Pre-Packaged Insolvency Resolution Process in India: The Present and the Future – By Ishi Rohatgi & Sanya Sethi

 -By Ishi Rohatgi & Sanya Sethi, 4^th year law students at OP Jindal Global University

Part I: Introduction

The Insolvency and Bankruptcy Code, 2016 (“IBC”) was introduced to consolidate a plethora of legislation dictating the insolvency regime in India in a tedious manner, which covered aspects such as insolvency resolution and realization of assets.^[1] The regime witnessed a complete overhaul with the enactment of the IBC. The objectives of the Code were to provide for reorganization and insolvency resolution of the Corporate Debtor (“CD”), maximizing the asset value of the company and balancing the interests of all stakeholders. It introduced the Corporate Insolvency Resolution Process (“CIRP”), a time bound insolvency proceeding.^[2] However, most of the companies that underwent CIRP were liquidated, rather than restructured.^[3] This is a problem faced, especially by MSMEs that have a higher likelihood of liquidation due to low investor interest in their assets, coupled with the time and costs that CIRP requires.^[4]

Moreover, with the onset of the Covid-19 pandemic, several companies have been projected to file for bankruptcies. The shock suffered by the GDP, added to the growth of Non-Performing Assets (“NPAs”), has created a dire situation for companies at the grip of bankruptcy. The likelihood of finding an investor for the company has become a far-fetched dream, which leaves the company with the only option to liquidate under CIRP. Hence, the government suspended CIRP till 31^st March 2021 and raised the default threshold from Rs. 1 Lakh to Rs. 1 Crore. However, this doesn’t address the issues faced by the companies and fix their financial condition. ^[5]

Pre-Packaged Insolvency Resolution Process (“PPIRP”) has been suggested as an alternative to reduce the financial distress faced by companies. Pre-Packaging is a global technique employed by various countries and is typically employed to preserve the business of the debtor company, that is, its tradeable or enterprise value.^[6] By building upon an informal understanding between the stakeholders, the scheme relaxes the whole process of corporate liquidation, thereby relieving the CD of the stress attached.^[7] Its main objective is to strike a balance between safeguarding the interests of the creditors and maintaining the assets of the debtor by facilitating a swift transition of these assets.^[8] A pre-pack is cheaper and less time consuming than the formal proceedings as the resolution is negotiated before initiating the statutory regulation framework.^[9] More recently, on 4 April 2021, the Central Government notified the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021, (“the Ordinance”) which provides for a PPIRP for Micro, Small and Medium Enterprises (“MSMEs”). Therefore, active steps have already been taken to implement pre-packs in India. The present paper undertakes a comparative analysis of India’s case with the cases of the USA and UK in light of the Ordinance and the challenges that might arise in the event India plans to roll out a PPIRP for its other corporations as well.

Part II: Position in USA and UK

A. Pre-Packs in the USA

USA was the first jurisdiction to introduce the concept of pre-pack insolvency through the Bankruptcy Reform Act in 1978. It allows for three routes to be taken- Pre-Packaged Insolvency, Resolution Process, Pre-Arranged Insolvency Resolution Process and Pre-Arranged Sale.^[10] The frequency with which these routes have been chosen is consistently increasing and can be largely attributed to speedy disposal of cases. Consequently, by 1993, one fifth of all public bankruptcies chose pre-packaging rather than the traditional route.^[11]

 Pre-Packaged/Arranged Insolvency Resolution Process

Chapter 11 of the US Bankruptcy Code provides for both, Pre-Packaged and Pre-Arranged Insolvency Resolution Process. While a bankruptcy trustee may be provided, it is not mandated since the US follows a debtor in possession model.^[12]

• The CD negotiates with interested parties and finalizes a restructuring plan. Subsequently, the CD solicits the acceptance of the stakeholders, supplemented by a disclosure statement containing all the relevant information as mandated. For the Pre-Arranged process, the acceptance of the stakeholders would be sought after the filing.^[13]

Acceptance by a class of creditors would require a two-third majority in amount and more than 50% in the number of allowed claims. If the majority is reached, the entire class would be deemed to be in favor of the plan.^[14]

• After acceptance, the CD may file a Section 11 application, accompanied with applications for operational continuity. If the plan has been confirmed by all classes, the court will approve the plan as long as it complies with Section 1129(a). Otherwise, proof that the plan is fair and equitable to all dissenting classes is mandated.^[15]

 Pre-Plan Sales

Section 363 of the US Bankruptcy Code allows for the CD to sell all or substantially all of its assets. A Pre-plan sale does not require acceptance or voting by the classes of interested parties. However, the CD is mandated to give a notice of at least 21 days to all interested parties. The bankruptcy court conducts a hearing where all objections are heard. A pre-plan sale is much quicker and allows for both private and public sale to take place.^[16]

