Treatment of individual credit in the draft Insolvency and Bankruptcy Code

by Shreya Garg and Renuka Sane.

The focus of thinking on bankruptcy and insolvency in India has primarily been upon defaults by firms. However, defaults by individuals are equally important for the economy. Most small firms obtain debt financing through the vehicle of personal borrowing of the entrepreneur. Households require credit for reducing the volatility of consumption. In this article, we sketch the treatment of individual insolvency in the draft Insolvency and Bankruptcy Code, and compare and contrast this against the treatment of firms.

The design of a sound insolvency process for individuals

In India, at present, we lack a well functioning market for personal credit, in part because of poor consumer protection, and the absence of well-functioning insolvency framework for enforcing repayment of loans. A key element of a credit contract is predictability around what happens if the borrower cannot repay. Creditors need mechanisms to enforce repayment, or alternatively, restructure obligations. At the same time, coercive collection mechanisms need to be blocked. Creditors need information on whether potential debtors have failed to repay in the past. Debtors need the assurance that if they fail to repay once, there is the possibility of starting all over again. Both creditors and debtors need to know that decisions will be taken swiftly. The following elements are thus important in the design of the insolvency process:

1. Participation of both the creditors and debtor: When the debtor is facing financial difficulties, it may in the interest of both the creditors and the debtor to re-negotiate the terms of repayment, and come to a new agreement. Voluntary decisions by both sides are best in terms of obtaining flexibility and maximising the recovery rate. This allows the debtor to reorganise payments in line with expected cashflows. A good insolvency process should aim to bring together all the creditors with the distressed debtor, and facilitate this re-negotiation.
   
   
2. Fair, orderly and timely: The process of re-negotiation needs to be fair and orderly for everyone to participate. It has to be timely as delays can be costly. If the re-negotiation fails, then there has to clarity on what follows, and in what time period the actions follow.
   
   
3. Release from financial liabilities: The debtor will only meaningfully participate in the process if there is the certainty that participation in the process will lead to a clean slate and the possibility of starting all over again. If the process allows the debtor to keep certain crucial assets such as tools of trade, then the debtor has a better chance at a restart.
   
   
4. Ex-ante incentives: The participants in the process will naturally want to maximise their own value first. In this process it is likely that either the creditors or the debtor will game the system to their own advantage at the cost of the others. This can skew incentives and lead to a poor credit market. For example, if the debtor knows that debt forgiveness can be had easily, it will encourage the debtor to be reckless with credit, while discourage creditors from lending. The outcome will be credit constraints.
   
   
5. Care about frictions: The institutional design needs to be mindful that for most individuals, as with most small firms, the magnitude of the debt at stake does not justify substantial expenditures on negotiation, payments for insolvency professionals, and processes at a judicial forum.
   
   

Individual insolvency in the IBC

These design principles are at the foundation of the report and the draft Insolvency and Bankruptcy Code submitted by the Bankruptcy Law Reforms Committee (BLRC). The draft Bill proposes three processes:

Insolvency Resolution Process

The Insolvency Resolution Process (IRP) is the process through which all creditors and the debtor agree on a negotiated repayment plan. This process is core to the IBC. Only on the failure of the IRP would a bankruptcy process be triggered. Individuals are required to attempt a resolution of their insolvency, as this provides debtors a chance to renegotiate and not be divested of their estate through bankruptcy, and thereby avoid the tag of being "bankrupt". The IRP can be initiated by the debtor or the creditor.
Establishing the validity of the claim of default is a bigger problem in the case of individuals than firms. If the debt is registered with an `information utility', the class of infrastructure providers envisaged by the IBC for recordkeeping, then the debtor would be precluded from contesting the validity of the debt. The absence of this electronic information would lead to delays.
Once the IRP has been triggered, a moratorium of six months would commence on all collection actions. Debtors and creditors would be required to agree on a repayment plan within this moratorium period under the supervision of a resolution professional. Once approved by the creditors and sanctioned by the adjudicating authority, the plan would be binding on the debtor and all the creditors mentioned in the plan. The debts would have to be repaid by the debtor under the terms of the repayment plan including the dates envisaged.
A certain class of assets of the debtor would remain outside the purview of this process: e.g. unencumbered assets like his dwelling house upto a certain value, life insurance policy, household items, items necessary for personal use and employment. Compared with the existing law, the ambit of excluded assets under the IBC has been expanded.
The negotiated plan would determine when the debtor is discharged from all debts. It is possible that the debtor is granted a discharge even before all dues are paid. The regulator, which has been named `Insolvency & Bankruptcy Board of India' would keep a record of the default by the debtor for a time period as may be prescribed by regulations and such information would be publicly available.

