The IBC 2016 & MSMEs: What the future holds? – By Nandani Anand

Nandani Anand
4th year BBA LLB student at SOL, UPES Dehradun

The IBC 2016 & MSMEs: What the future holds?

The spread of novel Corona Virus (herein after COVID-19 pandemic) has left an adverse impact on economies around the world. India being one of the most promising nations in terms of economic development and growth has seen a loss greater than ever. Micro Small and Medium enterprises in particular have been the worst casualty of Covid-19 induced lockdown. Considering the halt in economic activity over the past few weeks, it is unfathomable that a vast number of MSMEs will be choked, perhaps to the point of permanent closure. As a counter measure, the government has taken steps not only to facilitate supply of sufficient credit but also the revival of the stressed enterprises through an effective insolvency framework. Hon’ble Finance Minister in her announcements under the “Atma Nirbhar Bharat Abhiyaan” announced the suspension of initiation of fresh Insolvencies for all defaults arising post 25th March, 2020 for succeeding 6 months and a special Insolvency Resolution framework for MSME under Section 240A[1] of the IBC.

What are MSMEs?

Micro Small and Medium Enterprises are defined under the MSMED Act, enacted in 2006, which inter alia provides for establishment of a statutory National Board for MSME, backed by an advisory committee to support MSMEs and introduced the concept of enterprises as opposed to earlier concept of industries. The Act provides for filling of memorandum, measure for promotion, development and enhancement of competitiveness of MSMEs, provides schemes to enhance the credit facility, procurement preference, provision related to delayed payments. Earlier the definition classified MSMEs on the basis of Industry they operate into, i.e., Manufacturing and service.[2]

For manufacturing units, those having investment not more than 25 lakhs, 5 crores and 10 crores were termed as Micro, Small and Medium enterprises respectively and so far as service industry is concerned the enterprises with investment not exceeding 10 lakhs were termed as Micro enterprise, investment more than Rs. 10 lakhs but not exceeding Rs. 2 crores were termed as Small and for enterprises with investment ranging between Rs. 2 crores to Rs. 5 crores as Medium Enterprise. Certainly this criterion was long criticized by the authorities precisely because of non-availability of investment and turnover details. However, the recent notification[3] issued by the government of India has all together changed the bedrock of classification of these enterprises. The primary aim was to cater to the object of ‘ease of doing business’ which was previously hampered due to limited classification on the basis of manufacturing or service industry. Though 2018 amendment bill suggested MSMEs to be solely classified on the basis of turnover, the current notification is a clear departure from the same. The new criterion classifies them on the basis of Investment and Turnover.  Noteworthy, that current criterion provides for “and” and not “or” which enables the enterprises to be a MSM enterprise even if the investment has exceeded the required threshold but turnover is still the same.  The table below is tabular representation of the revised definition:

 

Micro

Small

Medium

Investment

Not more than 1 crore rupees for plant, machinery or equipment.

Not more than 10 crore rupees for plant, machinery or equipment.

Not more than 50 crore rupees for plant, machinery or equipment.

Turnover

Not more than 5 crore rupees.

Not more than 50 crore rupees.

Not more than 250 crore rupees.

 

In the past two decades MSMEs have acted significantly in improving the growth curve of the Indian economy in terms of Gross Domestic Product, Exports and Employment generation. MSMEs, often considered as the backbone of the Indian economy, are a vast network of 63.38 million enterprises that collectively contribute a maximum of 29% to the GDP and create over 1109 lakh employment opportunities in both urban and rural areas[4]. MSME are the drivers of Indian economy promptly after the agricultural sector acting as the engine of livelihood for a vast population.  Even after 14 years of the enactment of MSMED Act, MSMEs in the country have been facing exemplary hurdles. The origin of which is found in the basic infrastructural inadequacies, lack of financial literacy, procurement of raw materials, statutory obligations, skilled labour and lack of trust by traditional banks.

MSMEs often succumb to collateral requirements obligatory for availing finances. Banks often hesitate in granting loans to MSMEs due to lack of transparency, financial discipline and high mortality rates. According to a 2018 report by the International Finance Corporation the formal banking system supplies less than one-third of the credit compared to what is required for MSMEs. Due to exorbitant demand of credit and its inadequate supply, the sector is slapped with Rs. 25.8 trillion of potential credit Gap.[5] Most of the MSME funding comes from informal sources and this fact is crucial because it explains why the Reserve Bank of India’s efforts to push more liquidity towards the MSMEs has had a limited impact. One of the key reasons for such a huge credit gap is the high ratio of bad loans on the part of MSMEs.  Financing and working capital requirement in MSMEs subsist as a vicious circle. As an outcome of un-marginalized financing structure, MSMEs often lack working capital requirement and therefore struggle to repay the loans, if at all obtained.

