The Bankruptcy Code: A Brief Overview (Part Two)

Introduction

This article is the second in a 3-part series that discusses and analyses the new Insolvency and Bankruptcy Code, 2016 (the “Code”). With this 3-part series, we seek to provide a more extensive understanding and analysis of the important provisions of the Code. The first part of this series (available here) explored the insolvency and liquidation processes for companies and limited liability partnerships, by analysing both the substantive and procedural provisions in the Code in this regard. This second part shall explore the scope of the insolvency bankruptcy proceedings against individuals and partnership firms, as envisaged under Part III of the Code.

However, before analysing and describing the various processes that can be initiated under Part III of the Code, it is important to highlight that Part III creates categories of “excluded assets” (see S. 79(14)) and “excluded debts” (see S. 79(15)) which shall not be subjected to any of the debt recovery processes under this Part of the Code. This includes, among others, any liability imposed by a court/tribunal, any student loan, books or vehicles of the debtor which are required for personal use, employment or vocation, unencumbered life insurance policies, the single dwelling unit of the debtor, etc. Thus, for individuals and partnership firms, even if a bankruptcy/insolvency order is passed against them, the above-mentioned assets and debts will not come under the purview of the enforcement as per the Code.

The Fresh Start Process

The fresh start process for individuals and partnership firms has been created to give debtors with comparatively smaller debts the chance to discharge their debts, and start afresh without any liabilities. This process exists as an alternative to the insolvency and bankruptcy processes. To prevent the abuse of this debtor-centric process, the Code applies certain restrictions on the applicability and validity of fresh start processes

Firstly, the process will not apply to secured debts, to ensure that the secured creditors continue to remain protected. Secondly, to be eligible to avail of this process, there are a number of criteriaregarding the debt and assets of the debtor that will need to be fulfilled. The debtor can only have a maximum gross annual income of INR 60,000, and a maximum value of assets of INR 20,000.. Further, the value of the debt qualifying for the fresh start cannot exceed INR 35,000. If all the conditions under the Code are met, an application may be submitted either by the debtor himself/herself or by a resolution professional (an “RP”) on behalf of the debtor. Pursuant to this, the Code provides for an evaluation of the application by a RP, followed by a decision on its acceptance or rejection by the Debt Recovery Tribunal (the “DRT”) within 14 days of receiving the RP’s recommendations on the application.

In case the application is accepted by the DRT, the Code provides for legal protection from both current and future legal proceedings against the applicant/debtor, for a period of 180 days from the date of admission of the application. However, importantly, the Code provides the creditors in such situations with a right to object to any of the facts/grounds listed in an accepted application for a fresh start. Such objections shall be submitted by creditors to the RP, who then evaluates the accuracy and importance of such objections. In general, the RP will act as the main point of communication between the parties involved (the creditors/debtors) and the DRT. In case the RP is made aware of a change in financial circumstances, a previous malafide representation or omission by the debtor, or any other situation which could make the DRT change its decision on whether to accept or reject the initial application, it is the RP’s duty to ensure that the DRT is informed of the relevant change.

Finally, after the RP has reviewed all the qualifying debts and made a final list of these, the DRT may pass an order to discharge the debtor from all of his/her obligation with respect to these debts. This closes the fresh start process under the Code and provides a much-needed relief, albeit marginal, to small-time debtors.

The Insolvency Resolution Process

Chapter III of Part III of the Code provides for a regular insolvency resolution process, which is largely similar to the process designed for corporate persons under Part II of the Code. The application may be made by either the debtor or creditor(s), in case a fresh start process has not already been made. In case the application is made by a debtor who is a partner at a firm, then he/she can only make the application if all or a majority of the partners of the firm also file the application jointly. Further, from the date of application to the date of acceptance/rejection of the same, an interim moratorium will be active with respect to all present and future legal action against the individuals/partners and the debts.

In case the DRTaccepts an insolvency application, the moratorium against legal actions shall continue for a period of a further 180 days from the date of acceptance. Further, in order to ensure an effective resolution process, the DRT will also issue a public notice asking all those with claims as creditors to file their claims. These claims will be evaluated, registered if relevant, and eventually compiled into a repayment plan, prepared by the RP along with the debtor. Normally, the creditors are still given an option to analyse and give their opinion on the repayment plan by way of a meeting. If the RP feels that a meeting is not required, then he/she must provide reasons for the same as it skirts the participatory nature of the resolution process.

If the RP calls a meeting, then like the creditors in the insolvency process of a corporate person, the creditors here too have the option of approving, modifying, or rejecting the plan (as long as a 3/4th majority is present). However, an important difference captured in S. 108, which seems to put more power in the hands of the debtor in this situation, is that the debtor must approve any change before it is incorporated. In effect, it seems like the debtor has the power to determine the nature of the insolvency resolution, as well as block the demands of the creditors if he/she so wishes. This is, prima facie, against the objective and aim of this Code, which is to create a quicker process and provide more power in the hands of the creditors.

The above point is highlighted even further when we consider that under S. 110, every secured creditor must give up his/her right to enforce the security separately during the pendency of the repayment plan, before being allowed to vote at a creditors meeting (unsecured creditors are disallowed from voting). From the creditor’s perspective this is risky as there is no guarantee that any change voted for by the creditors will actually be implemented.

