Economics for Everyone: The Insolvency and Bankruptcy Code in India and the National Company Law Tribunal

The Insolvency and Bankruptcy Code, 2015 was introduced in Lok Sabha in December 2015. It was passed by Lok Sabha on 5 May 2016. The Code received the assent of the President of India on 28 May 2016. Certain provisions of the Act has come into force from 5 August and 19 August 2016.

Nov 19, 2017 05:11 IST Universal Business School Prof. M. Guruprasad |

Purpose
 
The Insolvency and Bankruptcy Code, 2016 (IBC) is the bankruptcy law of India which seeks to consolidate the existing framework by creating a single law for insolvency and bankruptcy. The Insolvency and Bankruptcy Code, 2015 was introduced in Lok Sabha in December 2015. It was passed by Lok Sabha on 5 May 2016. The Code received the assent of the President of India on 28 May 2016. Certain provisions of the Act has come into force from 5 August and 19 August 2016.
 
India had numerous acts in place to punish the defaulters like the Indian Contract Act, the Recovery of debts due to Banks and Financial Institution Act 1993, the Securitizations and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA). The Government decided to replace the existing insolvency laws with new stringent laws which would take care of the existing defaulters in a time bound manner.
 
The proposed bankruptcy legislation seeks to address the issues faced currently in the context of insolvency and winding up. The provisions of the Code are applicable to companies, limited liability entities, firms and individuals (i.e. all entities other than financial service providers).
 
After passing the bankruptcy code in Parliament for time-bound settlement of insolvency cases in non-financial firms, the finance ministry has released a draft bill to set up a resolution corporation to address similar issues among financial firms.
 
To quote the Finance Minister Mr. Arun Jaitley” “A systemic vacuum exists with regard to bankruptcy situations in financial firms. This code will provide a specialized resolution mechanism to deal with bankruptcy situations in banks, insurance firms and financial sector entities. This code, together with the Insolvency and Bankruptcy Code 2015, when enacted, will provide a comprehensive resolution mechanism for our economy,” Unquote.
 
The proposed legislation will not only improve the ease of doing business in India, but also facilitate a better and faster debt recovery mechanism. It is widely believed that this legislation, when implemented in letter and spirit, will change the negative perception of NPAs, recovery and litigation associated with India.
 
The new bankruptcy law will be a useful tool for international creditors and investors from the perspective of PE funds continuing to grow their investments in India
 
According to the World Bank’s Ease of Doing Business report, it takes more than four years on an average to resolve insolvency in India. The proposed insolvency and bankruptcy law seeks to cut down the time to less than a year. This will not only improve the ease of doing business in India, but also facilitate a better and faster debt recovery mechanism in the country. It is widely believed that this legislation will change the negative perception of recovery and litigation associated with India.
 
The Government has formulated a plan to refurbish the prevailing bankruptcy laws and replace them with one that will facilitate stress-free and time-bound closure of businesses. The draft legislation, since the report issued in November 2015 by a panel headed by former law secretary Mr. T.K. Viswanathan, has gone through various changes, including changes recommended by the Joint Parliamentary Committee in April 2016. The Insolvency and Bankruptcy Code, 2016 (“Code”) has now been passed by the Lok Sabha and the Rajya Sabha.
 
Process
 
Here, we will discuss some of the key features and Institution associated with the bankruptcy code
 
Key Features
 
Insolvency and Bankruptcy Board of India (“Board”)

The Board will be set up as the regulator under the Code.

Insolvency Professionals: The Bill proposes to regulate insolvency professionals and insolvency professional agencies. Under the oversight of the Board, these agencies will develop professional standards, codes of ethics and exercise a disciplinary role. Three sets of Resolution Professionals are sought to be appointed – Interim Resolution Professional, Final Resolution Professional and Liquidator.
 
Insolvency Information Utilities: The Code proposes for information utilities which would collect, collate, authenticate and disseminate financial information from listed companies as well as financial and operational creditors of companies. An individual insolvency database is also proposed to be set up for the purpose of providing information on the insolvency status of individuals. It is not clear whether this will dovetail into the existing Central Registry of Securitisation Asset Reconstruction and Security Interest of India (“CERSAI”) and/or Central Repository of Information on Large Credits (“CRILC”) or end up adding to the plethora of registries in India.
 
Insolvency Adjudicating Authority: The adjudicating authority will exercise jurisdiction over cases by or against the debtor.
  • The Debt Recovery Tribunal (“DRT”) shall be the adjudicating authority (“Adjudication Authority”) with jurisdiction over individuals and partnership firms other than Limited Liability Partnerships (“LLPs”). Appeals from the order of the DRT will lie to the Debt Recovery Appellate Tribunal (“DRAT”);
  • The National Company Law Tribunal (“NCLT”) shall be the Adjudicating Authority with jurisdiction over companies, other limited liability entities (including LLPs.). Appeals from the order of NCLT shall lie to the National Company Law Appellate Tribunal (“NCLAT”); and
  • NCLAT shall be the appellate authority to hear appeals arising out of the orders passed by the Regulator in respect of insolvency professionals or information utilities.
 
