Brief study on insolvency laws in India

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What is Insolvency?

When a type of situation is created in which an individual or a firm is unable to fulfil their financial liability to creditors as debts become due. Additionally, it can also be understood as a situation when the company gets closed because the debts become due. The corporation also transfers its assets and properties to its owners and creditors.

Although dissolution refers to the last step of insolvency, one can define it as the voluntary winding up or dissolution of the firm. It is possible for the insolvency procedure to be either mandatory or optional. The term “insolvency” means that the company looking to do it has completed the preparation to dispose of the majority of its assets.[1] 

What is the liquidator?

When the company is on the verge of bankruptcy or is about to get close, the person delegated to take over the business affairs of that company is known as the liquidator. Further, the assets of the company are transferred to the liquidator, and in order to settle the obligations of the company the proceeds are used.

The liquidator is legally allowed to discharge numerous functions for the company. In the event of insolvency, the liquidator has the authority to exchange the company’s assets for cash in the open market or other assets of equal value.

Various types of insolvency

  1. A voluntary form of insolvency

Imagine, the shareholders, owners or directors of businesses were informed that they would be unable to pay their debts under such conditions. In this circumstance, the liquidator will assume control of the company and controls the insolvency process. The closing process takes place in a variety of cases.

  1. Three types of insolvency

In compulsory insolvency in this case, creditors ask the court to order the closure of the company because they feel it is insolvent and unable to pay its debts. When taxes are owed and the government determines that the business is insolvent beyond recovery, HMRC is one of the most significant creditors to submit a petition to the court.

  1. Voluntary insolvency of creditors

When an organization’s shareholders or directors learn that it will be unable to pay its creditors, this type of insolvency occurs. Additionally, the court won’t be involved in any way.

  1. Priority of claims

Who do you have to pay in the insolvency procedure first? Well, the “priority of the claims” is how the rules and regulations decide.

More details are provided regarding who you paid when you paid him or her, and how you interacted with the staff.

Briefly, the order is as follows:

  • Unsecured creditor
  • Costs incurred by the insolvent estate
  • Secured creditor (often banks will take the collateral and offer it for sale)
  • Creditors with preferential rights (which includes employees and is now HMRC)
  • The practitioners of insolvency
  • Shareholders

Factors leading to insolvency

  • There are situations when a company hires personnel who are unskilled or lack skills and experience may lead to the insolvency of the company. This may result in inaccurate budget development and spending tracking, diluting the company’s recourse and generating insufficient revenues. Insufficient accounting or human resources personnel often leads to a company’s insolvency.
  • Multiple lawsuits that could result in extremely substantial contingent liabilities could cause enough harm to a company’s day-to-day operations to prevent it from continuing to be a sustainable enterprise. A high number of lawsuits from customers or business associates may lead to the insolvency of a company.
  • Companies can fail to adapt to the shifting needs or preferences of their clients. They frequently lose consumers to rival businesses’ better-quality or more varied goods and services. If a corporation doesn’t change with the market, it loses market share, which reduces profitability, and accrues debt. The inability to cater to changing customers’ needs may also lead to the insolvency of a company.
  • A company may occasionally have greater production or acquisition costs, which drastically reduces its profit margins. This results in a loss of revenue and the inability of the business to meet its debt obligations. Therefore, it can be said that increasing production costs may also lead to the company’s insolvency.

Insolvency of a company

The sale of each and every asset marks the beginning of the process of liquidating a corporation. The decision is made firmly based on priority and need, in accordance with the agreement, and is independent of funds and bank balances. After paying off the loans, the balance is distributed to the suppliers. However, the order of repayment is set. Priority is given to the company’s secured creditors, and the remaining funds are used to pay preferred creditors, such as taxes, employee salaries, and other expenses.

The remaining funds will assist in paying the holders of debentures and other liabilities of a different kind that the floating charges secure across all properties when these obligations have been settled. The unsecured creditors must be paid next.

The final stage is to determine whether there is a balance remaining after all payments to the aforementioned creditors. If there is a surplus, the funds are subsequently distributed to the shareholders. Shareholders are obligated to pay the unpaid portion of capital if they are in deficit.

Business Recovery

The liquidation and eradication of insolvent entities are not a primary emphasis of contemporary insolvency regulation. Instead, it focuses more on changing the debtors’ financial setup to make it possible for corporate operations to continue. A business turnaround or company recovery is what is happening here. To continue a business while it is insolvent is an offence in some jurisdictions, nevertheless.

Debt restructuring is a procedure that enables a business or a person that is having trouble making ends meet or managing their cash flow to renegotiate their obligations in order to regain liquidity and keep their operations going. Professionals with experience in bankruptcy and debt restructuring typically handle the procedure. Typically, it is a less expensive and preferable option to filing for bankruptcy.

Insolvency and Bankruptcy Code, 2016

A healthy credit flow and the creation of fresh capital are crucial in a developing economy like India, and when a corporation or business becomes insolvent or “sick,” it starts to default on its obligations. Banks or creditors must be able to recover as much money from the defaulter as rapidly as possible in order for credit to avoid getting stuck in the system or developing into bad loans.

The Insolvency and Bankruptcy Code (IBC) code was introduced in 2016 to overhaul India’s corporate distress resolution regime and consolidate previously available options as Non-Performing Assets and debt defaults were mounting and older loan recoveries mechanisms like the Lok Adalats, Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI), and Debt Recovery Tribunals were seen to be performing poorly.

