FINANCIAL STRESS & INSOLVENCY ISSUES FOR MSMEs

Micro, Small and Medium Enterprises (MSMEs) are amongst the strongest drivers of economic development, innovation, and employment. The sector also contributes in a significant way to the growth of the Indian economy with a vast network of about 63.38 million enterprises. The sector contributes about 45% to manufacturing output, more than 40% to exports, over 28% to the GDP while creating employment for about 111 million people, which in terms of numbers, stands next to the agricultural sector. The MSME sector in India is exceedingly heterogeneous in terms of size of the enterprises and variety of products and services, and levels of technology employed[1]

MSME is classified into two categories:

  1. Manufacturing enterprise; and
  2. Service enterprise.

They are defined in term of investment in Plant and Machinery/ Equipment as below:

Particular MICROSMALLMEDIUM
Manufacturing EnterprisesRs 2,500,000

Less than

Rs 50,000,000

Less than

Rs 100,000,000

Service Enterprises

Less than

Rs 10,00,000

Less than

Rs 20,000,000

Less than

Rs 50,000,000

 

In India, significant chunk of the formal credit market consists of loans to individuals, and to small and medium enterprises (“SMEs”) which may be in the form of sole proprietorship, Partnership, Company etc. In light of the above, stress and insolvency of MSMEs has become a prominent issues  in India.

REASON OF STRESS IN MSME SECTOR

 Often, in spite of best efforts by the promoters and accommodation by the lenders, MSME units fail and such units move towards insolvency or individual bankruptcy. In many economies, MSMEs are amongst the largest commercial beneficiaries of the insolvency system.In India, Outstanding MSME credit to enterprises stood at ₹14.68 lakh crore[2]. This includes ₹13.24 lakh crore from banks and ₹1.44 lakh crore from the NBFCs. Range of NPAs in MSMEs is 8.5%-11.3[3]% as on 30th September2018.

The MSMEs in India are currently facing stress due to a lot of reasons which include certain short-term effects of economic reforms as well as certain structural issues.Demonetization and implementation of GST has resulted in short term to medium term stress amongst MSMEs. Since a bulk of transactions in this sector are cash-based, a liquidity crunch, due to demonetizationhas contributed to the slowdown in the sector[4].While, GST was implemented with the intent to integrate the indirect tax regime across India however, the implementation of the same has always been under question due to various issues, especially when it comesto  the impact on the MSME sector. These issues include high compliance burden, taxation under reverse charge for un-registered purchases, taxation on stock transfers, availability of composite levy, condition for payment and filing of return for availing input tax credit, etc[5].MSME exports have been affected more adversely by issues relating to GST implementation than demonetization due to delay in refund of upfront GST and input tax credit affecting cash-driven working capital requirements[6]. Implementation of IBC has also led to the stress inthe sector, as the payment of many operational creditors which largely consists of  MSMEs is stalled for a period of at least 330 days and have to forgo certain part of total receivables.

Various inherent structural issues, faced by MSMEs in India include delayed payment to MSMEs, multiple registration, compliances under different statues, lack of innovation, technology adoption and non-availability of timely formal credit, etc[7].

MSME & IBC

 Insolvency and Bankruptcy Code, 2016 (“IBC” or “Code”) brought in a robust insolvency regime in India which isnovice for the corporates. The IBC is a one stop solution for resolving insolvencies which previously was a long process that did not offer an economically viable arrangement. The code aims to protect the interests of small investors andprovidesfor an ease of exit for businesses in India..Lawmakers are actively bringing changes in code as the law is taking its time in settling down because of procedural, structural and legal issues[8]. Such changes, inter-alia, includeproviding minimum liquidation value to the operational creditors,the inclusion of homebuyers within the definition of Financial Creditors, etc.

Going by  the recent data published by the IBBI, the code has been successful in increasing the average recovery from 23%[9] to 41.53%[10] for the financial creditors and reducing the collection period significantly. Enactment and implementation of the code has been a major factor, resulting in improvement in India’s ranking in Ease of Doing business as published by the World Bank[11]. However, there are doubtslooming over a large number of casesresulting in liquidation under the code. As per the data published by the IBBI[12], out of 743 Insolvency Proceedings Pronouncement, 587 (nearly 79%) have ended in liquidation. However, it is important to note that 72.86% of the CIRPs ending in liquidation (427 out of 587) were earlier in process of resolution under BIFR orwere defunct. The economic value in most of these CDs had already eroded before they were admitted into CIRP[13].

