Introducing a Special Framework for Resolving Insolvency of MSMEs

Problem

During a macro-economic crisis, such as the one caused by the Covid-19 pandemic, micro, small and medium enterprises (“MSMEs”) are particularly susceptible to distress and failure. This is because of limited access to new lines of credit, undiversified business structures, over-dependence on counter-parties and inability to downsize operations efficiently. In our assessment, a large number of MSMEs are likely to face severe solvency issues in the near term. Being the backbone of the economy and the second-largest source of employment, it will be crucial to resolve distressed MSMEs swiftly in a cost-effective manner for mitigating large-scale losses for the economy.

Modern insolvency laws are designed to revive economically viable debtors that are temporarily undergoing financial distress. However, globally, insolvency proceedings of MSMEs more often result in liquidations than successful revivals, as they cannot afford the costs of prolonged and complicated insolvency procedures. In India, corporate insolvency resolution process under the Insolvency and Bankruptcy Code, 2016 (“Code”), is designed as a creditor-friendly process, that envisages displacement of the existing management and promoters upon commencement of insolvency proceedings. Such displacement can be permanent if the creditors decide to bring in new owners as part of a resolution plan.

While this approach has been effective in resolving large recalcitrant borrowers, it may produce sub-optimal results in the case of MSMEs. This is because promoters and managers of MSMEs are often indispensable for their survival, owing to their personal relationships with other stakeholders in the business, which can be crucial for ensuring business continuity during insolvency. Further, MSMEs are also prone to inadequate record-keeping, which can hinder value discovery and third-party takeovers in the auction conducted under the regular insolvency process. The Code also recognises these limitations and empowers the government to make appropriate modifications to the processes for insolvency resolution of MSMEs. However, this power has never been invoked.

Solution

To provide an effective rescue mechanism for distressed MSMEs, a separate insolvency resolution framework should be designed by making appropriate modifications to the Code processes. 

Notably, Chapter IV of Part II of the Code already provides for a “fast-track corporate insolvency resolution process” (“fast-track CIRP”) for smaller debtors. However, this framework has not been utilised much, as, apart from mandating a shorter time-line, the process does not provide any significant relaxations or exemptions that may be beneficial for smaller debtors. Therefore, re-designing the fast-track CIRP, might be an effective way of providing relief to the MSME sector without disturbing other parts of the Code. The re-designed framework should envisage a simple and debtor-friendly process that results in swift and cost-effective resolutions. To achieve this, the existing management of an MSME debtor should be permitted to initiate proceedings even before a default occurs and allowed to remain in control during the process. Further, to allow the business to be run by the same management even after resolution, existing promoters may be provided a right of first refusal to retain control after completion of the regular bidding process. This right may be subject to a requirement of a specified premium over the best bid received in the auction to ensure that the promoters do not abuse the process at the cost of creditors. 

Implementation

• Chapter IV of Part II of the Code, which lays down a framework for fast-track CIRP, should be amended to make it more debtor-friendly for the purpose of MSME insolvencies. 
• Specifically, the amended fast-track CIRP framework should provide for a debtor-in-possession model, wherein the existing management can retain control over the corporate debtor, during the pendency of the resolution process.
• While the bidding process applicable to regular insolvency proceedings may be followed (with appropriate modifications to make it simpler), promoters should have the right to retain control as long as they submit better resolution plans in comparison to those submitted by third-party resolution applicants.

About the Authors

Oitihjya Sen

Oitihjya was a Research Fellow working in the area of Corporate Law and Financial Regulation and with the Vidhi Bankruptcy Research Programme.