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Pre-pack: Insolvency resolution option for MSMEs

Experts noted that the pre-pack provisions introduced by the central government also provided for adequate protection to ensure the provisions were not misused by errant promoters.

Written by Karunjit Singh , Edited by Explained Desk | New Delhi |
Updated: April 7, 2021 7:17:26 am
We examine pre-packs and their impact on the insolvency resolution process.

The central government has promulgated an ordinance allowing the use of pre-packs as an insolvency resolution mechanism for Micro, Small and Medium Enterprises (MSMEs) with defaults up to Rs 1 crore, under the Insolvency and Bankruptcy Code.

The move comes soon after the end of a one-year suspension of insolvency initiation imposed by the government in light of the Covid-19 pandemic. The government had last year also increased the minimum default threshold for insolvency proceedings from Rs 1 lakh to Rs 1 crore.  We examine pre-packs and their impact on the insolvency resolution process.

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What are pre-packs?

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A pre-pack is the resolution of the debt of a distressed company through an agreement between secured creditors and investors instead of a public bidding process. This system of insolvency proceedings has become an increasingly popular mechanism for insolvency resolution in the UK and Europe over the past decade. Under the pre-pack system, financial creditors will agree to terms with a potential investor and seek approval of the resolution plan from the National Company Law Tribunal (NCLT).

The approval of a minimum of 66 per cent of financial creditors that are unrelated to the corporate debtor would be required before a resolution plan is submitted to the NCLT.  Further NCLTs are also required to either accept or reject any application for a pre-pack insolvency proceeding before considering a petition for a CIRP.

What are the benefits of pre-packs over the Corporate Insolvency Resolution Process (CIRP)?

One of the key criticisms of the CIRP has been the time taken for resolution.  At the end of December 2020, over 86 per cent of the 1717 ongoing insolvency resolution proceedings had crossed the 270-day threshold. One of the key reasons behind delays in the CIRPs are prolonged litigations by erstwhile promoters and potential bidders.

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The pre-pack in contrast is limited to a maximum of 120 days with only 90 days available to the stakeholders to bring the resolution plan to the NCLT.

Another key difference between pre-packs and CIRP is that the existing management retains control in the case of pre-packs while a resolution professional takes control of the debtor as a representative of financial creditors in the case of CIRP. Experts note that this allows for minimal disruption of operations relative to a CIRP.

What is the key motivation behind the introduction of the pre-pack?

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According to sources aware of developments, pre-packs are largely aimed at providing MSMEs with an opportunity to restructure their liabilities and start with a clean slate while still providing adequate protections so that the system is not misused by firms to avoid making payments to creditors.

“Prepacks will help corporate debtors to enter into consensual restructuring with lenders and address the entire liability side of the company,” said Rajiv Chandak, partner at Deloitte India, noting that the government should consider setting up specific benches of the NCLT to deal with pre-pack resolution plans to ensure that they are implemented in a time-bound manner.

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How are creditors protected from misuse by promoters to simply reduce liabilities and retain control?

Experts noted that the pre-pack provisions introduced by the central government also provided for adequate protection to ensure the provisions were not misused by errant promoters. The pre-pack mechanism allows for a swiss challenge for any resolution plans which proved less than full recovery of dues for operational creditors. Under the swiss challenge mechanism, any third party would be permitted to submit a resolution plan for the distressed company and the original applicant would have to either match the improved resolution plan or forego the investment.

“… adopting plan evaluation process akin to Swiss Challenge, it (the pre-pack mechanism) retains competitive tension such that promoters propose plans with least impairment to rights and claims of creditors,” said Soumitra Majumdar, partner at law firm J Sagar Associates adding that the option available to creditors to require the promoters dilute their shareholding in case the resolution plan provides for impairment of claims by creditors would also be a significant deterrent against “unreasonable terms” in resolution plans.

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Creditors are also permitted to seek resolution plans from any third party if they are not satisfied with the resolution plan put forth by the promoter.

What next?

The pre-pack is expected to be rolled out to all corporations over time as legal issues around the provisions are settled through case law, according to experts.

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First published on: 06-04-2021 at 09:50:34 am
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