Under the IBC, there are two possible outcomes when insolvency is triggered: resolution or liquidation. If resolution attempts to settle the insolvency by developing a restructuring or new ownership plan fail, the company’s assets are liquidated.

Objectives Of Insolvency and Bankruptcy Code, 2016

The first goal of the IBC is resolution, or finding a way to salvage a business as a going concern through restructuring, a change in ownership, mergers, and other techniques, according to its regulator, the Insolvency and Bankruptcy Board of India (IBBI). The second goal is to increase the corporate debtor’s asset worth, and the third one is to encourage entrepreneurship, credit availability, and a balance of interests. According to the Code, the precedence of these goals is “sacrosanct.”[2]

Keeping this order in mind, when one looks at the IBBI data for the 3,400 cases admitted under the IBC in the last six years, half or more than 50% of the cases ended in liquidation, and only 14% could find a proper resolution, which is the first objective. While the situation was better in 2016 and 2017, since 2018, a majority of the cases ended in liquidation in most of the quarters while cases for which resolution plans were approved ranged between 15% and 25%.[3]

Process followed under the Insolvency and Bankruptcy Code

If a corporate debtor (CD), or a business that has borrowed money to operate, does not repay the loan, either the creditor (a bank or other organisation that has lent money for operational purposes) or the debtor may file an application under Section 6 of the IBC to begin a Corporate Insolvency Resolution Process (CIRP).

Prior to the pandemic, there was a 1 lakh rupee threshold after which a creditor or debtor could file for insolvency. However, the government raised this threshold to 1 crore in response to the strain the pandemic was putting on businesses.

A designated adjudicating authority (AA) under the IBC must be contacted in order to file an application for insolvency; these AAs are the several NCLT benches located throughout India.

If the admission is delayed, the Tribunal must give a justification and give the applicant 14 days to appeal the decision. As soon as an application is approved by the AA, the CIRP or resolution process gets started. The new required deadline of 330 days has been set for finishing the settlement procedure.

The AA names an interim resolution professional (IRP), who is registered with an insolvency professional agency, when the application is accepted (IPA). IRPs could be qualified and licenced solicitors, corporate secretaries, chartered accountants, and more.

After being appointed by the Tribunal, the IRP assumes control over the defaulter’s assets and business operations, gathers data from Information Utilities (repositories that track the debtor’s credit history) about the company’s state, and then coordinates the formation of a Committee of Creditors, or CoC.[4]

The most crucial corporate decision-making body in every CIRP is a CoC, which consists of all (unrelated) financial creditors of a defaulting company. A CoC determines whether the defaulting company is viable enough to be reformed and given a fresh start or liquidated. Additionally, it names an insolvency professional (IP), who may be the same person as the IRP or a different professional, to oversee the business’s operations throughout the CIRP.

The IP solicits and reviews suggestions for resolution plans for businesses, which may involve debt restructuring, mergers, or demergers. It sends the CoC eligible plans, which the CoC can accept if it receives 66% of the votes cast by committee members. The corporation pursues liquidation if the CoC rejects any settlement proposal.

In the event that a plan is accepted, the CoC submits it to the Tribunal (before to the allotted 330-day window), which then accepts the plan, which the debtor is required to carry out. AAs have the option to reject a plan.

Pre-packs, also known as pre-pack insolvency resolution procedure (PIRP) for Micro, Small, and Medium Enterprises, were added to the IBC in a July 2022 amendment (MSMEs).. A pre-pack resolution is an out-of-court agreement between a company’s creditors and owners to sell the company to a prospective buyer. The purchaser could be a business partner or a third party. The pre-pack resolution process is only permitted under the current law for defaults that do not exceed Rs. 1 Crore.[5]

Conclusion

When a person or business is insolvent, it means that they are unable to fulfil their financial commitments to a variety of lenders and are in a precarious financial situation. As an illustration, consider a costly purchase like a car or house that is frequently paid in instalments and the buyer is no longer able to make those payments because of financial changes. There are significant differences between insolvency and bankruptcy, default, and illiquidity. A revamp of accounting practices, prudent financial planning, and the sale of assets are just a few measures to prevent or escape from insolvency.

End Notes

[1] https://vakilsearch.com/blog/what-is-company-insolvency/

[2] https://www.thehindu.com/news/national/explained-what-is-the-insolvency-and-bankruptcy-code-ibc-and-where-does-it-stand-after-more-than-five-years-of-being-in-place/article65969421.ece

[3] https://www.thehindu.com/news/national/explained-what-is-the-insolvency-and-bankruptcy-code-ibc-and-where-does-it-stand-after-more-than-five-years-of-being-in-place/article65969421.ece

[4] https://www.thehindu.com/news/national/explained-what-is-the-insolvency-and-bankruptcy-code-ibc-and-where-does-it-stand-after-more-than-five-years-of-being-in-place/article65969421.ece

[5] https://www.thehindu.com/news/national/explained-what-is-the-insolvency-and-bankruptcy-code-ibc-and-where-does-it-stand-after-more-than-five-years-of-being-in-place/article65969421.ece


By: Satakshi Tripathi, a student at Banasthali Vidyapith, Rajasthan.


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