In the evolving corporate ecosystem of India, stringent laws like the Insolvency and Bankruptcy Code (IBC) have reshaped the balance of power, rendering lenders more powerful than traditional equity shareholders.
Today, an increasing number of businesses, especially MSMEs (Micro, Small, and Medium Enterprises) and SMEs (Small and Medium Enterprises), grapple with a legal framework that favours lender control once a company experiences financial distress.
This trend underscores the importance of re-evaluating our approach to corporate default, offering breathing room for genuine businesses to recover, while maintaining strict scrutiny on wilful and fraudulent defaulters.
“Financial distress is not synonymous with fraud; it is a condition requiring remedy, not retribution.”
How Lenders Have Become the New Owners
In the traditional corporate structure, shareholders, represented by their equity holdings, have held significant control over a company’s decisions, guiding its strategic direction. However, with the advent of the IBC, a shift has occurred.
Today, lenders—both institutional and private—play a decisive role in a company’s destiny. The framework grants creditors extensive power in determining the future of distressed companies, often sidelining the interests of shareholders. This phenomenon is particularly visible in sectors where high capital needs and debt obligations are prevalent.
Under the IBC, once a company defaults and a creditor initiates insolvency proceedings, the control shifts almost entirely to the lenders and insolvency resolution professionals (IRPs). This legal structure prioritizes lenders’ rights to recoup their investments, often at the expense of shareholders’ equity stakes. For companies struggling to regain financial stability, this can lead to a change in leadership or forced liquidation—a far cry from the initial purpose of corporate ownership by shareholders.
MSMEs and SMEs: The Vulnerable Middle Ground
India’s MSME and SME sectors are critical to economic growth, contributing significantly to employment and GDP. However, these enterprises frequently operate with limited capital reserves and rely heavily on credit for their survival and growth. With a rigid insolvency framework, a single setback—often influenced by market conditions or policy changes—can push them into insolvency, leaving them vulnerable to the stringent control of lenders.
Unlike large corporations, MSMEs and SMEs lack the financial resources and legal expertise to navigate the complex insolvency processes. For many small businesses, a default does not indicate poor governance or fraud but often reflects unforeseen market fluctuations or short-term cash flow issues. A rigid application of insolvency laws to these entities can lead to the premature demise of otherwise viable businesses, threatening the livelihoods of employees and the overall economic ecosystem.
“For MSMEs and SMEs, insolvency is often a result of circumstances, not a reflection of intent or governance. They deserve a second chance, not a swift exit.”
Default vs. Fraud: Understanding the Nuance
One of the fundamental issues with the current insolvency framework is the failure to distinguish between default and fraud. In the business world, financial distress is not uncommon, and a default on loan obligations does not automatically imply fraudulent intent. However, in a lender-centric framework, defaults are often treated with suspicion, blurring the lines between genuine business setbacks and deliberate deception.
Financial challenges can arise from various factors, including economic downturns, regulatory changes, or disruptions like the COVID-19 pandemic. In these situations, companies need adequate time and support to stabilize their operations. Equating all defaults with fraudulent activity creates a hostile environment for business owners and discourages entrepreneurship.
The Need for Breathing Room: A Case for Grace Periods and Tailored Policies
For genuine businesses experiencing temporary financial distress, stringent recovery timelines can lead to forced insolvency rather than enabling recovery. One solution to this issue is the introduction of grace periods and restructuring opportunities, especially for MSMEs and SMEs. Creating a framework that allows for temporary relief and provides customized solutions based on the size and nature of the business could support companies in overcoming short-term challenges.
Implementing a structured grace period, where lenders and companies can mutually negotiate terms of repayment or restructuring, can be instrumental in preventing unnecessary insolvency. Additionally, policymakers could explore specialized insolvency provisions for MSMEs and SMEs, helping them manage financial distress without facing immediate threats to their ownership and control.
“In times of distress, businesses require solutions, not seizures. An equitable framework acknowledges temporary setbacks and fosters recovery, not displacement.”
Addressing the Outliers: Wilful and Fraudulent Defaulters
While the call for flexibility and understanding is crucial, it is equally important to carve out exceptions for wilful defaulters and fraudsters. A wilful defaulter is a borrower who deliberately avoids repaying despite having the capacity to do so. Such cases undermine the integrity of the financial system and should not benefit from lenient provisions.
For wilful defaulters, the IBC should maintain its firm stance, ensuring that fraudulent behavior is met with strict penalties. This approach not only protects the interests of lenders but also preserves the trust of the wider financial ecosystem. By differentiating between genuine defaulters and those who misuse credit, the insolvency framework can maintain a balanced approach, fostering growth for honest entrepreneurs while upholding accountability for those who misuse their financial obligations.
“Forgiveness is a virtue for those who stumble, but accountability is essential for those who deceive.”
Potential Policy Reforms: A Balanced Framework
To foster a healthy business environment while protecting lender interests, several policy reforms could be considered:
1.Differentiation between MSME/SME and Large Corporations: The insolvency laws could adopt a differentiated approach based on the size and nature of the business. MSMEs and SMEs could be granted a more lenient, recovery-focused approach, allowing them to rebuild without facing immediate lender intervention.
2.Incentivized Loan Restructuring: Policies that encourage loan restructuring and repayment assistance programs for distressed businesses could enable them to regain stability without invoking insolvency proceedings. This approach would allow companies to maintain ownership and control, avoiding the debilitating effects of lender control.
3.Clearer Definitions of Fraud vs. Default: Establishing a legal framework that distinguishes between financial distress and fraudulent default can prevent misuse of insolvency laws. This distinction would ensure that legitimate businesses are not penalized alongside wilful defaulters, encouraging a culture of trust and transparency.
4.Introduction of a Mediation Process: A mediation process between lenders and companies before insolvency proceedings could enable both parties to reach amicable resolutions, saving jobs, businesses, and potentially valuable relationships.
Concluding Thoughts: Ownership Revisited
The transformation of corporate ownership in India, driven by stringent insolvency laws, underscores a new era where lenders often become de facto controllers of distressed companies. While this approach serves to protect creditors, it may also stifle entrepreneurship and impede the recovery of struggling businesses, especially in the MSME and SME sectors.
A more balanced framework that offers sufficient breathing room for genuine businesses to recover while maintaining strict scrutiny on wilful defaulters can create a more equitable and supportive business environment. Through thoughtful policy reforms, India can foster a corporate ecosystem that values resilience, respects ownership, and encourages entrepreneurship, all while safeguarding the integrity of the financial system.
“The strength of a nation’s economy lies in its ability to balance protection with empowerment, providing businesses a chance to rise, not just the room to fall.”
The future of Indian business lies not in condemning those who falter, but in uplifting them with fair, responsive policies that empower enterprises to overcome challenges. In this pursuit, lenders, shareholders, and policymakers must work together, respecting each other’s roles and prioritizing the shared objective of sustained economic growth.
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Akshat Khetan is a distinguished corporate and legal advisor. He is an expert in M&A, corporate restructuring, and turnaround specialist. He brings to the table a unique fusion of experience-driven business acumen and an unconventional approach to empower clients to conclusively address their problems. You can follow him on Twitter @akshat_khetan
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