Evaluating Some Strategies for Preventing Insolvency Proceedings in the Wake of the COVID-19 Crisis

In wake of the COVID-19 pandemic various countries are taking steps to modify the application of their insolvency laws. Many countries have taken steps to prevent the initiation of insolvency proceedings by suspending duties on directors to file for insolvency proceedings. However, some countries have also proposed steps that will effectively result in suspending the initiation of insolvency proceedings for a significant period of time. India for example has proposed that, if the lockdown due to COVID-19 continues beyond April 30, it may suspend all recourse to insolvency proceedings for a period of six months.

The adoption of an approach preventing the initiation of insolvency proceedings appears to be motivated by three factors. First, due to political economy-related reasons, lawmakers may want to comfort business owners (particularly those who run small businesses) whose businesses have been affected due to lockdowns, that they will not be placed in insolvency. This compulsion may be enhanced in countries like India where most large lenders are state-owned. Secondly, there is concern that institutional infrastructure such as bankruptcy courts and insolvency professionals would not be able to handle a large number of insolvency cases which could commence due to the economic crisis caused by COVID-19. This would lead to value destruction on account of delays and inefficient management of processes, which already tend to be costly. Thirdly, where insolvency procedures are more suited towards achieving sales of businesses rather than reorganization with the existing ownership and management in place, there is a concern that there may not be enough buyers for companies undergoing insolvency proceedings. This would mean that in many cases companies and/or their assets would be sold very cheaply in insolvency. In this light, a response to make it harder to file for insolvency is justified to some extent. 

However, these concerns ought to be counterweighed against other factors. Most obviously, there may be continuing need to give business owners a chance to have recourse to a formal and binding process that allows them to restructure their liabilities in a sustainable manner or exit the business when they are in a financial crisis. This is particularly important where not all debt enforcement proceedings are suspended (in addition to the suspension of insolvency proceedings), since in that case creditors may attempt piecemeal debt enforcement which the debtor will not get breathing space to defer. Some stakeholders may also be better protected by the commencement of insolvency proceedings. For instance, in the absence of robust social security systems, interests of creditors such as employees may be best accounted for if they have recourse to insolvency proceedings, which protect payments to them. Further, where creditors cannot refrain from enforcement, insolvency proceedings that are collective proceedings and offer a chance to keep the debtor’s assets together may lead to better recoveries for creditors, particularly when they are unsecured. In jurisdictions like India, financial institutions are already saddled with non-performing assets and debt enforcement is more time-consuming than insolvency proceedings in many cases. Given this, allowing recourse to insolvency proceedings in some cases may be helpful in preserving the health of financial institutions as well. Clearly, a proposal to suspend the initiation of all insolvency proceedings for a significant period of time, as in India, or even a proposal that suspends the initiation of all insolvency proceedings due to defaults that could be attributed to the COVID-19 crisis does not adequately take these into account.

Instead, steps should only be taken to prevent unnecessary insolvency proceedings, that is, to ensure that those businesses that are only temporarily facing a cash flow crisis do not need to have recourse to complicated restructuring or liquidation proceedings. One way to do that could be to try providing temporary liquidity support to businesses directly, so that they do not reach the point of insolvency. This could be complemented with a scheme allowing businesses who can negotiate forbearance on debt enforcement with a majority of their creditors to win a legally backed moratorium for a defined period of time, similar to what has been proposed in New Zealand. Such a moratorium would be based on the consent of creditors, meaning that creditors can by-and-large absorb the non-payment of debts, and will give businesses some breathing time within which they can restart their business. It should also not be designed as time-consuming and costly court-supervised restructuring procedure, recourse to which should be prevented unless necessary.

However, if creditors do not agree or the measures are not enough to resolve the financial problems of the business, recourse to insolvency procedures should be allowed. Even if the number of such cases is higher than usual, it may be more helpful to ramp up infrastructure and introduce less costly insolvency procedures (as has been done in the US) rather than completely suspending initiation of insolvency proceedings.

Shreya Prakash is a New Delhi-based lawyer.