CASH FLOW TEST/ CASH FLOW INSOLVENCY

A company is considered Cash Flow insolvent if it is unable to pay its debts “as they fall due”.
Along with inability to pay, the failure to pay the debt upon service of demand notice by the
creditor within the specified time period is also an application of cash flow insolvency.
The cash flow test can be sub-divided into the statutory demand test, where upon failure of
payment of the demand served notice by the creditor, the debtor can be declared insolvent and
judgment debtor test, where a decree or judgment order has been passed in favour of the creditor
to execute the debt.The benefits of cash flow insolvency lies in the fact that it creates a legally
certain determination of insolvency for recalcitrant debtors. The underlying foundation of any
insolvency statute should not be to utilize the balance sheet test as legal defence for the debtors
towards winding up, when prima facie the debtor is cash flow insolvent. Under the cash flow
test, the date of maturity of the debt is considered an adequate cause of action to file suit for
winding up.The test relies on the premise that a temporary lack ofliquidity is often a symptom of
larger problems affecting the debtor company and early resolution of debts can in fact aid the
debtor company to identify and resolve any deep-rooted problems with the management and
operations. The application of cash flow insolvency extends beyond determination of solvency,
to ascertain if the debtor company has carried on its business operations to defraud creditors by
providing preferential treatment to certain category of creditors. The date of maturity becomes
the relevant date for calculation of the look-back period to ascertain such suspicious transactions
and helping the directors of the debtor company to ascertain the twilight period, post which their
fiduciary duties towards creditors begin of preserving the liquidation estate.

BALANCE SHEET TEST / BALANCE SHEET INSOLVENCY

When the company’s reported assets as per the financial statements are less than the reported
liabilities, accounting for both contingent and prospective liabilities, then it is considered
Balance Sheet insolvent.
The balance sheet insolvency test doesn’t consider courts as mere forum of debt recovery but
also for resolution of the business of the debtor company. The US Bankruptcy Code provides for
a comparison of the asset side and liability side of the balance sheet to ascertain insolvency of
the debtor corporation, thus legislatively incorporating the balance sheet test. The balance sheet
test is argued as a practical application of commercial business practices where it is common for
creditors to extend the period of credit based on the friendly business relationships between the
parties.The reliability upon balances of assets and liability in the balance sheet test forming part
of financial statements, evidences the transparent nature of the test. A mechanical application of
the cash flow test, without reference to the future contingent and prospective liabilities can result
in closing down of start-up companies even before they are provided with a level playing field to
compete with the market leaders. Similarly, banks may not necessarily have ready cash flow with
itself on a particular day to pay-off the significantnumber of depositors and such a situation is not
characteristic of insolvency.3Similarly, an instance of abuse of dominance of its market position
by the dominant enterprise through winding up threats can result in establishment of monopoly
in the market by the dominant enterprise. The essence of balance sheet test lies in the fact that it
takes into consideration externalities on account of which the default of payment has occurred.
To illustrate, an Indian export-import company relying upon imports of Chinese textiles for sale
in the Indian market may be hampered when an embargo on trade is imposed between the
countries, resulting in significant business losses. However, such a force majeure situation has
arisen not on account of any imprudent business decision by the Indian company; but due to
unfavorable trade relations between the countries. Any threat of winding up for default in
payment of debts due to a single force majeure event can result in closing down of a growing
business without any fault on the part of its management. While the cash flow test has been a
popular choice in many jurisdictions, the test is also contested. It is argued that the cash flow
solvency test acts as a detriment towards the effective growth and sustainability of the debtor
company as the threats issued through an application for winding up can result in loss of
goodwill and downward trends towards the share price.

The Evolution of Corporate Insolvency Laws in India

Insolvency and bankruptcy law is essential to the smooth operation of any economy. These laws
assist in the restructuring of a company's numerous assets as well as their dissolution. The major
purpose of the law is to restructure and resolve corporate insolvency. The 2016 Insolvency and
Bankruptcy Code is a comprehensive piece of legislation that encompasses both the
rehabilitation and liquidation aspects of a debtor's financial failure.