However, the features of Section 363 may prove to be detrimental to other interest groups such as unsecured creditors. due to the lack of procedural safeguards. In 2014, the Report of the American Bankruptcy Institute Commission was released which made certain recommendations for improvement.[17] It was observed that while the secured creditors usually exercise a lot of control over the CD, and are privy to the sale negotiations, the unsecured creditors have the sole remedy to object. The fast-paced process of Section 363 sales has made it difficult for these interest groups to file objections, taking away their sole remedy. To rectify this situation, it was recommended that a 60-day moratorium after the filing of the application should take place, along with proof that the plan is in good faith, reasonable, and considers the interest of the unsecured creditors. However, these recommendations have not been acted upon.^[18]

B. Pre-Packs in the UK

Much like the USA, the practice of pre-packs is widespread and well-established in the UK. In the UK, there are no statutory regulations that specifically refer to pre-packs as they have evolved through the use of an administrator’s powers to sell a company’s assets without the approval of the creditors.^[19] The Insolvency Act of 1986 provides three routes for a formal rescue, namely, Company Voluntary Agreements (“CVA”), administrative receivership and administration.^[20] The administrative receivership only allowed the creditors to appoint administrative receivers if they held a charge that was created prior to September 2003 and therefore, it is declining in its use after the Enterprise Act, 2002. This Act resulted in a rise in the pre-pack sales in the UK as it introduced a more streamlined administrative procedure, including out-of-court appointment of administrators and thus, administrative receivership has largely been replaced by administration.^[21] Furthermore, a problem posed by the regular CVA method was that a single  creditor could ruin these efforts by filing a winding-up petition.^[22] Therefore, most pre-packs in the UK are facilitated through administration which is governed by Schedule B1 of the Insolvency Act.^[23]

Pre-Packs through Administration

In the UK, pre-pack sales have been made possible due to the powers granted to an administrator under Schedule 1 of the Insolvency Act and Schedule B1 allows the exercise of these powers. As opposed to a regular administration, most of the negotiations in a pre-pack happen in the pre-formal stage, that is, before the administrator is officially appointed.^[24] During this stage, the directors, promoters, shareholders and creditors of the distressed company can hire Insolvency Professionals (“IPs”) to help rescue the company.^[25] It is not necessary for the IPs to be practitioners who can fulfil the role of the administrators, but they are empowered to negotiate resolution plans that would be given effect in a statutory insolvency procedure. Moreover, they are free to protect the interests of their client over those of other claimants of the company since unlike the administrators, they are not office holders.^[26]

Once the negotiation is over, there exists a bias to conform to these negotiations even after an administrator has been appointed and the formal administration process has commenced. This bias largely exists because the IP who helped negotiate the pre-pack is appointed as the administrator. Therefore, the administrator is more likely to stick with the plan that they helped negotiate, instead of taking the insolvency proceedings in a different direction than the pre-pack negotiations. An IP once appointed as the administrator is required to act in the best interest of all the creditors and stakeholders. An IP may be held liable for misfeasance if he is found by the Court to act improperly during the course of the entire process.^[27] Additionally, if he is judged to have acted improperly by a professional body, he will be subject to that body’s disciplinary proceedings.^[28]

Part III: Analysis of the Current Model in India and Lessons from the US and UK

Recently, through an Ordinance dated April 4, 2021, the Government of India introduced a pre-packaged insolvency process which inserts Chapter III-A in the IBC to provide a PPIRP for corporations classified as MSMEs.^[29] This process aims to give respite to the MSMEs in light of the ineffective CIRP mechanism, along with the dire situation created by the Covid-19 pandemic. A company or LLP which has been categorized as a MSME under S.7(1) of the MSME Act, 2006 and has failed to pay a debt of Rs. 1 Million or more is eligible to apply for the PPIRP.^[30]

However, this eligibility criteria fails to take into account majority of the MSMEs in India. Only 26.42 Lakh MSMEs out of an estimated 6.3 Crore MSMEs have been registered till date. Further, this definition excludes sole proprietorship, partnerships, and Hindu Undivided Family forms of business.^[31] This operates as a major restriction for MSMEs to avail the pre-pack process. Therefore, it becomes important to analyze the PPIRP model introduced by India for MSMEs and to account for certain mechanisms that could contribute towards increasing the overall efficiency of not only the current model, but also when it is expanded to other corporations.

