CHALLENGES OF INSOLVENCY RESOLUTION IN SMES UNDER THE IBC FRAMEWORK
Small and medium-sized enterprises (SMEs) are the backbone of India’s economy, contributing significantly to employment and GDP. However, these enterprises often face financial difficulties due to market fluctuations, poor access to credit, or mismanagement. The Insolvency and Bankruptcy Code (IBC) introduced in 2016 was designed to provide a structured and time-bound process for resolving corporate insolvency. While the IBC has been successful in facilitating the resolution of large corporate defaults, its application to SMEs presents unique challenges.
As a law firm, The Law Codes, with over 20 years of experience in Insolvency and Bankruptcy Law, we have seen the complexities SMEs face under the IBC framework. This article will explore the specific challenges in resolving insolvency for SMEs and the impact of these challenges on their ability to recover and thrive.
IMPORTANCE OF SMES IN INDIA’S ECONOMY
SMEs form a crucial segment of India’s business ecosystem, providing employment to millions and contributing to the overall economic development. However, despite their importance, SMEs are often more vulnerable to financial distress than larger corporations. Their challenges range from limited access to financing to a lack of sophisticated management practices. As a result, when SMEs face financial difficulties, the resolution process can be more complicated.
The IBC framework aims to resolve insolvency in a fair and transparent manner, ensuring that the assets of a distressed company are either restructured or liquidated in the most effective way. While large corporations have the resources to navigate the insolvency process, SMEs often face significant hurdles that can delay or even prevent successful resolution.
CHALLENGES IN THE INSOLVENCY RESOLUTION PROCESS FOR SMES UNDER THE IBC
- Lack of Access to Professional Support
One of the primary challenges SMEs face during insolvency proceedings is their inability to afford professional expertise. Under the IBC, the resolution process involves the appointment of insolvency professionals (IPs) who play a critical role in managing the resolution or liquidation of the company. These professionals are responsible for evaluating the financial position of the SME, identifying assets, and ensuring compliance with the Code.
However, most SMEs operate on tight budgets, often unable to afford the high fees associated with insolvency professionals. Unlike large corporations, which typically have the financial strength to hire expert legal and financial advisors, SMEs face difficulties in procuring such services. This lack of expertise can hinder effective decision-making during the resolution process and impact the outcome for creditors and the company itself.
- Financial Constraints and Limited Access to Credit
SMEs often lack sufficient access to working capital and credit facilities, which makes it difficult for them to recover from financial setbacks. Banks and financial institutions are typically more reluctant to extend loans to SMEs, given their higher risk profile. When these businesses enter insolvency proceedings, they may find themselves without the necessary resources to carry out a meaningful restructuring or recovery process.
While the IBC allows for the resolution of distressed companies, SMEs’ limited financial backing often results in asset sales at depressed prices, reducing the likelihood of meaningful recovery for creditors. In many cases, the resolution process leads to liquidation because of insufficient funds, undermining the core goal of the IBC: corporate rehabilitation.
- Complexity of the Resolution Process
The IBC framework was primarily designed with large companies in mind, and its provisions may not always align with the needs of smaller firms. The timeline stipulated under the IBC for resolving insolvency, typically 180 days (with a possible extension of 90 days), can be difficult for SMEs to meet due to their limited resources. Small businesses often lack the organizational infrastructure to prepare detailed business restructuring plans, negotiate with creditors, or raise the necessary funds for a successful resolution.
Moreover, the involvement of multiple stakeholders, including financial creditors, operational creditors, and other stakeholders, can complicate the resolution process. The decision-making process within the Committee of Creditors (CoC) may become contentious when creditors have differing views, and the negotiations could further delay the proceedings, affecting the outcome.
- Undervaluation of Assets
In many cases, the assets of SMEs are undervalued during the insolvency resolution process. SMEs often operate with limited capital investment in physical assets, and their business models may rely heavily on intangible assets such as intellectual property or customer relationships. These assets, however, are harder to value and often do not attract the same level of interest from investors as more tangible assets.
Additionally, the market for distressed SME assets is often illiquid. Buyers may be wary of purchasing SME assets, particularly when the business lacks a strong brand reputation or has limited access to a customer base. As a result, when SMEs are liquidated under the IBC, their assets may be sold for less than their actual worth, leading to lower recovery for creditors.
- Inability to Attract Buyers for Restructuring
Unlike larger corporations, SMEs often struggle to attract potential buyers or investors interested in acquiring their business or assets during the insolvency process. The IBC aims to encourage resolution over liquidation by offering companies an opportunity to find a buyer who can restructure the business and restore it to profitability. However, the scale and scope of most SMEs are typically not attractive to large investors who prefer larger, more stable businesses.
Furthermore, the complex regulatory environment, lack of transparency, and the relatively low financial returns from distressed SME assets can make the resolution process less appealing to potential buyers. This makes it harder for SMEs to undergo successful corporate restructuring and, as a result, more SMEs end up being liquidated instead of being revived.
- Operational and Management Challenges
Many SMEs face operational challenges that make restructuring or recovery more difficult. These businesses often lack a professional management structure and are often dependent on the owner’s day-to-day involvement. When a business enters insolvency, the lack of professional management can hinder the process of resolving financial distress, especially when it comes to finding a sustainable path forward.
Without effective management, the resolution process is more likely to be inefficient, and this makes it difficult for creditors to recover their dues. Moreover, owners of SMEs may be emotionally attached to their businesses and may not be willing to accept restructuring solutions that would require changes in management or operational structure. These emotional and operational challenges can further complicate the resolution process under the IBC.
TAILORED APPROACHES FOR SMES
Given the unique challenges SMEs face during the insolvency resolution process, there is a growing need for a more flexible, SME-centric approach within the IBC. The government could consider creating a separate framework for resolving SME insolvencies, with provisions that take into account the specific needs and characteristics of smaller businesses. For example, relaxed timelines and simplified resolution procedures could be considered to allow SMEs a better chance of restructuring successfully.
- Access to Affordable Professional Services
To help SMEs overcome the financial challenges of hiring insolvency professionals, the creation of a more affordable, specialized pool of professionals for SMEs could significantly improve the resolution process. Providing access to lower-cost insolvency services and advisory could enable SMEs to receive the professional guidance they need without depleting their resources.
- Encouraging Investors to Participate in SME Resolution
To address the difficulty of attracting buyers for SME assets, efforts could be made to encourage greater investor interest in the SME sector. This could include providing tax incentives for investors involved in restructuring distressed SMEs or creating a dedicated marketplace for distressed SME assets. Such steps would encourage more active participation from the private sector and improve the chances of a successful resolution.
CONCLUSION
The IBC has undeniably been a groundbreaking development in India’s insolvency landscape, but its implementation in the context of SMEs presents several challenges. From financial constraints and limited access to professional help to the undervaluation of assets, SMEs face unique hurdles in the insolvency resolution process. As India’s insolvency framework continues to evolve, addressing these challenges will be crucial to ensuring that SMEs can take full advantage of the opportunities the IBC offers, and ultimately contribute more effectively to India’s economic growth.
At The Law Codes, we have over two decades of experience navigating the complexities of insolvency law, and we continue to advocate for solutions that ensure SMEs receive the support they need to recover and thrive in a challenging economic environment.