The legislation's principal purpose is to reorganise and resolve the insolvency of corporations,
partnership businesses, and individuals as quickly as possible in order tomaximise the value of
their assets. It is also critical to increase entrepreneurship and finance availability while doing so.
Insolvency is a condition in which a business is unable to obtain enough income to finance its
responsibilities and payments on time.

When a court recognises and acknowledges insolvency while rejecting instructions for resolving
it, it is said to be in bankruptcy. When a court determines that a corporation is insolvent, it makes
an order dividing the proceeds among the creditors in order to satisfy the company's debts. One
of the most significant impediments to bankruptcy in India is around 4 years average time it
takes to settle bankruptcy cases, which is much longer than USA and UK.

Current insolvency laws and finance commitment reconstruction acts place a greater emphasis on
the renewal of capital and gradable construction of account holders facing money problems in
order to allow them to restore and operate their businesses, rather than on the liquidation and
discontinuance of insolvency matters. Any legislation's goal is to strike a balance that is
beneficial to society, and a moral society requires laws to preserve an individual's rights.

The same can be said for bankruptcy and insolvency. Any new age firm will need capital to
grow, so it will take out a loan. It will be forced to borrow money, but if it fails to meet its
obligations to creditors then creditors will lose interest in lending money. There is a requirement
to protect the interests of lenders so that the borrowing and lending process can continue, which
helps the country grow its economy.

We understand that everything is interconnected and virtually benefits us, which is why it is
critical to ensure that this remains active and that the interests of creditors are protected, which is
why debt legislation was needed. When we investigate the Bankruptcy Act, we discover that it
has been completely disregarded. When a person is declared insolvent, he is no longer
considered trustworthy. Regardless of what has been said, the bankruptcy statute protects the
account holder from the shame, humiliation, and abuse of his creditors.

Evolution
The first insolvency court was established in the Presidency � towns by legislation which was
passed in 1828. Essentially, these courts were created to assist insolvent debtors. They served as
both individual and record courts. Anyone who is dissatisfied with the above-mentioned court's
decision can appeal to the Supreme Court, which is the highest court in the land. The Supreme
Court established the competence to hear and transfer such demands as it defined as fair and
substantial, and the same application or demand is to be deferred through the courts for insolvent
or borrower mitigation.

The Supreme Court entrusted the staff of the insolvency court. One of these officials was
referred to as a "normal appointee." The property interest of the indebted is entrusted in the
simple selected one by uprightness of the request in the event that an appeal for mediation was
begun or originated by one lender as well as an order for arbitration was established.
Furthermore, an agreement was reached regarding the break guarantee orders.

Indian Insolvency Act, 1848

The previous permits were cancelled in 1848, and a new Act, known as the Indian Insolvency
Act, was enacted. The terms of the Act were stored in the minds of all merchants and non-
brokers. The main purpose of this Act was to shift the Courts established by the Act of 1828 for
the relief of insolvent debtors, but the Courts were to be held under the constant supervision of
Supreme Court judges.

Administration towns Insolvency Act, 1909

It was felt in the early twentieth century that the Indian Insolvency Act of 1848 was obsolete.
The Act of 1848 was deemed to be of little value or to have been repealed, and a new Act, the
Presidency-towns Insolvency Act, was passed in 1909, taking into account the Bankruptcy
demonstration of 1883 and the Bankruptcy Act of 1890. The Indian Insolvency Act, like
anything else, has problems. One of the most serious and persistent shortcomings was that the
Act favoured debtors over lenders.

The Principle Legislation for Corporate Insolvency

In the third list of Schedule 7, known to as the concurrent List, the Indian Constitution,
promulgated in 1950, includes terms like "insolvency" and "bankruptcy." However, terms like
incorporation, command and liquidation of enterprise are included in the Union List. The
Companies Act of 1956, which gave the corporate sector a new structure, was enacted with these
features, or strong points, enshrined in the Constitution.

