The Bankruptcy code is passed in Parliament: Here is what startups can learn before the code is implemented through an amended Companies Act

Friday May 13, 2016 , 6 min Read

In 2016 we have seen some startups shutting down. One of the best known among them was PepperTap. Many of the failed startups just shut shops and moved on to kick start another idea. These failed ideas can do so because they are not registered with the Registrar of Companies. Most startups begin their startup journey without going through the legal requirement of registering a company. In such a case, the tax liability is based on the income of the founders and they pay service tax as consultants. So when the idea does not take flight, they shut shop and move on.

The legality steps in when an investor comes in and asks the founders to create a company(if it wasn't done already). It is the best day for a founder to see his disorganised business take flight. He gets a Director’s Identity Number with RoC and is liable for the fate of the business. This is where startup founders must understand that from here on everything that follows is based on legality(clauses) because the business starts acquiring consumers and business customers. Remember the Indian Bankruptcy laws – until recently with the passing of the Insolvency and Bankruptcy Code (I&BC)in Parliament - are made for manufacturing companies. Before we get in to how the I&BC can make closure of companies faster and allow the entrepreneur to move on to his next iteration of a company, one must understand the history of Indian laws.

A short history of bankruptcy

India has made laws that in grandeur helped the shutting down of large business houses and factories. It was never created with the small business in mind. Promoters of manufacturing or large trading companies could take refuge with the Board of Industrial and Financial Reconstruction Act or with Sick Industries Companies Act in case of a bankruptcy. The banks would not touch the promoters - in this case - till a settlement is reached in court or an appointed authority. However, these two Acts did not stop creditors from filing cases to extract payment from the promoters for non-payment. The archaic laws are the reason why we have myriad financial and shareholding structures created by lawyers and chartered accounts to protect promoter interests.

Unfortunately startups cannot take refuge under existing law and neither do they have the financial muscle to employ tax and audit professionals. This was the reason why the Insolvency and Bankruptcy Code(I&BC) was born in December 2015. So far the founders kept their companies alive to avoid the time taken to close a company. They continued to pay tax returns - with the RoC -for years on end. They also maintained all accounts and a balance sheet even if the company is not operational. It is well known that the old guard - of the startup game - know that it is cheaper to keep the startup alive than shutting it down. Here is why they do so?

For example, if you are a technology company and want to shut the company down and that you have no liabilities, you will go to the RoC asking them about winding up the company. They would then ask you to get a no objection certificate – to shut down the company - from all the vendors (creditors) and employees that you worked with. You may have 100s of people that you would have worked with and by the time you get these no-objection letters it will take you a good several years to close the company. The RoC will also ask for a letter from the tax authorities stating that there are no tax liabilities. No wonder the founder continues to maintain the startup even after its death just to save on the DIN number. If the DIN number is locked – for not filing returns of the company - then you cannot raise money for your next company. If you have liabilities then the vendors and banks will extract their pound of flesh, in a Shakespearean fashion, and then there could be an official liquidator appointed by the court who has all the power over every single penny that comes in from the sale of an asset. The time taken to close a company can take anything less than five to up to fifteen years, depending on the legal cases that the founder is handling.

Finally! Here is what the I&BC means to a startup

Appointment of professionals that understand insolvency for new age businesses.
A body will be set up to collect information on insolvency resolution.
Quick insolvency resolution of companies and individuals, which will be completed within 180 days. The assets of the borrowers may be sold to repay creditors if the dispute is not resolved.
Separation of powers between the National Company Law Tribunal (NCLT) and the Debt Recovery Tribunal (DRT). NCLT will handle the insolvency resolution for companies and the Debt Recovery Tribunal (DRT) will be specific to individual insolvency.
The Insolvency and Bankruptcy Board of India will handle all of the above.

What needs to be seen is whether the Code provides a specific procedure to liquidation. The code provides for secured creditors – like banks – have been given priority over trade creditors. Sources from Khaitan and Company say that the only way a law can become powerful is in the way it is enforced. The source from the law firm says that there is no sense in maintaining a dead company for the sake of it, provided there are no liabilities in the company.

For now, the startup founder must know at what point he is running out of money and pay off all the vendors with company’s cash that he or she has saved up. Or else founders may end up in court with several vendors filing multiple court cases. Remember that the funds will not protect you. They will manage with expensive lawyers and will not be perturbed by the situation that you are in. If you are lucky they will tell you that you are not running your company as per their requirement and ask you to wind up quickly. You are alone in this journey when you run out of money. But, the I&BC can bring smiles to your face when the Companies Act is amended by the end of this year.

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