IBC has also become an effective recovery tool for the Operational Creditors, which includes MSMEs as well. The same is reflected by the fact that almost 49%7 of the proceeding under IBC are initiated by Operational Creditors. However,according to Anil Bhardwaj, Secretary-General, FISME, ina recent interview published in Economic Times, “anomalies under IBC and Corporate NPAs can lead to bankruptcy in MSMEs”.

The code has been a major success in resolving stress in big companies, as they attract many buyers but for MSMEs, the code is still a gateway to liquidation. Various issues faced by MSMEs duringthe resolution process under the code,are as follows:

  1. Cost of resolution process is very high for the MSMEs;
  2. The process referred under Chapter-III of the code is very complex and cumbersome for the promoters of MSMEs to understand;
  3. There is lot of information asymmetry in terms of financial information and operational information of the MSMEs as its operations are being managed by individual promoter or small group of promoters;
  4. Record keeping by MSMEs is generally poor and therefore difficult for IPs to manage the company;
  5. There are very limited buyers for the MSMEs, therefore resulting in CIRP to become a gateway to liquidation for them.

 However, as noted by the Report[14] of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI,betterlegislation canreduce the cost of credit. This is important for MSMEs because a lower cost of credit makes financing more accessible and affordable. In Brazil, reforms to its insolvency legislation caused an average reduction in the cost of credit ranging from 7.8 % to 16.8% from the level prior to the reforms being enacted. A study involving SMEs in France, Germany, and the United Kingdom found that banks priced their loans based on their expected rights in the event of a default. In United Kingdom, revised reorganization laws resulted in new owners retaining all employees of enterprises in 65 percent of receivership and administration cases, where the business was sold as a going concern. Job preservation for MSME employees is particularly important because MSMEs are the largest source of employment in many economies.

Due to the above stated factors, there needs to be certain reconsideration of the insolvency process, in order to ensure the timely resolution and protection of the MSMEs. As stated in the executive summary of report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI, based on the vulnerability and size, insolvency code should provide for out-of-court assistance to MSMEs, who are predominantly proprietorships, such as mediation, debt counseling, financial education, etc.

Therefore, in order to ensure easy exit and resolution of stress amongst MSMEs,the following mechanism can be implemented:

CHANGES WITHIN THE CODE:

Fast track process under IBC:

 IBC has already provided carve-out for MSMEs under Section 29A, in order to ensure that the MSMEs are not pushed towards liquidation. However, the CIRP under Chapter-II of Part-II of the code is very costly in respect of MSMEs, therefore there is a need to bring MSMEs under fast track corporate insolvency resolution process under  Chapter-IV of Part-II of the IBC, which provides for quicker resolution in 90 Days, instead of 180 days. However such process needs to be revamped considerably, in order to make it tailor-made for small corporate debtors and MSMEs.

Such changes[15] in the process could include

  • basing the interface with the Adjudicating Authority through online means;
  • reducing documentation requirements;
  • deeming that the approval of the CoC has been received in some cases;
  • making the formation of the stakeholders’ consultation committee in liquidation, optional in some cases;
  • providing for a template resolution plan for small CDs, that may even be generatedusing appropriate software;
  • allowing for private sales in a larger number of circumstances in liquidation; and
  • providing for a duty to file in limited circumstances to incentivize timely filing, as opposed to relying purely on wrongful trading provisions which are difficult to

Pre-Packed Insolvency Process:

 As already discussed above, cost of insolvency process for the MSMEs is quite high, including in respect of non-monetary terms such as stigmatization by society, lost of trust amongst different market players etc. As noted by the Insolvency Law Committee[16], a business of an MSME attracts interest primarily from a promoter of an MSME and may not be of interest to other resolutionapplicants. Therefore by going ahead with this rationale, instead of making the firm to go through a costly and tardy CIRP, a pre-pack insolvency regime can be introduced, where the debts and payment of the firm can be restructured in such a way that, it is able to revive itself along with certain operational restructuring.