Moratorium: One of the most significant features of the Code is the grant of moratorium during which creditor action will be stayed. This is not automatic and has to be granted by the Adjudicating Authority on the recommendation of the Resolution Professional.
 
Corporate Liquidation: The commencement of liquidation process takes place on:
  • Recommendation of the resolution plan;
  • On account of failure to submit the resolution plan within the prescribed period or contravention of the resolution plan; and
  • Based on vote of majority of the creditors.
Liquidation Estate: To the extent assets held by the debtor belong to it, then will form part of the liquidation estate. Assets will be distributed by the liquidator in the manner of priorities laid in the law. Individual claimants or those claiming to have any special rights on assets of the debtor will form part of the liquidation process.
 
Priority:
 
The following debts will be paid in priority given below:
  1. Insolvency Resolution cost and liquidation cost
  2. Debts to secured creditor (who have relinquished their security interest) and workmens’ dues (for 24 months before commencement)
  3. Wages and unpaid dues to employees (other than workmen) (for 12 months before commencement)
  4. Financial debts to unsecured creditors and workmen’s dues for earlier period
  5. Crown debts and debts to secured creditor following enforcement of security interest
  6. Remaining debts
  7. Preference shareholders
  8. Equity Shareholders or partners
  9. The priority being given to secured creditors relinquishing security needs specific attention, especially on account of the same having the potential to be misused, especially if the debtor and the secured creditor can collide and impair the collateral.
 
Cross border insolvency
 
Given that many corporate transactions and businesses involve an international element, the Code attempts to address this by including provisions for cross border insolvency.
Particulars
Filing of Insolvency application – Details of what needs to be mentioned in the application has been specified
Adjudicating Authority- admission or rejection of application -
Before rejecting an application, the Adjudicating Authority shall give a notice to the applicant to rectify the defect in the application within 7 days.
If admitted, Adjudicating Authority to declare moratorium upon admission
Insolvency Resolution Professional appointment
Constitution of Committee of Creditors
Appointment of final resolution professional
Submission of Resolution plan
If approved- Moratorium ceases to have effect
If rejected- Initiation of Liquidation
Insolvency Resolution Process Completion
Insolvency Resolution Process Extension
 
Institution - National Company Law Tribunal
 
The National Company Law Appellate Tribunal (NCLAT) is a quasi-judicial body in India that adjudicates issues relating to companies in India. The NCLAT was established under the Companies Act 2013 and w as constituted on 1 June 2016.
 
The NCLAT has eleven benches, two at New Delhi (one being the principal bench) and one each at Ahmedabad, Allahabad, Bengaluru, Chandigarh, Chennai, Guwahati, Hyderabad, Kolkata and Mumbai.
 
The NCLAT has the power under the Companies Act to adjudicate proceedings:
  1. Initiated before the Company Law Board under the previous act (the Companies Act 1956);
  2. Pending before the Board for Industrial and Financial Reconstruction (BIFR), including those pending under the Sick Industrial Companies (Special Provisions) Act, 1985;
  3. Pending before the Appellate Authority for Industrial and Financial Reconstruction; and
  4. Pertaining to claims of oppression and mismanagement of a company, winding up of companies and all other powers prescribed under the Companies Act.
 
Decisions of the NCLT may be appealed to the National Company Law Appellate Tribunal. The decisions of NCLAT may be appealed to the Supreme Court of India.
 
One of the most celebrated provisions of the legislation is the setting up of National Company Law Tribunal. National Company Law Tribunal has been set up under Part IB of the legislation and is unique because this National Company Law Tribunal will have the combined powers of Company Law Board, BIFR and also the High Courts. Expectations are already running high with the NCLT but how effectively, it can carry out the responsibilities of various institutions vested in it is a matter only future can tell.
 
Power of NCLT
 
The constitution of Benches of the Tribunal are given under section 10FL and the principal bench will be in New Delhi. The principal bench will be presided over by the President of the NCLT. One of the important provisions of the Companies (Second Amendment) Bill, 2002 is to provide for the creation of Appellate Tribunal under the legislation which will hear appeals from the NCLT. The decision of the Tribunal or the Appellete Tribunal is not binding and there is a provision for filing an appeal to Supreme Court.
 
