Pre-packaged insolvency for small & medium firms

Pre-packaged insolvency (or “pre-pack”) refers to the process by which a distressed corporation formulates a resolution plan with its creditors and a purchaser before the initiation of insolvency proceedings. On April 4, 2021, Government of India promulgated an ordinance introducing pre-packaged insolvency for Micro, Small, and Medium Enterprises (MSMEs).

The framework of the ordinance governs the pre-formal and the formal stages of pre-packs. The formal stage commences once an application for pre-packaged insolvency has been filed. At the pre-formal stage, an MSME can negotiate a “base resolution plan” with its creditors and a purchaser. Prior to filing the plan and commencing the formal stage of the process, a resolution professional needs to be appointed and the committee of creditors (CoC) needs to approve the base plan with a majority vote of 66 per cent. In addition to this, a majority of the directors of the MSMEs need to have declared their intention to file a pre-packaged insolvency application and three-fourths of the members of the MSME must also approve of commencing the pre-packaged insolvency resolution process.

Pertinently, the ordinance allows the incumbent management of the MSME to remain in control of its operations (Section 54H). This leaves the debtor in possession for pre-packs but provides for oversight by the resolution professional and allows the CoC to replace the incumbent management with the resolution professional (Section 54J).

Once the base plan is filed with the National Company Law Tribunal (NCLT), the formal stage of the pre-packaged insolvency resolution process commences. During the formal process, the resolution professional calls for the submission of claims against the debtor and votes for the plan are once again solicited, requiring the plan to be approved by a 66 per cent majority of the CoC. In case the resolution plan impairs the claims of operational creditors, the resolution professional will call for plans to be submitted by other resolution applicants. These plans will also need to be approved by the CoC before they are submitted to the NCLT for approval.

Important issues

A notable feature of the ordinance is the pre-packaged process’ two-step voting structure. Creditors have to vote on the base insolvency plan before it is filed (Section 54A) and will also have to vote on it after it is filed with the NCLT (Section 54K), approving it on both occasions. It is unclear why the entire process cannot be completed with one round of voting before filing the plan with the NCLT.

Such a process is followed in the US under Chapter 11 of the Bankruptcy Code where votes for a plan (along with adequate disclosures) are solicited from creditors prior to a formal filing. Thereafter, the bankruptcy court only verifies that the required procedures and safeguards have been followed. The bankruptcy court also retains the power to order for votes to be re-solicited if Chapter 11 procedures are not followed.

Another step in the MSME pre-pack scheme that can be moved to the pre-formal stage is the confirmation of claims. The ordinance provides for the confirmation of claims against the corporate debtor by the resolution professional after formal proceedings commence; this is the case with the regular insolvency resolution process as well. Even in a resolution plan of a pre-pack, proceeds need to be distributed based on the liquidation hierarchy of Section 53 of the Insolvency and Bankruptcy Code, 2016. Accordingly, there will be an incentive to properly invite and distribute claims even if implemented at the pre-formal stage. In case there is some discrepancy in this process, the NCLT continues to act as a check and can refuse to approve the plan if distributional requirements are not met.

The effect of some provisions under the pre-pack framework is yet to be fully understood. As discussed above, under the current framework, new resolution plans are invited in case the base plan impairs the claims of operational creditors or the CoC rejects the base plan at the formal stage. In this situation, the CoC can decide to approve and submit one of the new resolutions plans it receives to the NCLT if it believes that it is significantly better than the base resolution plan. If the CoC does not consider any new resolution plan to be better than the base resolution plan, the framework provides that the base resolution plan and the new resolution plan will need to be compared based on “conditions as may be specified” (Section 54K). How this will affect a CoC’s decision making can be ascertained only once these conditions have been published.

The authors are with the Indian Institute of Management Ahmedabad