Understanding MSME from the Lens of IBC

Micro, Small and Medium Enterprises (MSME's) are basically small-sized business units defined in terms of their investment. MSME(s) are governed and regulated by The Micro, Small and Medium Enterprises Development Act, 2006 which classifies MSME's into two classes, namely, service and manufacturing. Micro, Small, and Medium Enterprises (MSMEs) have been an undeniably important part of the Indian economy for decades. MSMEs are often referred to as the 'power engines of the economy', for generating the largest employment opportunities at comparatively lower costs. The Micro, Small & Medium Enterprises Development Act classifies MSMEs into two classes: Service and Manufacturing. Manufacturing enterprises engage in producing or manufacturing goods in any industry while service enterprises are engaged in providing support & services. MSMEs are basically small-sized business units defined in terms of their investment. The Micro, Small and Medium Enterprises have unequivocally been an integral part of the Indian Economy for decades now. 

The Central Government through the Union Ministry of Micro, Small and Medium Enterprise has issued a Gazette Notification S.O. 2119(E) dated 26 June 2020 for implementation of the upward revision in the definition and criteria of MSME(s). As per the said gazette notification, the new definition and criterion for MSME(s) have come into effect w.e.f. 1st July 2020.

Now the criteria is not divided between the two categories viz. manufacturing and service industry but a composite criterion is provided without any difference. Under the said Gazette Notification, it is also specified that the procedure for filing the memorandum for MSME will now be known as “Udyam Registration” The notification also provides for registration of MSME(s), grievance redressal of enterprises etc.

 

The Insolvency and Bankruptcy Code, 2016 was enacted in the year 2016 to provide comprehensive consolidating legislation concerning insolvency and bankruptcy in India. The Insolvency and Bankruptcy Code provides a comprehensive framework for the Resolution of Insolvency and Bankruptcy of Corporate persons, LLP, Individuals, Partnerships, and Sole Proprietorship Firms in a time-bound manner for maximization of value of assets. The Code, however, doesn't offer any express or distinct resolution process for MSMEs. Most MSMEs under being a partnership or proprietorship firms, have to resort to the standard Corporate Insolvency Resolution Process. However, these enterprises are excluded from the implications imposed by section 29A of the code. The legislative intent behind the insertion of Section 29A in the Code was to prevent defaulting persons, including the promoters, from buying back the corporate debtor, which could occur potentially at steep discounts to the grave prejudice of other stakeholders. Hence, this is the exact reason why only limited exemptions have been granted under section 240A in a purely contextual purpose of the Code, and the importance of MSME(s) in the Indian economic paradigm. The aims and objectives of the Code explicitly specify that the Code is enacted with the purpose of, inter alia, consolidation of laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms, and individuals in a time-bound manner for maximization of value of assets of such persons. For this purpose, a Resolution plan under section 5(26) of the Code is designated to be the ‘way-out’ for insolvent entities coming under the Code.

In the case of Chitra Sharma and Others v. Union of India and Others, REED 2018 SC 08562, the Hon’ble Apex Court remarked, “The Court must bear in mind that section 29 A has been enacted in the larger public interest and to facilitate effective corporate governance. Parliament rectified a loophole in the Act which allowed a back-door entry to erstwhile managements in the CIRP” and has ruled that strict adherence to section 29A is mandatory and those wilful defaulters shall not be permitted to participate in the CIRP as the court held, ‘To allow them to participate in the process of resolution will render the provisions of the Act nugatory. This cannot be permitted by the Court.’

In the case of Swiss Ribbons v. Union of India, REED 2019 SC 01504, it was remarked, “The Insolvency Code is a legislation which deals with economic matters and, in the larger sense, deals with the economy of the country as a whole.” While added that,” would also show that the legislature is alive to serious anomalies that arise in the working of the Code and steps in to rectify them.”. The court noted that “It can thus be seen that when the Code has worked hardship to a class of enterprises, the Committee constituted by the Government, in overseeing the working of the Code, has been alive to such problems, and the Government, in turn, has followed the recommendations of the Committee in enacting section 240A”

In the abovementioned matter, the court also observed that “To stay experimentation in things economic is a grave responsibility, and denial of the right to experiment is fraught with serious consequences to the nation” on the question of the experiment contained in the Code, judged by the generality of its provisions and not by so-called crudities and inequities that have been pointed out by the petitioners, in the Swiss case which was with a line of the case the United States Supreme Court in Secretary of Agriculture v. Central Roig Refining Company, 94 L Ed 381: 338 US 604 (1950), wherein the court held, “Every legislation, particularly in economic matters is essentially empiric and it is based on experimentation or what one may call trial and error method and therefore it cannot provide for all possible situations or anticipate all possible abuses. There may be crudities and inequities in complicated experimental economic legislation but on that account alone it cannot be struck down as invalid.”

