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BUSINESS FAILURE AND REORGANIZATION

INTRODUCTION
A business failure is an unfortunate circumstance. It can be considered from both an economic and a
financial viewpoint. In an economic sense, business success is associated with firms that earn an adequate
return (equal to or greater than the cost of capital) on their investments.

Similarly, business failure is associated with firms that earn an inadequate return on their investments.

An important aspect of business failure involves the question of whether the failure is permanent or
temporary. For example, suppose a company has Rs 100 crore invested in assets and only generates
operating earnings of Rs 1 crore. Obviously, this 1 percent return on investment in inadequate. However,
the appropriate course of action depends to some extent on whether this business failure is judged to be
permanent or temporary.

If it is permanent, the company probably should be liquidated. If failure is temporary, the company
probably should attempt “to ride out the storm,” especially if steps can be taken to speed the company’s
return to business success. From an economic standpoint, business failure also is said to exist when a
firm’s revenues are not sufficient to cover the costs of doing business.

TYPES OF BUSINESS FAILURES

A firm may fail because its returns are negative or low. A firm that consistently reports operating losses
will probably experience a decline in market value. If the firm fails to earn a return that is greater than its
cost of capital, it can be viewed as having failed. Negative or low returns, unless remedied, are likely to
result eventually in one of the following more serious types of failure.

A second type of failure, technical insolvency, occurs when a firm is unable to pay its liabilities as they
come due. When a firm is technically insolvent, its assets are still greater than is liabilities, but it is
confronted with a liquidity crisis.

If some of its assets can be converted into cash within a reasonable period, the company may be able to
escape complete failure. If not, the result is the third and most serious type of failure, bankruptcy.
Bankruptcy occurs when a firm’s liabilities exceed the fair market value of its assets. A bankrupt firm has
a negative shareholders’ equity. This means that the claims of creditors cannot be satisfied unless the
firm’s assets can be liquidated for more than their book value. Although bankruptcy is an obvious form of
failure, the courts treat technical insolvency and bankruptcy in the same way. They are both considered
to indicate the financial failure of the firm.

FREQUENT CAUSES OF FAILURE

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Although causes of business failure vary from firm to firm, we can identify several common ones. The
predominant cause of failure is managerial incompetence. Also, the following key structural problems
within management may appear:

(1) An imbalance of skills within the top echelon. A manger tends to attract other managers of similar
skills. For example, the corporate management may consist principally of individuals having a background
in sales, without anyone having production experience.

(2) A chief executive who dominates a firm’s operations without regard for the inputs of peers.

(3) An inactive board of directors. The board of directors’ lack of interest in the financial position of the
company may lead to insolvency.

(4) A deficient finance function within the firm’s management. Not infrequently, the only substantial input
provided by the financial officer occurs when the budget is submitted to the board. A company may have
an effective financial information system, however this information is of no avail if it does not flow to the
board through a strong financial officer.

(5) The absence of responsibility for the chief executive officer. Although all other managers with a
company are responsible to a superior, the chief executive seldom must account of his actions.
Conceptually, this person is responsible to the shareholders, the link is tenuous or even missing
altogether.

The foregoing deficiencies render the firm vulnerable to several mistakes. First, management may be
negligent, in developing effective accounting systems. Second, the company may be unresponsive to
change—unable to adjust to a general recession and unfavourable industry developments. Third,
management may be inclined to undertake an investment project that is disproportionately large relative
to firm size. If the project fails, the probability of insolvency is greatly increased. Finally, management may
come to rely so heavily on debt financing that even a minor problem can place the firm in a dangerous
position.

