Pre-package Insolvency: A Maiden Chapter Towards the Rescue of MSMEs?

Authors- Harsh Kumar Dubey, ICFAI Law School, Dehradun

Aryak Wadhawan, ICFAI Law School, Dehradun

Abstract

An effectively operating economy requires an effectively operating bankruptcy system. Before the enactment of the Insolvency and Bankruptcy Code, 2016, the legislative structure in India which dealt with insolvency and restructuring procedures of partnership firms, corporate entities, and individuals, was very complex and was fractured across various legislations viz. the Recovery of Debts due to Banks and Financial Institutions Act (RDDBFI Act), 1993, the Sick Industrial Companies (Special Provisions) Act, 1985, the Companies Act, 1956, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), etc.

The ramification of the existence of multiple laws, convolutions, and forums led to delay in timely resolutions of partnership firms, individuals, or distressed entities. This led to the devaluation of assets of the debtor, making insolvency parleys redundant.  To increase the efficiency of the bankruptcy system in India, the Insolvency and Bankruptcy Code 2016 was enacted.

Corporate rescue has acquired substantial popularity in insolvency practice, as a substitution to liquidation. The pre-package perspective has popped as an innovative corporate rescue. The pre-pack system of insolvency proceedings has seen a surge of acclaim in Europe and the United Kingdom over the past decade.

The pre-packs grant a distressed company an option to negotiate a plan with its creditors and investor(s) before engaging in a formal insolvency process. Pre-packs provide a discreet and swift way of concluding the insolvency resolution process by allowing the terms to be negotiated before formal proceedings. In the United States and the United Kingdom, the pre-packs have drawn attention due to the speed and confidentially offered by them. The pre-packs introduced by the Insolvency and Bankruptcy Board of India in the Indian regime have faced some unique disputes due to some features in India’s insolvency regime.  This paper aims to explore the concept of pre-packs and discuss some of the challenges that it faces. 

INTRODUCTION

“India is a paradise for those wanting to invest; we are working on the ease of doing business in the country” has been ingeminated by the Hon’ble Prime Minister of India Narendra Modi on various occasions. India ranks 135 out of 190 countries in the World Bank ease of doing business. On 28th May 2016 an act called insolvency and bankruptcy was published in the official gazette after its passage in parliament to promote entrepreneurship and speedy resolution for cases of insolvency.

 Earlier attempts were made to resolve insolvency issues faced by creditors and the general public in large through (Recovery of debts to banks or financial institutions 1993 referred to as RDBEI Act) and for scrutinization (Reconstruction and enforcement of security interest act 2002 referred to as “SARFESI”). This act was ordained to tackle the different facets of corporate insolvency. The above-mentioned acts were visioned to safeguard the interest of shareholders and time-barred resolution of insolvency in the case of individuals, partnership firms, and Corporate; but failed to do so.

The failure of the above two acts, the inception of a sense of loss in investment among investors. Seeing a diminution in investment and business growth, the Parliament enacted insolvency and bankruptcy code on 28th May 2016 (hereinafter referred to as code) to address the issues which were not resolved by the above two acts and to bring them under one roof for improvement in result. In India it takes almost 4.5 years on average to solve the bankruptcy and insolvency case while comparing to other nations like the U.K takes 1 year, U.S.A takes 1.5 years.

The insolvency and bankruptcy code when enacted was being considered as one of the critical legislation with the hope to bring changes in ease of doing business and for the speedy redressal of bankruptcy and insolvency cases. This act boosted up little confidence in the mind of the investor. The code is an institutional legal framework that consists of (insolvency and bankruptcy board of India) which comprises insolvency experts, the utility of information, and adjudication mechanism through (NCLT and NCLAT).

 The code comprises of two-step process firstly from Section (6 to 32) which illustrates the insolvency resolution process and role of creditors in assessing and determining whether to continue business or not and what are the chances of its growing again. Secondly from Section (33 to 54) illustrates liquidation that if the idea of revival fails or revival is not a good option then creditors can decide to wind up the business and distribute debtor assets.

Despite the inclusion of several important points to consider issues in insolvency and bankruptcy certain provisions thus didn’t seem to be effective as a result of which there was an incessant hike in the prolonging cases of insolvency and bankruptcy. Considering which a Bill for inclusion of “Pre-Package” was passed in the Parliament on July 28, 2021, as an amendment to the insolvency and bankruptcy code, 2016. Pre-package has shown the ray of hope to the creditors of Small, Micro, and Medium Enterprises (MSME) as the inclusion of pre-pack in code state that creditors can sell off the business to the interested buyer before going to the court to get the agreement sanctioned. This article tries to explore more about the pre-package bill.    