The Central Government recently promulgated the IBC Amendment Ordinance 2021, allowing a pre-packaged insolvency process for micro, small and medium enterprises (MSMEs), in consonance with international best practices. The Central Government has promulgated Insolvency and Bankruptcy Code (Amendment) Ordinance 2021 to allow pre-packaged insolvency process for MSMEs for pandemic-hit micro, small and medium enterprises (MSMEs), which will be completed within 120 days. The pre-packaged, informal, hybrid and debtor-driven pre-insolvency process, called ‘pre-pack’, will operate under the Insolvency and Bankruptcy Code and is used in overseas jurisdictions like UK, US & Singapore.

This amendment, in essence, has amended the Insolvency and Bankruptcy Code 2016 and allows the Central Government to notify such pre-packaged processes for defaults of not more than Rs 1 crore. The government had been looking to offer a pre-packaged resolution framework for stressed companies under the IBC. A pre-packaged resolution essentially translates to a company preparing a restructuring plan with its creditors before initiating insolvency proceedings. This helps to cut down the time and costs in the overall process.

A new chapter III-A has been inserted in those deals with the pre-packaged insolvency resolution process. The second amendment to the code. w.e.f. 6th June 2018, which included amendments to section 29A, which was itself inserted through an amendment to the code which was added with a retrospective effect from November 23, 2017. Section 29AA of the Code provides for the persons who are ineligible to be Resolution Applicant(s) and thus, forms an important criterion of eligibility to submit a Resolution Plan. The committee thought it fit to grant exemptions to corporate debtors which are MSME(s), by permitting a promoter who is not a wilful defaulter or covered under any other specific disqualification as provided under section 29A, to bid for the Resolution Plan of an MSME. The recommendation relating to the exemption of MSME under section 29A enumerated that, a new section namely section 240A in the Code be inserted, which specifically exempted resolution applicants from the ambit of section 29A, and paved the way for them to submit Resolution Plans for MSME(s) that are undergoing Corporate Insolvency Resolution Process. Thus, the Ministry of Law and Justice through the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, inserted section 240A in the Code. Section 240A specifies that clauses (c) and (h) of section 29A shall not apply to the resolution applicant in respect of CIRP of any MSME.

However, it is important to note that Promoters of MSME(s) may try to take undue advantage of the enacted legislation. Therefore, the following persons are prohibited from submitting a Resolution Plan under the Scheme of the Code, including, MSME(s): 

• Any person, who is declared an insolvent [U/S 29A(a)], 

• Any person who is a wilful defaulter in terms of the RBI Guidelines issued under the Banking Regulation Act, 1949[U/S 29A(b)], 

• Any person who has been convicted for any offence punishable with imprisonment for two years or more under specified Acts; or for seven years or more under any law for time being in force [U/S 29A(d)], 

• Any person who is disqualified to act as a director under the Companies Act, 2013[U/S 29A(e)], 

• Any person who is prohibited by the Securities and Exchange Board of India (SEBI) from trading in securities or accessing the securities market [U/S 29A(f)], 

• Any person, who has been in the management, control or promoter of a Corporate Debtor in which a preferential transaction, undervalued transaction, extortionate credit transaction or fraudulent transaction has taken place and in respect of which an order has been made by the Adjudicating Authority under the Code. [U/S 29A(g)], & 

• Any person who comes within the purview of a connected person [U/S 29A(j)].

The Insolvency and Bankruptcy Code, provides relaxations to MSMEs, vide section 240A as the section expressly says that, the provisions of clauses (c) and (h) of section 29A shall not apply to the resolution applicant in respect of corporate insolvency resolution process or pre-packaged insolvency resolution process of any micro, small and medium enterprises. The sections say that the Central Government may, in the public interest, by notification, direct that any of the provisions of this Code shall— (a) not apply to micro, small and medium enterprises; or (b) apply to micro, small and medium enterprises, with such modifications as may be specified in the notification wherein the term “micro, small and medium enterprises” in this section shall mean any class or classes of enterprises classified as such under sub-section (1) of section 7 of the Micro, Small and Medium Enterprises Development Act, 2006 (27 of 2006).