Revival of a Sick Company- Changing definition
 
Part VI A of the Second Amendment Act 2002 contains provisions on revival, rehabilitation and winding up of sick companies. The Second Amendment Act 2002 has brought about a change in the definition of the Sick Company. Section 2 (46AA) of the Company Amendment Act 2002 defines “a sick company as one whose accumulated losses in any financial year are equal to the or more than 50% of its average net worth during one financial year immediately preceding such financial year or a company who fails to repay its debt within any three consecutive quarters on demand, for its repayment by a creditor or creditors." This definition is in stark contrast to the definition of Sick Industry under SICA Act, 1985. The Sick Industry was earlier defined as “one which has at the end of any financial year accumulated losses equal to or exceeding its entire net worth and is registered for not less than five years". This change in definition has improved the chances of Sick industry to improve because according to the new definition, a company can be referred to the tribunal even before 5 years and it can be referred also by the banks and other financial institutions in addition to referring by Board of Directors.
 
Principles: Economics and related concepts of insolvency and Bankruptcy
 
The economic analysis of law deals with legal rules, whether made by legal experts or courts, not just as a way of handing out rewards and punishments, but as a system of incentives intended to affect behaviour.
 
Economic theory is used to predict how rational individuals will respond to such rules and what consequences will be. Economics has made a substantial contribution to our understanding of law, but the law has also contributed to our understanding of economics. Courts routinely deals with reality of such economic abstractions as property and contract.  The study of law thus gives economists an opportunity to improve their understanding of some of the concepts underlying economic theory. The most notable example is the work of University of Chicago economist Ronald Coase.  Coase received the 1991 Nobel Prize in economics,  in part for using ideas based on his study of the law of nuisance to revolutionise the corresponding areas of economics –the theory of externalities.
 
Economic objectives     
 
The economic objectives are similar in corporate and personal bankruptcy. One important objective of bankruptcy is to require sufficient repayment that lenders will be willing to lend – not necessarily to the bankrupt debtor but to other borrowers. Reduced access to credit makes debtors worse off because businesses need to borrow in order to grow and individuals benefit from borrowing to smooth consumption. On the other hand, repaying more to creditors harms debtors by making it more difficult for financially distressed firms to survive and by reducing financially distressed individuals’ incentive to work. Both the optimal size and the division of the pie in bankruptcy are affected by this trade-off. A second important objective of both types of bankruptcy is to prevent creditors from harming debtors by racing to be first to collect. When creditors think that a debtor is in financial distress, they have an incentive to collect their debts quickly, since the debtor will be unable to repay all creditors in full. But aggressive collection efforts by creditors may force debtor firms to shut down even when the best use of their assets is to continue operating, and may cause individual debtors to lose their jobs (if creditors repossess their cars or garnish their wages). A third objective of personal bankruptcy law that has no counterpart in corporate bankruptcy is to provide individual debtors with partial consumption insurance. If consumption falls substantially, long-term harm may occur, including debtors’ children leaving school prematurely in order to work or debtors’ medical conditions going untreated and becoming disabilities. Discharging debt in bankruptcy when debtors’ consumption would otherwise fall reduces these costs. An additional objective that applies only to corporate bankruptcy is to reduce filtering failure. Financially distressed firms may be economically either efficient or inefficient, depending on whether the best use of their assets is the current use or some alternative use. Filtering failure in bankruptcy occurs when efficient but financially distressed firms shut down and when inefficient financially distressed firms reorganize and continue operating. The cost of filtering failure is either that the firm’s assets remain tied up in an inefficient use or that they move to an alternative use when the current one is the most efficient. Many researchers have argued that reorganization in Chapter 11 tends to save economically inefficient firms that should shut down.
 
Insolvency is when an individual, corporation, or other organization cannot meet its financial obligations for paying debts as they are due. Insolvency can occur when certain things happen, some of which may include: poor cash management, increase in cash expenses, or decrease in cash flow. A finding of insolvency is important, as specific rights are enabled for the creditor to exercise against the insolvent individual or organization. For example, outstanding debts may be paid off by liquidating assets of the insolvent party. Prior to proceedings, it is common for the insolvent entity to meet with the creditor in order to attempt to arrange an alternative payment method. According to some experts, It is possible that a business may be "insolvent" in cash flow, yet still solvent on the balance sheet. These cases may involve illiquid assets, which help the balance sheet's solvency but not the cash flows. This can also work the other way around with negative net assets (balance sheet insolvency), yet a positive cash flow. In this case, the flow of cash is simply enough to pay off debts, despite the fact that the business has more liabilities than assets. Bankruptcy is not exactly the same as insolvency. Technically, bankruptcy occurs when a court has determined insolvency, and given legal orders for it to be resolved. Bankruptcy is a determination of insolvency made by a court of law with resulting legal orders intended to resolve the insolvency. Insolvency describes a situation where the debtor is unable to meet his/her obligations. The main reasons behind insolvency are primarily poor management and financial constraints. This is much more prevalent in smaller companies. Specifically, the reasons are: Market – Company did not recognize the need for change Bad debts – obviously money owed by customers Management – failure to acquire adequate skills, imprudent accounting, lack of information systems Finance – loss of long term finance, over gearing or lack of cash flow Knock on effect – i.e. from other insolvencies Other – for example excessive overheads etc.  It is however observed that the larger the company, the better the chance of survival and of receiving remedial treatment and of paying creditors.
 
