Can IBC Pre-packs be the “Six Packs” for MSMEs?

By Sanjiv Rathi

Under the Insolvency and Bankruptcy Code, micro, small, and medium businesses will now be able to choose a pre-packaged insolvency resolution. The step comes shortly after the government's one-year moratorium on insolvency filings was lifted in the wake of the Covid-19 pandemic. Last year, the government raised the default amount for insolvency proceedings from Rs. 1 lakh to Rs. 1 crore. No insolvency proceedings against the MSME can be started when the pre-pack process is in progress. Instead of a formal competitive bidding process, a pre-pack is the settlement of a distressed company's debt by an arrangement between secured creditors and investors. Over the last decade, this system of insolvency proceedings has grown in popularity as a means of resolving insolvency and have operated on this fundamental premise in jurisdictions such as the United Kingdom, the United States, Singapore, and Germany in one form or the other.

Applicability of Prepacks:

• MSMEs only , as per the definition under MSMED Act
• Actual Default by MSME Corporate Debtor (CD)
• Minimum Threshold Default of Rs. 10 Lacs by MSME CD

The key features of the Scheme are as follows:

Prepacks- When and by Whom?

If members of the MSME have approved the proposal by a special resolution, a pre-pack can be started. In addition, 66 percent of unrelated financial creditors by value must have agreed to a pre-pack settlement.

The proposal has to be Section 29A compliant. Promoters of non-performing assets, wilful defaulters, and any other types of people are prohibited from presenting a resolution plan for a corporate debtor under Section 29A.

If a pre-pack phase is started with the intent to defraud, or MSME handles the affairs in such a way that the creditors are defrauded, there are penal provisions.

How the Process Works?

When a pre-pack phase is in progress, there will be a moratorium. Within 120 days, the procedure must be completed. The MSME's promoters and directors will continue to manage and monitor the company throughout the pre-pack period. The company's management of affairs will be monitored by the resolution professional.

After seeking court approval, the committee of creditors will vest the management with the resolution professional with a 66 percent vote. If the MSME qualifies under Section 29A, it must submit to the resolution professional a base resolution plan.

Approval of Resolution Plan

The resolution professional will invite prospective applicants to send a competing proposal if the MSME's plan is rejected by the Committee of Creditors (CoC) or if operation creditors' dues are affected. These applicants would also have to comply with Section 29A. Such applicants will benefit from Section 32A, which states that they will not be held accountable for previous management's conduct.

After assessing the plan's feasibility and profitability, 66 percent of financial creditors by value will approve it. The CoC will also have to consider the proposed method of distribution, taking into account the order of priority among creditors, as well as the priority and importance of a secured creditor's security interest. The CoC may direct the corporate debtor's promoters to dilute their shareholdings, voting rights, or control rights.

There is a business case for easing the Section 29A mandate for pre-packs. Because of the direct conflict between promoters and creditors' interests, the insolvency process has been extremely litigious. Pre-packs are meant to be less formal and not a rigid, statutory platform for resolving pre-insolvency situations.

Prepacks Insolvency Resolution Process (PIRP) Vs. Corporate Insolvency Resolution Process (CIRP)

One of the most common critiques of the CIRP has been the length of time it takes to resolve cases. Almost 90 percent of the pending insolvency resolution proceedings had reached the 270-day mark by the end of December 2020. Prolonged litigation by former promoters and prospective bidders is one of the main causes of CIRP delays.

An interesting question arises what happens in case of simultaneous proceedings under PIRP and CIRP? It has been clarified by Section 11A of IBC as follows:

Perhaps the most valuable aspect of PIRP is that a settlement can be reached when a defaulter is still operating. If the insolvency process drags on too long, asset values will quickly depreciate, forcing lenders to forego a greater portion of their loans.

The pre-pack, on the other hand, is limited to a period of 120 days, giving stakeholders just 90 days to submit a resolution plan to the NCLT.

A lot of homework need to be done even before the PIRP starts (Pre NCLT) ranging from getting agreement of Financial Creditors, identifying and shortlisting the resolution Applicant to Identification of Avoidance Transactions.

