedings under different statutes by different creditors.  While some creditors chose the RDDBFI Act to independently recover their debt or the SARFAESI Act to independently enforce their security interest, unsecured creditors often chose a winding-up action under the 1956 Act to pursue collective enforcement.  As a result, the debtor had to fight many battles with different sets of creditors in different forums, which resulted in significant costs and delays in achieving effective resolution and recovery for the creditors.

Moreover, the availability of parallel options resulted in a lack of synchronization among creditors, and it was difficult to clearly ascertain the position of one creditor vis-à-vis the debtor or even other creditors.  In addition, there was no guarantee that the relief which one creditor got under one route would result in recovery as there was always a chance of such a relief being affected by an order that another creditor, or even the debtor, may have obtained under some other proceeding.

All in all, speedy resolution of banking and insolvency matters became a chimera.  It was against this backdrop that the need for a robust and efficient insolvency law was strongly felt.

The advent of a new law

Accordingly, the Bankruptcy Law Reforms Committee (“BLRC”) was constituted to study the insolvency and bankruptcy framework in India and recommend improvements.

 

After a thorough study, the BLRC recommended several changes to the law governing insolvency and bankruptcy and submitted to the Government of India (the “Government”) a draft legislation reflecting these recommendations. The legislation, christened “The Insolvency and Bankruptcy Code, 2016” (the “Code”), was introduced in the Indian Parliament on December 21, 2015.  Following its passage in Parliament on May 11, 2016, the Code received the assent of the President of India on May 28, 2016.  Note that, although the Code has been signed into law, its operation will commence only after the Government, by a notification in the official gazette, declares it to have come into force, which should happen shortly.

Salient features of the Code

The Code aims to put in place a more robust and efficient insolvency resolution mechanism. It takes into account the interests of various stakeholders and attempts to arrive at a more holistic solution.

Some of the key features of the Code are as follows.

1. An attempt at unification: The Code is extremely wide in its scope and provides for the insolvency resolution of not just individuals, but also partnership firms, companies and LLPs. The consolidation of all extant laws on the subject under one head will ensure greater legal clarity and coherence.  It must be noted that the Code does not deal with insolvency resolution of entities that provide financial services, and these entities are proposed to be covered under another statute titled, “The Indian Financial Code.”

2. Harmonization: The Code attempts to harmonize and ease the friction and tension between the laws governing debt recovery and insolvency resolution. This harmonization is brought about by retaining the basic character of the independent debt recovery mechanisms as stand-alone options, but subjecting them to the rules governing collective action in case insolvency resolution is adopted.

3. Incentivizes collective action over individual action: Although the Code allows individual action, it strongly advocates adoption of collective action over individual action. The Code endeavors to bring every stakeholder to the table and accords to all a better chance of receiving the benefits they seek. By providing strict timelines and effective procedures, the Code makes insolvency resolution more attractive and pragmatic.  In fact, if the Code is implemented well, the individual debt recovery laws such as the RDDBFI Act and the SARFAESI Act may become redundant and may, consequently, be repealed.

4. Benefits foreign lenders: Under the Code, unlike under the RDDBFI Act and the SARFAESI Act, a foreign lender (who does not have a branch or subsidiary in India) may take action against a debtor.  This will allow holders of foreign convertible debt or foreign loans to take action under the Code and seek a moratorium on all other pending proceedings and asset disposals (as elaborated below).

5. Comprehensive framework for insolvency resolution and liquidation of corporate persons: For corporate entities such as companies and LLPs, the Code elaborately spells out the procedure that must be followed when a corporate insolvency resolution process (“CIRP”) is initiated or if liquidation is ordered. Broadly, a CIRP involves the following steps:

1. Initiation: A CIRP may be initiated when a debtor commits a default in payment of a debt of at least INR100,000 (US$1,482) (the “Minimum Default Amount”). However, the Government may increase this Minimum Default Amount to an amount not exceeding INR10,000,000 (US$148,214). Although the Code provides that a CIRP may be initiated upon the commission of a default, it does not specify the time within which such CIRP should be initiated. However, one may reasonably assume that the initiation should be within the limitation period (three (3) years) prescribed for recovering debts that have become due and payable.

