The Bankruptcy Code: A Brief Overview (Part One)

This article is part of a 3-part series that discusses and analyses the new Insolvency and Bankruptcy Code, 2016 (the “Code”). Our previous post, written when the Code was still just a Bill that had been introduced in Parliament, had sought to give a brief overview of the changes that were proposed. With this 3-part series, we seek to provide a more extensive understanding and analysis of the important provisions of the Code, in the background of the ever-increasing difficulty in debt collection in India.

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In this first part of the series, we explore the insolvency and liquidation processes for companies and limited liability partnerships. The article focuses on the substantive and procedural provisions in the Code in this regard. The second part of the series will explore the scope of the bankruptcy proceedings against individuals and partnership firms. In the final part of this series, we will evaluate the infrastructural changes that the Code seeks to bring about, and understand whether these operational changes are effective in improving the overall experience and efficiency of debt recollection and bankruptcy proceedings in India.

Introduction

India has had a myriad of bankruptcy and insolvency laws for many years now. These legislations have often grappled with the complex nature of the insolvency process, and the Government has previously resorted to enacting new legislations to address, sometime specific, problems. This has led to the existence of multiple legislations such as the Presidency Towns Insolvency Act, 1909 and Provincial Insolvency Act, 1920, the Companies Act, 2013, Sick Industrial Companies (Special Provisions) Repeal Act, 2003 (SICA), Limited Liability Partnership Act, 2008 (LLP Act), Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) and others. This new law, which received Presidential assent on 28 May 2016, seeks to consolidate and support quicker resolution of bankruptcy.

The objectives of the Code, as stated in its preamble is as follows:

“…to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto.”

The Insolvency Resolution Process

Parts III & IV of the Code deal with the insolvency resolution and liquidation proceedings with respect to corporate debtors, which, by definition, includes companies, LLPs, and any other person incorporated with limited liability under a law for the time being in force, but excludes financial service providers.

Under Section 4 of the Code, the insolvency resolution process (“IRP”) can be initiated against a company when there is a default of INR 1,00,000/- (Indian Rupees OneLakh Only) and above. Depending on whether the debt is financial [see Section 5(8) of the Code] or operational [see Section 5(22) of the Code], there are three separate processes to be followed:

  1. Financial Creditors can make a direct application to the Adjudicating Authority (“AA”) for initiating an IRP. They also have to submit records of default to the Information Utilities (“IU”).
  2. Operational Creditors must first submit an invoice or notice demanding payment from the corporate debtor. In case the debtor does not repay the amount in 10 days from the receipt of the demand notice or copy of the invoice, the operational creditor can make an application to the AA for initiating an IRP. The records evidencing the debt must also be submitted to the IU.
  3. Corporate Applicants (the corporate debtor, its shareholders, management or employees) can make an application for the initiation of IRP under Section 10 of the Code.

If the AA accepts the application to initiate an IRP, it first makes a public announcement that the concerned creditor will be involved in such a process. It also appoints an Interim Resolution Professional (either by itself, or one suggested by the applicant) within 14 days of accepting the application. This Interim Resolution Professional (RP) will take charge of the business and affairs of the company. While the Board of Directors of the defaulting company continues, the decisions and instructions are as per the RP. This is to ensure that the RP can take care of the accounts of the company, and protect all assets till the IRP is completed.

Further, a moratorium starts from the insolvency commencement date, and will continue for 180 days, till the end of the IRP. While the moratorium is active, no one can initiate any suits, proceedings or recovery actions of any kind against the debtor. The RP’s primary responsibility after assuming his position is to appoint a Committee of Creditors (“COC”). This will be constituted of all financial creditors. This Committee will then take over the running of the company from the RP, and take care of its business and assets. Each creditor will have a say equal to the percentage of the debt that is owed to him. In case a creditor is both financial and operational, he/she will be on the COC and have a vote equal to the percentage of only the financial debt owed to him. Further, under Section 24 of the Code, operational creditors (one or as a group) who are owed 10% or more of the total debt, can have one person attending all COC meetings. This representative can only observe the meetings, and have no voting powers.

On being appointed, the COC first appoints an Insolvency Professional (IP). This can either be the same one appointed by the Court, or another from the pool of Insolvency Professionals, as appointed by the Insolvency Professional Agencies. However, the most important task of the COC is to review the Insolvency Resolutions submitted to it by a resolution applicant (this can be a financial creditor, an operational creditor, or a corporate applicant). The purpose of the resolution is to lay down the exact process to be followed by the company to repay its debts to the creditors. If 75% of the COC members agree on a resolution, it is sent to the AA (through the IP).

