We must make insolvency pre-packs work for MSMEs

Pre-packaged insolvency resolution processes, or pre-packs, were introduced to India’s Insolvency and Bankruptcy Code (IBC) in April 2021 with the goal of giving micro, small and medium enterprises (MSMEs) a fast, cost-efficient and effective way to resolve financial stress.

Debtors and creditors are expected to put an early effort into resolving a troubled MSME’s liquidity problems quickly. The pre-insolvency regime is especially important for MSMEs, which have simple business structures and can’t absorb sudden disruptions. Pre-packs were introduced with covid having paralysed the sector. Their performance so far, however, has been abysmal.

The present scheme of pre-packs is daunting. The pre-admission stage needs 11 sub-processes to be ticked, and if the debtor is admitted, there are myriad process flows to be adhered to. Such a complex process is difficult to execute for financially sound businesses, let alone those in distress. This has led to today’s state of affairs, with just 17 cases underway (as of 2 February 2024) even after nearly three years of being introduced. A review of cases reveals that only four plans have been approved of the nine admissions. The cases that were admitted took an average of 483 days in the insolvency process.

The pre-insolvency process faces several challenges. There is a stigma associated with insolvency. Also, a vast number of MSMEs are non-corporates, beyond the purview of the legislation. The pre-pack pre-supposes that debtor businesses are sophisticated enough to undertake the processes envisioned. This is not the reality for a vast majority of insolvent MSMEs.

A systemic problem has been low awareness. Creditor passivity hampers the process. Banks are keen to restructure loans under prudential guidelines or the government’s credit guarantee scheme. Else, they always have the recovery option under the Sarfaesi Act. Time and costs are critical denominators, considering the size of the businesses and internal procedures.

Then there is the ‘trust’ in a creditordebtor relationship that erodes when businesses face distress. Some businesses, it seems, proposed the process only to evade legal demands, leading to wastage of judicial time. Finally, it may be wishful to expect a business owner to initiate the process, given the possibility faced of losing ownership to an alternate party with a better plan.

The valuation of businesses often fails to include intangibles such as promoter goodwill capital. Business distress quickly devalues enterprise value, which can lead promoters to suppress negative information. This is complicated by the fear of having to vest management elsewhere, avoidance actions and their repercussions. There are attendant risks with litigation costs if the process ends without resolution.

The objective of a prepack is meant to be resolution that is “fast, cost-efficient and effective,” and not always value maximization.

In essence, pre-packs are hybrid, as they combine informal workouts with formal proceedings. As their aim is to help economic activity continue, the process needs to be simple. Stigma should be addressed by rechristening the process so that ‘insolvency’ is not mentioned, with a narrative focused on giving entrepreneurs a chance to make a fresh start. We also need more education on the concept through MSME associations and professional platforms.

Costs also need to be rationalized to reduce hesitancy. Illustratively, the resolution professional’s fee could be a mix of fixed and performance-oriented components and the requirement of authorized representatives could be dispensed with. Insolvency costs could be covered by a centralized fund to incentivize MSMEs to take the risk of pre-pack failure.

Pre-packs need not mirror the usual insolvency resolution processes. We can do away with third-party plans, the need to vest management apart or make selfdeclarations of avoidance transactions. A failure to restructure debt does not infringe the creditor’s right to alternate remedial actions.

The role of resolution professionals should be expanded. They can act as mediators, debt-counsellors and restructuring and turnaround specialists. The focus should be on

“identifying and reacting to the debtor’s financial distress and on taking immediate action to stabilize the enterprise.”

Businesses in distress need operational solutions along with reworked debt. Insolvency professionals are bound by codified covenants of independence and impartiality. They must act as ‘friends of the stakeholders’ and so their appointment should require the mutual consent of debtors and creditors.

Debtor-friendly insolvency laws for MSMEs would provide a safety net for entrepreneurs. If MSME debtors are granted concessions, entrepreneurs are less likely to be deterred from pursuing business ventures by the fear of insolvency, knowing that they could quickly recover from their mistakes or market reversals and re-enter the marketplace. An inherent advantage of a pre-pack is that personal guarantees cannot be invoked and a creditor takes a haircut now in the expectation of future benefits once the business is operational.

As other measures to promote pre-packs, the central bank may allow relaxed provisioning for financial institutions. Government rescue grants, subsidies or corrective action plans could also be routed through pre-packs. We need a formal, well targeted and professional mechanism.

These offer a good way of settling distress cases although policy tweaks are needed for their success