In INSOL International publication[17], the relevance of pre-packed insolvency in relation to SME in England and Wales is stated as follows:

“From practical experience, the pre-pack sale has become the procedure of choice when trying to save the business of an MSME. Even though it is a controversialprocedure, a sale back to the existing owners often provides the best value for creditorsin terms of asset realizations[18]”.

Such a regime can include following features15, in order to ensure that they are effective

  • Initiation of the process before actual default on the instance of the debtor in additionto the commencement on default on the instance of the creditor;
  • The debtor in possession, with the potential of having a supervisor;
  • Reducing the involvement of courts, including by deemed approval of a resolutionplan where creditors approve of it; and
  • Allowing the debtor to propose a resolution plan which, if approved, could bindminority creditors.

 

CHANGES OUTSIDE THE CODE:

Better Formal Restructuring Arrangements

 Reserve Bank of India has issued prudential norms, commonly known as June 7 Circular, making it mandatory for Bank, Financial Institution and other lenders to first consider resolution outside IBC and if such exercise doesn’t result in resolution, then they may proceed with IBC. However, such norms are applicable toonly for certain large borrowers. There is need for such kind of structure, even for MSMEs.

The major reason for stress[19]in relation to MSMEs includes:

  • Overall 30-35 % borrowers in this category have debtor days > 90 days;
  • High rotation with lending bank, end-use of funds in the line of business, timely submission of regulatory requirements, management involvement, competency in areas of business and compliance conscience; and
  • Average utilization of 60-70% on a portfolio basis, hence additional funds available with them to meet any contingency on account of delay in receivables.

Such kind of issues can be addressed with formal restructuring with banks and other lenders if such stress is detected at an early stage. RBI has issued certain guidelines in this respect, however the same is not enough, as in case of lenders there is high information asymmetry. Therefore, in order to ensure turnarounds and resolution of stress, lenders can provide for strict monitoring guidelines and efficient restructuring framework can provide for better opportunity and resolution for MSMEs

Ensuring timely debtors payment and effective implementation of the MSMED Act:

As discussed above, the MSMEs in India are facing issues relating to delayed payment to MSMEs. In India, normal debtor cycles have been more than 90 days[20], which has resulted in increasing the working cycle of MSMEs, to a period of 300 Days20. Various government companies, state authorities also delay payment of MSMEs. Such delayed payments affect the efficiency and cost for such entities, which may also lead to defaults by MSMEs. It was observed, more than 35% of NPAs in the MSMEs sector haveoutstanding debtors more than 90 days[21].

To solve the problem of delayed payments of small-scale (Micro and Small) sectors, government introduced Micro, Small and Medium Enterprise Development Act, 2006 that includes provision of payment of 45 Days to MSMEs in case of no written agreed period. However, its implementation is not as intended and no benefit could be derived by MSMEs under this act as bargaining power of MSMEs is much lower.

There are certain efforts taken by the government to address the issues, that include introduction of form MSME-1[22] under the Companies Act, 2013,introduction of MSME SAMADHAAN[23] portal that aims at solution of delayed payment to MSMEs, establishment of TReDS portal[24], etc. However, these efforts are not enough and entities are still facing these issues.

Therefore wayshave to discovered for better implementation of MSMED Act and ensuring that the debtors are timely converted into cash as per the working capital requirement.

Easy and cheaper availability of formal source of Funds:

MSMEs in India largely rely on informal sources for equity, i.e. own saved funds and funding from family & friends. Debt has been preferred mode of borrowing for entrepreneurial activity in India through products such as Loan Against Property (LAP) and Jewel Loans[25]. As per data collated by RBI, as on March 2018, outstanding MSME credit to enterprises stood at ₹14.68 lakh crore. This includes ₹13.24 lakh crore from banks and ₹1.44 lakh crore from the NBFCs9. The total addressable demand for external credit is estimated to be ₹37 trillion. Therefore, the overall credit gap in the MSME sector is estimated to be ₹ 20-25 Trillion[26] which implies that the formalsource of finance is being utilized by very few enterprises.

