Insolvency and Bankruptcy: Social, Legal, Economic and Financial Perspectives

Insolvency and Bankruptcy: Social,
Legal, Economic and Financial

Perspectives
Insolvency:
The inability of a person or corporation to pay their

bills as and when they become due and payable.
Bankruptcy:
When a person is declared incapable of paying their
due and payable bills.
Liquidation:
The process of winding up a corporation or
incorporated entity.
Differentiating Insolvency and
Bankruptcy
• The term Insolvency is the term to cover all types of

debt problems, while Bankruptcy is the term for an
individual (whether in business or not) who has been
declared bankrupt.
• Therefore bankruptcy is a type of insolvency.
• Bankruptcy is the term for when an individual is
declared bankrupt by the Court because they are
insolvent.
Purpose of Insolvency Law
There are two schools of thought on insolvency.
• The prevailing school is that of the “proceduralists”
represented in the main by the pioneering work of
Thomas Jackson.
• That the purpose of insolvency is primarily to effect the
orderly distribution of the debtor’s assets to its
creditors, and to avoid the inefficiencies of letting
creditors individually collect the unpaid debt from the
insolvent company.
• The other school is composed of “traditionalists”
who at its inception is represented in literature
by the work of Elizabeth Warren.
• The traditionalists would allow the disregard of
an absolute priority rule and consequently “take
into account the interests of weaker or non-
adjusting economic parties, such as employees,
tort victims, or other stakeholders with no formal
legal rights.”
Need for Insolvency Regime
• Market participants need freedom broadly at

three stages of a business - to start a business
(free entry), to continue the business (free
competition) and to discontinue the business
(free exit).
• This enables new firms to emerge continuously;
and the firms do business when they remain
efficient, and vacate the space when they are
no longer efficient.
• This ensures free flow of resources from
inefficient uses to efficient uses - the first
stage ensures allocation of resources to
the most efficient use, the second stage
ensures efficient use of resources
allocated, and the third stage ensures
release of resources from inefficient uses
for fresh allocation to efficient uses - and
consequently the highest possible growth.
Importance of Credit Infrastructure
• Since the economic reform process of the

1990s, there has been significant progress
in the development of financial markets and
services in India.
• However, this development has been
skewed largely towards equity markets.
Although debt claims are an important
instrument of financing in an emerging
market, the development of debt markets
has seen little progress in India.
• India’s private credit to GDP ratio is low
relative to comparable countries, its
corporate bond market virtually non-
existent, and retail credit is growing rapidly
but from a very low base.
Need for institutional and legal reforms
• In order for credit to flow freely, lenders should

have sufficient knowledge about borrowers, be
able to take the borrower’s assets as collateral, be
able to enforce penalties in case the borrower
defaults (such as shutting the borrower’s access
to credit, at least for a while, or seizing the
borrower’s pledged assets), and be able to
renegotiate their claims in an orderly fashion in
case the borrower is simply not able to pay.
• A strong credit infrastructure allows
widespread credit information sharing,
low-cost pledging and enforcement of
collateral interests, and an efficient
bankruptcy system, which renegotiates un-
payable financial claims while preserving
the assets in their best use.
Essential features of an Effective Insolvency and
Bankruptcy Law
• Non-payment by a debtor firm may be due to a

short term cash-flow stress even when the
underlying business model is generating revenues
or due to a fundamental weakness in the business
model because of which the business is unable to
generate sufficient revenues to make payments. As
long as the debt obligations are met, equity owners
have full control and the creditors of the firm have
no say in the running of the business.
• When the debtor defaults on payments,
the control transfers to the creditors and
the equity owners should have no further
say. Upon default, the creditors have the
incentive to be the first to recover their
amounts. Consequently, a race to collect
may ensue, with firm liquidation as the
inevitable outcome.
• What should ideally happen is that the creditors
and the debtor should negotiate a financial
rearrangement to preserve the economic value
of the business and keep the enterprise running
as a going concern.
• If however the default is due to a business
failure, then the enterprise should be shut down
as soon as possible. The insolvency and
bankruptcy law of the country provides a
framework through which these decisions can
be taken and hence it assumes great
importance.
The existing Legislative Landscape
• When a company defaults on a debt payment,

there are three kinds of legal procedures
available to creditors and debtors that are
common to all jurisdictions: (i) foreclosure or
enforcement of the debt by a creditor or group
of creditors, (ii) liquidation of the debtor and a
distribution of its remaining assets to creditors,
and (iii) a reorganisation or revival of the
business, which results in a continuation of the
business in some form or in the sale of the
business as a going concern.
Collective Insolvency Laws
• In the area of collective insolvency

proceedings, India has separate laws to
deal with rescue and rehabilitation, on the
one hand, and liquidation, on the other.
• The law which used to govern rescue and
rehabilitation of distressed companies was
SICA, which applied exclusively to
industrial companies.
• Under SICA, industrial companies in
distress (based on a test involving an
erosion of their net worth by 100%) used
to make a reference to the Board for
Industrial and Financial Reconstruction
(BIFR), which, after considering the
viability of the debtor company, either
sanctioned a rehabilitation scheme or
refers the company to the high court for
winding up.
• However, it did not take long for SICA to
acquire a reputation for delays and for
lending itself to significant abuse by
debtors who often used the BIFR as a
“safe haven” to siphon off assets from
creditors.
• In fact, SICA had been universally
condemned from so many different
quarters that an Act was passed for its
repeal in 2002.
Debt Recovery Laws
• The most basic mechanism for debt

recovery that is available for all types of
creditors involves filing a petition in a civil
court of competent jurisdiction and this
mechanism remains available today.
However, a series of laws were enacted in
the 1990s and 2000s to facilitate debt
recovery for certain classes of creditors
given the high pendency of cases in the
civil courts and experience of abuse with
laws such as SICA.
• The Recovery of Debt Due to Banks and
Financial Institutions Act (RDDBFI Act)
was enacted in 1993 to make it easier for
banks and financial institutions to recover
debt. The RDDBFI Act is available to both
secured and unsecured creditors, but they
need to be banks or notified financial
institutions.
• This Act provided for the establishment of
debt recovery tribunals (DRTs) and debt
recovery appellate tribunals (DRATs) and
any cases pending before the civil courts
that involved debt of over Rs 10 lakh were
automatically transferred to the DRTs.
Insolvency and Bankruptcy Code,
2016
• Please refer the PPT uploaded on A bird’s eye
view of IBC for basic features of IBC. The same
can be found in Introduction to Law and
Corporate Law folder uploaded at LMS.
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Insolvency and Bankruptcy: Social, Legal, Economic and Financial Perspectives

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Insolvency and Bankruptcy: Social,

Legal, Economic and Financial

The inability of a person or corporation to pay their

• The term Insolvency is the term to cover all types of

• Market participants need freedom broadly at

• Since the economic reform process of the

• In order for credit to flow freely, lenders should

• Non-payment by a debtor firm may be due to a

• When a company defaults on a debt payment,

• In the area of collective insolvency

• The most basic mechanism for debt

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