1. To initiate the CIRP, any financial creditor, operational creditor (e.g., a service provider, a seller of goods or an asset leasing company) or the debtor on its own may make or file an application with the National Company Law Tribunal (“NCLT”). An operational creditor cannot file a CIRP unless he has served upon the debtor, a notice demanding the repayment of the money owed, and despite such notice, the debtor has neither disputed the sum owed nor paid it back within ten (10) days from the date of the notice.  The CIRP application must be admitted by the NCLT within fourteen (14) of submission, and the CIRP must be concluded within one hundred and eighty (180) days from the date of admission by the NCLT (the “CIRP Deadline”). However, under justifiable circumstances, the NCLT may extend the CIRP Deadline for a further period of up to ninety (90) days.  Such an extension, however, cannot be granted more than once.

1. Declaration of moratorium: Upon admitting the application for initiating a CIRP, the NCLT declares a moratorium on: (i) the institution of suits, or the continuation of pending suits or proceedings against the debtor; (ii) the transferring, encumbering or disposal of assets by the debtor; (iii) any action to foreclose or recover any security interest by a creditor; and (iv) the recovery of any property by an owner or lessor when such property is occupied by the debtor. The moratorium will operate until the conclusion of the CIRP or until the commencement of the liquidation of the debtor.

The imposition of a moratorium aims to ensure that pending the completion of the CIRP, actions by creditors to enforce their interests or actions by the debtor to strip its assets are prohibited, so as to offer a level playing field to both sides to arrive at a mutually agreeable resolution.

1. Appointment of Interim Resolution Professional: After declaring a moratorium, the NCLT must appoint an Interim Resolution Professional (“IRP”). During his tenure, the IRP’s duties mainly involve managing the affairs of the debtor as a going concern, collating claims submitted by the creditors and constituting a Committee of Creditors (“CC”).

1. Constitution of the CC and next steps: Upon collating all the claims submitted by the creditors, the IRP must constitute the CC, which should comprise all the financial creditors of the debtor. Operational creditors, although not a part of the CC may, if the amount of their aggregate dues is not less than 10% of the debtor’s total debt, send one person to represent them in the CC meetings. However, such representative is not eligible to vote in such meetings. Similarly, to ensure that a debtor does not feel completely alienated, its directors or partners may attend the CC meetings. They also have no right to vote.

Upon its establishment, the CC may, by a 75% majority vote, choose to retain the IRP as the Resolution Professional (“RP”) or may choose someone else to act as the RP.

The RP is entrusted with the responsibility of conducting the CIRP, and managing the affairs and protecting the assets of the debtor during the CIRP.  However, before taking critical actions such as creating any security interest over the assets of the debtor, raising interim finances, amending the constitutional documents of the debtor, etc., the RP must take the authorization of at least 75% of the members of the CC

The RP’s duty to protect the assets of the debtor coupled with the CC’s retention of control over the RP’s authority over key matters aims to ensure that the affairs of the debtor are, at all times, managed in a prudent manner after taking into account the interests of both, the debtor and the creditor.

1. Formation of Resolution Plan: The next step in the CIRP is the formation of a Resolution Plan (the “Plan”). Any person may submit a Plan to the RP.  Essentially, the Plan is a revival strategy which aims at balancing the interests of both sides – the creditor is assured of receiving his dues, and the debtor is salvaged from distress and is allowed to continue to do business.

The RP has to examine the Plan submitted to him and place it before the CC.  The CC may, by a 75% majority vote, approve the Plan.  Once a Plan is approved by the CC, the RP has to file it before the NCLT. Thereafter, the NCLT must approve the Plan if it finds the Plan to be in order.  Upon approval of the Plan by the NCLT, the CIRP is concluded.