In reality, nearly every provision relevant to or connected to the operations of corporations, as

well as the procedure for dissolution, were included in this Act. It's even thought to have cut
down on the number of fraudulent transactions. Even though the Act was the primary law for the
purpose of adjusting corporate bankruptcy, another fact suggests that it never made much sense
in terms of expressions like insolvency or bankruptcy, and that it has no power to deal with debt
payment, despite the fact that it was the primary law for the purpose of adjusting corporate
bankruptcy.

Background of Individual Insolvency Law in India

Before the British came to India, there was no insolvency law in India. The Indian regulation that
dealt with insolvency law was initially found in Government of India Act, 1800. In 1828, a
statute was passed which marked the beginning of special insolvency legislation in India and the
statute applied to Presidency towns namely Bombay, Madras and Calcutta.

It was originally meant to be in force for a period of four years but was extended till 1843. In
1848 another statute of insolvency law namely the Indian Insolvency Act, 1848 was passed
which made a distinction between traders and non-traders. Insolvency jurisdiction under the
statute was transferred to High Courts. Its jurisdiction was also limited to presidency towns. In
1909 the present Presidency Towns Insolvency Act, 1909 was passed.

Later, the Provincial Insolvency Act, 1907 was passed which was repealed by present Provincial
Insolvency Act, 1920. Then, in 2016, Insolvency and Bankruptcy Code, 2016 (the Code) was
passed in order to deal with the increasing level of Non-Performing Loans in India, in a better
way.

The parts in the Code, which deal with individual insolvency matters are yet to be notified.
However, the Central Government vide gazette notification dated 15.11.2019[1] specified that
the provisions of this part that relate to the Personal Guarantors to the Corporate Debtors shall
come into effect from 01.12.2019, save and except provisions dealing with the Fresh Start
Process.

Earlier the individual insolvency framework was primarily governed under two acts, namely, the
Presidency Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920. These acts had
parallel provisions and their substantial content was also similar but the two differed in respect of
their territorial jurisdiction. While Presidency Towns Insolvency Act, 1909 applied in presidency
towns namely, Kolkata, Mumbai and Chennai, the Provincial Insolvency Act, 1920 applied to all
provinces of India.
The Presidency Towns Insolvency Act, 1909 and Provincial Insolvency Act, 1920 law allow an
application to be filed either by the creditor or the debtor, to initiate insolvency proceeding, if the
debtor is unable to pay his, debts amounting to five hundred rupees. In case of a petition by a
creditor, he had to show that the insolvent had committed an act of insolvency which included
the debtor alienating his property to a third person, taking action to defeat or delays his creditors
filing a petition for insolvency, failing to respond to a creditor's notice of insolvency, etc. within
three months before the presentation of the petition.

Issues and challenges faced in the Individual Insolvency Framework

There were many issues and challenges that were faced in the working and implementation of
the individual insolvency framework. Some of them include:

 The old insolvency laws had become outdated and dormant

The legal framework dealing with individual insolvency was rooted in century old laws
and there were no substantial changes made to these laws over these years, thus, this
framework proved to be largely ineffective and these acts were considered inadequate
and outdated. Further, the paucity of case laws dealing with these acts shows that these
acts were used very rarely and had turned dormant in practise.

The Code was enacted with a view to increase the effectiveness and efficiency of the
insolvency laws in India. The provisions of the Code are framed as per the situation of the
Indian credit market and hence, are up to date.

 The procedures of insolvency under the old acts were complicated and time consuming

This was one of the major reasons for the set back of these acts. These acts prescribed
that the procedures provided under the Civil Procedure Code, 1908 shall be followed for
the proceedings under the acts. This caused delays in the whole process. Further, high
intervention of the court prescribed under these laws made it a less attractive mode of
recovery of debt for the creditors.