In the pre-corona times, MSMEs were already in a state of struggle in terms of declining revenues and capacity utilization. This pushes them into a state of debt or liquidity crunch and creates a danger of existential crisis. Along with that also comes one of the major havocs created by this pandemic that is reverse migration of laborers across the states. While many of the MSMEs were still recovering from the effects of demonetization and GST implementation, primarily because most of them were/are not registered by virtue of their size. This apparent invisibility tends to work for enterprises as well as against them. Being out of the formal network, they do not have to maintain accounts, or adhere to regulatory norms etc. This brings down their costs. But, as it is clear in a time of crisis, it also constrains a government’s ability to help them. The combination of challenges faced by MSME make them prone to insolvency. The pandemic ushered a new set of challenges and thus made it difficult to stay afloat and maintain the employability of workers in these sectors.

The Government of India has been taking several crucial steps with the motive of rejuvenating the economy. The Government has planned to establish an INR 1000 crore debt fund with partial guarantee support for the sector as well as extended the compliance date under GST and other statutes for MSMEs. It’s also noteworthy that a guarantee free and collateral free loan of total 3 lakh crore is to be provided to these enterprises. Moreover, reduction in CRR by 100 basis points thus injecting liquidity in banking system and a 3 months moratorium was granted, moreover, Deferment in payment during moratorium will not make the accounts SMA or NPA under the June 7 circular of RBI.[6] Although these announcements are expected to assist MSMEs in tackling economic stress, they may not prove to be in as much effective owing to low demand and longer period to derive economic normalcy. Several steps have also been taken to revive the stressed MSMEs under the aegis of RBI, MSMED Act & IBC, 2016.

Framework for Revival and Rehabilitation of Micro, Small and Medium Enterprises’ 2015

In order to provide a simpler and faster mechanism to address the stress in the accounts of MSMEs and to facilitate the promotion and development of MSMEs, the Ministry of Micro, Small and Medium Enterprises, had notified a ‘Framework for Revival and Rehabilitation of Micro, Small and Medium Enterprises’ 2015[7]. Under the said framework every bank is required to constitute a committee at each district which shall resolve the stress of MSME accounts on an approach from either the lender or the debtor. The committee shall then decide measures to be taken under Corrective Action Plan. The plan doesn’t create any kind of moratorium and allows availing of credit during the said period. The outcome could either be Rectification so as to regularize the account by pinching additional finance repaid within 6 months or Restructuring and in case both aren’t feasible then Recovery proceedings under the eligible Act shall be carried on.

MSMED ACT, 2006

Although MSMED Act addresses the issue of delayed payment, the said process has been highly questionable owing to enforceability of the awards passed by the council.[8]  Section 15 of the Act creates a preliminary liability on part of the buyer to make all payments on or before the date agreed between them, if in absence of such agreement; the MSME is entitled to receive payments within 45 days from the date of acceptance of goods or services[9]. On failure to oblige, the buyer is liable to pay a compound interest on three times the bank lending rate for any goods and services supplied.[10] This secures a time limit on the payments to be made to the MSME. On failure of such payment, a reference can be made to the Micro and Small Enterprise Facilitation Council. MSEFC are body established by state governments[11] and comprises of 5 members, where such number can’t be less than 3.[12] The council has to decide the matter within 90 days from the date of making the reference.[13] MSEFC basically endorses an out of court settlement process. In the process the parties are first directed to conciliation, upon failure of such conciliation, it’s on the parties to either continue or reject. In case the parties continue they are then referred to arbitration. This process is to a certain extent beneficial because the recovery of amount by the creditors isn’t limited to just liquidation amount but the principal amount as well as interest accrued during the period.