What is Pre-Package?

The Insolvency and Bankruptcy Code, 2016, was introduced to amalgamate a surfeit of regulations covering realization of assets and insolvency resolutions. These regulations dictated the insolvency system in a monotonous and unsystematic manner. There was a dire need to break the shackles of this haphazard and tedious regime. Thus, a sub-committee of the Insolvency Law Committee (ILC) was formed by the government to construct the pre-pack framework.

For the Indian market, the ILC drafted a pre-pack structure within the basic framework of IBC. The same structure was explained in detail in their report of October 2020. The Ministry of Corporate Affairs (MCA) also invited public views and comments on its proposed Pre-packaged Insolvency Resolution Process (PIRP) via a notice dated January 8, 2021.

A pre-pack is a method of settling the issues between the owners of a distressed business and creditors. A pre-pack foresees the resolution of the debt of a distressed company through a direct accord between the creditors and the owners of the company or outside investors, in place of the public bidding process.

Under the pre-pack system, the financial creditors seek approval of the resolution plan from the National Company Law Tribunal (NCLT) after mutually agreeing upon the said resolution with the promoters or potential investor. Before the submission of the said resolution plan, the approval of at least 66 per cent of financial creditors that are not related to the corporate debtor is required. Before considering a petition for Corporate Insolvency Resolution Process (CIRP), the NCLTs are required to either accept or reject any application for pre-pack insolvency. 

Objectives and Rationale

The concept behind the introduction of the pre-pack scheme, was the addition of a new chapter to the Insolvency and Bankruptcy Code (‘IBC’) which was four years old, providing an offer that is an alternative way to turn around small business houses.

 In contrast to the general provisions for larger companies, this does not replace the subsisting management.

The rationale is to ensure that the scheme does not lead to any disruption in the working of the business given that MSMEs have distinctive features and informal business ties up.

The overall interest is to keep the business’s existence in a long run and protect it from disruption of any type, which could uplift the risk of employment losses.  MSMEs are considered the backbone of the economy and supply chain.

It is expected that the incorporation of the pre-packaged insolvency resolution process for MSMEs in the IBC will eliminate the distress faced by MSMEs due to the impact caused by the pandemic and the unique nature of their business,  and in terms of the economy, they are important which should be duly recognized.

Difference between Pre-Pack and CIRP

One of the main opprobrium of the CIRP has been the time taken by it for a resolution. At the end of March 2021, 79 per cent of the 1,723 ongoing insolvency resolution proceedings had crossed the 270-day threshold[1]. The protracted litigation process between the former promoters and potential bidders is the major reason for such delays. On the contrary, PPIRP gives the corporate debtor an option to settle the matter with the creditors outside the court by formulating a resolution plan.  

PPIRP includes a pre-pack, i.e., the MSME will have to approach its financial creditors accompanying a foundation resolution plan and obtain their permission before formally starting PPIRP. The MSME debtor has to submit a foundation resolution plan against which competing plans are evaluated and one plan is finally selected. The base resolution plan submitted can also be improved by the MSME. This option is not available to debtors in CIRP.

Another significant difference between pre-packs and CIRP is that, in the case of CIRP, a resolution professional is appointed who takes control of the debtor as a representative of financial creditors; while in the case of pre-pack the management remains in control. This ensures minimum interference of operations relative to a CIRP.     

Process of initiating PPIRP

Any corporate debtor who has been categorized as micro, a small, or medium enterprise under section 7(1) of the MSME Development Act, 2006; or any defaulter under Section 7(1) of the Code, can initiate the process PPIRP[2], subject to the following conditions:

The debtor has not sustained pre-package insolvency process or settled the corporate insolvency resolution process, as the case may be, during three years precursive to the initiation date;

The debtor is not undergoing a CIRP;

No order has been passed to liquidate it has been passed under Section 33;

The debtor is eligible to proffer a resolution plan under section 29A;

The moniker of the insolvency professional who is to be appointed as resolution professional for administering the pre-packaged insolvency process of the corporate debtor shall be proposed by the financial creditors, not being related to the debtor representing such number and such manner as specified.

The proposal shall be approved by sixty-six per cent of the financial creditors, not related to the corporate debtor.

The filling of the application for initiating the pre-packaged insolvency resolution process shall be approved by the members of corporate debtors, or at least three-fourths of the total number of the partners, as the case may be.