Connected Parties

While applying for a PIRP, the corporate debtor is required to satisfy the conditions under Section 29A of the IBC. However, the promoters of  MSMEs are exempted from clauses (c) and  (h) of this provision, as prescribed by Section 240A of the IBC in order to provide exemptions to promoters with NPAs.^[32] Therefore, by allowing promoters to remain in control of the resolution process, the Ordinance protects the already limited resources of the corporate debtor and incentivizes the promoters to act in the best interest of the debtors. Before filing an application, the CD must get an approval from 66% of the FC, along with a special resolution from the shareholders. Moreover, they must be provided with a declaration and the base resolution plan.^[33] After filing the application for PIRP, the CD has been given the sole right to submit a base resolution plan to the IRP within 2 days. The base resolution plan must be accepted by the CoC, and it must not impair the claims of the operational creditors.  Failing these requirements, a “Swiss Challenge” is undertaken, where competing plans are invited.^[34] This is similar to the procedure followed in the US, where the CD has the sole right to submit a plan for a period of 120 days, which can be extended up to 18 months. Only after the termination of the exclusive period can competing plans be submitted.^[35]

Although, this process incentivizes the promoters of a CD to meaningfully engage with its creditors, but to increase the overall efficiency of the process, additional safeguards should be added with respect to connected party pre-packs. For instance, the COC should be required to file a statement with the Adjudicating Authority (“AA”), outlining the reasons for approving a plan proposed by the existing management or any of its connected parties.^[36] Another such safeguard could be submitting these plans before an independent body of experts such as a “pre-pack pool of experienced people”^[37] in the UK, prior to placing them before the COC, where the pool scrutinizes the transaction and issues its opinion in a prescribed form, while maintaining the confidentiality of the transaction.

Regulation of IRPs

Under the current IBC framework, an Insolvency Resolution Professional (“IRP”), the IBC equivalent of the administrator appointed in the UK, is appointed after an application for commencement of the resolution process is admitted by the NCLT. The responsibility of managing the business of the debtor during the CIRP is entrusted with the IRP.  While the qualifications^[38] for an individual to be licensed as an IRP are contained in the IBC, certain objections have been raised on the sufficiency of having the complex businesses of large-scale debtors during CIRP being managed by one individual.^[39] Moreover, in certain cases,^[40] there have been instances of fraud and mismanagement by IRPs.

The pre-pack introduced for MSMEs follows a debtor-in-possession model, similar to the US model, where the control of the company is retained by the management.^[41] Hence, the role of IRPs remains limited, with the NCLT having the power to shift the control to an IRP only if there is fraud or gross mismanagement.^[42] In India, IRPs are similar to the position of a US trustee. The trustees are rarely used and reserved for limited cases. They have a supervisory role and monitor compliance with the filing requirements. However, the control of the company shifts to a Case Trustee if the court on an application from an interested party or the US trustee finds gross mismanagement, fraud, incompetency on part of the management.^[43]

Given the current insolvency framework in India, and its similarities with the UK model, it could be argued that the IRPs would play a significant role in balancing the interests of all the stakeholders when the PPIRP is expanded to other, bigger corporations in India. Following the example of the UK, an IRP can be made liable by the NCLT in cases of fraud or mismanagement during the course of the process. Furthermore, the IBC would have to undergo certain amendments to establish the powers and responsibilities of the IRP, before pre-pack transaction. For this, guidance may be sought from the Statements of Insolvency Practice 16 applicable in the UK since it contemplates the role of an IP in a pre-pack. On the other hand, India has followed the US model for the PPIRP introduced for the MSMEs. If the debtor in possession model is utilized for the expansion, the power of the NCLT to shift control with the IRP must be retained.

Conversion to Traditional Method of Insolvency

As per the Ordinance, with a majority of 66% of the COC, the IRP can file an application with the AA, which may terminate the PPIRP or vest the management of the company with the IRP.^[44] However, there are no guidelines on which the AA decides the conversion of PPIRP. An arbitrary procedure may defeat the purpose of the PPIRP, and the Ordinance loses its meaning, as a plan which has been accepted by the COC is vulnerable to be transformed into a CIRP at any time. This can be resolved by incorporating the mechanism followed in the US, where an interested party may file an application for conversion of a Chapter 11 case into a traditional case if there is “cause”, and it is in the best interests of the creditors and the estate.^[45]

Part IV: Conclusion

The Supreme Court of India has observed that “one of the important objectives of the IBC is to bring the insolvency law in India under a single unified umbrella with the object of speeding up of the insolvency process.”^[46] The PPIRP model is a unique mechanism, developed to serve the very same purpose. Pre-packs have been extremely successful in the US and UK for debtors with concentrated debt and a group of small creditors. Therefore, adopting the pre-pack process for MSMEs in India seems to be a step in the right direction. However, MSMEs are only a part of the corporate structure in India and therefore, an enhanced framework would be required for dealing with the challenges that are not yet anticipated and for resolving the financial distress of larger conglomerates in a timely and cost-efficient manner. This expansion must be undertaken in a phased manner keeping in the mind the capability of the Adjudicating Authority.[47] Moreover, the expansion should follow the steps of the PPIRP introduced for MSMEs retaining sufficient checks and balances to ensure that the rights of all parties are secured.