 The IBC, 2016

The Insolvency and Bankruptcy Code, 2016 is a comprehensive legislation providing a framework for resolution of insolvency and bankruptcy of corporate persons[14], LLP[15], individuals[16], partnerships and sole proprietorship firms[17] however, rules are only notified for corporates and personal guarantors to Corporate Debtors[18]. The Code doesn’t provide any express or a distinct resolution process for MSMEs. As most of the MSMEs are partnership or proprietorship firms the IBC rules doesn’t provide them any relief.  They have to resort to the standard Corporate Insolvency Resolution Process. However, these enterprises have been excluded from the implication imposed by section 29 A of the code[19]. Meaning thereby, the promoters of the defaulting MSME aren’t barred under section 29 A to bid for the enterprise.

One of the crucial aspects that is being currently ignored is that MSMEs aren’t in every case the ‘Corporate Debtors’, In a vast number of insolvency cases these MSMEs act as the ‘Operational Creditors’. Accrediting them the position of Operational creditors[20] itself restricts their participation in the CIRP.

MSMEs as Corporate Debtors

Indian Insolvency framework has been adopted from the western jurisdictions and that itself is a big drawback for Indian style of business. MSMEs in India are mostly financed as a mixture of personal debt and corporate debt, in case the enterprise goes into the state of bankruptcy, it’s more likely that the proprietor in his personal capacity has also lost the capabilities to pay back the debts. Moreover, most of these entities operate as Sole proprietorship and aren’t registered MSMEs have recourse under both The MSMED Act and The IBC, 2016. So far as MSMED Act is concerned, it facilitates recovery of dues to MSME whereas; IBC is anything but a recovery mechanism. Therefore, the question still persist as to how to structure the legitimate interest of creditors and maximize a reasonable rehabilitation of MSMSEs and the owners of such enterprises and the society that benefit from its renewed efforts.

An added layer of complexity to this matter is distinguishing between personal and business debt of a natural person given the fungible nature of money and credit.[21] This further makes it difficult to determine how they shall be treated under Insolvency.  In most of the cases MSMEs lack the sufficient asset to carry out a standard Corporate Insolvency Resolution Process. Post Insolvency financing is also a major concern for MSMEs. Owing to the unwanted and negative publicity even if the debtor has managed to repay his debt or restructure his finances, the post insolvency trauma last a long way.  In case of MSMEs, cost of insolvency has also been an imperative issue, such as public notices (especially in newspapers), meetings of creditors, and claims verification procedures achieve very little in context of most cases where little or no value is available for distribution, or so little value that creditors rationally choose that pursuing it is not worth the cost. When the return is likely to be low, the expense and time incurred in organizing CoC does not justify the return. Creditors may rationally decide to let small debts owed by MSMEs go, especially if there are no assets, or so few that the return will be truncated.

MSMEs as Operational creditors

 The increased threshold under the code may be a boom for MSMEs that are corporate debtors and have credit outstanding up to INR 1 crore but what about the operational creditors which are MSMEs, such an action may boost MSMEs departure from taking recourse to a standard Corporate Insolvency Process. By the virtue of its requirements, the standard CIRP Process may not benefit MSMEs, reason being the CIRP process tends to be cumbersome for MSMEs and therefore time and again the Adjudicating Authority has reiterated that in case of MSME resolution, the company is not bound to follow all the procedures under the ‘Corporate Insolvency Process’.[22] The code which has been time and again criticized for being partial towards the Operational Creditors yet again lands itself in a controversial spot.

The Bottom Line

MSME insolvency is and will be a crucial aspect of the entire Insolvency regime. Especially in countries like India where development is majorly backed by such enterprises. To mitigate these teething troubles, it’s important that the hectic procedure and formalities to be scrapped or replaced with much more efficient electronic noticing and submission practices. Therefore it’s necessary for the rules made by government in this regard to emphasize on the reduction in formalities. MSME must have open access to personal discharge regime or Personal insolvency in India, which is till now not being notified by the government. In order to establish a disparity, different tests may be adhered to such as the nature of activity being undertaken, the amount of debt and the connection between debt and the economic activity. [23] Operationalizing the personal insolvency provisions under the IBC may help in mitigating the crisis. Publicity of liquidation cases should be limited to the degree necessary to administer the case and only provide sufficient information to enable future creditors to behave prudently in extending credit to debtors. In most parts of United Kingdom[24], Small enterprises find recourse under Pre- Packs.[25] Most of the MSMEs being Individuals and sole proprietors it’s necessary to keep the business as going concern even after a resolution process and therefore, Pre-packs should be one of the recourse available to MSMEs. Further, during an insolvency proceeding, it’s extremely important to lay emphasis on the future  and revival prospects of the Industry that corporate debtor operates in rather than just procedural ramifications.[26] Reduction in cost & timelines for MSME insolvency could garner the process. India’s ranking in the ‘world bank ease of doing business’ has taken a hit from 77th to 63rd rank among 190 nations. An important aspect of ease of doing business enshrines not just ‘easy entry’ into business but also ‘easy formulation of exit’. Therefore, insolvency framework for MSMEs shouldn’t only focus on reorganization/restructuring, but also expeditious liquidation mechanism because this will encourage the entrepreneurs to reestablish themselves with a better reallocation of resources, generating firm creation and economic growth. [27] Since a close intersection of personal and sole proprietorship insolvency with MSME exists, a fresh start should be made viable to MSMEs who are sole proprietors or Natural persons.

