Vol 12 (2015) - Issue 1

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Insolvency and the Investment Climate for SMEs in India

Why insolvency? Why is it important for SMEs?
Lack of an appropriate exit mechanism stifles risktaking and entrepreneurship, which are essential in a dynamic modern economy. When small entrepreneurs are insolvent, they need an effective and efficient exit mechanism that distributes the remaining assets of the enterprise and allows the entrepreneur, the individual, to gain a fresh start and return to economically productive activity as soon as possible. The current system in India does not allow the type of effective exit described. Without an effective mechanism, the entrepreneur can be shackled by debt indefinitely. In India, statutory debt, or debt to government entities, can be particularly burdensome, and there is little escape. In such a climate, a promising risk-taker will be prevented from using his skills and courage to undertake another venture. Instead, he will be obligated to service the debts from a prior failure indefinitely.

Relevance to Indian SME sector: Composition of Indian firms/companies
The overwhelming number of Indian businesses, as counted in units (not by portion of revenue or employment) are either proprietorships or partnerships. According to the 2001-2002 census of Small Scale Industries (SSI), proprietorships or partnerships constitute 97.3% of all units in India, leaving a tiny minority of business units, and a very tiny proportion of small units, that are incorporated. SMEs are responsible for about 45 percent of manufacturing output in India. Financial troubles have been rising in recent years, as the banking industry estimated a doubling and possibly tripling of bad loans in 2008, from 5-7% bad loans to 14-19% for some banks. Thus addressing the growing financial problems of SMEs which form such a substantial part of the economy is crucial. Allowing the entrepreneurs that run these companies to recover and reenter the marketplace is essential to support a dynamic economy. Further, maintaining the integrity of the broader creditor-debtor context through predictable and effective distribution of remaining assets of failed enterprises is crucial to preserving access to credit for the small entrepreneur.

Current system in India for SME insolvency
The current system in India is fragmented and ineffective for small entrepreneurs. It does not serve their needs. As stated by Anil Bhardwaj in relation to the plight of the insolvency Indian small entrepreneur, ‘In the quagmire of legal battles, the life of entrepreneur is ruined and productive assets get locked for years.’

A. Companies Act and other laws for larger companies
There is no comprehensive bankruptcy policy or law in India. The Companies Act contains the provisions for bankruptcy proceedings in court for companies under its jurisdiction. Companies may also be subject to the jurisdiction of other laws and institutions when they are in financial trouble. The Sick Industrial Companies Act of 1986 (SICA) was enacted to handle financially weak industrial companies.5 SICA established the Board for Industrial and Financial Reconstruction (BIFR).