SYMPTOMS OF SICKNESS
Sickness does not occur overnight, but develops gradually over the period of time. Some of the common
symptoms which predicts the company is heading for a failure by sick/bankruptcy are:

• Delay or default in payment to suppliers

• Irregularity in the bank account
• Delay or default in payment to banks and financial institutions
• Non submission of information to banks and financial institutions
• Frequent requests to banks and financial institutions for additional credit.
• Decline in capacity utilisation
• Poor maintenance of plant and machinery
• Low turnover of assets
• Accumulation of inventories
• Inability to take trade discount
• Excessive turnover of personnel
• Decline in the price of equity shares and debentures
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• Poor internal control systems

• Very Highly leveraged capital structure.
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VOLUNTARY REMEDIES TO INSOLVENCY

Once a firm begins encountering these difficulties, the firm’s owners and management have to consider
the alternatives that are available to failing businesses. In general, a failing company has two alternatives:

First, it can attempt to resolve its difficulties with its creditors on voluntary, or informal, basis.

Second, it can petition the courts for assistance and formally declare bankruptcy. A company’s creditors
also may petition the courts, and this may result in the company’s being involuntarily declared bankrupt.

Regardless of whether a business chooses informal or formal methods to deal with its difficulties,
eventually the decision has to be made whether to reorganise or liquidate the business.

Before this decision can be made, both the business’s liquidation value and its going-concern value have
to be determined.

Liquidation value equals the proceeds that would be received from the sale of the business assets minus
liabilities.

Going-concern value equals the capitalised value of the company’s operating earnings minus its liabilities.

Basically, if the going-concern value exceeds the liquidation value, the business should be reorganised;
otherwise, it should be liquidated. However, in practice, the determination of the going-concern and
liquidation values is not an easy matter. For example, problems may exist in estimating the price the
company’s assets will bring at auction. In addition, the company’s future operating earnings and the
appropriate discount rate at which to capitalise the earnings may be difficult to determine. Also,
management understandably is not in a position to be completely objective about these values.

INFORMAL REMEMIDES TO INSOLVENCY

Informal Alternatives for Failing Businesses Regardless of the exact reasons why a business begins to
experience difficulties, the result is often the same; namely, cash flow problems.

Frequently, the first steps taken by the troubled company involved stretching its payables. In some cases,
this action can buy the troubled company up to several weeks of needed time before creditors take action.
If the difficulties are more than just minor and very temporary, the company may next turn to its bankers
and request additional working capital loans. In some situations, the bankers may make the additional
loans, especially if they perceive the situation to be temporary. Another possible action the company’s
bankers and creditors may take is to restructure the company’s debt.

Debt restructuring by bankers and other creditors can be quite complex. However, debt restructuring
basically involves either extension, composition, or a combination of the two. In an extension, the failing
company tries to reach an agreement with its creditors that will permit it to lengthen the time it has to
meet its obligations.

In a composition, the firm’s creditors accept some percentage amount less than their actual original
claims, and the company is permitted to discharge its debt obligations by paying less than the full amounts
protected from any further actions on the part of the creditors while it attempts to work out a plan of
reorganisation. The debtor company has 120 days to work out a plan of reorganisation. After that, the
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creditors may file a plan of their own. The court has considerable latitude in a bankruptcy case. For
example, depending on the nature of the case, it may decide to appoint a trustee who will be responsible
for running the business and protecting the creditors’ interests. Normally, the troubled company is
allowed to continue operations. If there is reason to believe that continuing operations will result in
further deterioration of the creditors’ position, however, the court can order the firm to cease operating.

An important aspect of the bankruptcy procedures involves what to do with the failing firm. Just as in the
case of the informal alternatives, a decision has to be made about whether a firm’s value as a going
concern is greater than its liquidation value. Generally, if this is the case and a suitable plan of
reorganisation can be formulated, the firm is reorganised; otherwise, it is liquidated.

REORGANAISATION

Settlement with creditors

A sick unit is normally in a financial strain mode and is not able to honour its commitments to its creditors
(financial institutions, debenture holders, commercial banks, suppliers and govt authorities). To alleviate
its financial distress, a settlement scheme has to be worked out which may involve one or more of the
followings : rescheduling of principal interest payment; waiver of interest; reduction of interest;
conversion of debt into equity; payment of arrears in instalments.

