Difference Between Insolvency And Liquidation?
At the very outset, it is important to distinguish between insolvency and liquidation. Insolvency, triggered on the inability to repay debts, is a rehabilitation-oriented mechanism, whereby the lenders, the government, and prospective investors work together to try and revive a company reeling under debt. Upon successful completion of insolvency, a company can function normally free of that inability to repay debt.
Liquidation is a mechanism which is resorted to when there is no hope for a company’s revival. It leads to a distribution of its assets to its creditors and owners. Upon successful completion of liquidation, a company would cease to exist (legally called dissolution/winding-up).
For example, where no investment plan for Clutch Auto Limited was approved by its committee of creditors, and thus, there was no hope of its revival, the liquidation of the company was initiated in February 2018.
Necessity for laws on insolvency
Any corporate entity incurs a plethora of liabilities while functioning, be it by way of service or sale agreements, loans from banks and financial institutions, or judgment/quasi-judicial authority, or even through its interaction with the government. A corporate entity may at times, become so ridden with debt, that it endangers its existence and functioning altogether, and on the other hand, the creditors of such corporate entity are at a risk of losing their investment completely. In order to balance both interests, the governments devise reconstruction and rehabilitation mechanisms with a view to wipe off an entity’s debt while satisfying the creditors’ claim to the greatest extent possible, with the ultimate aim of ensuring the company’s survival.
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It is to be noted that the alternative to the insolvency proceedings is liquidation or wind-up of a company, which would lead to a complete wrap-up of the company in a fashion that the company would no longer exist. Wind-up proceedings cause a greater loss to the economy as compared to insolvency proceedings, as in the former process, the employees lose their job, the creditors’ claims are satisfied only proportional to the amount of assets of the company, the investors and all other stakeholders lose their money. Therefore, insolvency proceeding is a preferred choice amongst all class of stakeholders.
Laws governing insolvency prior to Insolvency and Bankruptcy Code, 2016
Prior to the commencement of the Code, the Sick Industrial Companies (Special Provisions) Act, 1987 facilitated survival of a debt-ridden industrial company. The Board for Industrial and Financial Reconstruction ( BIFR ) was established under SICA. SICA
obligated the board of directors of the sick or potentially sick industrial companies to report sickness to BIFR, determined on the basis of financial criteria (that is, when the losses in a particular financial year exceed its entire net-worth). In comparison, under the Code, an organization which has unpaid and overdue debt exceeding INR 1 lakh can be potentially subject to an insolvency proceeding. This, as a trigger point, is hit much before a company’s net-worth is eroded, and provides significant opportunity for the revival of the company.
Additionally, the BIFR could suo moto examine the sickness of a company as well. Once, a company was referred to BIFR, a moratorium came into place which prevented any lender from proceeding against the company.
Any rehabilitation was to be taken up by means of a scheme prepared by an operating agency, typically a state-level institution or a bank. In comparison, the Code provides for a very robust system of bidding for a company now.
Additionally, RBI had released certain non-statutory mechanisms such as corporate debt restructuring, strategic debt restructuring, sustainable structuring of stressed assets, joint lenders forum, all of which have been scrapped now, with the enactment of the Code.
Individual bankruptcy is till date governed by the Provincial Insolvency Act, 1920, as the provisions of the Code governing individual bankruptcy have not yet come to force.
Where did Sick Industrial Companies Act, and other RBI schemes fall short?
Problems with SICA:
i. Ambiguities regarding its scope and application – SICA’s scope relied upon the concepts of ‘sickness’ and ‘industrial character’. Since the time SICA was enacted, there had erupted a debate on meaning and scope of ‘sick industries’, more particularly, what happens if a company which has been referred to BIFR and is under moratorium loses its industrial character. The question was left unanswered even till the enactment of the Code, and the repeal of SICA.
ii. Lenders could not refer a company to SICA – The Board of Directors, Central Government, RBI, state-level institutions or scheduled banks could only refer. If a creditor is not a scheduled bank or is simply a vendor with a huge amount of overdues, such creditor could not refer for insolvency.
