IBC’S CASH FLOW TRIGGER: A FAST TRACK OR A FAULT LINE?EXAMINING INDIA’S DEFAULT-BASED INSOLVENCY TRIGGER IN A GLOBAL CONTEXT

- by Jacob Kalararikkal, junior editor at CBLT

Introduction

The enactment of the Insolvency and Bankruptcy Code, 2016 (IBC) marked an important moment in India’s economic and corporate landscape. Lauded as a step towards a mature market economy, the IBC sought to overhaul a fragmented and inefficient insolvency and bankruptcy framework that previously existed in the country.. The previous regime, with legislations like the Sick Industrial Companies Act, of 1985 Presidency-Towns Insolvency Act, of 1909 and The Provincial Insolvency Act, of 1920 etc., grappled with significant delays, erosion of asset value and notoriously low recovery rates for creditors. This system severely hindered credit availability as creditors were afraid to lend money. In this scenario, the IBC arrived at an ambitious objective to consolidate the existing laws, introduce a time-bound resolution process and maximise the value of assets. And crucial to these goals is the very mechanism that initiates the whole insolvency process – the insolvency test. The cash flow test, as adopted under the IBC, examines whether a debtor is currently or imminently unable to pay their debts as they fall due. This blog will delve into the specific approach taken by the IBC,  a form of the cash flow test, compare its benefits and disadvantages, and contrast it with the dual test model prevalent in mature economies like the US and UK.

The Present Scenario

The basis on which the Corporate Insolvency Resolution Process (“CIRP”) under the IBC is initiated is  “default”. Section 3(12) of IBC defines default simply as the “non-repayment of debt when the whole or any part or instalment of the amount of debt has become due and payable and is not paid by the debtor or the corporate debtor” This definition is the basis on which applications are filed by the financial creditor, operational creditor or even the corporate debtor itself. The immediate basis here is the failure on the part of the corporate debtor to pay their debt in full or even to pay an instalment. This is fundamentally a cash flow test. It squarely depends on the corporate debtor's immediate ability, or inability to meet its payment obligations.

This represents a shift from the pre-IBC era where Indian courts applied both the tests, i.e. the cash flow test, as explained above, and the balance sheet test, which in simple terms, means that the assets and liabilities of the debtor will be evaluated, and if the liabilities exceed the assets, only then is the insolvency procedure continued. Aiming for uniformity, the IBC moved away from the complex “inability to pay” concept, which requires various financial assessments  to be undertaken to understand the entire economic situation of the debtor to the simpler “failure to pay” where only the default in payment is necessary. This choice seems to be rooted in the objectives of the IBC, where a demonstrable event, that is the non-payment, is the preferred event as it is more straightforward and easily ascertainable. This simplicity is intended to facilitate quicker admission of cases by the NCLT, thereby helping reach the overarching goal of the limited-time resolution and minimising the value erosion of assets.

Global Perspective

In contrast to this, the UK, in its Insolvency Act of 1986, explicitly outlines two distinct and free-standing tests for insolvency. Section 123 (1)(e) provides for the classic cash flow test as present in the IBC, and Clause (2) lays down the balance sheet test, or the value of a company being weighed against the amount of its liabilities. In a practical sense,, establishing insolvency under either test is sufficient to initiate proceedings in the UK, but both tests are necessary as they allow for flexibility and recognize that a corporate debtor might be commercially insolvent (unable to pay immediate dues) while technically being balance-sheet solvent, where the value of assets is more than the liabilities. UK courts in cases like Cheyne Finance Plc (in receivership) [2007] EWHC 2402 (Ch) and BNY Corporate Trustees Services Ltd v Eurosail-UK 2007-3BL plc often adopted a dual perspective relying on the debtor's complete financial reality, rather than relying rigidly on one metric. The availability of the balance sheet test provides an alternative route to understanding the long-term viability of the debtor.

In the US, The balance sheet test is statutorily incorporated under, Section 101(32) of the US Bankruptcy Code, with the standard of  “debts greater than property at fair valuation”, while the cash flow tests remain highly relevant in some cases and “generally not being able to pay debts as they become due” can become a ground for initiating proceedings. For instance, in re Roblin Industries, Inc., the court applied the cash flow test to determine that the debtor was unable to meet obligations as they matured, justifying insolvency. Similarly, In re Taxman Clothing Co. reaffirmed the use of both tests as valid grounds for determining insolvency depending on the context.Thus both the US and the UK insolvency systems provide mechanisms to consider both the immediate liquidity and the overall asset liability status of the debtor.

Critique of the Default-Based Approach

Given this global context, the rationale behind India’s deliberate choice to adopt the cash flow test warrants a critical analysis. The primary benefits of the cash flow test are its efficiency and certainty.  It allows creditors to initiate insolvency proceedings promptly, based on a clear and objective trigger, non-payment of a due debt rather than requiring a complex evaluation of the debtor’s overall financial health. Additionally, it helps prevent value erosion of the debtor’s assets by enabling quicker intervention, which is especially crucial in preserving going-concern value. Compared to the previous regime, which was plagued by huge delays, the IBC with its cash flow test was enacted to shift the focus from complex financial diagnostics at the initiation stage to rapidly admitting cases and initiating the resolution. The drawbacks of this regime should also be analysed, that the IBC in pursuit of speed and simplicity, relying solely on the cash flow test, is highly likely to initiate premature CIRP process against debtors that are fundamentally solvent, that is, balance sheet solvent, but are simply facing temporary liquidity issues. This issue was presented before the Supreme Court in the case of  Vidarbha Industries, wherein a significant payment of the debtor was under dispute in the Supreme Court and the creditor without waiting for a final decision , applied for the insolvency process to begin. The Supreme Court held that the National Company Law Tribunal (NCLT) could consider factors beyond just the appearance of debt and default, such as the debtor's overall financial health under its current management, before starting the insolvency procedure. Therefore, a formal framework incorporating the balance sheet test may potentially strengthen the insolvency regime in the country.

Need for Balanced Framework

Moreover, completely ignoring the balance sheet test potentially overlooks valuable information about the company's viability. Global practice, as shown above in the examples of UK and the USA, demonstrates that as India moves forward towards a mature market economy, it should find value in considering both perspectives.  Even if the primary trigger remains default-based, the question arises whether the NCLT should have clear statutory backing to consider balance sheet insolvency, perhaps not as a primary trigger, but as a relevant factor, potentially leveraging its inherent powers under Rule 11 of the NCLT Rules, 2016, to meet the ends of justice but solely relying on inherent powers, deprives stakeholders of the clarity and consistency of formally incorporated tests.

Conclusion

The initial recommendation of the Banking Law Reform Committee Report, 2015 (5.2.2), which brought forward the idea of the IBC, wanted to include both tests, the established practices in other mature economies, and the potential benefits for assessing overall viability, all of which point towards the enduring relevance of the balance sheet test. While the IBC has undoubtedly been transformative, the debate on whether its insolvency trigger strikes the optimal balance between speed and comprehensive assessment remains pertinent. The Indian regime might find that incorporating the international experience by acknowledging both tests, perhaps in a tailored manner that is suitable to the Indian context, could lead to an even more robust, adaptable, and ultimately fairer insolvency framework for the future. The current approach reflects a prioritizing immediate default as the key indicator; whether this remains the most effective long-term strategy in all situations is a question worthy of ongoing evaluation.