Once the conditions laid down under Section 54A are fulfilled by the corporate debtor, it may file the application with NCLT for initiation of the PPIRP along with the specified indentures. Within 14 days of receiving the application, the Adjudicating Authority shall either admit or reject the application. The process of PPIRP shall begin from the date of the submission of the application and shall be completed within 120 days from the date of commencement.

The responsibility to conduct the pre-packaged insolvency is vested with the resolution professional under Section 54F(1). The various duties and powers of the resolution professional to conduct the PPIRP are mentioned under Section 54F(2). The corporate debtor shall provide the resolution professional with the base plan, on which they shall work. The resolution professional shall also consult on the base plan and the ensuing resolution plans with the committee or creditors. Once the committee of creditors approves the resolution plan, an application to the NCLT can be made to get its approval.

If the NCLT is satisfied with the resolution plan and the said plan meets the requirements mentioned under Section 30(2) of the Code, it shall approve the plan, within thirty days of obtaining the application.

Before passing an order of approval of a resolution plan the NCLT shall satisfy itself that the provisions of the said plan are for its effective implementation.

Governance of the Affairs of the Corporate Debtor during PPIRP

  In PPIRP, the board of directors of the corporate debtor continues to superintend the corporate debtor’s affairs during the PPRIP. The responsibility to preserve and protect the value of the corporate debtor’s property remains in the hands of the board of directors.

Directions/guidelines on which the corporate debtor’s management may be continued can be provided by the committee of creditors. The committee may seek any information that it deems fit necessary for that purpose from the corporate debtor. The affairs of the corporate debtor may be vested with the resolution professional in the cases where the former has acted fraudulently.

Devising the List of Claims

The corporate debtor devices a list of claims which includes the information of individual creditors, interests, security, and guarantees, and provides it to the resolution professional. Based on the precursory information memorandum which is obtained from the corporate debtor, the resolution professional authenticates the list of claims and notes the information memorandum.

The corporate debtor shall be liable to any loss or damage sustained by any person because of the omission in the information memorandum.

The case where the application for both CIRP and PPIRP is filled

The PPIRP shall be given a preference over CIRP in the cases where both have been filed. This is crucial because, upon the occurrence of any default, any operational or financial creditor may seek the initiation of CIRP. This provides the corporate debtor with an option of resolving its bankruptcy through PPIRP. 

Transmutation into Corporate Insolvency Process (CIRP)

Section 540 of the IBC permits the committee of creditors to commence with CIRP proceedings against the corporate debtor after the commencement of PPIRP but before the approval of the resolution plan. This can be achieved only when a majority of the creditors, i.e. 66% vote in this favour.

In such a case, an application shall be filled in the NCLT for the initiation of CIRP by the resolution professional. An order of termination of PPRIP and commencement of CIRP may be passed by the National Company Law Tribunal.

 Benefits of Pre-Package Insolvency

The traditional insolvency process is at the juncture where the debtor company has toppled in the ditch and has become incompetent to carry out its regular operations due to the dearth of funds or intricate regulatory requirements.  On the other hand, the pre-packs can ascertain that the company needs debt restructuring at the earliest stage. Therefore, when identified at an early enough stage, the pre-packs permit the company to run regularly, even though it is going through the insolvency process. 

The Supreme Court recently announced that suspension of IBC was retrospective in nature and there would be a sudden increase in cases being filed as soon as the suspension ends[3]. The burden on the courts shall be reduced through PPIRP by reducing the number of resolution affairs taken up by the concerned adjudicating authority.

The pre-packs allow the maximization of the value of assets by providing a faster resort to a resolution plan in consultation with the stakeholders. The provision for commencement of proceedings under PIRP on the initial instance of default can limit the room for liquidation and the intent of sustaining the business can be attained. Pre-packs also increase the investors’ confidence as it is similar to the proceedings under the IBC, therefore making the approved plan binding on all stakeholders.

In pre-packs, negotiation on resolution takes place before invoking the statutory framework. This proves to be less time-consuming and more cost-friendly. A lot of times, rapid disposal through pre-pack may prove to be the essential factor between the companies ending up in liquidation under CIRP compared to small businesses thriving after the PPIRP.

Challenges Ahead

The pre-packs had been presented to deduce benefits right from the onset. Its main area of coverage is to reduce the time taken to complete the proceedings, and low dealing cost, along with the continuation of corporate debtor’s business proceedings. However, there are a lot of challenges that it still has to face along with its way.

The paucity of transparency:- Pre-Pack has been added as an alternative for the insolvency process for MSME corporate debtors. The very first in-built hurdle that comes in the way of pre-packs is that it promotes private negotiation between the debtor and creditor, which clarifies that there will be less public participation. Pre-Pack is comparatively less transparent than CIRP because the former envisages the right to agree to the disposal of the debtor asset between financial debtors and potential investors and the public bidding process has not been taken into account. The interest of unsecured creditors and connected party transactions has not been considered.

