The Insolvency and Bankruptcy Code, 2016 (“IBC”), which attempts to completely revamp the policy approach to insolvency and company rehabilitation, is one of the most significant pieces of legislation to be enacted in the last several years.
The basic problem
The word “insolvent” means that the liabilities of a person, company, or other legal entity exceed its assets. Another way to understand it is that the company owes more money than it has or is likely to make.
Take the example of a company manufacturing DVDs and CD-ROMs. It has employees to whom it pays salaries and suppliers from whom it purchases raw materials, machinery, and other items required for production. It may need to pay rent on the land where its factory is located, it will need to repay the loans it has taken (and the interest on those loans) to its bankers, and it will need to pay taxes to the government and would like to pay dividends to its shareholders.
The company needs to earn enough from its sales to make all these payments. What happens when the company becomes insolvent and cannot make all the payments it is supposed to?
If they do not get paid, all the stakeholders of a company have their own individual remedies. They can file suits under the Code of Civil Procedure, 1908 for the recovery of their dues. Some of them also have the benefit of specialised legislation such as debt recovery laws, tax laws, and labour laws. At any given point of time, there will typically be various claims being made against the company. However, if the basic problem is that the company is not generating enough revenues to pay its dues, individual actions may not be enough for the claimants to recover their dues and for the company to pay all its debts.
Rehabilitation v Liquidation
The most drastic solution is liquidation or winding up. The company is shut down and all its assets are sold and the proceeds distributed to its various creditors. The value that can be obtained from liquidating and selling the assets of the company is generally referred to as “liquidation value”.
But there is a basic question that needs to be answered before a liquidation or winding up is contemplated – what if it is possible for the company to be revived and changes made in its business which may enable it to earn enough in the future and pay off all its creditors? The value of the company, taking into account the potential future earnings of the company’s business is referred to as its value as a “going concern”.
The liquidation value is typically inferior to the value of the company as a going concern. Perhaps the company in our example above is facing insolvency because with the advances in online data transfer, it is not finding enough customers for its products. If the company is wound up and its assets sold, not much value will be obtained from the sale of manufacturing equipment and technology for a product that is becoming obsolete. The liquidation value would be very low in this case.
Maybe there is a business solution. Perhaps the company can diversify into manufacturing other more relevant electronic products. Perhaps a change in management will be able to revive it. Perhaps the company will become viable if its banks agree to waive some part of the loans due to them.
A liquidation also has various other public costs. The employees will lose their jobs, the suppliers will lose a customer, the company’s customers will lose a supplier, and the government may lose the taxes which the company is supposed to pay and may pay in the future if it is revived. The cost of the liquidation process can also be significant.
Legal Framework prior to the IBC
A liquidation regime was previously set out under Section 433 and 434 of the Companies Act, 1956 (later Section 271 of the Companies Act, 2013), which dealt with winding up of a company. Under Section 433(e), a creditor could approach a court (later, the National Company Law Tribunal) for winding up a company on the grounds of the company’s inability to pay debts. Under the provisions of the Act and the jurisprudence that developed under it, the court had the discretion to determine whether the company should be wound up.
This was an imperfect situation. Whether or not a company has the capability to be revived is, apart from being a business question, also a speculative one with many different views possible, each involving an analysis of financial projections in different fact scenarios. A court perhaps would not necessarily possess the business acumen to take a firm view under such circumstances. Moreover, the process was not constructive. If it was determined that the company should not be wound up, there was no revival plan that would be binding on all the stakeholders.
The Sick Industrial Companies Act, 1986 (“SICA”) attempted to address this. It provided that the Board for Industrial and Financial Reconstruction could sanction a scheme for the rehabilitation of a “sick company”, that is, a company which has at the end of any financial year, accumulated losses equal to or exceeding its entire net worth. An essential part of the Act was that while the scheme was being prepared and approved, there was a moratorium on taking any legal action against the company for recovery of debts, enforcement of security, winding up, etc.
Unfortunately, SICA was largely unsuccessful as companies ended up staying within the protection of the SICA moratorium for years without any successful scheme for rehabilitation.
The new code on insolvency and bankruptcy was born out of the failures of the existing laws to effectively deal with company rehabilitation and liquidation, and in the backdrop of failing businesses and mounting debts owed to the banking sector, particularly public sector banks. We will take a look at the framework and provisions of this code in another post.
Uday Khare is a Partner at Cyril Amarchand Mangaldas.