There have been many barriers[27] to lending to MSMEs that includes

  • High credit risk as the NPA rate is quite high. Currently, it is18% for the Medium category of the entities;
  • Cost-to-serve, in relation to MSMEs,is quite uncertain, due to information asymmetry, particularly with respect to the financial performance of the business;
  • Lender coverage. While many urban areas have sufficient lenders,there are limited number of lenders in rural area.
  • Another barrier includes credit coverage, as there is very poor credit depth in large parts of the country. This remoteness translates into weaker access to formal credit.

Reserve Bank of India and Government has tried to resolve the issue by taking various steps, that includes PSBLoansIn59Minutes, Interest Subvention to MSMEs[28]. CGTMSE Scheme by SIDBI[29]etc.

However, the said efforts are not enough as there is still requirement of 20-25 trillions more funds. Such gap can be filled with funding from venture capitalist or making a certain change in lending policy or establishment of stress assets fund, which provide certain extra funds, if an entity is going through stress and ensuring turnaround of MSMEs, establishment of exchanges where such exchanges can help them to get easy access to debt and equity market. Sincere efforts are required to decrease dependence of MSMEs over informal finance. To implement such changes, there is a need for active participation of SIDBI and other financial institutes, who were given mandate to finance MSMEs.

 Access to External Commercial Borrowings:

 External Commercial Borrowing is basically a loan availed by an Indian entity from a non-resident lender. Most of these loans are provided by foreign commercial banks and other institutions. It is a loan availed of from non-resident lenders with a minimum average maturity of 3 years.During several years, contribution of ECBs was between 20 to 35 percent of the total capital flows into the country. The large number of Indian corporate and PSUs have used the ECBs as sources of investment.

The bulk of the overseas loans or ECBs into the country are obtained by private sector corporates. For the corporate, ECB is dependable and easy to obtain funds and helps them to make business/investment expansion[30].

In recent years, RBI has liberated norms related, to borrowing through ECBs, however under the current regime, MSMEs are not able to take advantage of such capital.

As per RBI circular RBI/FED/2018-19/67, there is a lock-in period of at least 3 years for borrowing any money under ECBs, which get increased to5 years if the same is provided for the working capital requirement. Such kind of barriers has made it difficult for MSMEs to access ECB.

ECBs can be used by MSMEs in a very effective manner as it will help in reducing their costs, especially for those who are naturally hedged against foreign currency payment.

It must be noted that SIDBI has made huge borrowing from ECBs, in order to provide cheaper loans to MSMEs, however it would be much beneficial for MSMEs to directly get access to ECBs and get a cheaper loan. Therefore, certain steps should be taken in liberalizing the norms in such regards.

Conclusion

MSMEs play a crucial role in development, sustainability, and growth of any economy, especially in case of emerging economy like India. We have noticed that the reason for stress is generally either finance related or fundamentals related. There have been regular efforts in relation to fundamental issues, which include providing TUFF subsidies for technology up-gradation, relaxation in GST filing and other compliances for MSMEs but finance related deficiencies are still to be addressed.

In order to ensure the survival and healthy growth of MSMEs, certain steps, as discussed above, are required to be undertaken by the relevant authorities and stakeholders. This requires contribution and efforts from Government authorities, as well as Public State Banks, as well as Financial Institutions and regulators, like IBBI, SEBI, RBI, etc.

Footnotes

[1]Based on the information provided in Para 1.1.1 of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[2]Based on data of March 2018, published by RBI, provided in Box X of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019.

[3]Based on data of March 2018, published by RBI, provided under 7.2.3 Credit Exposure and NPAs by Segment of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019.

[4]The said opinion is based on the research paper published by Dr. Karigoleshar in International Research Journal of Management and Commerce, published in Impact factor 5.5.64 Volume 4, Issue 10, October 2017.

[5]The said opinion is based on the report by Institute of Chartered Accountant of India in relation to GST Impact on MSME Sector. Link of the saidreport: http://idtc-icai.s3.amazonaws.com/download/knowledgeShare17-18/GST_Impact_in_MSME_Sector.pdf

[6]The said opinion is based on the Mint Street Memo No. 13 published by RBI,  How have MSME sector Credit and Export fared, authored by Harendra Behera and Garima Wahi.

[7]Based on the executive summary of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[8]Law has been amended thrice, i.e. in year 2017,2018,2019 since its introduction in year 2016 and also have constituted many committees, that includes Insolvency Committee on Group Insolvency, Cross Border Insolvency etc.