 

About the Author : This Article has been authored by Nandani Anand, 4th Year, Law student at School of Law, UPES Dehradun under the mentorship of Adv. Amir Bavani, Principal Associate at Dhir & Dhir Associates.  

 

Reference

[1] The Central Government may, in the public interest, by notification, direct that any of the provisions of this Code shall not apply to micro, small and medium enterprises; or  apply to micro, small and medium enterprises, with such modifications as may be specified in the notification, Insolvency and Bankruptcy Code, Ss 240 (A) (2).

[2] The Micro, Small and Medium Enterprises Development Act, 20016, Ss 7

[3] http://www.dcmsme.gov.in/Gazette-notification.pdf

[4] https://msme.gov.in/sites/default/files/Annualrprt.pdf

[5] Ibid.

[6] https://msme.gov.in/gallery/people/rbi-relief-measures

[7] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=10304&Mode=0

[8]MSEFC isn’t a judicial body and hence the awards passed during arbitration between the parties under Arbitration and Conciliation act will have to be enforced by a court of law.

[9] The MSMED Act, 2006, Ss. 15

[10] The MSMED Act,2006,  Ss. 16

[11] The MSMED Act,2006, Ss 20

[12] The MSMED Act,2006 , Ss 21

[13] The MSMED Act, 2006, Ss. 18

[14] The Insolvency and Bankruptcy Code, 2016 Ss 2(a), (b), (d)

[15] The Insolvency and Bankruptcy Code, 2016 Ss 2(c)

[16] The Insolvency and Bankruptcy Code, 2016 Ss 2(g)

[17] The Insolvency and Bankruptcy Code, 2016 Ss 2 (f)

[18] The Insolvency and Bankruptcy (Application to Adjudicating Authority for Bankruptcy Process for Personal Guarantors to Corporate Debtors) Rules, 2019, available at, https://ibbi.gov.in//uploads/legalframwork/17662452f16d75fe4c221f39e303033f.pdf

[19]Report of the high level committee on corporate social responsibility, 2018, available at, https://www.mca.gov.in/Ministry/pdf/CSRHLC_13092019.pdf

[20] The Insolvency and Bankruptcy Act, 2016, Ss 5(20, (21)

[21]Legislative Guide on Insolvency Law, UNCITRAL, https://www.uncitral.org/pdf/english/texts/insolven/05-80722_Ebook.pdf

[22]Sarvana Global Holdings Ltd. & Anr. Vs. Bafna Pharmaceuticals Ltd. & Ors. Company Appeal (AT) (Insolvency) No. 203 of 2019 (04.07.2019)

[23]Micro, Small and Medium Enterprise Insolvency in Africa: a comparative study, http://www.uncitral.org/pdf/english/congress/Papers_for_Programme/135-MARTINEZ-SME_Enterprise_Insolvency_in_Africa.pdf

[24] In Australia pre-pack liquidations are used as an alternate process to restructure businesses in the MSME economy. 

[25] Company Voluntary Arrangements Administration (CVA) is used by SMEs in England and Wales.  

[26]US Bankruptcy Code,  Ss. 1125 (f)

[26] US Bankruptcy Code, Ss. 1121 (e) (1) (2) , 1129(e)

[27]Doing Business 2020, Comparing business regulations in 190 economies,  http://documents.worldbank.org/curated/en/688761571934946384/pdf/Doing-Business-2020-Comparing-Business-Regulation-in-190-Economies.pdf

 

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