This article is written by Molika Garg, pursuing a Certificate Course in Insolvency and Bankruptcy Code from lawsikho.com.
This article gives an insight on Insolvency and Bankruptcy being a structured ladder going downwards with least chances of revival as it touches the rock bottom of liquidation/ winding up for the Individual or corporate. It further elaborates on the type as well as factors causing the Insolvency & Bankruptcy.
Insolvency is an unfortunate fact of life, whether Personal or Corporate. Insolvency is a state wherein the Liabilities > the Assets and there is inability to repay the debts. Before an Individual or Corporate gets in Insolvency Proceedings it’s likely that they are involved in informal settlement with the Creditors of both Operational and Financial nature. Insolvency can arise due to improper cash management or increase in expenses over income generated in the longer run. It’s a stage when an Individual or a Corporate has crossed the delinquency timely in case of Financial Creditors or defaulted on the due date payments in case of Operational Creditors against the supplies or facilities availed.
Insolvency is a state of economic distress. It can lead to bankruptcy if the insolvent party is unable to successfully address its financial condition. Insolvent companies can reverse course by cutting cost, selling assets, borrowing money, renegotiating debt and allowing themselves to be acquired by a larger corporation via acquisition or amalgamation etc.
Bankruptcy is when an Individual or corporate is unable to pay off its liabilities and debts then he files for bankruptcy and then he seeks assistance from govt. or bodies of government to pay off his debt to the creditors. Bankruptcy is a court order that decides how an insolvent debtor will deal with his unpaid liabilities.
Liquidation is when the business is brought to an end and the assets are distributed to the creditors/claimants. This is the last step after this the dissolution of the company is executed.
The chance of revival of an Individual or a Corporate increases with early detection of symptoms for Insolvency thus the government of India brought in the Insolvency and Bankruptcy Code 2016 under Insolvency and Bankruptcy Board of India with Adjudicating Authority of NCLT and Appellate body NCLAT.
Thus we can easily state that:
It’s more like a ladder where the business steps from one step down towards the next and if needed corrective actions and revival plans are not initiated it leads to closure of the business.
Factors contributing to insolvency
- Cash Flow Management: Is the management of operating expenses and generating operating revenues to meet the cash flow requirements of working capital. When there is skewness towards the expenses and the revenue generated is having diminishing margins this directly starts hampering the working capital flow and is one of first indicators wherein the corrective actions need to be taken by management else it leads to Insolvency.
- Working Capital Structure:
- Vendor Costs & Payment Terms: Another aspect of working capital is the Vendor management, how we are assuring the quality, timelines and payment terms with competitive rates impacts the solvency status of the company.
- Customer Credit Cycle: Herein if we have customers paying in advance the cash flows are better managed, but the situation gets grim when there is an allowance of credit period which also creates bad and doubtful debts.
- Debt/ Borrowing Structure: The insolvency is triggered faster when the rate of interest at which the capital is borrowed is higher than the margins earned.
- Human Resource Structure: It is a major point of contention as human resources, if not placed at the right position with the right work structure, can cause damage to the entire planning and execution. The main resistance also comes from this factor in case of any change caused due to working capital management.
- Technology and R&D Expenditure: The cost is capitalized in the longer term, thus the business structure and investment in this factor has to be proportioned in the right mix, otherwise this becomes detrimental.
- Sales & Marketing Expenditure: When the expenditure under this head is higher than the expected revenue generation then it causes direct impact on the working capital.
- Decline in Revenue: This factor is dependent on a lot of other factors but when this declines it causes cash flow insolvency.
- Management Adequacy: Lack of Knowledge of promoters and senior management, size and age of the firm and experience of the management are also the factors that contribute to the insolvency factors of a company.
External Factors: The business is not only impacted by Internal Factors, but external factors also have a wider impact.
- Economic Climate: Currency Fluctuations, Export Import Policy Changes, Govt Duties and Taxes, Economic Slowdown etc.
- Related Industry: Increase in demand for Substitute product, Decrease in Supply of Raw Material, Competition Price Decline etc.
- Hazards: Pandemics like COVID-19, Natural Calamities etc.
Types of Insolvency:
- Cash Flow Insolvency: It is when a person or company has enough assets to pay what is owed, but does not have the appropriate form of payment. For example, a person or company may have large house property or commercial property and movable assets like Vehicles, but do not have enough liquidity to pay debt when it falls due.
- Balance Sheet Insolvency: It is when a person or company does not have enough assets to pay all their debts.
Types of Bankruptcy:
- Reorganization Bankruptcy: Extension of Repayment Terms (Time limit).
- Liquidation Bankruptcy: to sell assets to pay off the loans of the creditors.
Impact of amendments on the downward slope
- The latest amendment on 24.03.20 made in section 4 of IBC, 2016 the threshold to initiate Corporate Insolvency Resolution Process has increased from Rs. One lacs to Rs. One Crores. This has not only put the creditors on the back foot but also given a loop-hole wherein the detection of solvency status of a Company will be hidden for a longer period and the chances of revival will become tougher.
For e.g. when the threshold was Rs. One Lacs and if a company was unable to clear a small amount then the entire system was alerted and the management of the company would get alarms for taking immediate corrective actions which are internal in nature. But as the threshold is Rs. One Crore thus the management will also be alarmed at later stages where the situation for revival might not be easier. Thus this change in threshold will cause a long term impact on the revival chances of companies in the near future.
- Amendment in case of Home Buyer as Financial Creditors the threshold that 10 percent of the total financial creditors or 100 financial creditors in number of the Project (whichever is lesser) The Second Amendment Act, 2020 empowers even a single homebuyer cannot file an application under the code against the builder. Rather for an allottee to file an application he has to meet the criteria laid down.
Now for e.g. in case of builders how will one allottee know that how many individuals are stuck in such a scenario, this has created a big dissatisfaction amongst the buyers and has a spiral impact on the economy as the buyers are failing in repayment of their debts as their money is stuck and they are paying rentals also, which is causing personal/ individual insolvencies at a higher rate. With the impact of COVID-19 the job losses will further add on as a detrimental factor.
If we look at this amendment from the perspective of the Builder, he might take corrective actions if smaller chunk of buyers put up the appeal and try to find solutions of repaying or giving the flats by arranging capital at small level and complete the construction, but as the size and quantum increases of the creditors, the builder will also have less chances of revival and this will further give a downward ladder towards bankruptcy.
The government has brought in Insolvency and Bankruptcy Code 2016, with all hopes to revive the companies and create a Business Friendly Atmosphere where entry and exit barriers are minimized and the scope of continuous growth is always a long term vision. Taking into the factors impacting insolvency if handled by timely trigger or alarms the situation at whole can be managed in a better manner. But with the various amendments that have been introduced in recent times, the essence of the whole vision towards IBC is seemingly going on a downward ladder that is why businessmen like N.R. Narayan Murthy commented: “Flagging fears that the country’s GDP growth may even touch its lowest since Independence.”
- Manish Kumar v. Union of India [WP(C) No. 26 of 2020 (Supreme Court)]
- Pioneer Urban Land and Infrastructure Ltd. v. Union of India, 2019 SCC online SC 1005
- Section3 Insolvency and Bankruptcy Code(Amendment) Act, 2020
- Swiss Ribbon Case
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