iii. No time bound process for resolution and rehabilitation – The SICA did not prescribe specific time limits for completion of inquiry by the BIFR to pass an order directing an operating agency to prepare a scheme of rehabilitation. Timelines were only prescribed after such an order was passed. In contrast, under the Insolvency and Bankruptcy Code there is a time-bound limit of 180 days for insolvency resolution.
iv. Lack of checks on companies that used SICA as a measure to impose moratorium and avoid lenders – The Board of Directors could itself use the
SICA as an advantage against lenders because upon reference to BIFR other lenders will not be able to proceed against the Company. Under the Code, though a company may suo moto initiate insolvency, misuse of the process is more difficult, as once the insolvency process is admitted, an insolvency professional takes over the management of the company, and all major decisions are taken with the approval of the committee of creditors.
v. Rehabilitation scheme could be violative of any law – Section 32 of SICA stipulates that all schemes sanctioned under SICA would have effect irrespective of anything inconsistent with any other law. Therefore, a scheme of rehabilitation under SICA may contain anything is violative of any other provision of law, hence, giving a clean chit to the sick industrial company for any transgression. In contrast, section 30 of the Code expressly and particularly states that a resolution plan may be put to vote only if it does not violate any prevalent law.
vi. Lenders to be part of operating agency only in suitable cases – It was upto the discretion of the BIFR to appoint an operating agency for the sick industrial company referred to it, only in suitable cases. Therefore, the mechanism under SICA was not uniform and did not promise a defined way rehabilitation of a company would be taken up. In sharp contrast, the Code defines very clearly each step of the insolvency resolution process, which would at the first instance involve the constitution of a committee of creditors, to account for every decision made in respect to the management of the company.
It is to be noted that with the introduction of the Code, SICA has been scrapped.
Problems with RBI schemes:
i. Discretionary remedy – Over the years, there have been multiple instances where the banks have rejected a restructuring proposal. Hence, the RBI schemes are not the safest route for any company to restructure its debt. The banks only take up the proposal if there can be sufficiently proved a chance of revival. On the other hand, the Code provides a surer path for insolvency resolution, whereby an insolvency petition would be rejected only if specific criteria is not met, or the application is fraudulent.
ii. Lack of powers granted to the banks – the RBI schemes have been too rigid in their framework allowing the banks little or no leeway in arranging a deal with the company. As every company undergoing restructuring is dealing with a distinct issue, and the banks did not feel comfortable providing a similar solution to each company. For instance, the Strategic Debt Restructuring Scheme mandates that the management of the borrower’s business ought to be changed, with the underlying assumption that the cause of non-performance lied in managerial factors, irrespective of whether or not the company is failing owing to its management.
Contrastingly, the Code provides a looser structure whereby the appointed resolution professional takes over the management of the company temporarily and the decisions are taken based upon what is best for the company, in consultation with the members of committee of creditors.
iii. Rigidity in rules -The RBI contained strict rules governing the process and procedure for rehabilitating a company undergoing reconstruction. For instance, initially under the strategic debt restructuring, it is mandated that the banks acquire shares of the defaulting company by converting their loans into equity. Upon the banks’ dissatisfaction with the policy, the RBI introduced of directive of change of management.
As stated above, the Code allows the creditors flexibility to come up with a course of action most suitable for the defaulting company.
It is to be noted that with the introduction of the Code, all the RBI schemes for restructuring have been scrapped.
Development of Insolvency and Bankruptcy Code, 2016
The Code was drafted by Dr. T K Vishwanathan chaired Bankruptcy Law Reforms Committee ( BLRC ), which was set up by the government of India in 2014. The final report of the BLRC was submitted in November, 2015, and the draft bill was introduced in the parliament in the December, 2015. The Code received presidential assent on 28 May 2016.
How is the mechanism under the Code different?