As a result, these acts were very rarely used by the creditors as a mode of recovery of
their loan or debt. The creditors preferred other modes of recovery of their money which
were easy and less time consuming like out of court settlement methods which resulted in
partial or no recovery at all, or the Negotiable Instruments Act, 1881 which could be used
only in cheque bounce cases. A large category of creditors in turn found themselves with
no effective mechanism for recovery at all. These ineffective legal procedures led to
creditors using intimidating tactics to recover their loans.

The insolvency procedures under the Code are comprehensive and time-bound. Further,
 the Code prescribes limited intervention of the adjudicating authorities which is aimed at
reducing the time that is wasted in unnecessary litigations. The Code also provides for
fast track procedures to be used in appropriate cases.

 Restricted ambit for filing insolvency petition against the debtor

Under the old insolvency acts the scope of filing of insolvency petition by a creditor was
very limited. A creditor could file an insolvency petition against the debtor only on
grounds specified in the act. This further discouraged the creditors from having a
recourse through these old insolvency acts.

On the other hand, under the provisions of the Code, a creditor can file an application
against a debtor n the event of inability of the debtor to repay the loan or debt.

 No provisions for participation of the creditors and debtor

The old insolvency acts lack provisions for participation of the creditors and the debtor.
For a successful resolution and maximisation of the value of their assets, it is necessary
that both the creditors and the debtor are allowed to participate and negotiate with each
other.

The Code contains adequate provisions for the meeting of the creditors where they can
negotiate the terms of the resolution plan and arrive at a mutually acceptable resolution
for the debtor.

 Weak credit recovery

This ineffective insolvency regime also resulted in very low credit recovery which had an
adverse impact on the Indian credit market. Credit markets are important from the
perspective of economic growth and insolvency laws play an important role in facilitating
the growth of credit markets.

It was thus felt that there is a need to bring a reform in the insolvency laws. This led to
the enactment of Code which was essentially passed in order to deal with the increasing
level of Non-Performing Loans in India, in a better way.

 No separate provision for Bankruptcy of the individual

The old insolvency acts only provide for insolvency of the individual. These acts do not
contain any separate provision for the bankruptcy of the individual.

On the other hand, the Code contains separate and elaborate provisions for both
 insolvency and bankruptcy of the individual. This enables both the creditor and the debtor
to maximise the value of their assets.

 There was no separate adjudicating authority dealing specifically with insolvency matters

The effectiveness of these laws was further hampered by the inefficiency of the Indian
judicial system. The jurisdiction to try insolvency matters was vested with the district
courts under these acts. Since, there was no separate adjudicating authority dealing
specifically with insolvency matters, the whole process became more time consuming
because of slow functioning of the courts. This was on account of the “quantity” of
judges, as well as the “quality” of the process wherein a large proportion of the judge’s
time was spent in administrative matters leaving little time for judicial decisions. The
quantity aspect assumes more importance in personal insolvency as it is expected that
people from all parts of the country should be able to access the system. Therefore, weak
institutional infrastructure posed another challenge in the implementation of the legal
framework dealing with individual insolvency.

On the other hand, under the framework of the Code, the jurisdiction is vested with the
National Company Law Tribunal and National Company Law Appellate Tribunal.
Additional measures are also taken by the Government of India to improve the
institutional infrastructure for efficient and effective implementation of the Code.

 Absence of a unified insolvency law

Another issue with the previous insolvency regime was that there was no separate unified
insolvency law covering all the aspects of insolvency in one place. Further, there were a
lot of state amendments made to the insolvency acts dealing with individual insolvency
matters which further made it complicated for the creditors, who are spread all over the
country, to resort to these laws.

Thus, having a unified insolvency Code was considered to be a need of the hour, which led to
enactment of the Code. This Code has consolidated all the laws related to insolvency at one
place.
 CHAPTER 2

Need for Insolvency and Bankruptcy Code

Introduction

The Insolvency and Bankruptcy Code, 2016 (IBC) was enacted in India to provide a
comprehensive framework for resolving the insolvency and bankruptcy of companies,
individuals, and partnerships. The IBC was designed to overhaul India’s outdated insolvency and
bankruptcy laws and to provide a more efficient and effective system for resolving insolvency.