6. Liquidation: If: (i) a Plan is not submitted to the NCLT before the expiry of the CIRP Deadline; (ii) the NCLT rejects the Plan on the ground that it is not in order; (iii) during the CIRP, the CC owing to reasons such as the impossibility of formulating a viable Plan decides to liquidate the debtor; or (iv) the debtor contravenes any provision of the Plan, then the NCLT may order the liquidation of the debtor. The liquidation process involves the following major steps:

 

1. Declaration of moratorium: Once an order of liquidation is made, a second limited moratorium is imposed (mainly preventing the institution of suits or other proceedings by or against the debtor). However, the liquidator (the “Liquidator”) may, on behalf of the debtor, institute a suit or other legal proceedings with the prior permission of the NCLT.
2. Appointment of Liquidator: Following the order for liquidation, the NCLT appoints the RP as the Liquidator. The Liquidator is entrusted with the responsibility of conducting the liquidation process. The Liquidator is given wide powers including taking over the management of the debtor and selling of its properties to ensure that the liquidation process is properly and meaningfully conducted.
3. Formation of liquidation estate: For the purposes of liquidation, the Liquidator must form an estate known as the liquidation estate. The liquidation estate comprises of all assets of the debtor, as also the liquidation proceeds as and when they are realized. However, the liquidation estate will not include any asset in which a secured creditor (“SC”) has not relinquished his security interest.  In this regard, it must be noted that upon commencement of liquidation, a SC may choose to recover his dues either by participating in the liquidation process or by enforcing his security interest by staying outside of liquidation. When a SC opts to recover dues by participating in the liquidation process, the SC is said to have relinquished his security interest. However, if the SC, despite standing outside the liquidation process, is unable to recover its dues fully, the SC may compel the Liquidator to pay from the sale proceeds of the liquidated assets, any deficiency.  Conversely, when the SC recovers more than what it is entitled to, the SC will have to compulsorily deposit the surplus with the Liquidator.

1. Realization of liquidation estate assets and distribution of proceeds: Once the assets included in the liquidation estate are sold and their value is realized, the Liquidator has to distribute the sale proceeds in the following priority:

• the costs of the CIRP and liquidation are to be paid in full;
• the dues owed to workmen for a period of twenty-four (24) months preceding the liquidation commencement date and the debts owed to the secured creditors who have relinquished their security interest are to be paid on a pari passu basis;
• wages and unpaid dues owed to employees other than workmen for the period of twelve (12) months preceding the liquidation commencement date are to be paid;
• financial debts owed to unsecured creditors are to be paid;
• dues to the government (central and state) and debts owed to a secured creditor for any amount that remains unpaid following the independent enforcement of a security interest are to be paid on a pari passu basis;
• any remaining debts and dues are to be paid; and
• preference and equity shareholders are to be given their respective dues.

It must be noted that, under the Code, dues to the Government rank much lower in priority than debts owed to workmen, secured creditors, other employees and unsecured creditors.  This is a marked departure from the earlier position where the Government’s dues ranked immediately below the dues of workmen and secured creditors.  To give effect to this, various other laws, like tax and central excise laws, have been amended.

Dissolution: Once, the debtor is liquidated, the Liquidator must make an application to the NCLT and request it to pass an order of dissolution.  Upon receiving such an application, the NCLT has to pass an order dissolving the debtor.

7. Fast Track CIRP: In certain circumstances that will be prescribed by the Government, the Code will allow an applicant to opt for a fast track CIRP. A fast track CIRP has to be completed within ninety (90) days from the date on which such fast track CIRP was commenced.  However, a one-time extension may be sought for a period not exceeding forty-five (45) days.  A fast track process is, but for a shorter deadline, similar to a regular CIRP.

8. Voluntary Liquidation: The Code also provides for the voluntary liquidation of a corporate entity who has not committed any default. In case the corporate entity opting for voluntary liquidation is a company, it must make a declaration that it is solvent and is not going into liquidation merely to defraud its creditors.  Further, this declaration has to be supplemented by a shareholders’ resolution spelling out the company’s intention to go into liquidation. Furthermore, if the company is indebted, a 2/3^rd majority of the creditors of the company must approve the liquidation. Once, the resolution receives the approval of the creditors, liquidation is deemed to have commenced.

