Increased Threshold under IBC - A Double Edged Sword
[Aditya Shukla and Lakshaya Grover are students at NALSAR University of Law.]
The Ministry of Corporate Affairs, Government of India, by a notification dated 24 March 2020, raised the minimum amount required under Section 4 of the Insolvency and Bankruptcy Code 2016 (Code) for initiation of insolvency proceedings from INR 1,00,000 to INR 1,00,00,000. This increase in the minimum threshold is being touted as a welcome change, considering the prevalence of frivolous proceedings under the Code being admitted by the adjudicating authorities, but it seems to lack foresight as to the short term and the long-term implications of the same. This piece aims to analyse and understand the reasons for this change and also the implications that this might have in the near future as well as in the longer run.
The first reason for increase in the threshold is the recent COVID-19 outbreak that has wreaked havoc in India after touring much of the globe. As the outbreak continues to debilitate industries and economic activity across sectors which will inevitably lead to financial distress for India Inc., the medium and small enterprises will be affected the most, as they lack the cash reserves to fall back on unlike the larger corporate houses. The increase in the threshold is not a new idea; in October 2019, government officials were hinting towards an increase. It had been argued that one single homebuyer with claims exceeding INR 1,00,000 can bring down a company to its heels, which is not the most sensible way of resolving small claims. The Finance Minister said that the increase was to “provide relief to cash strapped MSME sector amid the pandemic.” Since the quantum of debt amounting to INR 1,00,000 is commercially minimal, invoking insolvency proceedings against a debtor for such default puts the functioning of even healthy companies at risk. When the quantum of loan amount is small, it disproportionately targets smaller enterprises.
Another reason for the move is the huge quantum of frivolous applications for initiation of insolvency proceedings. The initial threshold of INR 1,00,000 was too low and was something that the creditors generally misused in bringing the company to insolvency proceedings. The veracity of such applications was questionable but that could be ascertained only at a later stage of the insolvency process. The new threshold of INR 1,00,00,000 looks more agreeable to adjudicating authorities and to creditors genuinely seeking to file their claims under the Code. There are expected to be some adverse effects of classifying all insolvency applications below INR 1,00,00,000 as frivolous, and those concerns will be dealt with in later portions of the article.
The lack of incentives for insolvency professionals is another reason that manifests into the increase in the insolvency default threshold. The insolvency professionals are the ones who are appointed by the adjudicating authority to take over the process of resolving the debts of a company undergoing insolvency. They charge a certain amount, depending on the amount of debt that is to be recovered. The previous threshold was unviable for them, as the insolvency proceedings continue for a relatively long duration, and investing their time and effort for that long a period to receive paltry amounts as remuneration dis-incentivised them. The increase in threshold is a welcome move from their point of view as it allows them to be more involved in the process with the satisfaction that the remuneration that they will be receiving at the end of the proceedings will be commensurate with the time they spend.
The move will have far reaching consequences for creditors, debtors as well as the adjudicating authorities. Broadly, the implications of the move will be palpable in three major ways. Firstly, it will ease the burden on the adjudicating authorities like the National Company Law Tribunals which were burdened with frivolous insolvency legislation even prior to the present economic crisis. The number of these proceedings would have only increased due to the pandemic pandemonium. The threshold raise will bring down the number of proceedings invoked under the Code and aid the tribunals in focusing more on matters of greater commercial significance. In times like these when the functioning of the authorities is limited due to the lockdown, it is beneficial to afford some respite to the adjudicating authorities so that they can focus on more pertinent matters.
The second important implication of the move will be a respite to the MSMEs. The distress caused by the pandemic is going to squeeze resources out of the smaller enterprises and starve them of income. If the threshold were maintained at INR 1,00,000, it would be a death blow to these enterprises. However, there may be an intriguing downside of this reasoning. The claims which do not qualify the revised threshold of INR 1,00,00,000 are not only against the SMEs but also by the SMEs. It is clear that a smaller creditor will have smaller claims. The Code promised to be an expeditious way for enterprises of all sizes to recover their claims. If the threshold remains at the present levels forever, it might end up harming the SMEs in the long run. If the Code does not provide remedies for smaller claims, these claims will have to go for tedious litigations in the courts. This will be inapposite to the intent of streamlining the insolvency regime. It will also be perceived as an unequal treatment as far as small and medium enterprises are concerned. The government needs to examine all facets critically if they are to extend this change beyond the aftermath of the pandemic. There is news that this might be a permanent change, rather than a crisis management manoeuvre.
The third possible effect might give rise to a more financially prudent insolvency regime. It has been noted that low thresholds for invoking insolvency proceedings lead to superfluous litigation and endangers healthy companies. This tendency of creditors to invoke inconsequential claims puts well-functioning enterprises in jeopardy. Although this problem is certainly aggravated by the present crisis, the issue is not limited to the same. Even prior to the present crisis, too many insolvency petitions with too little substance had been plaguing the system. The lower threshold initially made the Code creditor friendly. However, there have been several creditors invoking insolvency proceedings with the sole intent of debt recovery. This is in contradiction to the primary goal of the Code to make insolvency proceedings an opportunity to restructure the corporate debtor and keep it as a going concern. Thoughtless invocations of the Code for recovery of commercially trivial amounts hinder the debtor from existing as a going concern. Therefore, the move is in the interest of a prudent insolvency regime and the country’s growing economy.
An issue presents itself in the form of a lack of clarity with respect to the status of threshold with respect to personal guarantors. The notification by the Ministry of Corporate Affairs, Government of India, did not state anything about the status of personal guarantors under the new threshold. It can be inferred from the notification that the insolvency process for them will continue as per the existing law i.e. on the default of a minimum of INR 1,000, but clarity will have to be sought from the government in this regard. In purely numerical terms, a hundred times raise in the threshold is a significant change, and it becomes essential to understand the implications that the move is going to have on different stakeholders and, more broadly, the economy.
Lastly, the move may mean disaster for some operational creditors. The Code strives to strike a balance between both classes of creditors. However, the raised threshold is expected to disproportionately affect operational creditors seeking to petition against corporate debtors. The explanation to Section 7 of the Code posits that two or more financial creditors may come together and bundle their claims to satisfy the threshold required to institute proceedings, though no such provisions exist for operational debtors. Coupled with the fact that the very nature of operational debt is such that individual claims will rarely exceed the INR 1,00,00,000-mark, the raised standard will be a major handicap for operational creditors. Since its inception, the Code has been criticised for its differential treatment of financial and operational creditors. The operational creditors will be forced to use other legal mechanisms to recover their dues which will bog down the corporate debtor as well. It is imperative to balance the interests of economic expediency and those of the creditors. On the whole, the move will be respite to the distressed enterprises struggling to keep themselves as a going concern, but if the change is here to stay, these concerns must be addressed.
To conclude, the authors iterate that the increased threshold has several outstanding implications not just in the near future but also in the long run. The present economic crisis needs measures like these which safeguard the interests of the small and medium enterprises in the face of financial destruction. However, it is critical to carefully weigh in the drawbacks of the new policy before it is extended beyond the present circumstances. A fair insolvency regime will balance interests of economic prudence, creditor rights, and legal expediency judiciously.