Insolvency

Topic: Banking Regulation, NPAs and Financial Stability · NCERT: Beyond NCERT

Meaning

Insolvency is a financial condition in which a person or a firm cannot pay its debts when they fall due.

It matters because one borrower's insolvency becomes the bank's problem. When a borrower stops paying, the loan turns into an NPA (non-performing asset: a loan whose interest or principal is unpaid for 90 days). India's main legal tool for dealing with insolvent borrowers is the Insolvency and Bankruptcy Code (IBC), 2016.

Explanation

How insolvency shows up

• Two textbook tests:
• Cash-flow test: the debtor cannot pay bills and loan instalments on the due date.

• Balance-sheet test: what the debtor owes (liabilities) is more than what it owns (assets).

• Insolvency is the money problem. Bankruptcy is the legal label that can follow.

• The adjudicating authority (the tribunal that decides these cases) declares a person or firm bankrupt.

• So a firm can be insolvent without yet being declared bankrupt.

• Why it matters for the whole economy:

• Borrower defaults → bank loan becomes an NPA → bank must set money aside for the loss → bank has less capital to lend.
• When many big firms default together, stressed banks and over-borrowed companies drag each other down. This is the twin balance sheet problem.

From default to resolution: the IBC process

• Trigger: a default of Rs 1 crore or more. The limit was raised from Rs 1 lakh in March 2020.
• Who can file:
• Financial creditors (lenders such as banks and bondholders) can file, and they vote.

• Operational creditors (owed for goods, services, wages or government dues) can file, but they do not vote.

• CIRP steps (Corporate Insolvency Resolution Process): 1. NCLT admits the case. It must decide within 14 days or record its reasons in writing (IBC Amendment Act 2026) [2][3]. 2. s.14 moratorium (a legal freeze): no suits, recovery or asset sales against the firm. 3. A Resolution Professional takes over management from the board. 4. The Committee of Creditors (CoC), made up only of financial creditors, votes on revival plans. A plan needs 66% of the vote by value. 5. Deadline: 180 days + 90-day extension, with an outer limit of 330 days including litigation (2019 amendment) [3]. 6. No plan approved → liquidation (the firm is shut down and its assets are sold).

• Key shift: from "debtor in possession" (the promoter keeps running the defaulting firm) to "creditor in control" (the lenders decide the firm's future).

Outcomes: haircut and realisation

• Haircut: the loss creditors accept when they recover less than they are owed.
• Haircut (%) = (Admitted claim − Amount realised) ÷ Admitted claim × 100

• Realisation (%) = 100 − Haircut (%)

• Worked example:

• Admitted claims = Rs 1,000 crore. The resolution plan pays Rs 330 crore.
• Haircut = (1,000 − 330) ÷ 1,000 × 100 = 67%, so realisation = 33%.
• Liquidation value = Rs 200 crore, so the plan gives 330 ÷ 200 = 165% of liquidation value.
• Lesson: the haircut is high, but creditors still get far more than they would if the firm were shut down.

If the firm is liquidated: the s.53 waterfall

• The s.53 waterfall is the order in which sale money is paid out. Each rank is paid in full before the next rank gets anything: 1. Costs of the insolvency process 2. Secured creditors and workmen's dues for 24 months (ranked equally) 3. Other employees' dues for 12 months 4. Unsecured financial creditors 5. Government dues and the secured creditors' shortfall 6. Other debts 7. Preference shareholders 8. Equity shareholders

• 2026 Act: tax dues are excluded from "secured creditor" status [2]. A security interest now exists only when the parties create it by agreement [3].

In India

• Law: the IBC 2016 replaced SICA/BIFR (1985). The Supreme Court upheld it in Swiss Ribbons v. Union of India (2019).
• Before 2016, several laws overlapped: the Companies Act, SICA, debt recovery laws and SARFAESI (the law that lets secured lenders seize and sell collateral without going to court). Cases stayed pending for years and asset values kept falling [3].
• Institutions (four pillars):
• IBBI (Insolvency and Bankruptcy Board of India): the regulator [3].
• NCLT for companies, with appeals to NCLAT [3]. DRT (Debt Recovery Tribunal) for individuals.
• Insolvency professionals: they run the distressed firm [3].

