Reframe insolvency mechanism

Anil Bhardwaj, Secretary General, FISME

‘Temporary stresses’ in business and eventual closure in many cases are inevitable. So a fair and effective mechanism to deal with insolvency and bankruptcy is a prerequisite for enabling risk-taking and enterprise creation.

Though insolvency and bankruptcy are generally used together, the terms are not synonymous. Bankruptcy represents a body of law designed to protect interests of creditors, allowing for confiscation and distribution of debtor’s assets among creditors.

In insolvency, the body of law protects debtors, who would voluntarily declare insolvency, cede all their assets to the court, and be discharged from the ‘debtor’s prison.’ In practical terms, insolvency means that the fair market value of the net assets of the insolvent is less than the liabilities. This necessitates the liquidation of assets through a court-ordered bankruptcy process.

For bankruptcy, there is no comprehensive policy or law in India. The insolvency mechanism for companies is through the Companies Act, and for individuals (and proprietorship/partnership), there are two Acts: The Presidency-Towns Insolvency Act, 1909, and The Provincial Insolvency Act, 1920. As an overwhelming majority of small enterprises in India are proprietorship or partnership (97.3% as per third census of small-scale industries), the two insolvency Acts are applicable to them.

When a business fails, there are three types of creditors whose liabilities need to be settled: Statutory dues (such as central and state taxes, dues of labour, of utilities such as electricity, water, finance by state institutions etc.); dues payable to banks and financial institutions; and dues to sundry creditors (buyers, suppliers and others).

The insolvency Acts provide for respective legal recourse for recovering statutory dues from individuals, firms or companies, prescribing fines, attachment of assets and also, in most cases, imprisonment. The final recovery procedures, whether on behalf of central or state governments, are effected by state governments through their administrative machinery.

In the Indian mechanism, there are specific problem areas for small enterprises. The first problem is that two set of institutions—the statutory authorities and banks/ financial institutions—-seek to recover dues under different set of laws simultaneously.

Most provisions for recovery of statutory dues are through a mechanism under land revenue Acts in the states. Typically, the process entails arrest and detention of the person and attachment and sale of debtor’s assets.

Banks and financial institutions have several options for restructuring a stressed account and recovering their dues: the State Level Inter-Institutional Committee (SLIC) route for a revival or restructuring when more than one financial institution is involved or a ‘one-time settlement’ (OTS) or a restructuring of the failed/sick as per RBI guidelines or finally recovery of dues through the DRT Act and the Sarfaesi Act. However, there is no institutional mechanism to guide the process.

The report of the ‘Working Group on Rehabilitation of Sick SMEs’ (RBI, 2007) highlights the shortcomings of the current dispensation succinctly.

It states: “the normal action plan of any banker when a small unit is in stress is to stop operations in the account, serve a recall notice and initiate action under Sarfaesi Act. Efforts for rehabilitation, if any, are ad hoc and not properly structured after viability study or analysis of the root causes of sickness etc. The bank staff puts in efforts to avoid classification of the account as NPA. All focus of the banks is centred on the asset classification and not health classification.”

While the entrepreneur may be trying to restructure the unit, the statutory authorities could move for attachment of assets and his imprisonment. Though theoretically, the legal remedy to escape attachment of assets and accompanying imprisonment for an entrepreneur would be to take shelter under the two insolvency Acts.

The insolvency mechanism through the two Acts is all but dysfunctional. The conditions attached are almost impossible to meet and terms are antiquated, hugely subjective. Most importantly, in the current dispensation, under the two Acts, there is no protection from ‘criminal cases’ —as the defaults under statutory dues are construed, and the eventual attachment of assets and imprisonment. There is no BIFR-type mechanism for small enterprises to seek a stay. Not only all personal belongings of a debtor are attached and auctioned but also of all their guarantors.

The key issues are: (i) The case of small enterprise is fundamentally different from that of corporates, both in terms of personal liabilities of promoters and related legal provisions. The liabilities of small enterprises in the event of default are unlimited and there is no BIFR-like mechanism for recourse.

(ii) There is no mechanism for addressing eventualities borne out of ‘temporary stresses’ in the life of an enterprise. While the ineffectual mechanism of SLIIC does exit—its jurisdiction is limited to institutional credit only—there is absolutely no system for restructuring multi-agency statutory liabilities.

(iii) The insolvency mechanism under the two Acts is largely dysfunctional both because of uninterested judicial dispensation for insolvency cases as well of extremely harsh post-insolvency treatment meted out to a debtor.

There is no wholesome mechanism for bankruptcy in India. Therefore, there is no functional system for recovering debt when creditors include government agencies (Centre and state), public institutions (central and state), banks/FIs and private parties.

(v) There being no single administrative mechanism for insolvency and bankruptcy, there is no one to decide whether or when the firm is to be liquidated or be sent for restructuring. Therefore, even a ‘temporary stress’ or shock is enough to bring a small unit to ‘sickness’ and to ‘closure.’

With the current conditions of economic slowdown financially injuring a large number of individuals and small entrepreneurs and leading to closure of units, the following steps are to be taken urgently:

The two insolvency Acts should be substantially amended or replaced with a new, single and comprehensive law, and a comprehensive bankruptcy law mechanism covering non-corporate entities be enacted;

Suitable revisits be made to other central and state statutes affecting recovery procedures and clauses of imprisonment and an authority/registrar/central registry system to be constituted where all the orders declaring a person as insolvent may be filed. 

A time-bound restructuring mechanism for the small-scale sector may be devised, learning from the shortcomings of BIFR and providing effective protection against attachment of assets and imprisonment during the restructuring exercise.

Finally, there is a need to institute specialised bankruptcy and insolvency courts (fast-track) and a cadre of specialists providing a ‘single window’ to address all related issues: restructuring, liquidation, bankruptcy and insolvency.

— The article appeared in The Financial Express on April 17, 2009. For more details see the policy paper: ‘Towards establishing modern insolvency and bankruptcy codes for small enterprises’, which can be downloaded from http://www.fisme.org.in