Although the company may make a declaration that it is not going into liquidation merely to defraud its creditors, the truth of such a declaration cannot be established unless the creditors are offered an opportunity to examine the reasons which impel the company to opt for voluntary liquidation.  As the creditors would be materially affected by the outcome of the liquidation process, the Code for obvious reasons allows them a say.

9. Adjudicating Authorities: The NCLT is the adjudicating authority for CIRP and the liquidation of corporate entities. The orders of the NCLT can be appealed to the National Company Appellate Tribunal (“NCLAT”) within thirty (30) days of the passing of the orders.

Although the Code allows an appeal to be filed in respect of any order of the NCLT, appeals against orders approving a Plan can be filed only on certain grounds such as contravention of the provisions of any law in force, material irregularity in the exercise of the RP’s powers, failure to provide for the debts of operational creditors and failure to provide for the costs of the CIRP.  Similarly, appeals against orders ordering liquidation can be filed only when a material irregularity or fraud is committed in relation to such orders.  Limiting the grounds for challenging a Plan or an order directing liquidation will ensure that frivolous appeals, aimed solely at undermining the CIRP or the liquidation process, are curbed.

Appeals, on questions of law, against the orders of the NCLAT, can, within forty-five (45) days of the receipt of such orders, be filed before the Supreme Court of India (the “Supreme Court”).

The appeal provisions, though commendable, fail to fix a strict deadline for disposing of the appeal.  The NCLT has been entrusted with strict timelines across many tasks and a similar approach could have been adopted for the NCLAT as well.

10. Offences and penalties: The Code lists out various offences and penalties. Offences include fraudulent initiation of CIRP (which has not been defined), entering into transactions to defraud creditors, misconduct by the debtor or the RP during the CIRP, falsification of accounts, false representations to creditors and contravention of the moratorium or the Plan. The punishment for such offences includes fines ranging from INR100,000 (US$1,482) to INR10,000,000 (US$148,214), and in some cases, even imprisonment.

11. Comprehensive framework for insolvency resolution and bankruptcy of individuals and partnership firms: A comprehensive framework, quite similar to that for corporate persons, has been established for the insolvency resolution and bankruptcy of individuals and partnerships.

Although there are some similarities between the CIRP and the insolvency resolution process for individuals, the two are not identical.  Owing to the fact that an individual functions differently than a corporate body, appropriate modifications have been made to suit the peculiar needs of individuals.  The minimum default threshold to trigger the insolvency process for individuals is INR1,000 (US$15 approximately), which appears to be very less.

To resolve insolvencies of individuals, the Code envisages a “fresh start process” (“FSP”), under which a debtor who fulfills certain criteria may obtain a discharge for “qualifying debts” (these debts can include credit card debts, unsecured loans, credit from friends and family, etc.), which are not in excess of INR35,000 (US$520).  An FSP, if successful, culminates in a discharge and relieves a debtor from the burden of repaying his qualifying debts.  An FSP will be ideal for small businesses and low net-worth individuals.

This apart, the Code envisages an elaborate insolvency resolution process (the “Process”) which culminates in a repayment plan.  A repayment plan is akin to a Plan as prepared for corporate debtors. The Process is considered successful, if the repayment plan is approved by the Debts Recovery Tribunal (“DRT”), the adjudicating authority for individuals and partnership firms.

However, in case the DRT rejects the repayment plan or the repayment plan is not implemented within the stipulated time frame, a creditor or the debtor himself may apply for bankruptcy.  A bankruptcy application may also be preferred before the commencement of the Process, if an application for initiating the Process is rejected on the ground that it seems to have been preferred for defrauding creditors.

The bankruptcy process comes to an end when the debtor is discharged.  The order discharging the debtor is passed either after the lapse of a period of one (1) year from the date of commencement of the bankruptcy or at a time prior to such elapsing if the creditors confirm that the administration of the debtor’s estate has been completed.  However, a discharge after one (1) year will not affect the administration and distribution of the debtor’s estate, if still incomplete.