• Information utilities: electronic stores of debt records. Under the 2026 Act, an IU record is enough proof of default [2].

• Other routes:

• Pre-packaged insolvency (PPIRP, 2021): for MSMEs only, with a default of Rs 10 lakh or more. The debtor keeps control, and it must finish in 120 days.

• CIIRP (IBC Amendment Act, 2026): started out of court by notified financial creditors with 51% by debt value. It must finish in 150 + 45 days [2].

• Latest figures:

• 8,987 CIRPs admitted and 1,419 companies resolved (till March 2026) [3].
• Creditors realised about Rs 4.32 lakh crore, which is over 94.56% of fair value (March 2026) [3].
• Plans delivered over 170% of liquidation value (August 2025) [1].
• Average recovery was 33% of admitted claims, and average resolution time was 602 days (30 June 2025) [2].
• 43% of closed cases ended in liquidation (30 June 2025) [2].

• The IBC brought in 52.4% of banks' recoveries in 2024-25, more than any other channel [3].

• World Bank Doing Business, "Resolving insolvency" rank: 108 → 52 (2019 to 2020 editions). This is the last ranking, because the report was discontinued in 2021.

Don't confuse with

• Bankruptcy: insolvency is a financial condition. Bankruptcy is a legal status that the adjudicating authority declares.
• Illiquidity: an illiquid firm has enough assets but is short of cash right now. An insolvent firm cannot meet its debts even after its position is fully counted.
• Liquidation: this is one possible outcome of insolvency (closing the firm and selling its assets). It happens only when no resolution plan is approved.
• NPA: this is how the bank classifies the loan (unpaid for 90 days). Insolvency describes the borrower's condition.

Prelims Hooks

• Insolvency = cannot pay debts when due (a financial condition). Bankruptcy = a legal status declared by the adjudicating authority.
• NCLT hears corporate insolvency and DRT hears individual insolvency. Appeals go from NCLT to NCLAT and then to the Supreme Court.
• CIRP threshold is Rs 1 crore (raised from Rs 1 lakh in 2020). PPIRP threshold is Rs 10 lakh, for MSMEs only.
• The CoC has financial creditors only. A plan needs 66% by value, and operational creditors do not vote.
• Timelines: CIRP 180 + 90 days, with a 330-day cap. PPIRP 120 days. CIIRP 150 + 45 days [2].
• Case-law trap: Swiss Ribbons (2019) upheld the IBC's validity. Essar Steel (2019) held that the CoC's "commercial wisdom" is supreme.

Mains Points

• Are haircuts too high?
• Realisation is only about 33% of claims, with an average of 602 days to resolve (June 2025) [2].
• But the right benchmark is liquidation value, and plans deliver over 170% of it (August 2025) [1].

• Delay itself destroys value. So the fix is more NCLT capacity and less litigation, not weaker creditor control.

• Insolvency law and financial stability:

• The IBC gives 52.4% of bank recoveries (2024-25) [3].
• The threat of losing the company makes promoters pay on time, which improves credit discipline [3].

• This supports lower NPAs, stronger bank capital (Basel III) and helps ease the twin balance sheet problem.

• Debtor-in-possession vs creditor-in-control:

• Under PPIRP and CIIRP, the debtor keeps control. This saves time and keeps the business running, but promoters might strip assets.
• Safeguards include s.29A (which bars defaulting promoters from bidding) and the CoC's power to switch to a regular CIRP [2].
• The agenda is unfinished. There is only a rule-making power for group and cross-border insolvency, and India has not adopted the UNCITRAL Model Law [2].
• Workers and operational creditors (often MSMEs) rank low in the waterfall, which raises a fairness issue.

Related concepts

• Bankruptcy
• Corporate Insolvency Resolution Process
• Committee of Creditors
• Resolution professional
• Liquidation waterfall
• Haircut
• Pre-packaged insolvency
• Financial and operational creditors
• Cross-border insolvency

Read more

• The Insolvency and Bankruptcy Code: CIRP, pre-packs and haircuts