IBC is a threat that works, but MSME creditors still get short-changed: Study

A comprehensive new study has revealed that the Insolvency and Bankruptcy Code (IBC) functions less as a formal resolution mechanism for Micro, Small, and Medium Enterprises (MSMEs) and more as a high-pressure settlement tool, where most cases are resolved before they even enter the courtroom.

The report, titled “MSMEs in the IBC” and released by the Management Development Institute (MDI) Gurgaon for the Insolvency and Bankruptcy Board of India (IBBI), provides the most detailed analysis yet of how India’s flagship insolvency law is playing out for the country’s economic backbone.

The ‘funnel’ effect

The study analyzed data from over 39,000 insolvency applications and found a striking pattern: nearly 80% of all petitions—and 85% of those filed by Operational Creditors (OCs), who are often MSME suppliers—are disposed of before formal admission into the Corporate Insolvency Resolution Process (CIRP).

“The NCLT functions less as a venue for actual insolvency resolution and more as a credible enforcement and negotiation platform,” the report states, noting that the mere threat of admission forces financially healthier corporate debtors (CDs) to settle dues.

However, once a case is admitted, outcomes for MSME creditors worsen dramatically. While financial creditors (FCs) see modest recoveries, the median recovery rate for operational creditors is barely 5% , with many receiving nothing.

Who settles, who fails?

Using financial data from over 1,000 firms, the researchers found a clear divide. Companies that settle before admission are financially robust, choosing to pay to avoid losing control of their enterprise. In contrast, firms that enter the full CIRP are already deeply distressed, with over 77% of those petitioned by financial creditors being insolvent or near-insolvent at the time of filing.

The report also exposes a dangerous lag: financial creditors take much longer to file cases than operational creditors, leading to significant value erosion of the debtor’s assets by the time the case is admitted.

The Liquidity Trap

For MSMEs specifically, the study paints a picture of chronic vulnerability. Using a strict 45-day payment cutoff (mandated by the MSMED Act), the report found that only 8% of MSME creditor applicants receive payments from their debtors and pay their own vendors within the stipulated 45-day window.

“This illustrates the precarious liquidity position of MSMEs and their lack of negotiating power with both customers and vendors,” the authors write. This liquidity stress, the data shows, quickly cascades into solvency problems.

Major Reforms Proposed

To fix these structural flaws, the study proposes a radical redesign of the IBC auction process. It recommends scrapping the current multi-objective bidding system, where resolution applicants must balance payouts to financial creditors (who vote) with operational needs (of MSMEs who don’t vote).

Instead, it proposes a single-objective auction coupled with a ‘Quasi-Absolute Priority Rule’ (Quasi-APR) with an MSME orientation. Under this rule:

• Financial creditors would be paid first, but only up to the company’s liquidation value.
• Any remaining ‘resolution premium’ would be shared proportionally between financial and operational creditors, ensuring MSMEs get a fair slice.

“This approach maximizes the asset value and reduces the need for voting on the amounts involved, speeding up the process significantly,” the report notes.

Other key recommendations include:

• Mandating that all accepted invoices above Rs. 1 crore be recorded on the NeSL platform to reduce disputes.
• Allowing aggregation of small claims, permitting a group of up to 10 MSMEs to combine their dues to cross the Rs. 1 crore filing threshold.
• Waiving post-admission costs for MSME operational creditors to make the IBC economically viable for smaller players.
• Overhauling the Pre-Packaged Insolvency Resolution Process (PPIRP), which has seen only 14 filings in four years due to misaligned incentives between debtors and creditors.

Settlement is Not Subversion

Crucially, the study defends the high rate of pre-admission settlements, arguing that forcing healthy firms into CIRP destroys value. “The objective of the IBC is not resolution for the sake of resolution,” it states. “It is the optimisation of firm value either through resolution, liquidation, or settlement.”

The authors conclude that without the realistic chance of a pre-admission settlement, a rational MSME creditor would simply never use the IBC, rendering the law toothless for the very sector it was meant to protect.

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