The Code has heavily borrowed from the other jurisdictions and has been drafted to fill the myriad of loopholes as were present in the other mechanisms for reconstruction and rehabilitation of a company. The Code presents the following features, which makes it an effective tool for rehabilitation of a company:
- Active involvement of lenders in the decision-making process, as they form part of a ‘committee of creditors’. Lenders have the power to decide which investment plan is accepted too. Under the SICA, the BIFR had a lot of responsibility to take inputs and objections from creditors and decide on them. With lenders’ involvement, such commercial decisions become easier and all parties have very clear skin-in-the game with respect to revival of the company. Voting in the committee of creditors is on the basis of the amount of debt overdue, so commercial interest prevails here.
- The appointed resolution professional manages the affairs of the company while the process is ongoing- Though the moratorium restricts any action by the creditors etc. against the defaulting company, the operations and ordinary business is continued and managed by the resolution professional with prior approval taken from the committee of creditors. Thus, a company is kept as a going concern.
- Greater accountability of all persons responsible- The Code has introduced various levels of accountability and responsibility for all the persons involved in the insolvency proceedings. Hence, the committee of creditors keeps a check on the functions of the resolution professional and vice versa. Further, the resolution
professional also has to submit regular progress reports with the NCLTs, to apprise them of the developments in the insolvency process.
- A strictly time-bound process – Timelines have been introduced at every stage of the process from beginning to end. The duration of the entire insolvency resolution process is capped at 180 days, which may be further extended to 270 days.
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Therefore, the Code has introduced a new and fresh regime for corporate insolvency resolution, which is significantly better than the regime under SICA. For example, section 22 of SICA contained provisions for moratorium, which was enforced once the company was referred to BIFR. Once the moratorium began, no lender could proceed against the company. A number of debt-ridden companies used the process to stay under moratorium for years to avoid the lenders.
The Code has introduced a strictly time-bound process. As per section 12 of the Code read with section 33, the insolvency process can go on for a maximum of 270 days, post which the company would automatically go into liquidation. Furthermore, the moratorium under section 14 also extends till the insolvency process continues, i.e. a maximum of 270 days.
How to decide whether to invoke SARFAESI, RDBA or IBC?
It is pertinent to understand that insolvency is not a debt-recovery mechanism unlike SARFAESI or RDBA. Small description of the three mechanisms is explained below:
RDBA – T he Recovery of Debts due to Banks and Financial Institutions Act , 1993 was enacted by the government of India to facilitate speedy recovery of debts by banks and financial institutions. Separate tribunals, namely the Debt Recovery Tribunals were instituted under the Act to ensure specialized and expedited remedy to the banks and the jurisdiction of ordinary courts was taken away with a view to speed up the process of recovery.
Thus, a bank/financial institution having a secured or unsecured debt may approach the DRT for a speedy recovery of its debt. There is no minimum amount of debt necessary for the same. However, note that the availability of this mechanism is restricted to banks and financial institutions only.
SARFAESI – SARFAESI Act or the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002, was enacted to enable banks and financial institutions to recover their secured loans and advances, by simplifying the process of taking possession and selling the secured asset, without approaching a court for the same.
Thus, a bank/financial institution having a secured debt may utilize the provisions of SARFAESI with a view to take over the possession of the secured assets [section 13] and thereafter, auction off the same to recover its debt, with minimal intervention of the court. This speeds up realization of the security.
Insolvency and Bankruptcy Code – The Code has been enacted not as a debt recovery mechanism, but as a measure to restructure the debt of a corporate entity or rehabilitate a company reeling under debt. An individual bank or financial institution cannot file under the Code with a view to recover its loan.
Thus, a bank/financial institution or even an individual creditor may approach NCLT to initiate insolvency resolution process of a company, provided that unpaid debt owed to it by an entity is greater than INR 1 lakh.
The Code provides a very effective mechanism for the lenders, suppliers and other creditors to ensure payment of the loan. However, insolvency process not being a recovery mechanism, one lender cannot facilitate repayment of only his loan back, while the other creditors stand in line. The Code paves the way for a full and final settlement of the company with all its creditors. The creditors, however, must stay cautious of the number of creditors of a particular company and the amount of their debt, which would decide the amount of the haircut that every creditor receives.