Why the IBC ordinance to suspend insolvency pleas for six months, spells trouble

For corporates caught in the Covid led crisis, the recent amendment to Insolvency and Bankruptcy Code (IBC) promulgated through an ordinance offers respite. Essentially the amendment has suspended fresh insolvency proceedings against a debtor for a default occurring on or after March 25, for a period of six months (can be extended upto one year). While the move may offer relief to stressed companies, certain provisions in the amendment can spring unwarranted consequences and open up the possibility of gross misuse of the leeway by wilful defaulters and fraudulent promoters.

By exempting Covid related defaults from insolvency under IBC permanently, not addressing the issues faced by operational creditors or financial creditors other than banks and financial institutions (not coming under the purview of the RBI moratorium) and closing the door on corporate debtor to voluntarily file for insolvency, the IBC ordinance spells some trouble.

What it says

Taking cognisance of the widespread impact that the Covid is having on businesses and the disruption post the national lockdown, the IBC amendment has suspended Section 7, 9 and 10 of the Code, to prevent companies from being pushed into insolvency.

Section 7 of the IBC pertains to the initiation of the insolvency process by a financial creditor, while Section 9 covers insolvency plea by an operational creditor – supplier, employee and workman. Section 10 of the IBC comes into play when the corporate debtor files for insolvency.

A new section 10 A has been inserted in the Code which states that no insolvency application will be filed for defaults arising on or after March 25 for a period of six months (can be further extended upto one year).

This is line with the announcement made by the finance minister, Nirmala Sitharaman in March when the threshold for initiating insolvency proceedings was increased to Rs 1 crore (from Rs 1 lakh). The finance minister had stated that fresh insolvency pleas will be suspended if the situation so warrants.

With the Covid situation only worsening and hitting businesses hard, the move to suspend IBC proceedings has been on expected lines. The FM’s statement that it is empowered to remove Covid-19 related debt from the definition of ‘default’ under the Code for the purpose of triggering insolvency proceedings, has also been covered under the amendment. The amendment has imposed a blanket ban on initiating insolvency proceedings against all defaults arising post March 25 (from when the lockdown was in force) for a period of six months (can be extended upto one year). This removes the ambiguity over what constitutes ‘Covid related defaults’, as it would otherwise have been a herculean task to draw a distinction between specific Covid led defaults and others.

But certain other provisions in the amendment have caused unnecessary confusion and run the risk of gross misuse.

What does ‘forever’ mean

What is really raising concerns among legal experts is the permanent ban on insolvency proceedings against Covid related debt. A provision in the newly inserted Section 10 A states that ‘no application shall be ever filed for initiation of corporate insolvency resolution process of a corporate debtor for the said default occurring during the said period’.

On the face of it, this implies that defaults occurring post March 25 for a period of six months or one year, will be exempt from insolvency under IBC permanently. This raises grave concerns and questions.

One, companies could use this leeway and default during this period (even if they have the propensity to pay their debts) and escape insolvency forever. This could do more harm by allowing fraudulent promoters and wilful defaulters to game the system.

It is also unclear as to how a default during the six month period or one period that remains a default (unless the debtor repays during this period) after the exempted period, can escape insolvency. After all, once the moratorium granted by banks or NBFCs ends, the debtor will have to repay the revised monthly instalments (after incorporating the accumulated interest) or the existing instalment (over longer revised tenure). Failure to do so should ideally give financial creditors the power to proceed against such debtors.

But the wordings of the provision sends across a different message which can be misinterpreted as a lifetime holiday for defaulters during the exempted period.

Other concerns

The suspension on insolvency runs hand in hand with the six-month moratorium (March 1 to August 31) granted by banks, NBFCs and other financial institutions to borrowers and RBI’s asset classification standstill on such accounts. Hence with fewer accounts slipping into NPAs for banks and NBFCs during the moratorium period, the need for filing insolvency in such cases would be low.

But this does not address the issue of other financial creditors or operational creditors. For instance, what happens to bond holders where moratorium does not apply or in case of inter-company loans? In such cases, the IBC amendment closes the door for initiating insolvency in case of default.

Similarly for operational creditors who could be suppliers to the corporate debtor, there is little recourse under IBC, in case of default. Many of these operational creditors could in turn be MSMEs (for whom the suspension on insolvency and increase in threshold limit for filing a plea was brought in the first place) who may be left in the lurch now.

Suspending Section 10 of the Code will also hurt businesses stuck in the vicious cycle of debt and wanting to exit. Remember this section in the Code allowed corporate debtors to file for insolvency themselves, in case of a default. Suspension of this provision could hurt businesses, finding it difficult to recover from the Covid impact, by not giving them a viable exit option.