[9] Based on the data published by EODB,2017 report.

[10] Based on the data published by IBBI Newsletter for July-Sept,2019 quarter on Table 7, Page 15

[11] Ease of Doing Business rank has improved to 77  from 132 i.e. post and pre IBC period. Refer Page 18 of EODB, 2019 Ranking of EODB for the clause Refer Page 18 of EODB, 2019 under the head strengthening legal rights of borrowers and lenders for impact of IBC.

[12]Based on the data, published by IBBI Newsletter for July-Sept,2019 quarter on Table 1, Page 14 where total 743 insolvency proceeding has started .

[13]Based on the data, published by IBBI Newsletter for July-Sept,2019 quarter on Table 6, Page 14

[14]Based on the para 4.12.2 of the report

[15]Changes and said recommendation are based on the Research paper, Re- designing the Fast Track Insolvency Process by Ms. Shreya Prakash, published by IBBI-A Miscellany of Perspectives,

[16]Based on the para 27.4, of Report of Insolvency Law Committee Report,2018 published in March 2018

[17]Insol International-restructuring options for MSMEs and proposals for reforms, published in year 2018

[18]Refer para 4.1 in Insol International-restructuring options for MSMEs and proposals for reforms, published in year 2018

[19]Based on the information provide in Box XI of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[20]Based on the information provide in Para 4.3.1 of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[21]Based on the information provide in Box XI of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[22]the MCA wide order dated 22nd January, 2019 directed all companies, who get supplies of goods or services from micro and small enterprises and whose payments to micro and small enterprise suppliers exceed forty five days from the date of acceptance or the date of deemed acceptance of the goods or services as per the provisions of section 9 of the Micro, Small and Medium Enterprises Development Act,2006 (27 of 2006) (hereafter referred to as “Specified Companies”), shall submit a half yearly return to the Ministry of Corporate Affairs stating the following:

(a) the amount of payment due; and

(b) the reasons of the delay;

[23]Portal was setup under the  provisions of Delayed Payment to Micro and Small Enterprise (MSEs). (Section 15- 24) of The Micro, Small and Medium Enterprise Development (MSMED) Act, 2006. The provisions under the Act are implemented by MSEFC chaired by Director of Industries of the State /UT having administrative control of the MSE units. State Government/UTs are requested to ensure that the MSE Facilitation Council hold meetings regularly and delayed payment cases are decided by the Councils within a period of 90 days as stipulated in the MSMED Act, 2006.

[24]The scheme for setting up and operating the institutional mechanism for facilitating the financing of trade receivables of MSMEs from corporate and other buyers, including Government Departments and Public Sector Undertakings (PSUs), through multiple financiers is known as Trade Receivables Discounting System (TReDS)

[25]Based on the information provide in Para 7.19  of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[26]Based on the information provide in Para 7.2.1  of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[27]Based on the information provide in Para 7.3  of Report of the Expert Committee on Micro, Small and Medium Enterprise published in June 2019 by RBI

[28]RBI issued circular number RBI/2018-19/125 dated 21.02.2019, to provide for interest subvention to

[29]Launched in 2000, Credit Guarantee Funds Trust for Micro and Small Enterprises (CGTMSE) is a government initiative by the Ministry of Medium, Small and Micro Enterprises (MSME) in association with the Small Industries Development Bank of India (SIDBI). Its focus is to provide credit guarantee to financial institutions that provide loans to MSMEs. CGTMSE provides a guarantee to lending institutions up to a certain limit for all lending done by them to the MSME sector. This initiative allows banks and other lending institutions to provide funds to first generation entrepreneurs without the need for collateral/security or third party guarantees.

[30]Source of Information: https://www.indianeconomy.net/splclassroom/what-is-external-commercial-borrowings-ecbs-what-are-their-advantages/

Archit Gupta, is a chartered accountant, having experience of more than 3 years in various fields of the profession including forensic audit, valuation, indirect taxation, statutory audit, etc. He is DISA qualified and holds a certificate on forensic audit and fraud prevention issued by ICAI. He has also cleared the exam for registered valuer for asset class of securities and financial assets, held by IBBI and will soon be a registered valuer.