Before the enactment of the IBC, India’s insolvency and bankruptcy laws were archaic and
fragmented, making it difficult for creditors to recover their dues and for insolvent companies to
restructure or liquidate their assets. The IBC aimed to create a single, comprehensive framework
that would provide a time-bound and cost-effective process for resolving insolvency and
bankruptcy.

The IBC came into force on May 28, 2016, and has since undergone several amendments to
improve its effectiveness and address practical challenges.

Objective of IBC

The primary objective of the IBC is to provide a time-bound and efficient process for resolving
insolvency and bankruptcy in a transparent manner. The IBC seeks to:

 Maximize the value of the assets of the debtor,

 Promote entrepreneurship and encourage entrepreneurship,
 Ensure a timely and effective resolution of insolvency and bankruptcy cases,
 Balance the interests of all stakeholders, including creditors, debtors, and employees,
 Facilitate the promotion of a competitive market and economy, and
 Provide a framework to deal with cross-border insolvency cases.
 The IBC seeks to achieve these objectives through a well-defined process that includes
various stages, including initiation of insolvency, appointment of an insolvency
professional, submission of claims by creditors, resolution plan, and liquidation.

Insolvency Resolution Process

The Insolvency Resolution Process (IRP) is the key feature of the IBC. The IRP is a time-bound
process of resolving insolvency and bankruptcy cases that involves the appointment of an
insolvency professional to manage the affairs of the debtor and the resolution of the case in a
transparent and efficient manner. The IRP begins with the initiation of the insolvency process by
a creditor or the debtor. Once the process is initiated, an interim resolution professional (IRP) is
appointed to manage the affairs of the debtor during the insolvency process. The IRP has 180
days to complete the resolution process, which can be extended by another 90 days with the
approval of the National Company Law Tribunal (NCLT). During the IRP, the IRP invites claims
from creditors and manages the assets of the debtor. The IRP then prepares a resolution plan,
which can be submitted by the creditors or the debtor. The resolution plan must be approved by
the NCLT before it can be implemented. If the resolution plan is not approved, the debtor is
placed in liquidation, and the assets of the debtor are sold to recover the dues of the creditors.

Impact of IBC

The IBC has had a significant impact on the Indian economy since its enactment. The IBC has
provided a more efficient and effective system for resolving insolvency and bankruptcy cases,
leading to faster recovery of dues for creditors and a more transparent process for resolving
insolvency. The IBC has also encouraged entrepreneurship by providing a clearer framework for
resolving insolvency, making it easier for entrepreneurs to start new businesses and take risks.
The IBC has also helped in resolving several high-profile cases, including the resolution of
Bhushan Steel and Essar Steel, which were among the largest insolvency cases in India.

Challenges and Way Forward

Despite the success of the IBC, there have been several challenges that need to be addressed.
One of the key challenges is the backlog of cases in the NCLT, which has led to delays in the
resolution process. Another challenge is the lack of infrastructure and trained professionals to
manage the insolvency process. The shortage of insolvency professionals has led to a high
demand for their services, which has driven up the costs of the resolution process. To address
these challenges, the government has taken several measures, including increasing the number of
NCLT benches, increasing the number of insolvency professionals, and amending the IBC to
address practical challenges.
Conclusion
The Insolvency and Bankruptcy Code, 2016 has revolutionized the insolvency and bankruptcy
laws in India. The IBC has provided a more efficient and effective system for resolving
insolvency and bankruptcy cases, leading to faster recovery of dues for creditors and a more
transparent process for resolving insolvency. The IBC has encouraged entrepreneurship by
providing a clearer framework for resolving insolvency, making it easier for entrepreneurs to
start new businesses and take risks. Despite the challenges, the IBC has been a success, and the
government’s continued efforts to address the challenges will ensure that the IBC continues to be
an effective tool for resolving insolvency and bankruptcy cases in India.