Decisions of the DRT can be appealed to the Debts Recovery Appellate Tribunal (the “DRAT”) within 30 days.  Decisions of the DRT on questions of law can be appealed to the Supreme Court within forty-five (45) days.

Similar to the chapter of the Code dealing with corporate insolvency, the chapter dealing with insolvency for individuals and partnership firms also provides for various offences and severe penalties.

12. The Insolvency Resolution Profession: The Code aims to establish insolvency resolution as a full-fledged profession, and to that end, envisages the creation of an Insolvency and Bankruptcy Board of India (“Board”), whose functions, inter alia, will include regulation of Insolvency Professional Agencies (“IPA”) and Insolvency Professionals (“IP”). The Board will be subject to the general direction of the Government and may, in certain circumstances, be superseded by the Government.

An IP will play a crucial role in an insolvency or liquidation.  In a CIRP or a corporate liquidation, it is the IP who will play the role of the RP or the Liquidator, as the case may be.  Similarly, for the insolvency resolution or bankruptcy of an individual, the IP will play the role of a RP or Bankruptcy Trustee, as the case may be.

An IPA is an association of IPs.  Membership with an IPA will be mandatory for any IP who wishes to render services as an IP.

The Code provides vast powers to the Board to effectively regulate the functioning of IPs and IPAs. Such powers include the stipulation of conditions to admit persons as IP or IPAs, and in prescribing standards which IPs and IPAs must conform to in discharging their functions.

Treating insolvency resolution as a profession to be monitored by a professional regulator is a positive move.  It will ensure that the insolvency resolution process is conducted by competent people in a highly efficacious manner.   However, strict Governmental control may hamper the Board’s autonomy and affect its effectiveness as an independent regulator.

13. Information Utilities: The Code envisages the creation of Information Utilities (“IU”) whose main function will be to collect and disseminate financial information. Creditors may file information regarding their debt with IUs.   Doing so will have advantages; for instance, in an insolvency resolution process for an individual, the registration of a debt with an IU will be prima facie evidence of the existence of such debt.  In a CIRP, information regarding a default lodged with the IU may be used as evidence for submitting an application for the initiation of a CIRP.  IUs will, thus, provide critical financial information which will facilitate the functioning of the insolvency resolution process.  Much like the IPAs and IPs, IUs will be subject to the supervisory control of the Board.
14. Cross-border insolvency: The Code attempts to cover cross-border insolvency, albeit not satisfactorily. The Code empowers the Government to enter into treaties with other countries for the purposes of enforcing the provisions of the Code in those countries. This means that, in an insolvency resolution or liquidation proceeding in India, any attempt to include an asset located in a foreign country will be fruitless unless the Government has entered into an agreement with the government of the foreign country, which allows foreign assets to be included in the Indian proceedings.

This provision seems to be cumbersome and time consuming as the Government may have to enter into agreements with different countries.  Further, the terms of each agreement may be different, and may lead to different procedural rules for different countries.  In our view, the Parliament could have considered adopting the UNCITRAL Model Law on Cross-Border Insolvency with appropriate modifications.

15. Amendments to various statutes: In order to ensure that existing laws are in tune with the Code, the Code amends a plethora of laws including the RDDBFI Act, the SARFAESI Act, the Limited Liability Partnership Act, 2008, and the Companies Act, 2013. The Code, as it takes care of insolvency for individuals and partnership firms, repeals the Presidency-towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920 and omits the portion relating to dissolution of a firm on the insolvency of the partners in the Partnership Act, 1932.

Our comments

The Code, as a whole, seems to be a sincere attempt at remedying the appalling credit default situation in India.  It seeks to locate financial failure at the earliest stage and enables a creditor to take corrective action by triggering the insolvency resolution process on the commission of a default.  An effective time-bound mechanism for recovering debts will come as great relief to many and will significantly improve India’s perception as a favorable business destination.

However, notwithstanding an iron-clad Code, its effectiveness will be visible only when it is put into active practice.  The real test will lie in implementation, and only time will tell whether this law is a game changer or just a run-of-the-mill reform.