Provision of additional capital

Typically, a revival program entails provision of additional capital. This may be required for modernisation
and repair of plant and machinery, for purchase of additional equipment, for sustaining a new market
drive, and for enhanced working capital needed to support a higher level of operations. The additional
capital has to be provided on concessional terms, at least for the initial years, so that the financial burden
on the unit is not high.

Divestment and Disposal

The revival program may involve divestment of unprofitable plants and operations and disposal of slow
moving and obsolete stocks. The thrust of these action should be to strengthen the liquidity of the unit
and facilitate reallocation of resources for enhancing the profitability of the unit.

Reformulation of product-market strategy

Many a business failures can be traced to an ill conceived product market strategy. For reviving a sick
unit, its product market strategy may have to be significantly reformulated to improve the prospects of
the profitable recovery. This requires great deal of imagination and penetrating analysis.

Upgrading technology

IN order to improve the manufacturing efficiency, the technology has to be revisited and upgraded and
accordingly plant and machinery have to be modernised, renovated and repaired. This would be useful
for maintaining certain cost standards in production.
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Reduction in Man power

The manpower requirement has to be revisited, and superfluous manpower has to be removed. Like old
saying, Leaner the organization, greater are its chances of success. This is normally achieved by golden
handshake, by encouraging the employees to go on voluntary retirement so that man power is reduced
without any industrial unrest.

Strict control over the cost

Since the firm is running in the path of recovery, the Zero based approach on all its expenses have to
strictly analysed and approved. The firm cannot afford to be luxurious in expenses, even if it is operating
expenses. It has to fix standards of expenses at each stage of production, and constantly compare the
actuals, and enforce discipline in expenditure in the organization

Streamlining the operation

The supply chain logistics have to completely be streamlined where each department works in
coordination with other departments, and work as islands. Value engineering, cost benefit analysis have
to exploited fully. The hierarchy of management should also work as a whole unit, with escalation clauses
are strictly followed if any deviation of standards are noticed.

Workers participation

During revival phase, the dedication, commitment and support of workers is indispensable and hence
workers participation in management, and listening to workers ideas and plan enhances their morale,
which is a very vital factor for quicker revival

Change of Management

A change in management is absolutely necessary, since the present management which lead to this
financial distress, had shown inefficiency or may even be dishonest. A brand new management have to
be reconstituted with professionals in various fields in relation to the industry to which the unit belongs.
Then only visible changes in revival can be felt.

Merge with a healthier company

If a sick firm cannot pull itself by its own bootstraps, then the option of merger with a healthy firm must
be seriously explored. The healthy firm can leverage its resources to revive the sick firm.

LIQUIDATION
Liquidation (or "winding up") is a process by which a company's existence is brought to an end.

First, a liquidator is appointed, either by the shareholders or the court. The liquidator represents the
interests of all creditors. The liquidator supervises the liquidation, which involves collecting and realising
the company's assets (turning them into cash), discharging the company's liabilities, and distributing any
funds left over among the shareholders in accordance with the company's constitution (or the
COMPANIES ACT 1993 if there is no constitution). After these steps have been carried out, the company
is formally dissolved.
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The law classifies liquidations into two types: voluntary (which is by a shareholders' resolution) or
compulsory (by a court order)

The procedure for liquidation

Broadly speaking, the liquidation process is as follows:

• A liquidator is appointed, either by the company shareholders passing a resolution (voluntary

liquidation) or by the Court making an order (compulsory liquidation).

• The liquidator collects the assets of the company (including uncalled capital; that is, amounts
unpaid on shares) and pays the creditors in order of priority.

• The liquidator distributes any surplus funds to the shareholders.

• The company is then formally dissolved.

What are the consequences of liquidating a company?

The main consequences of the company being liquidated are as follows:

• The company no longer has the power to dispose of its property.

• The company may carry on business only for the limited purpose of completing the liquidation
process.