Another significant distinction between pre-packs and CIRP is that in pre-packs, current management maintains control, while in CIRP, a resolution professional assumes control of the debtor as a representative of financial creditors.

We're back to the debtor-in-possession paradigm in a pre-pack, where the defaulting promoter or management may bid. Only for MSMEs have pre-packs been announced as of now. MSMEs do not have the resources to compete for distressed assets in the same way that larger companies do. They're also excluded from the IBC's Section 29 A, which prohibits defaulting promoters from bidding on their own assets.

Pre-packs are primarily intended to provide MSMEs with the ability to restructure their obligations and start over with a clean slate, while also providing sufficient safeguards to ensure that the scheme is not abused by businesses to escape paying creditors. The central government's pre-pack provisions have included sufficient safeguards to ensure that the provisions are not abused by rogue promoters. The pre-pack process provides for a Swiss challenge for any settlement proposals that result in less than complete payment of operating creditors' debts. Any third party could propose a resolution plan for the distressed business under the Swiss challenge framework, and the original applicant would have to either match the better resolution plan or forego the investment. If creditors are dissatisfied with the promoter's resolution strategy, they have the option of seeking resolution from any third party.

When this scheme is expanded to include large companies, new problems can arise. Will the debtor-in-possession paradigm still be acceptable to lenders? If this is permitted, we will be back to square one in terms of bad asset resolutions, i.e., the days of promoter entrenchment. One of the major disadvantages of pre-packs is that they may be abused by sweetheart deals even after.

The nature of a pre-packaged insolvency resolution process is that a resolution plan is agreed in advance between the CD and the creditors, and then sent to the AA for approval. Where the base resolution plan has not been accepted by the CoC, or Operational Creditors (OC) claims have been undermined, the RP can invite plans from outsiders.

The resolution Plan cannot provide for impairment of OCs’ claims –Hence, PIRP is essentially designed to restructure claims of Financial Creditors only.

Nonetheless, if the CoC believes that the CD's affairs are being grossly mismanaged or operated in a dishonest manner under the DIP Model, section 54J (1) empowers the CoC to decide, with the approval of at least 66 percent of its members, to transfer management control from the Board to the RP, i.e. a shift from the DIP to the Creditors-in-Possession ('CIP') Model. Following such a resolution, the RP must submit an application to the AA, who must accept or deny the application in accordance with section 54J (2) of the Ordinance. Given that the DIP solution is not definite, and is subject to non-action by the CoC, it appears to be the sole motivator for choosing PIRP over the alternative modes, implies that the ultimate decision whether the management shall continue to vest with the CD is subject to the judgment of the CoC. As a result, by getting admitted in PIRP, the CD is exposing itself to the risk of losing management power – the CD is not able to prevent the CoC from demanding a management change.

Why would a Financial Creditor go for Prepacks instead of Other Alternatives of resolution?

The benefits of a structured scheme - under the Code, the benefits of a moratorium and washout of all pre-PIRP liabilities - are the primary motivator for a pre-packaged scheme. It's worth noting that, in a traditional CIRP, a resolution proposal restructures Operational Creditors’ claims in such a way that the Financial Creditors just have to bear a residual haircut, with the added advantage of a binding effect on all stakeholders, understandably preferable to Financial Creditors. The rider under section 54K of the Code, however, states that the Base Resolution Plan does not hinder OC claims, leaving only FC claims to be restructured, appears to be restrictive from the point of view of the FC. Therefore this raises a big question mark, why would the FC support PIRP over an OTS or even CDR with its additional risk of liquidation of CD?

The OTs and CDR is purely an exercise between the CD and the FC and there is no looming threat of loss of Control, whereas under PIRP there is a looming risk of change of management, and above all the probability of drastic step of liquidation could make the PIRP almost a non-starter.

The OTS and CDR are alternatives available in the hands of FC, therefore there has to be a strong case for preference to PIRP over the other alternatives, which does not appear to be so, in the current form of Prepacks at least. More will need to be done before MSMEs are able to flaunt the Prepacks as their “6 Packs”.