Insolvency

How Does Insolvency Occur?

There are two main types of insolvency:

• Cash-flow Insolvency: This happens when an entity owns valuable assets but does not have enough liquid funds to repay debts on time. For example, someone may own property worth ₹2 crore but lack the cash to service a loan installment of ₹10 lakh.

• Balance-sheet Insolvency: This arises when the total value of liabilities exceeds total assets, leading to negative net worth. It is a deeper financial issue that often pushes businesses into restructuring or bankruptcy proceedings.

Example

XYZ Company buys machinery with a loan equal to its market value. When the value of the equipment drops due to rapid innovation, the company's total assets fall below its liabilities. Even if the firm still has a steady cash flow, it is technically balance sheet insolvent because its liabilities are higher than its assets.

Key Elements of Insolvency

• Debt Restructuring: Borrowers can negotiate new repayment terms with creditors to ease repayment pressure.

• Resolution Process: In India, the Insolvency and Bankruptcy Code (IBC) outlines a formal resolution process, including the appointment of insolvency professionals and the formation of a committee of creditors.

• Asset Protection: Some assets, like a primary residence, may be protected during the insolvency process.

• Creditor Hierarchy: The order in which different creditors are paid is clearly defined, with secured creditors generally getting priority.

Benefits of a Structured Insolvency Framework

• Path to Recovery: Insolvency does not always lead to liquidation. Businesses can restructure and continue operating.

• Asset Protection: Essential assets may be safeguarded to protect individual dignity and allow recovery.

• Debt Discharge: Upon successful resolution, remaining debt may be legally discharged.

• Creditor Recovery: Lenders can convert non-performing loans into performing assets or regain partial funds through structured settlements.

Challenges in the Indian Context

• Time-Consuming: Despite improvements under the IBC, resolutions can still take years due to delays in the National Company Law Tribunal (NCLT).

• Lack of Skilled Professionals: The process depends on insolvency professionals, yet there is a shortage of experienced individuals in this space.

• Low Recovery Rates: Lenders often recover only a portion of the original loan amount.

• Complex Business Structures: Modern conglomerates with multiple subsidiaries and cross-holdings make asset tracking and resolution more difficult.

• Creditor Conflicts: Disagreements among various classes of creditors can stall the process.

Conclusion

Insolvency is a financial signal that action is needed. While it can be a stressful phase for individuals and businesses alike, India’s maturing IBC framework offers a structured path to resolution. With the right professional guidance and legal support, insolvency can be a turning point towards recovery rather than a dead end.