Meaning of Sick company

The Term "Sick Companies" refers to those companies that are unable to meet their financial
obligations and are on the verge of closure. There are various legislations in India that deal with
sick companies, including the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA),
the Insolvency and Bankruptcy Code, 2016 (IBC), and the Companies Act, 2013.

Under the Sick Industrial Companies (Special Provisions) Act, 1985, a company is considered
"sick" if it has accumulated losses equal to or exceeding its entire net worth, and it has been
unable to repay its debts for a period of at least three consecutive quarters. The Act provides for
the appointment of a Board for Industrial and Financial Reconstruction (BIFR) to examine the
company's financial situation and recommend measures for its revival. The BIFR has the power
to order the winding up of the company or suggest a scheme for its rehabilitation.

The Insolvency and Bankruptcy Code, 2016 provides a mechanism for the resolution of
insolvency and bankruptcy cases. Under the Code, a company is considered "sick" if it is unable
to pay its debts when they become due or if it has defaulted on its payments for more than 90
days. The Code provides for the appointment of an Insolvency Resolution Professional (IRP) to
take over the management of the company and suggest a resolution plan. If the resolution plan is
not approved by the creditors, the company may be liquidated.

The Companies Act, 2013 also provides for the revival of sick companies. Under the Act, a
company is considered "sick" if it has defaulted on the repayment of its debts and is unable to
meet its financial obligations. The Act provides for the appointment of a Company Liquidator to
take over the management of the company and sell its assets to repay its creditors. The Act also
provides for the initiation of a scheme of revival and rehabilitation for the company, which may
include the restructuring of its debts, the infusion of fresh capital, and the appointment of new
management.

Nature of Sick Company

Under Indian law, sick companies can be classified into two broad categories based on their
nature. These are:

1. Industrial Sick Companies:

These are companies that operate in the manufacturing sector and are unable to operate
profitably due to various reasons, such as outdated technology, inadequate market
demand, lack of funds, etc. Industrial sick companies are mainly dealt with under the
Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), which provides for the
identification, protection, and revival of such companies.

2. Financially Sick Companies:

These are companies that are unable to pay their debts and meet their financial
obligations. Financially sick companies can operate in any sector, including
manufacturing, services, and trading. These companies are mainly dealt with under the
Companies Act, 2013 and the Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest (SARFAESI) Act, 2002.

The nature of sick companies can also be further classified based on the causes of their sickness.
These causes include external factors such as changes in government policies, market
fluctuations, economic slowdown, etc., and internal factors such as mismanagement, fraud,
embezzlement, etc. The identification of the causes of sickness is important for formulating a
revival plan for the company.
Based on potential of debt recovery of Sick Companies can be further classified into two
more classification:

1. Potentially viable sick companies:

Potentially viable sick companies are those that have the potential to be revived and
become profitable with the right intervention and support. These companies may be
facing financial difficulties due to factors such as mismanagement, a lack of funds, or a
decline in demand for their products or services. Under the various Indian laws, such
companies are given an opportunity to be restructured and rehabilitated through
mechanisms such as debt restructuring, infusion of new capital, or change in
management.

2. Non-viable sick companies:

Non-viable sick companies are those that have no realistic chance of being revived or
generating sufficient revenues to meet their expenses. These companies may have been
suffering from long-term financial losses, poor management, or structural problems in
their business model. Under the Indian laws, such companies may be subject to
liquidation, closure, or amalgamation with another company.

The nature of sick companies is important to determine the appropriate intervention mechanism
to be applied. For potentially viable sick companies, the focus is on restructuring and
rehabilitation, while for non-viable sick companies, the focus is on liquidation or closure. The
objective is to protect the interests of various stakeholders, including employees, creditors, and
shareholders, while ensuring the long-term viability of the company.

Modes of Debt Recovery of Sick Company

Debt recovery and restructuring are crucial processes in the Indian economy, as they help to
revive sick companies, reduce the burden on the banking sector, and promote economic growth.
In this answer, I will explain the procedures under various Indian legislation for debt recovery
and restructuring of sick companies.