Reference:

^[1] Hitesh Mankar, Understanding the Proposed Pre-Packaged Insolvency Resolution Process and its Implications, BAR AND BENCH (Mar. 11, 2021, 10:42 AM) https://www.barandbench.com/columns/understanding-the-proposed-pre-packaged-insolvency-resolution-process-and-its-implications.

^[2] Id.

^[3] Singh, supra note 2; Between 2017 and 2019, out of 2542 companies, only 156 debtors have been approved for a resolution plan, 587 debtors have been liquidated and the rest have withdrawn their application. Moreover, over 5,000 applications have been pending before the tribunals for a period of more than 180 days.

^[4] Sanjana Rao, Insolvency Procedures- Investigating the Pre-Pack Paradigm in India, 10 Law Rev. Gov’t LC 69 (2019).

^[5] SUB-COMMITTEE OF THE INSOLVENCY LAW COMMITTEE, PRE-PACKAGED INSOLVENCY RESOLUTION PROCESS 15-17 (2020).

^[6] Rao, supra note 5 at 73.

^[7] Mankar, supra note 1.

^[8] Rao, supra note 5 at 73.

^[9] VANESSA FINCH, CORPORATE INSOLVENCY LAW PERSPECTIVES AND PRINCIPLES 456 (2nd edn, Cambridge University Press 2009).

^[10] Sen, supra note 11.

^[11] Id; While pre-packaged and pre-arranged processes take two and four months respectively, the traditional method of court restructuring takes eleven months.

^[12] MP Ram Mohan & Vishakha Raj, Pre-Packs in the Indian Insolvency Regime, IIMA 1,8 (2020).

^[13] Supra note 6 at 30.

^[14] Sen, supra note 11.

^[15] Sen, supra note 11.

^[16] Sen, supra note 11.

[17] Mohan & Raj, supra note 15 at 28.

^[18] Mohan & Raj, supra note 15 at 28.

^[19] Mohan and Raj, supra note 15 at 18.

^[20] The Insolvency Act, 1986 (c 45), parts I-III, Act of the UK Parliament, 1986.

^[21] Finch, supra note 10 at 458.

^[22] Id. at 366-367.

^[23] In re Transbus Ltd. (2004) EWHC 932 (Ch).

^[24] Finch, supra note 10, at 371.

^[25] Mohan and Raj, supra note 15 at 20.

^[26] Id.

^[27] Association of Business Recovery Professionals, ‘Statement of Insolvency

Practice – England & Wales’ at https://www.r3.org.uk/what-we-do/publications/professionallstatements-of-insolvency-practice/e-and-w/sip-16-list

^[28] Id.

^[29] The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021, (April 4, 2021).

^[30] Insolvency and Bankruptcy Code, 2016, §54A(2)(a), No. 31, Acts of Parliament, 2016.

^[31] Shreeja Singh, Why Most MSMEs Are Not Eligible For The Pre-Packaged Insolvency Process, MONEY CONTROL (April 12, 2021, 5:35PM), https://www.moneycontrol.com/news/trends/why-most-msmes-are-not-eligible-for-the-pre-packed-insolvency-resolution-process-6758611.html.

^[32] Insolvency and Bankruptcy Code, 2016, §54A(2)(d), No. 31, Acts of Parliament, 2016.

^[33] Insolvency and Bankruptcy Code, 2016, §54A(2)(g) & §54A(3), No. 31, Acts of Parliament, 2016.

^[34] Insolvency and Bankruptcy Code, 2016, §54(K), No. 31, Acts of Parliament, 2016.

^[35] Chapter 11, Bankruptcy Basics, US COURTS (2019), https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics.

^[36] Sen, supra note 11 at 25.

^[37] Teresa Graham, Graham Review into Pre-pack Administration: Report to The Rt Hon Vince Cable MP (2014).

^[38] Insolvency and Bankruptcy Code, 2016, §2(27), No. 31, Acts of Parliament, 2016.

^[39] Veena Mani & Ishan Bakshi, The Curious Case of Synergies Dooray and its Implications, BUSINESS-STANDARD (Sep. 20, 2017), https://www.business-standard.com/article/companies/flaws-in-the-insolvency-code-117091900999_1.html.

^[40] Id.

^[41] Insolvency and Bankruptcy Code, 2016, §54(H) & §54(F), No. 31, Acts of Parliament, 2016.

^[42] Insolvency and Bankruptcy Code, 2016, §54(J), No. 31, Acts of Parliament, 2016.

^[43] Supra note 37.

^[44] Insolvency and Bankruptcy Code, 2016, §54(O), No. 31, Acts of Parliament, 2016.

^[45] Supra note 37.

^[46] Innoventive Industries Ltd. v ICICI Bank and Ors, AIR 2017 SC 4084 (India).

[47] Supra note 6.