The process of entering into pre-pack arrangements is not transparent enough as the agreements are undertaken in consultation with the management of the corporate debtor thus, the interests of the management are prioritized along with the secured creditors being at a higher podium than the unsecured creditors. Further, it is apt to infer that the value agreed upon, in the resolution plan is not maximized to the full extent.

Bulwark of Moratorium:- In the usual insolvency proceedings under sections 7 and 9 of the insolvency and bankruptcy code, a push-button of stay, that is, moratorium comes into operation that restrains the creditors from claiming remedies against the corporate debtors and the assets owned by them.

Nevertheless, a debtor looking for pre-packs can’t enjoy the benefit of the moratorium. This leads to a situation where the creditors can plea courts or tribunals and carry out their remedies provided to them, while the debtor is negotiating a Pre-Pack resolution. Such litigations not only threaten the assets of the debtor but also force the company into CIRP or liquidation. To alleviate such threat the government must bring in a provision or extend the benefit of the moratorium to the Pre-Pack mechanisms. However, securing such co-operation among debtor and creditor is easier said than done. 

The cramped ambit of applicability:- As per the Ordinance, corporate debtors that have been classified as  “micro, a small or medium enterprise under sub-section (1) of section 7 of the Micro, Small and Medium Enterprises Development Act, 2006” are not restricted to apply to seek remedies through PIRP. The Regulations act as an umbrella to the companies that fall under the ambit of the PIRP mechanism, it does not provide the benefit of Pre-Pack to various other MSMEs, which includes partnerships, sole proprietorships, Hindu undivided families (“HUFs”), and other unregistered business houses, that limits the number of MSMEs eligibility for PIRP.

According to the reports of the India Brand Equity Foundation, the MSME sector of India consists of approximately 6.3 cr business houses. Though India is considered the land of MSME enterprises, not all MSMEs are registered under the provisional registration law[4]. Reviewing the recent statistics currently at the Udyam Registration portal for MSMEs, the number of registered MSMEs is only 26.42 lakh. Thus, the Ordinance applies only to a handful of entities in this sector. Hence, the legislative intent to provide relief to MSMEs against the repercussions of Covid-19 stands unaccomplished. The limited applicability of these provisions reduces the number of MSMEs that can enjoy the benefits of these schemes. 

Manifold approvals:-  Referring to  Chapter III-A of the IBC, which lays down certain provisions for a corporate debtor to secure several permissions before PPIRP starts, starting from shareholders, unrelated financial creditors, and at last, the adjudicating authority. In terms of approval by financial creditors, regulation 14(1) illustrates that this permission must be obtained at a meeting of unrelated financial creditors, which must be held in adherence to the procedure in which regulations have been formulated. 

Furthermore, regulation 14(8) illustrates that if there are no financial creditors for a particular corporate debtor, the above-mentioned approval must be obtained from the unrelated operational creditors following the procedure laid down in regulation 14(1). The regulation implies that the corporate debtor needs to convene a meeting with all its operational creditors. However, the number of operational creditors is considerably higher than unrelated financial creditors, thus making the entire process more complex and logically absurd. Instead of holding a meeting, it is advised that quicker approval can be acquired by obtaining a “Letter of Assent” signed by the operational creditors.

Inconsistent DIP mechanism:- The PPIRP comes up for a debtor-in-possession (“DIP”) strategy for management or operations of companies, which provides the corporate debtor with an assurance that it may revive the operations with the management being unchanged. The method of DIP, as explained by the Ordinance, enables the corporate debtor’s board of directors to inspect its business operations, subject to the insolvency professional’s observation and certain restrictions that may apply.

However, this approach towards DIP does not seem to be much effective while looking at regulation 50(2). As per this regulation, the assent of the Committee of Creditors (“CoC”) is mandatory for expenses exceeding the stipulated sum (which shall be decided by the CoC). Regulation 50(2) (b) permits the CoC to identify any further conditions that the corporate debtor should consider and abide by while taking any actions. This increases the chances of the CoC imposing superfluous requirements, thereby producing a creditor-in-possession (“CIP”) mechanism rather than the desired DIP. As a result, the corporate debtor managing the operations will fall prey to the powers of CoC.