Bankruptcy Process

The IBC envisages three grounds for failure of the IRP which can lead to bankruptcy proceedings: (a) If the application to the IRP is not accepted due to failure to provide requisite information, (b) If creditors and the debtor cannot agree on a repayment plan, and (c) If the debtor fails to implement the repayment plan within the period prescribed for such implementation in the plan.
The bankruptcy proceeding will not start automatically: the creditor or the debtor would have to make an application to trigger it. On the admission of the application for bankruptcy, a bankruptcy order will be passed by the adjudicating authority.
It will have the effect of declaring the debtor as 'bankrupt' and vesting a subset of the estate of the bankrupt with a resolution professional. A moratorium will begin, on all collection actions of unsecured creditors. Secured creditors will have the option to participate in the process or enforce their security outside the process. On the vesting of the estate of the bankrupt, the resolution professional will declare the amount to be distributed amongst the creditors of the bankrupt, in the order of priority encapsulated in the IBC. The record will be kept by the Board for a time period to be prescribed by regulations. Such information will be publicly available.

Fresh start

An IRP makes sense only when there is a possibility of a repayment plan. In the case of low-income, low-asset debtors, transaction costs in the process of resolution or bankruptcy may exceed the debt at stake. There is also the danger in India that politically motivated loan-waivers destroy the credit culture. A smooth process of dealing with insolvent poor people, which works every day, could potentially de-politicise the problem.
The IBC, therefore, proposes a concept of a Fresh Start, aimed at providing debt relief to the poorest. A debtor with gross annual income of less than Rs.60,000, assets less than Rs.20,000, debts less than Rs.35,000, and no home-ownership, will be eligible to get a complete waiver of debts. These thresholds have been designed using the SECC, 2011, Deprivation Index as well as the Key Indicators of Debt and Investment in India for 2013 and will need to get revised over time.
Only the debtor can trigger this process and on submission of the requisite information, the adjudicating authority may grant him a discharge order. A moratorium will become applicable on all the creditors of the applicant for a period of six months, to provide a conducive environment for the process to go through. The Board will keep a record of the default by the debtor for a time period as may be prescribed and such information is publicly available. Facts about fresh start would stay on the record of the individual and be available to future creditors, thus containing moral hazard.

How does this process differ from corporate insolvency?

While the individual insolvency provisions mirror the corporate insolvency provisions, there are a few differences.

1. In individual insolvency, an interim moratorium starts from the date of the application, unlike corporate insolvency. This is to prevent coercive debt recovery action.
   
   
2. The corporate insolvency framework divides creditors into financial and operational creditors. This distinction is not made in respect of individuals. This is because it is expected that the debt structure of an individual or a partnership firm is likely to be less complex and it should be possible for both sets of creditors to be included in the negotiations on repayment.
   
   
3. In individual insolvency, secured creditors are permitted to stay out of IRP entirely by enforcing their security interest, unlike corporate insolvency. One reason for this is that SARFAESI has seen the greatest success in situations where the lender has extended a single loan to a single individual borrower and it was considered worthwhile to retain SARFAESI rights to individual lenders. It may also be easier for an individual or partnership to rebuild the value destroyed on account of security enforcement.
   
   
4. In corporate insolvency, the fast track IRP makes it possible for the firm to go into liquidation directly. In the case of individuals, there is no such provision. Only when the possibility of a repayment plan is completely ruled out, will the debtor be taken to bankruptcy proceedings. The thrust of the IBC is thus to resolve insolvency through re-negotiation.
   
   
5. In corporate insolvency, failure of the IRP directly triggers the liquidation proceedings. In the case of individuals, a failure of the IRP only entitles the debtor or the creditors to make an application for triggering the bankruptcy proceedings. The trigger is not automatic. The rationale for the distinction lies in the higher stigma attached to an individual's bankrupt status.
   
   
6. Corporate insolvency does not have an option of a fresh start process, as this process has been conceptualised specifically to provide debt relief to poor individuals, for whom the recovery procedure is likely to be more expensive than the amount recovered.
   
   
7. Adjudication for firms will take place at NCLT, while individual insolvency cases will go to DRTs. Over time, individuals from all corners of the country will want to access the DRTs. In terms of organisational capabilities, DRTs as presently structured are not modern courts. A tremendous effort will be required, on the lines of the work that has begun for constructing the Financial Sector Appellate Tribunal, in order to make NCLT and DRT deliver what is required for IBC.
   
   

Conclusion

The draft IBC is the first attempt at a comprehensive law for insolvency by individuals. If the code is implemented, and if the infrastructure in the form of resolution professionals, the information utilities, and the adjudication infrastructure falls into place, this could yield a sea change in the working of the market for individual credit.

Acknowledgments

We thank Richa Roy for useful comments.


Shreya Garg is a researcher at Vidhi Centre for Legal Policy. Renuka Sane is an academic at the Indian Statistical Institute, New Delhi.