The final say on the validity of a repayment plan lies with the DRT. In case of a rejection by the DRT, the debtors/creditors can file an application of bankruptcy instead. In case of an acceptance by the DRT, the implementation of the repayment plan shall be overseen by the RP. On completion of implementation, the RP shall give notice of the same, and a copy of a report detailing the same, to all parties involved and the DRT. In case a repayment plan is ended prematurely, then the DRT must pass a relevant order, and the debtor or the creditors whose claims under the plan have not been fulfilled, will be entitled to file for bankruptcy. In case of a successful completion of the plan, the DRT may pass an order discharging the debtor with respect to his/her debts.

Bankruptcy Related Processes

The Bankruptcy Order

An application for bankruptcy to the DRT can be made by the creditor(s)/debtor if the insolvency application is rejected, the repayment plan is rejected, or if the repayment plan ends prematurely. Here too, if the creditor’s debt is secured, then he /she shall have to forego it in favour of all other creditors who are part of the bankruptcy application (i.e., creditors wishing to take part in the bankruptcy application and further process, shall have to give up their right to enforce the security against their debt). Our understanding of this concept is that all creditors taking part in the bankruptcy process would have to “donate” the security that each of them has a right to, towards a common pool created for all creditors. On the passing of a bankruptcy order, money from the all the securities collected would be divided between the creditors proportionately.

Further, in a bankruptcy proceeding, creditors are allowed to file applications in respect of unsecured debts as well, while ensuring that they specify the part and quantum of the debt that is unsecured. Like the insolvency resolution process, on the filing of a bankruptcy application too an interim moratorium shall commence against the individual/all partners of the firm, and shall continue till the bankruptcy commencement date. Further, communications between the debtor/creditor(s) and the DRT shall be managed by an insolvency professional (an “IP”).

Within 14 days of the appointment of the IP, the DRT is supposed to pass an order with respect to the bankruptcy application. In case a bankruptcy order is passed, then the estate of the bankrupt immediately vests in the bankruptcy trustee (the “BT”), and the order stays in effect till the time the debtor is discharged from his/her debts. Pursuant to such an order, the debtor is expected to file a statement of his financial position, following which the DRT opens the process up to claims from all creditors. This is done to ensure that the process covers more creditors, and is consequently more effective. Following a registration of all creditor’s claims, and a meeting to establish a committee of creditors, the IP takes up the task of actually administering and distributing the estate.

After the administration is complete, and the creditors have accepted the BT’s report regarding the same, the DRT shall pass an order to officially release the debtor from all of his debts. However, it is important to note that under the Code the debtor has multiple restrictions placed on him/her during the pendency of a bankruptcy application. He/she shall be disallowed, among other things, from being a director of a company, creating a charge on his/her assets, engaging in any financial or commercial transaction beyond a value decided by the BT, or travelling overseas without the DRT’s permission. This ensures that the debtor does not have a way of evading the repayment of his debts through the bankruptcy process, or of making undue gains in his favour.

Administration of the Estate

Chapter IV of Part III of the Code mainly deals with the procedures involved in the administration and distribution of the debtor’s estate by the BT, the calculation of the amounts due to each creditor depending on the debts registered by them, along with the various obligations and powers available to the IP while executing the above function. Apart from these matters, this part of the Code also lists out various activities, which if undertaken by the BT, shall require the prior approval of the committee of creditors. This includes activities like carrying on the business of the bankrupt for the purpose of winding up, mortgaging or pledging any property of the bankrupt for the purpose of raising money, making a compromise or arrangement with respect to any claim under the bankruptcy, or appointing the bankrupt as the manager/supervisor of his own estate.

This Chapter also stipulates that any proceedings relating to the administration/distribution of an estate shall continue even if the bankrupt dies at any time. This ensures that the death of a debtor does not in any way jeopardise the rights of the creditors to recover any or all of their money. Lastly, and perhaps most importantly, S. 178 creates the waterfall structure required to guide the bankruptcy trustee on the order of the repayment of debts:

  1. First, the costs and expenses on behalf of the BT, incurred as part of the above administrative process, are to be repaid;
  2. Secondly, all workmen’s dues from the 24 months preceding the bankruptcy commencement date, along with the debts owed to secured creditors, are to be repaid;
  3. Thirdly, all unpaid wages and dues owed to employees (not workmen) from the 12 months preceding the bankruptcy commencement date, are to be repaid;
  4. Fourthly, all debts owed to the Central and State Government are to be repaid; and
  5. Fifthly, all other dues (including dues to unsecured creditors) are to be repaid.

An important proviso to the last point above is that if via contract, the debtor has agreed to prioritise/rank certain unsecured creditors above others, then this prioritisation will remain valid between the unsecured creditors only. Lastly, this waterfall clause states that if any surplus is remaining after repayment of all debts, then the excess shall be paid to all creditors as interest on their debts, in proportion to the duration of the debt but without any prioritisation in repayment.

Conclusion

Part III of the Code follows a lot of the same processes for insolvency resolution as those present in Part II of the Code (insolvency resolution for corporate persons). However, the process related to bankruptcy resolution is an extra option available to creditors; and the process of a “fresh start” seems to be a tool in the hands of debtors who have relatively smaller debts, but want to start over. However, the idea that the debtor can overrule the changes proposed by creditors in an insolvency process, seems questionable to the very purpose of the Code.

Beyond the above however, the Code seems to continue in the same path of attempting to protect creditors, putting more control in the hands of the creditorsand ensuringspeedy resolution as stipulated under the Preamble of the Code.

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

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