Bankruptcy is the legal process whereby financially distressed firms, individuals, and occasionally governments resolve their debts. The bankruptcy process for firms plays a central role in economics, because competition tends to drive inefficient firms out of business, thereby raising the average efficiency level of those remaining. Bankruptcy also has an important economic function for individual debtors, since it provides them with partial consumption insurance and supplements the government-provided safety net. This article discusses the economic objectives of bankruptcy and surveys theoretical and empirical research on corporate and personal bankruptcy Bankruptcy law
 
For both corporate and individual debtors, bankruptcy law provides a collective framework for simultaneously resolving all debts when debtors’ assets are less valuable than their liabilities. This includes both rules for determining which of the debtor’s assets must be used to repay debt and rules for dividing the assets among creditors. Thus bankruptcy is concerned with both the size of the pie – the total amount paid to creditors – and how the pie is divided.
 
An important difference between personal and corporate bankruptcy law is that, while corporations may either liquidate or reorganize in bankruptcy, individuals can only reorganize (even though the most commonly used personal bankruptcy procedure in the United States is called liquidation). This is because part of individual debtors’ wealth is their human capital, and the only way to liquidate human capital is to sell debtors into slavery – as the Romans did. Since slavery is no longer used as a penalty for bankruptcy, all personal bankruptcy procedures are forms of reorganization in which individual debtors keep their human capital and the right to decide whether to use it.
 
Corporate bankruptcy Theory
 
A central theoretical question in corporate bankruptcy is how priority rules affect the efficiency of decisions made by managers (who are assumed to represent the interests of equity), particularly whether the firm invests in safe or risky projects and whether and when it files for bankruptcy. Inefficient investment decisions lower the firm’s return, and inefficient bankruptcy decisions result in filtering failure. Both reduce creditors’ returns and cause them to raise interest rates or to reduce the amount they are willing to lending.
 
Problems
 
According to the some economists, during the first six months of its operationalization in India, most of the cases were triggered by creditors. Of these, most were filed by unsecured operational creditors. This indicates that operational creditors, who hitherto had weak enforcement rights, have taken recourse to the IBC to enforce their claims. There may be multiple reasons for the relatively low number of financial creditors taking recourse to the IBC during the first six months. Some researchers also point out that firm debtors default to financial creditors the last. Financial creditors may largely be secured creditors who may choose to enforce their claim by realizing their security. There was lack of regulatory certainty on provisioning norms for banks and the apprehension of scrutiny by the anti-corruption investigative agencies among bank management. It is important to note that the rights of secured creditors have been modified by the Insolvency & Bankruptcy Code (IBC), 2016.
 
Secured credit for productive purposes drives the economy and creates wealth, generates employment and encourages entrepreneurship. If a secured creditor’s rights to priority over other claims and taxation dues are recognised under the secured transactions law as well as insolvency law, it will result in increased secured lending and better growth and development. Under the Insolvency & Bankruptcy Code, a secured creditor’s claims are given priority only if the secured assets are surrendered to the liquidator. It is for this reason that the SARFAESI Act is also proposed to be amended to strengthen secured creditor rights and extend priority to secured creditors even outside insolvency proceedings.
 
The intention of the Code is to do away with the modify the existing laws covering aspects of insolvency and bankruptcy. Given that many corporate transactions and businesses involve an international element, the Code attempts to address this by including provisions for cross border insolvency. The Code provides that the Central Government can enter into agreements with any country outside India for enforcing provisions of the Code and notify applicability of the same from time to time. Further, assets of the debtor located outside India (in countries with whom India has reciprocal arrangements) may also be included for the purpose of the insolvency resolution process and/or liquidation before the Adjudicating Authority.
 
The Code according to some experts is a landmark piece of legislation establishing a robust legal framework which brings about a much overdue reform that is aimed at creating necessary procedures for swift resolution of insolvency and bankruptcy in India. It attempts at bringing the Indian statutory regime at par with some of the most legally advanced jurisdictions of the world.
 
Source:
NCLT, National Company Law Tribunal
Ministry of Company Affairs, Government of India
Economic Times
Legalyindia
Bloomberg
 
The author is Prof.M.Guruprasad, UNIVERSAL BUSINESS SCHOOL

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