The Insolvency Law Committee Report of March 2018 had recommended the grant of certain concessions to MSMEs due to their vital role in the economy.  Section 240A gives power to the Central Government to notify any non-application of provisions of the Code to MSMEs and under such power, the provisions of section 29A (c) to (h) have been exempted from applying to MSMEs.

Although the MSMED Act addresses the issue of delayed payment, the said process has been highly questionable owing to the enforceability of the awards passed by the council. The MSMED Act provides speedy recourse through the council to resolve pending issues. The IBC is not a mechanism for the recovery of dues but the resolution of disputes between the parties. MSMEs aren't in every case the 'Corporate Debtors' as is often wrongly assumed. In a vast number of insolvency cases, these MSMEs act as the 'Operational Creditors'. There is a disadvantage associated with the IBC whereby the debtor may undergo liquidation and as per the waterfall mechanism, the Operational Creditor may receive close to nothing. With the suspension of sections 7, 9, and 10, causing financial stress apart from the economic slowdown caused by the pandemic, the MSME’s can still avail the benefits of the MSMED Act to assure that some amount of recourse is provided by way of debt recovery.

Conclusion

MSME insolvency shall be a crucial aspect of the entire Insolvency regime especially in countries like India where development is majorly backed by such enterprises. To mitigate these teething troubles, the hectic procedure and formalities must be scrapped or replaced with more efficient electronic noticing and submission practices. The pre-pack will act as an efficient alternative insolvency resolution process for corporate persons classified as micro, small and medium enterprises under the Insolvency and Bankruptcy Code and ensure quicker, cost-effective and value maximising outcomes for all the stakeholders, in a manner that is least disruptive to the continuity of their businesses and which preserves jobs, the ordinance added.

Section 29A of the Insolvency & Bankruptcy Code, 2016 (IBC) makes certain persons ineligible to buy the assets of the insolvent corporate debtor, since they are either undesirable or have, due to their misconduct in the past, contributed to the present insolvency of the corporate debtor. It is pertinent to analyse the relevance of section 29A in the recently promulgated Insolvency & Bankruptcy Code (Amendment) Ordinance, 2021 (the “Pre-Pack Ordinance”) which introduced pre-packaged insolvency resolution process only for corporate debtors, registered as micro, small & medium-sized enterprises (MSMEs) under the Micro, Small and Medium Enterprises Development Act, 2006. The author believes that, due to a minor drafting error, the applicability of section 29A to the Pre-Pack Ordinance remains unclear, but can be conveniently rectified by changing the wording of the law. According to section 29A(c) of the IBC, if, at the time of submission of the resolution plan, a person (or concert party) has an account or an account of the corporate debtor under the control of such person or a promoter and such account has been classified as a non-performing asset by the Reserve Bank of India (RBI) and at least one year has passed from the date of such classification until the commencement of CIRP, then such person would be ineligible to submit the resolution plan under IBC. Further, according to section 29A(h) of the IBC, if a person (or any concert party) has executed a guarantee against the debts of the corporate debtor, which has been invoked but the debt remains unpaid either fully or partially, then such person would be ineligible to submit the resolution plan. In essence, these two clauses of section 29A disqualify the erstwhile promoters of the corporate debtor from re-entering the fray and buying the assets in the CIRP.

The introduction of the Pre-Packaged route is a step further in strengthening the Indian insolvency resolution framework. Creating an alternative mechanism that is not as time-consuming or costly serves to promote the objectives of the IBC in achieving a quicker and smoother resolution of distressed assets. While it is only limited to MSMEs at the moment, in the event the IBBI plans to roll out Pre-Packaged insolvency for other corporates as well, it should be kept in mind that the success/failure of the same with MSMEs should be not treated as an indicator of how the same will play out with all corporates. MSMEs serve as a distinct group of enterprises and have provisions such as section 240A protecting them. Further, the current deliberations on the introduction of a Special Insolvency Resolution Process (SIRP) indicate that the legislature intends to create a very tailored approach to MSMEs due to the special nature of the industry and its importance to the Indian economy.