How to implement pre-packaged insolvency

By Charanya Lakshmikumaran and Puneeth Ganapathy, Lakshmikumaran & Sridharan
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Since last year, the government has been considering introducing pre-packaged insolvency schemes within the framework of the Insolvency and Bankruptcy Code, 2016 (IBC). With COVID-19 severely affecting the credit ecosystem, however, the right to initiate insolvency proceedings under the provisions of the IBC may be suspended for six to 12 months. Pre-packaged insolvency mechanisms should be introduced simultaneously with any such suspension to allow lenders and borrowers in distress to resolve debts quickly and cost-effectively. Whether such mechanisms will apply to existing unresolved cases before the National Company Law Tribunal (NCLT) or only to fresh applications will be known only after the suspension has been formalized.

insolvency
Charanya Lakshmikumaran
Partner
Lakshmikumaran & Sridharan

Pre-packaged insolvency mechanisms are already in use in the UK, the EU and the US. They usually start with an invitation from a distressed corporate debtor to prospective buyers to negotiate and draw up resolution or restructuring plans (RP) before formal insolvency proceedings are started. This has statutory backing and is binding on relevant stakeholders in the debtor. The debtor will pre-empt and prevent its own default, before reaching the stage of entering insolvency under the IBC. This forces the debtor and potential buyers to understand, address and provide for claims in advance, thus avoiding delays during the corporate insolvency resolution process (CIRP) by having to wait for buyers to show interest in the debtor. This additional stage may limit insolvency proceedings to those initiated only with the objective of resolving the debts of a company rather than as a litigation strategy for debt recovery, as often happens. Pre-packaged insolvency schemes have advantages such as confidentiality, time-saving and cost effectiveness.

insolvency
Puneeth Ganapathy
Senior Associate
Lakshmikumaran & Sridharan

There are four key aspects to be addressed in any implementation of pre-packaged insolvency mechanisms. First, when should a debtor be allowed to invite creditors to approve a pre-packaged RP? The goals of such schemes suggest that a debtor may be able to initiate the process before the occurrence of a default. There is a good reason for this as a default may cause involuntary proceedings and defeat the purpose of the scheme. Signs of distress prior to default, such as poor asset-liability ratios and average net revenues, may be good triggers for such debtor invitations. Setting out uniform criteria would ensure that the interests of creditors are secured and would prevent debt-ditching and phoenixing.

Second, there should be a consensus among creditors. A debtor seeking a pre-packaged insolvency resolution may not have the protection of a moratorium as exists in insolvency proceedings. While the trigger for inviting creditors to discuss a pre-packaged scheme will probably occur prior to the default, a default may occur during negotiations terminating the process. Provisions must counter this, for example by requiring the actions of the creditor to be submitted to the committee of creditors or to the NCLT, and giving dissenting creditors a way to exit the process. This will ensure that the process is not derailed by a few creditors.

Third, management of the affairs of the debtor and section 29A disqualification must be considered. Without an independent body taking charge of the management and the affairs of the debtor, interruption to business activity will be minimized. This ensures maximisation of assets and cash flow, and enables debt-servicing during negotiations, thus demonstrating good faith. Pre-packaged mechanisms may avoid the replacement of existing management and this is unlikely to be affected by section 29A of the IBC, which makes certain persons ineligible to submit an RP. If the section were to apply, it would be counterproductive. It is the debtor that initiates the resolution process, but no interest will be generated if ultimately it is the resolution professional (RPro) and not the debtor who negotiates with third parties.

Fourth, preferential and undervalued transactions have to be prevented. In insolvency proceedings, the RPro may apply to the NCLT to avoid such transactions by the debtor. Similar provisions should be introduced for pre-packaged insolvency mechanisms to ensure that creditors are not deceived into agreeing to a pre-packaged RP where distress is anticipated but is caused by deliberate actions or inactions of the debtor. The provisions should calculate the reference period from the date of identification of distress and not the date of invitation by the debtor in order to maximize debtor value.

For pre-packaged insolvency mechanisms to work, the system must achieve the right balance between resolving debts and introducing a means to avoid insolvency-triggering default. Progress towards the achievement of a creditor-friendly environment should not be undermined by its implementation.

Charanya Lakshmikumaran is a partner and Puneeth Ganapathy is a senior associate at Lakshmikumaran & Sridharan.

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