 Limitation for completion of PPIRP:- Under regulation 49, a corporate debtor has 90 days to submit a CoC-approved resolution plan before the adjudicating authority. The adjudicating authority has 30 days to pass an order, either accepting or rejecting the resolution plan. Such time boundness of 90+30 days is an unrealistic one, considering the records of compliance with CIRP limitations. The 90-day timeframe includes the drafting of a CoC, corporate debtor appraisal by registered valuers, and the transaction inquiry. It may also take a long time to get clearance from a creditor. Due to this, this will only come into action if the corporate debtor lays down the spadework before the PIRP’s formal start date.

Suggestions

Transparency and Indisputability

One of the biggest drawbacks of pre-packs is that it lacks transparency. The pre-packs advocate for private negotiation between the debtor and creditors. The interests of the unsecured creditors and connected parties are not considered. The PPIRP should be made more transparent and incontrovertible. The operational creditors should be treated equally to the financial UI.  The main aim of the PPIRP is to revive the company’s business operations and to put it back on track. For this, the debt of the operational creditors should be paid off to restart the operations.

Increasing the ambit of applicability

The pre-packs were introduced with an intent to provide relief to the MSMEs from the repercussions of Covid-19. Unfortunately, this aim still stands unaccomplished as the number of MSMEs registered is only a fraction of the original number. Therefore, the ordinance applies to a handful of the entities in the sector. The enjoyment which is deducted from the benefits of the pre-packs reform should not be confined to the registered MSMEs.  A more innovative way to bestow the benefits to the unregistered MSMEs should be brought forth.

Compromising on speed for fairness and stability

Under the pre-pack reform, a corporate debtor has 90 days to submit a Coc approved resolution plan before the NCLT. The adjudicating authority has 30 days to pass an order either accepting or rejecting the resolution plan. Such a short period is an unrealistic one. The 90 days timeframe includes the formation of a committee of creditors, negotiating on a resolution plan, and submitting it before the adjudicating authority. It may take a long time just to get the resolution plan approved from the creditors making it a little unfair for the corporate debtor. This may also result in instability. Thus to avoid this, the time frame should be extended to a more reasonable one.

CONCLUSION

This lately developed legal mechanism for MSMEs, inter alia providing for quicker & cost-effective resolution and allowing the debtor to be in command, may fairly be anticipated to add to strengthen both the financial and operational position of MSMEs, more importantly considering the havoc caused during time of Covid. Thus, pre-packs will ensure to help corporate debtors to set foot into consensual restructuring along with creditors and address every liability aspect of the company. It can also lessen litigation, triggered by the defaulting promoters to gain control of their firms and help thousands of MSMEs wrestling to cope with the damage caused by the Covid-19 pandemic.

This ordinance introduces a mixed perspective towards the resolution of insolvent MSMEs and ensuring the balance between the interests of creditors on the one hand and the need to maintain the autonomy of MSMEs on the other hand, to best serve the interests of both the parties.

Like any other legislation, this Ordinance will also be required to develop, as it moves forward to mark application issues that will crop up with time. Illustratively, the payment and restructuring terms to which creditors disagree may have to be considered soon, especially in consideration of judgment of the Supreme Court. At present government has limited Prepacks provisions for MSME and may extend to other Corporates over course of time. The government requires to further increase the NCLT’s infrastructure so that pre-packs can be applied within time bound limit. The government may also take into consideration setting up particular benches looking at Prepack and Insolvency above a certain size to accelerate the resolution of large cases in a time-bound manner.

Will IBC Pre-packs prove to be the “Savior” for MSMEs? To conclude we can say that, this ordinance is a welcome move at this point but its application in the future will notify us if this ordinance meets its objectives and if so, under what circumstances. The pre-packaged insolvency resolution process is a proactive move to ensure speedy insolvency resolution for MSMEs. MSMEs are considered as the backbone of the Indian economy and it is admirable that the ordinance was introduced keeping the MSMEs in mind. Like any other regulation, only time can tell us about the potency of Chapter III-A

Considering everything, the amendment is a notable effort towards reducing the difficulties faced by the stakeholders be it creditors or the debtors while going through the lengthy process of CIRP. The bare reading of the draft code illustrates that all possible procedural irregularities that might crop up during the implementation have been dealt with in advance by the amendment ordinance however the real-time procedural glitches can only be discovered once it is used and misemploy by the ones benefitting from it.

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[1] https://www.ibbi.gov.in/uploads/whatsnew/2021-05-29-204258-5pyve-3363461de858b06bfa1afdbf13151b90.pdf

[2]  Section 54A(2) of Insolvency and Bankruptcy Amendment Code,2021.

[3]  Ramesh Kymal v. M/s Siemens Gamesa Renewable Power Pvt Ltd.

[4] MSME Development Act, 2006