Pre-pack problems

MSME Ordinance violates basic principle of IBC

The government has decided that a “pre-packaged” resolution process for micro, small, and medium enterprises (MSMEs) is needed to supplement the Insolvency and Bankruptcy Code (IBC) and has now introduced an Ordinance on that. It has been argued that the pandemic’s effect on MSMEs in particular makes such a hybrid pre-insolvency process necessary. The package will retain the emphasis on timelines that was part of the structure of the IBC, with the requirement that the process be completed within 120 days. It has a somewhat informal element, in that the resolution will be negotiated with a possible buyer of the business prior to the formal appointment of a resolution professional. In other words, the company will continue to be controlled by the existing board and management while resolution negotiations proceed, instead of by a resolution professional. This comes one year after the government had raised the threshold for invoking insolvency proceedings under the IBC from a default of Rs 1 lakh to Rs 1 crore, supposedly to protect MSMEs — though many MSMEs that were operational creditors were also hurt by the hike in the threshold.

It is easy to see what the government’s hopes and expectations are from this change, and why it was felt to be necessary. First, a large part of the cases still clogging up the IBC pipeline are of relatively small firms. It might be hoped that the existence of a pre-packaged resolution process for such firms would help streamline the IBC process, and ensure that many of the larger cases are resolved in accordance with the proper timelines. Second, it is argued that MSMEs have specific requirements, in that in many cases they may have a single customer, and a shortage of qualified buyers for the distressed assets. If existing promoters are ruled out, then considerable capital destruction might take place. Third, getting lenders to agree to changes if the amounts outstanding are small might be easier, so the lenders, including banks, might not seek in these cases the additional security provided by close supervision under a resolution professional or the court. Fourth, similar systems in other jurisdictions have worked well. Finally, there is a gap in the system for both out-of-court resolutions and for small companies, which this Ordinance might conceivably fill.

These concerns are valid, and the government’s efforts understandable. Even so, one basic guiding principle of the IBC has been undermined. The point of the IBC has always been to not just ensure that capital is not destroyed, but that accountability returns to business. Distressed assets are to be auctioned, and those who originally sent the company to the wall are not supposed to be able to buy them back. Introducing this fairness to the system is essential for the long-term health of Indian capitalism. The government’s arguments in favour of the Ordinance are sound as far as they go, but they are not enough to outweigh the basic principle of the IBC. Promoters should not be able to retain control of their companies. Once this principle is weakened, such dilution will inevitably spread in time to the larger companies as well. If the efficiency of the IBC is what is holding up the resolution of MSMEs, the answer is to increase capacity and the number of resolution professionals, not undermine the principles of the IBC itself.