Under Section 30(2), the AA will review it and determine its validity on the basis of certain criteria. It is also possible that the COC decides that there is no effective resolution on which they can reach a consensus. If necessary, the COC can also request the NCLT to grant a 90-day extension for the IRP to draft a more effective resolution.

Liquidation

Following from the above processes, there are three situations when the NCLT(National Company Law Tribunal) may pass an order for initiation of liquidation proceedings:

  1. If it does not receive a resolution application from the COC during the allotted time period;
  2. If it has not accepted any resolution applications till the end of the allotted time period; or
  3. If the corporate debtor contravenes some provisions of an accepted resolution plan, and a prejudiced party makes an application for liquidation to the AA.

The first job of the AA is to make a public announcement about the liquidation of the concerned debtor. After this, the AA normally appoints the Resolution Professional as the liquidator, unless they change their decision under Section 34(4), due to RP’s previous resolution plan being rejected, or due to the Insolvency and Bankruptcy Board recommending the replacement of the RP.

The liquidator is to act as the fiduciary of the creditors, protecting all the assets and properties belonging to the debtor to ensure effective debt recollection for the creditors. In addition, the liquidator assesses the claims of all creditors, and may carry on the business of the debtor if he considers it beneficial to the liquidation process. As a creditor, the claims must be submitted to the liquidator within 30 days from the start of the liquidation process. Under Section 40, the liquidator is free to ask for evidence and information from the creditors to support their claims, and may also reject a claim. In the case of rejection, the concerned creditor will have 14 days from the receipt of notice of such rejection, to file an appeal with the AA.

The final important part of the liquidation process is the repayment of dues by the debtor. Sections 51 and 52 of the Code provide a waterfall structure to determine the order of repayment. After the initiation of the liquidation process, secured creditors have the option of either enforcing the security, or relinquishing it to the liquidation estate. In case they choose to enforce/realise the security independently, they may be faced by any of the following situations:

  1. If the amount realised is equal to the amount owed to such creditor, the creditor shall excuse himself/herself from the liquidation process.
  2. If the amount realised is less than the amount owed to such creditor,the creditor will continue to be a part of the liquidation proceedings to the extent he/she is still owed money. However, the creditor will then fall down the waterfall structureand will be considered only at the time of repayment of Government dues.
  3. If the amount realised is more than the amount owed to such creditor, the creditor must inform the liquidator and return the excess amount to him/her. The excess amount in such case gets used when the remaining assets are realised in the liquidation process.

In case the creditors relinquish their security to the liquidation estate, they automatically fall within the waterfall structure listed under Section 53. This structure ranks the various dues as follows:

  1. The costs related to the IRP and the liquidation proceedings;
  2. The amount due to workmen (for a period of 24 months preceding the liquidation commencement date), and the amount due to secured creditors who have not realised any of their securities;
  3. The money due to employees other than workmen (for a period of 12 months preceding the liquidation commencement date);
  4. Debts due to unsecured creditors;
  5. Governments dues (for a period of 2 years preceding the liquidation commencement date) and amounts left unpaid to secured creditors who had previously realised their security;
  6. Dues to preference shareholders; and
  7. Amounts due to equity shareholders and partners.

Lastly, Section 53 also stipulates that contractual arrangements disrupting the hierarchy between recipients who are ranked equally, will be considered as invalid.

The above waterfall structure raises some interesting questions and difficulties of its own, which have not been answered clearly in the Code. Firstly, if taxes come under Government dues, it is interesting to note that amounts due to secured creditors take precedence over the payment of taxes. This questions whether the Code is perhaps prioritising individual interests. Secondly, corporate debtors often have contractual waterfall liabilities to comply with, which often get incorporated in the Articles of Association of a company, therefore becoming part of the bylaws of the company. It remains to be seen how the judiciary implements a waterfall structure, in case of a conflict.

Finally, the Code mandates that the AA must make a public announcement of the commencement of any IRP or liquidation proceedings. However, there is no provision to allow the debtor to defend himself/herself before making such announcements and therefore this may be criticised from the perspective of breach of privacy and the right to be heard.

Overall, the Code seems to be a step in the right direction, with shorter timelines, and clear demarcation of the rights and responsibilities of the parties involved. It is in this background that we will discuss the bankruptcy process of individuals, and the infrastructural mechanisms under the Code, in the second and third parts of this series, respectively.

 

Authors: Madhav Rangrass, Associate and Sohini Mandal, Junior Partner

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