Debt Recovery
Debt recovery refers to the process of recovering the unpaid loans or dues from a borrower.
There are several laws in India that govern debt recovery, including the Recovery of Debts Due
to Banks and Financial Institutions Act, 1993 (RDDBFI Act), the Securitization and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI
Act), and the Insolvency and Bankruptcy Code, 2016 (IBC).

Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI Act)
The RDDBFI Act provides a speedy and effective mechanism for the recovery of unpaid loans or
dues from borrowers. The Act established Debt Recovery Tribunals (DRTs) and Debt Recovery
Appellate Tribunals (DRATs) to facilitate the recovery process. The DRTs have jurisdiction over
the recovery of debts from banks and financial institutions, while the DRATs hear appeals
against the orders of the DRTs.
The process of debt recovery under the RDDBFI Act starts with the issuance of a notice to the
borrower demanding the repayment of the loan or dues. If the borrower fails to repay within 60
days, the bank or financial institution may file an application before the DRT for the recovery of
the debt. The DRT then issues a summons to the borrower, and after hearing both parties, passes
an order for the recovery of the debt.

Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest

Act, 2002 (SARFAESI Act)
The SARFAESI Act provides for the securitization and reconstruction of financial assets and
enforcement of security interest. The Act empowers banks and financial institutions to take
possession of the security provided by the borrower and sell it to recover the unpaid loans or
dues.

Under the SARFAESI Act, the bank or financial institution must first issue a notice to the
borrower demanding the repayment of the loan or dues. If the borrower fails to repay within 60
days, the bank or financial institution may take possession of the secured assets and sell them to
recover the unpaid loans or dues. The borrower has the right to appeal against the possession
notice before the Debt Recovery Tribunal (DRT).

Insolvency and Bankruptcy Code, 2016 (IBC)

The IBC is a comprehensive law that provides for the insolvency and bankruptcy of companies,
partnerships, and individuals. The Act provides for a time-bound process for the resolution of
insolvency and bankruptcy cases, with the aim of promoting the maximization of the value of the
assets of the debtor and balancing the interests of all stakeholders.

The IBC provides for two main procedures for debt recovery,The corporate insolvency
resolution process (CIRP) and the liquidation process. Under the CIRP, the debtor's management
is suspended, and a resolution professional is appointed to manage the affairs of the debtor. The
resolution professional invites resolution plans from interested parties, and the plan that
maximizes the value of the debtor's assets is accepted by the creditors. If no resolution plan is
accepted, the debtor goes into liquidation.

India’s rising NPA problem

Despite the introduction of prudential norms and a stringent regulatory mechanism, the
Indian banking system is still under continuous stress. According to the data from the Reserve
Bank of India (RBI), Non-Performing Assets (NPAs) for unrated loans has increased to 24%
(2018) from about 6% (2015).

