Thursday, April 26, 2012



By K P C Rao.,

"Who will win in globalization?"  A country that has " …...the bankruptcy laws and courts that actually encourage people who fail in business venture to declare bankruptcy and try again, perhaps fail again, declare bankruptcy and then try again before succeeding and creating the next".[2]

Thomas Freidman 

Balancing the rights of creditors and debtors post failure or closure of business, is a complex but a critical issue. Countries attempt to strike this balance through legislations on insolvency and bankruptcy by providing a way of dealing with unpaid debts, sharing of debtor's assets among creditors fairly and ensuring a way out to the debtor. A fair and effective mechanism for insolvency and bankruptcy is considered a prerequisite for inducing risk taking and for enterprise creation in an economy.

The question as to what treatment should be meted out to a person who fails to meet his commitment to pay back or pay for the resources he had consumed, has remained a complex but important question since time immemorial. 

Economists in the 20th century onwards paid greater attention to effects of insolvency regulations on the economic growth of a nation. As Wood (1995) noted:  

"Insolvency law.. the piercing indicator of the doctrine that divides the world's legal system in the context of financial law. It is the destructive force of bankruptcy, which has molded the central tenets of a commercial law, and it is bankruptcy, which is the ultimate test of a jurisdiction's ability to realize its own view of fairness, equity and legal civilization."

Accommodating the regional and national variations, the legislations on insolvency and bankruptcy all over the world attempt to address the following key issues with varying degrees of success:

a)     Providing a way of dealing with debts which a debtor cannot pay
b)     Freeing the debtor from overwhelming debts so that it can make a fresh start, subject to some restrictions
c)     Ensuring that debtor's assets are shared out fairly among the creditors. 

Over the centuries, the insolvency and bankruptcy regimes have evolved into a complex subject shaped by prevailing sociological, political and economic thoughts. In the era characterized by free flow of capital and goods across national frontiers, fierce competition among nations and companies and resultant uncertainties within which businesses have to operate, the issue has assumed a new significance 

With regard to the insolvency and bankruptcy regime the Indian scenario has some peculiar features. Firstly, India does not have a comprehensive policy or law on bankruptcy. Individuals are declared 'insolvent' in the event of the individual's inability to meet his/her total liability. A company may also be wound up if it is unable to pay its debt.  

During the pre-independence period the word 'bankruptcy' was never used in the Indian legal system. Insolvency was used for denoting an individual or a firm that is not able to meet the liability. In the case of a company, the system included winding up and dissolution.

Insolvency Mechanism in India 

In the case of individuals there are two Insolvency Acts, one for the presidency towns –The presidency-Towns Insolvency Act, 1909 and other for the rest of the country-The Provincial Insolvency Act, 1920. Under the Insolvency Act of 1920 which is applicable throughout India except for the Presidency Townships, the jurisdiction of courts is significantly restricted. ‘In fact court can admit insolvency proceedings which are a shade better than Roman laws’. The conditions attached are almost impossible to meet and terms are hugely subjective. Moreover, many of these conditions fall under criminal courts having their own timetable, independent of insolvency courts resulting in enormous delays.

Secondly, during the interim period when the insolvency petition is pending for disposal, there is no protection available against the proceedings for recovery initiated under different Acts for recovery of statutory dues. There is no BIFR type of mechanism for small enterprises. All the while when the entrepreneur struggles to revive the unit or in process of getting himself insolvent, because of his inability to pay statutory taxes or settle liabilities, he could be sued and penalized under several regulations (mentioned in previous section: creditors’ options). Further, rules are such that under a single Act (for example of Provident Fund), multiple jail sentences could be secured under one case against the entrepreneur.
In brief, in current dispensation under the two Acts, there is no protection from ‘criminal cases’ and all personal belongings are attached and auctioned as economic offences are routinely defined as ‘criminal’ in Indian jurisprudence. The prevailing legal system does not recognize ‘financial stress’ that a unit may face. For example, when a unit is facing financial crisis, it is natural that it might default on post-dated cheques. In such an eventuality also, the default becomes a criminal offence punishable under Section 138 of the Negotiable Instruments Act (dishonour of cheque) with imprisonment. Similar is the case with provisions of Indian Contracts Act of 1872 and several other economic legislations.
 Further, all guarantors and directors - which form the critical social safety net of the small entrepreneur, are involved and in the eventuality of failure they also get implicated and the whole safety net crumbles.

Finally, the cost of being labeled as ‘insolvent’ is extremely punitive in law and annihilates all future prospects of an honorable living in the future. The entrepreneur delays and avoids this till the end.

Problems of SMEs

Temporary stresses and also eventual closure in many cases are inevitable in business. In fact with intense global competition, risks associated with business are greater than ever before. It is critical to have an effective and fair mechanism to deal with untoward business eventualities such as failure, sickness, closure and like. When a business fails there are chiefly three types of creditors whose liabilities need to be settled:

a)     Statutory dues (liabilities towards authorities of Central and State taxation; labour, electricity, water, State Financial Corporations etc.)
b)     Liabilities towards Banks and Financial Institutions
c)     Liabilities to sundry creditors (buyers, suppliers and others) 

With regards to statutory dues, respective Acts provide for appropriate legal recourse for recovering dues from individuals, firms or companies through prescription of fines, attachment of assets and also, in most cases, imprisonment. The final recovery procedures, whether on behalf of central or state governments, are effected by state governments through their administrative machinery. 

The banks and financial institutions also have several options for restructuring a stressed account and recovering their dues. There is State Level Inter-Institutional Committee (SLIC) route for revival or restructuring when more than one Financial Institutions are involved or ‘One Time Settlement’ (OTS) or restructuring of the Sick as per RBI guidelines or finally recovery of dues through the DRT Act and the SARFAESI Act. 

