How effective would Pre-Packaged Insolvency Proceeding be in Saving the MSME Sector?

[By Prarthana Gupta & Tanya Shukla

The authors are students at the National Law Institute University Bhopal.

INTRODUCTION

The covid-19 pandemic has severely impacted the entire world, including financial markets. Of these financial markets, the Micro Small and Medium Enterprises (MSMEs) have taken a great hit too. Forming the backbone of the Indian economy, and contributing a whopping 29% to the nation’s GDP[i], the MSMEs constitute 60% of the Indian industry. The nationwide lockdown imposed in the wake of Covid-19 has severely impacted this industry, making it difficult for them to pay off their loans. Over the last year, the defaults in payments have risen steadily, driving a considerable number of them into insolvency. [ii]

This article attempts to shed light on the problems that Indian MSMEs have been facing, particularly relating to lack of funding and liquidity, fall in creditworthiness and insufficient capitalisation. Such issues have directly affected the business of the MSMEs, leading them to bankruptcy. The authors have analysed the recent amendment to the Insolvency and Bankruptcy Code, 2016 vis-a-vis the MSME sector to show how effective would it be for these businesses.

PROBLEMS FACED BY MSMES IN COVID

The lack of liquidity in the financial markets has most severely affected the MSMEs. MSMEs are a major source of providing service and generating employment in the country.

Various studies have repeatedly demonstrated that this sector acts as a catalyst for the country’s socio-economic growth. This becomes more essential in light of the government’s stated aim to achieve a $5 trillion economy by 2025. Within this objective, the MSME sector will play a major role, with a contribution to GDP anticipated to exceed 50%. The potential of the Indian MSME sector remains unexplored, which is one of the reasons why government policies are now more convergent on creating a robust ecosystem with more breadth and depth.[iii]

Surveys have shown that the pandemic has reduced the earnings of MSMEs by 20-50%. With external funding frozen in the wake of Covid-19, the immediate challenge on MSMEs to meet their legal responsibilities becomes all the more difficult. There is a likelihood of a significant increase in default levels of loans from NBFCs (Non-Banking Financial Companies). In addition to this, there is insufficient recapitalisation and the constant fear of being shut down. A staggering 43 per cent of MSMEs will close[iv] if the COVID-19 lockdown extends beyond the effective end date. Hence, activities are urgently needed in the sector that employs more than 114 million people.[v]

The credit crisis being faced by MSMEs will turn the liquidity concerns into solvency problems, create more non-performing loans and raise the sector’s vulnerability to a vicious cycle, which might hamper their actual recovery. In such a situation, seeking a protectionist approach in business before the recovery of local interest suggests a larger risk of the economy becoming caught in a low-interest cycle. Furthermore, the continued exemption of labour regulations jeopardises the revenue of labourers, slowing the repair speed of consumer demands.

Support from RBI and policies like the recent exemption granted to banks to maintain cash reserve ratio to first time MSME borrowers for the period of January 1, 2021, to October 31, 2021[vi], will be significant in resisting liquidity crunch and help make more fund available for MSMEs.

Nonetheless, the sector is dealing with long-standing issues such as lack of operating capital, complex regulatory and licensing mechanisms, rigorous loan disbursement rules, extensive compliance requirements, embryonic digital adoption, and, last but not the least, a convoluted taxation structure.

In order to assuage these concerns, an amendment to the Insolvency Bankruptcy Code (IBC), 2016 was passed last year, raising the default limit for initiation of insolvency proceedings against a corporate debtor from 1 lakh to 1 crore. The government recently took another significant step in the same direction by promulgating the IBC (Amendment) Ordinance, 2021 (“amendment ordinance”), which has introduced the “Pre-Packaged Insolvency Resolution Process” (PRIRP) for Indian MSMEs.

Let us now look into what a PRIRP is and how it works.

Understanding the Pre-packaged insolvency resolution process

The pre-Packaged Insolvency Resolution Process has been gaining worldwide attention and has proved to be successful in countries like the US and UK. As the nomenclature suggests, Pre- Pack is meant to provide an opportunity to the distressed company and its financial creditors to informally pre-arrange a resolution plan, before the plan can go for approval to the court or tribunal and the proceedings can be formally initiated.

Pre-Package has been defined by the Association of Business Recovery Professionals as “an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator and the administrator effects the sale immediately on or shortly after his appointment.”[vii]

Chapter IIIA of the Amendment Ordinance mandates the procedure of a PRIRP, intended for defaults ranging from 10 lacs to 1 crore. Approval of 66% (in terms of debt due by the MSME) of the total unrelated financial creditors of the MSME (and unrelated operational creditors in absence of financial creditors) is also required for the application. However, it must be noted that the corporate debtor must not be undergoing a Corporate Insolvency Resolution Process (CIRP) under the IBC, and must not have undergone either a PRIRP or a CIRP in the previous three years (from the date of application for initiating PRIRP).

A PRIRP may be administered in a number of ways, including as a standalone process, as part of an Insolvency Resolution Process (IRP), or as part of a voluntary administration process.