• The powers of the company directors come to an end when a liquidator is appointed.

• A liquidation order operates as a notice of dismissal to all of the company's employees. Note,
however, that if an employee is on a fixed-term contract and is required under this contract to be
given a period of notice, then a liquidation order will breach this and the employee will be entitled
to damages.

• When an application is made for a court-ordered liquidation, the court may stay or restrain any
proceedings against the company as the court sees fit. When a liquidator is appointed, no person
can begin or continue legal proceedings against the company or in relation to its property, unless
the liquidator agrees or the court permits it.

INSOLVENCY LAWS IN INDIA

The Presidency Towns Insolvency Act, 1909 and

Provisional Insolvency Act, 1920 are two major enactments that deal with personal insolvency and have
parallel provisions and their substantial content is also similar but the two differ in respect of their
territorial jurisdiction.

While Presidency Towns Insolvency Act, 1909 applies in Presidency towns namely, Kolkata, Mumbai and
Chennai, Provincial Insolvency Act, 1920 applies to all provinces of India. These two Acts are applicable to
individuals as well as to sole proprietorships and partnership firms.
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Under the Constitution of India ‘Bankruptcy & Insolvency’ is provided in Entry 9 List III - Concurrent List,
(Article 246 –Seventh Schedule to the Constitution) i.e. both Center and State Governments make laws
relating to this subject.

The major legislations currently governing Corporate Insolvency are :

• Companies Act, 1956, relating to winding up of companies.

• The Sick Industrial Companies (Special Provisions) Act, 1985

INSOLVENCY LAW FOR CORPORATE SIDE

Industrial sickness had started right from the pre-Independence days.

– Government had earlier tried to counter the sickness with some ad-hoc measures.

Nationalisation of Banks and certain other measures provided some temporary relief.

– RBI monitored the industrial sickness.

– A study group, came to be known as Tandon Committee was appointed by RBI in 1975.

– In 1976, H.N. Ray committee was appointed.

– In 1981, Tiwari Committee was appointed to suggest a comprehensive special legislation designed to
deal with the problem of sickness laying down its basic objectives and parameters, remedies necessary
for revival of sick Units.

– The committee submitted its report to the Govt. in September 1983 and suggested the following :

(a) Need for a special legislation

(b) Need for setting up of exclusive quasi-judicial body.

Thus the SICA came into existence in 1985 and BIFR started functioning from 1987.
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III AFA UNIT -5 BUSINESS FAILURE ADV FM NOTES -2020

Insolvency and Bankruptcy Code, 2016 in the context of corporate Insolvency

• The preamble of the code reads as under:

To consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate
persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of
such persons, to promote entrepreneurship, availability of credit and balance the interests of all the
stakeholders including alteration in the order of priority of payment of Government dues and to establish
an Insolvency and Bankruptcy Fund, and for matters connected therewith or incidental thereto.

• The Code proposes to cover Insolvency of individuals, unlimited liability partnerships, Limited Liability
partnerships (LLPs) and companies.

• The Insolvency Resolution Process (IRP) for individuals and unlimited liability partnerships varies from
that of companies and LLPs. The Debt Recovery Tribunal (“DRT”) shall be the Adjudicating Authority with
jurisdiction over individuals and unlimited liability partnership firms. Appeals from the order of DRT shall
lie to the Debt Recovery Appellate Tribunal (“DRAT”). The National Company Law Tribunal (“NCLT”) shall
be the Adjudicating Authority with jurisdiction over companies, limited liability entities.

Appeals from the order of NCLT shall lie to the National Company Law Appellate Tribunal (“NCLAT”).

• The Code proposes to establish an Insolvency Regulator (The Insolvency and Bankruptcy Board of India)
to exercise regulatory oversight over

– Insolvency Professionals,

– Insolvency Professional Agencies and

– Information Utilities.

• The Code proposes to regulate insolvency professionals and insolvency professional agencies.