Though, sundry creditors can file civil suites to recover their dues, most prefer ‘out-of-court settlements’ through alternative mechanisms such as arbitration.

Major Challenges Encountered by SMEs 

When under extended duress, a unit has to brave the actions born out of default on statutory dues on the one hand, pacify the bankers and financial institutions for not pressing for repayment or initiating legal course and mollify the buyers, suppliers and employees on the other hand. In the current dispensation, following problems are encountered: 

1)     Whereas a sick firm can apply for rehabilitation to the financial institutions, there is no protection available to the firm in the interim from other creditors and liabilities particularly statutory ones. All the while when the entrepreneur struggles to revive the unit or in process of getting himself declared insolvent, because of his inability to pay statutory taxes or settle liabilities, he could be sued, penalized under several regulations and imprisoned. Because of a lack of single institutional mechanism which could coordinate with these multiple agencies, most work at cross purpose. 

2)     Particularly bothersome are the procedures for recovery of statutory dues under archaic Land Revenue Acts of the States which are routinely employed to imprison entrepreneurs even while the process of the restructuring of the firm is underway. The problem with recovery as arrears of land revenue is the implicit scope for discretion. While the arrest and detention is prescribed as only one of the resorts, the provisions are greatly misused for hand-twisting and rent seeking. These laws are the single biggest cause of misery and hardship for entrepreneurs facing failure. 

3)     Because of absence of an effective institutional mechanism re-structuring or exit, they are classified as sick and are kept in state of ‘suspended animation’. Given the conditions, it is no surprise that the Small Scale Sector suffers from the huge backlog of sick units. It may not be out of context to mention here that the normal action plan of any banker when a small unit is in stress is to stop operations in the account, serve a recall notice and initiate action under SARFAESI Act. Efforts for rehabilitation, if any, are ad hoc and not properly structured after viability study or analysis of the root causes of sickness etc. The bank staff puts in efforts to avoid classification of the account as NPA. All focus of the banks is centered on the asset classification and not health classification. 

4)     Theoretically, the legal remedy to escape attachment of assets and accompanying imprisonment in the event of failure to pay the statutory dues, the entrepreneur could take shelter through insolvency under either the Presidency Town Insolvency Act, 1909, or the Provincial Town Insolvency Act, 1920, as the case may be. Practically, however, both the laws are entirely outdated and the route is all but dysfunctional. 

5)     While a mechanism for State Level Inter-Institutional Committee (SLIIC) was set up for restructuring of sick SMEs, its jurisdiction is limited to institutional credit only leaving aside restructuring of multi-agency statutory liabilities. There is no doubt that the mechanism is largely ineffective.  

Therefore, while on one hand there is absence of bankruptcy law and specialist courts which can take up cases of stressed units and preside over restructuring or closure. On the other, insolvency laws meant to provide the dignified exit to entrepreneurs in case of failure is dysfunctional. 

The Imperative Change

 “In the middle of difficulty lies opportunity”
-Albert Einstein

During the last decade, not only did India assume its position as a preferred outsourcing destination for IT services and other niche areas of manufacturing with many global companies expanding their India operations, but Indian companies have also indulged in acquisitions of overseas entities fuelled by easy access to debt financing by foreign banks and private equity placements in India at steep valuations. The, introduction ofForeign Exchange Management Act, 1999[3] (FEMA) has changed the entire perspective on foreign exchange particularly those relating to investment abroad. It changed the emphasis from exchange regulation to exchange management. It aimed to facilitate external trade and payments as well as to promote an orderly development and maintenance of foreign exchange market in India. 

The impact of the rapid organic and inorganic growth is reflected in the Consolidated Financial Statements of the Indian Parent Entities highlighting an unprecedented growth both in size, scale, aspiration and risk taking abilities. The capital markets have shown a meteoric rise with BSE Sensex growing from 4,000 points in 2004 to its peak of 21,000 points in early 2008. 

Truly, India has arrived in the global economy and is being recognised as one of the fastest growing economies with attractive return on investment and a projected double digit growth in GDP.  

However, with the economic global meltdown in 2008, Indian companies with cross border entities are faced with cross-border insolvencies and cross-border creditor claims. It is therefore imperative that the Government implements a comprehensive law on Corporate Bankruptcy maintaining the intent and spirit of various recommendations of Expert Committees. A fair and effective mechanism for insolvency and bankruptcy is considered a prerequisite for inducing risk taking and for enterprise creation in an economy. What is needed is the following: 

a)     Amendments in The presidency-Towns Insolvency Act, 1909
b)     Amendments in The Provincial Insolvency Act, 1920
c)     New legislation on bankruptcy incorporating SME perspective.
d)     Setting up of specialized bankruptcy and insolvency courts (Fast Track) and a cadre of specialists providing a ‘single window’ to address all related issues like restructuring, liquidation, bankruptcy and insolvency.
e)     Removal of clause of imprisonment and detention under Land Revenue Act. 

Whilst other countries in Asia have successfully developed and implemented new or substantially revised insolvency regimes in the past ten years (most notably Asia’s other growing economic giant and India’s key rival - China), India has lagged behind, weighed down by indecision and bureaucratic hurdles.

Published in Monthly Magazine of ICWAI 'Circuit', in  April, 2011]

[1]    Small and medium enterprises
[2] ‘The Lexus and the Olive Tree ‘is a 1999 book by Thomas L. Friedman that posits that the world is currently undergoing two struggles: the drive for prosperity and development, symbolized by the Lexus, and the desire to retain identity and traditions, symbolized by the olive tree.
[3] The Foreign Exchange Management Act, 1999 (FEMA) which seeks to replace the Foreign      Exchange Regulation Act, 1973 (FERA), was brought into effect from 1st June, 2000.

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