Now that we’ve gained an understanding of the process, let’s understand how is it different from the existing CIRP model under the IBC.

PRIRP vs CIRP: the better option?

PRIRPis a novel addition to the Indian financial market. As opposed to the CIRP model, PRIRP imposes a “debtor in control” model whereby the debtor retains control over the assets and business till the process is completed.

The primary benefit of the PRIRP model over CIRP is that it assures the protection of sensitive information as well as trade secrets which become particularly vulnerable during change of management. The transfer of control of the business to a Resolution Professional while the process is underway, provided through section 54J of the amendment, assures that the fraudulent intent or maladministration of the debtor is ruled out.

Due to a shorter timeline (120 days in total, non-extendable), PRIRP ensures that the insolvency procedure is completed efficiently without any unnecessary delay. Additionally, CIRP can always be undertaken in case PRIRP fails. CIRP on the other hand can only result in the liquidation of assets.[viii] Moreover, the process of CIRP can often cause conflict between the Corporate Debtor and the resolution professionals. However, since in PRIRP, the resolution plan is largely pre-packed, the role of the resolution professionals is simply supervisory in nature. The introduction of PRIRP, in the opinion of the authors, is a great step towards facilitating MSMEs in such times of distress. However, with the nuts and bolts of IBC still being new in the corporate market, the introduction of a new scheme will have to be implemented in the smoothest manner possible for it to prove successful in the manner it has been intended. There are certain practical challenges that are likely to arise in the way. For instance, the timeline of 120 days would not be easy to meet, considering the fact that around 86% of ongoing CIRP cases have breached the 270 days’ timeline[ix]. Additionally, even though PRIRP claims to be making insolvency resolution easier with lesser intervention from authorities, quite a lot of judicial control still seems to be guiding the entire process, with a threefold approval process.

Concluding Remarks

Considering the present state of the economy and finance market, PRIRP would be a boon to the MSME sector. Not only would it help expedite the insolvency procedure but also help in effective streamlining of the restructuring of debts. However, a less formal procedure with minimal statutory interference would be further in line with the international standards of PRIRP implementation from which the Indian government has clearly deviated with the present amendment. Admirable as the debtor in the control model is, the government should aim in establishing a framework allowing for a chance for promoters to regain control during the settlement of debts. Such a system would effectively minimise friction and help both creditors and debtors reach a middle ground.

Additionally, certain policy changes require immediate discussion for incentivising an increase in credit and capital accessibility to MSMEs. Policies such as incentives for digital adoption in the industry, increasing digital literacy, addressing skill shortages, GST reduction, reducing the number of licence and compliance rules and making initiatives that will lead the sector to larger markets via e-commerce would help strengthen and ease the marketplace for lending and borrowing.

The new reforms make a strong statement in favour of ease of doing business, balancing competition for local businesses and entrepreneurs, broadening the network of beneficiaries, and increasing transparency. However, given the breadth of the issues, it is critical that the government strengthens its reforms and implements some game-changing measures for the industry.

[i]MSME industry in India, India Brand Equity Foundation, August 11, 2021, https://www.ibef.org/industry/msme.aspx.

[ii] Agyeya Tripathi, Covid-19 effect on Micro, Small and Medium Enterprises (MSMEs), Times of India Opinion, Sept. 23, 2020, 1:01 PM IST, https://timesofindia.indiatimes.com/blogs/agyeya/covid-19-affect-on-micro-small-and-medium-enterprises-msmes/

[iii] Covid-19 Challenges faced by MSME, indifi, ndifi.com/blog/covid-19-challenges-faced-by-msme/.

[iv] Gireesh Babu, Covid-19 impact: MSMEs require support to survive, says industry expert, Mar 23, 2020, https://www.business-standard.com/article/current-affairs/43-of-msmes-will-close-if-covid-19-lock-down-exceeds-eight-weeksexpert-120032300461_1.html.

[v]MSMEs will be the biggest casualty of Covid-19 in India: study, March 16, 2020, https://www.thehindu.com/business/msmes-will-be-the-biggest-casualty-of-covid-19-in-india-study/article31084751.ece.

[vi]Pankaj Sharma, Ways for MSMEs to emerge stronger after the Covid pandemic, February 27, 2021, https://economictimes.indiatimes.com/small-biz/sme-sector/ways-for-msmes-to-emerge-stronger-after-the-covid-pandemic/articleshow/81241109.cms.

[vii]https://www.r3.org.uk/about-r3-insolvency-restructuring/about-insolvency-and-restructuring/corporate-insolvency-procedures/pre-packs/

[viii]PCS Prashant Thakre, Pre-Packaged Insolvency Resolution Process for MSME Sector, April 19, 2021, https://taxguru.in/corporate-law/pre-packaged-insolvency-resolution-process-msme-sector.html.

[ix]86% insolvency cases pending over 270 days, April 6, 2021. https://economictimes.indiatimes.com/news/economy/policy/86-insolvency-cases-pending-over-270-days/articleshow/81925890.cms.

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