Problem of Rising NPA Ratio

 Credit Boom: The problem of rising NPAs began since credit boom which the country
witnessed during 2003-04.
 o Between 2003-04 and 2007-08, the outstanding non-food credit or
the commercial credit expanded by three times, which during 2007-08 and 2011-
12 got doubled.
o It was a period during which the world as well as the Indian economy were
booming. Indian firms borrowed furiously in order to avail the growth
opportunities.
o Credit booms are generally succeeded by stress in the banking system which
actually happened in India.
 The substantial flow of credit to infrastructure (power, roads, telecom),
mining, aviation, iron and steel was important for growth but these were
also subject to severe output fluctuations, which raised a huge burden on
the banks. Also, large Chinese imports during that period affected the
iron and steel industry.
 Monetary Policy: The Reserve Bank of India also followed a tightened monetary
policy at that time.
o The Repo rate was increased from 6% (March 2004) to 9% (August 2008). Also,
the Cash Reserve Ratio was raised from 4.75% to 9%.
o But even after tightening the norms, the credit expansion happened which
ultimately led to rising NPAs.
o However, during 2008, the repo rate and CRR were lowered substantially in
response to the global financial crisis. There was a mild reversal of this step as
was marked by a slowdown in real growth (between 2009 and 2012).
 Role of NBFCs: In addition to that, the assets under management of mutual funds and
credit extended by Non-Banking Financial Company (NBFCs) also expanded
enormously during that period.
 Stalling Legislative & Judicial Procedure: Court judgments had an adverse impact on
mining, power and steel sectors. There were problems in acquiring land and
getting environmental clearances because of which several projects got stalled and
consequently, the project costs soared.
 Regulatory Forbearance: Although there were some regulatory steps that were initiated
like Asset Quality Review introduced in 2015 which tightened the situation to bring out
greater transparency led to a doubling of the NPA ratio in one year. But, by that time, the
banks were left with a huge problem with no immediate relief.
 Other reasons:
o With the onset of the global financial crisis in 2007-08 and the slowdown in
growth after 2011-12, revenues fell well short of forecasts. As a
result, financing costs rose as policy rates were tightened in India in response to
the crisis.
o Further, the depreciation of the rupee meant higher outflows for companies that
had borrowed in foreign currency.
 This combination of adverse factors made it difficult for companies to maintain and repay
their loans to banks. Higher NPAs meant higher provisions on the part of banks which
rose to a level where banks (especially PSBs) started making losses. Therefore, once
NPAs happen, it is important to resolve them quickly, otherwise, the interest on dues
causes them to rise relentlessly.
What needs to be done?

Reserve Bank of India

 Regulatory design needs to quantify financial and business cycles and take appropriate
remedial measures in time in the backdrop of challenges faced by the RBI on account of
external factors like the global financial crisis (2008-09).
o As international experience shows, increase in compliance cost does not
automatically translate to better regulation. The regulatory regime needs to
pinpoint parameters that need special attention for good governance.
 Also, as RBI has the responsibility to monitor macro-prudential indicators (such as
overall credit growth). This has implications when the RBI tightens or loosens
monetary policy.
o Therefore, RBI’s concerns must be communicated to the government/owners
within time limits, and made public so that informed decisions can be timely
taken.
 Notwithstanding several measures taken by the RBI, including the 2016 guidelines,
the performance of the resolution process has been slow and needs to be reviewed.
The Insolvency and Bankruptcy Code (IBC) is an important innovation but glitches
need to be timely resolved.
o The recent RBI issued new set of norms for dealing with stressed
assets/NPAs in the banking sector are a welcome step.

Government

 The government has the responsibility for overall management of the economy and
being the owner of the banks, it may push the banks in certain directions. The
government must ensure that banks run in the larger national interest but commercial
decisions are best left to bank boards.
o The relationship between the government and the boards/CEO is still an
unresolved question. Therefore, improvement in governance of the boards needs
to be done.
o Banks’ Boards must be empowered to decide on capital raising plans from the
market within a well-defined framework.
 Recapitalisation may be done in cash rather than through bonds or in some combination.
 The government and regulators need to promote specialised institutions for project
finance (funding long-term infrastructure/industrial projects, and public services using a
limited financial structure). The promotion of corporate debt markets both for
performing loans as well as distressed loans needs special attention.
 Also, reliance on project appraisal by just one single institution has entailed losses to a
number of small and medium banks. Hence, there is a need for institutionalized
mechanism that can efficiently perform such function.

Banks
  Management: Banks need to take responsibility for the soundness of credit decisions.
They need to identify and define their own risk taking capabilities rather than leaning on
the big lenders’ appraisal.
o Banks need to significantly upgrade their appraisal and monitoring skills and
invest in personnel training. Risk management needs to be improved at all levels.
 Audit: Assurance systems (internal & external audits and credit rating) need to be
strengthened.
o Given the reported large scale siphoning (illegal transfer) of funds, round
tripping of debt as equity through dozens of shell companies needs to be
checked through forensic audits at annual reviews.

The need of the hour is a concentrated focus on the part of the government and efficient
implementation of policies like Project ‘Sashakt’ so as to effectively tackle the problem of
rising NPAs.