Under Regulator’s oversight, these agencies will develop professional standards, codes of ethics and
exercise a disciplinary role over errant members leading to the development of a competitive industry for
insolvency professionals.

• The Code proposes for information utilities which would collect, collate, authenticate and disseminate
financial information from listed companies and financial and operational creditors of companies. An
individual insolvency database is also proposed to be set up with the goal of providing information on
insolvency status of individuals.

• The Code proposes a swift process and timeline of 180 days for dealing with applications for corporate
insolvency resolution. This can be extended for 90 days by the Adjudicating Authority only one time
extension. During insolvency resolution period (of 180/270 days), the management of the debtor is placed
in the hands of an interim resolution professional/resolution professional.

Further, an insolvency resolution plan prepared by the resolution professional has to be approved by a
majority of 66% of voting share of the financial creditors. Once the plan is approved, it would require
sanction of the Adjudicating Authority. If an insolvency resolution plan is rejected, the Adjudicating
Authority will make an order for the liquidation.
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• The Code proposes for a fast track insolvency resolution process for companies with smaller operations.
The process will have to be completed within 90 days, which may be extended upto 45 more days if 75%
of financial creditors agree. Extension shall not be given more than once.

Impact of the Code on other Legislations.

• The Code seeks to repeal the Presidency Towns Insolvency Act, 1909 and Provincial Insolvency Act,

1920.

• The Code seeks to amend the following 11 Legislations :

1. The Indian Partnership Act, 1932

2. The Central Excise Act ,1944

3. The Income Tax Act, 1961

4. The Customs Act, 1962

5. Recovery of Debts Due to Banks and Financial Institutions Act, 1993

6. The Finance Act, 1994

7. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest

Act, 2002

8. Sick Industrial Companies (Special Provisions) Repeal Act, 2003

9. The payment and Settlement Systems Act, 2007

10. The Limited Liability Partnership Act, 2008

11. The Companies Act, 2013

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The words “Insolvency” and “Bankruptcy” are generally used interchangeably in common parlance but
there is a marked distinction between the two. Insolvency and bankruptcy are not synonymous.

The term “insolvency” notes the state of one whose assets are insufficient to pay his debts; or his general
inability to pay his debts. The term “insolvency” is used in a restricted sense to express the inability of a
party to pay his debts as they become due in the ordinary course of business.

The word “bankruptcy” the condition of insolvency. It is a legal status of a person or an entity who cannot
repay debts to creditors. The bankruptcy process begins with filing of a petition in a court or before an
appropriate authority designated for this purpose. The debtor’s assets are then evaluated and used to pay
the creditors in accordance with law.

The term insolvency is used for individuals as well as organisations/corporates. If insolvency is not
resolved, it leads to bankruptcy in case of individuals and liquidation in case of corporates.

Liquidation, on the other hand, in its general sense, means closure or winding up of an corporation or an
incorporated entity through legal process on account of its inability to meet its obligations or to pay its
debts. In order to clear the indebtedness, the assets are sold at the most reasonable rates by a
competent liquidator appointed in this regard

Section 2 of the Insolvency and Bankruptcy Code, 2016 as amended vide the Insolvency and Bankruptcy

Code (Amendment) Act, 2018 provides that the provisions of the Code shall apply to –

(a) any company incorporated under the Companies Act, 2013 or under any previous company law,

(b) any other company governed by any special Act for the time being in force,

(c) any Limited Liability Partnership incorporated under the Limited Liability Partnership Act, 2008,

(d) such other body incorporated under any law for the time being in force, as the Central Government

may, by notification, specify in this behalf,

(e) personal guarantors to corporate debtors,

(f) partnership firms and proprietorship firms; and

(g) individuals, other than persons referred to in clause (e)

☺- For Insolvency process/Voluntary Winding up - Refer ICAI -INSOLVENCY AND

BANRUPTCY CODE 2016 NOTES. (ENCLOSED)
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