Common Myths and Misconceptions About Bankruptcy Law

Bankruptcy law in India is a complex and often misunderstood subject, surrounded by numerous myths and misconceptions. Over the years, individuals and businesses have grappled with inaccurate information, leading to confusion and hesitation in dealing with insolvency issues. The Insolvency and Bankruptcy Code (IBC) of 2016 has made significant strides in providing a more transparent, structured, and efficient system for dealing with insolvencies. However, there are still several common myths surrounding bankruptcy law in India that can hinder its effective utilization.

In this blog, we will debunk some of the most prevalent myths about bankruptcy law in India and provide a clearer understanding of how the system works.

1. Bankruptcy Means Losing Everything

Myth: One of the most widespread misconceptions is that if someone files for bankruptcy, they will lose all their assets—homes, cars, savings, and so on. Many people assume that declaring bankruptcy will strip them of everything they own.

Reality: Bankruptcy laws in India, specifically under the Insolvency and Bankruptcy Code (IBC), aim to resolve financial distress while preserving a fair balance for both creditors and the debtor. In the case of individuals, while certain assets may be liquidated to repay debts, the debtor is often allowed to retain essential assets such as a home or a reasonable amount of personal property. The process focuses more on restructuring debts and ensuring that the individual or company has a fair chance to recover rather than purely punishing them for financial difficulties.

For corporate insolvency, a business may undergo a resolution process where an effort is made to restructure the company to keep it operational and viable, rather than selling off assets immediately. The goal is to preserve jobs, the value of the business, and the interests of stakeholders.

2. Bankruptcy Is the Same as Liquidation

Myth: Many people think that bankruptcy always leads to the liquidation of assets and the closure of businesses. They assume that when a person or company declares bankruptcy, they are automatically going to be liquidated.

Reality: Bankruptcy under the IBC does not always lead to liquidation. In fact, one of the core objectives of the IBC is to give businesses a chance to restructure and resolve their debts. The Code outlines two possible outcomes:

1. Restructuring/Resolution: For corporate debtors, the IBC provides for a Corporate Insolvency Resolution Process (CIRP). During CIRP, the business can continue its operations under a new management if creditors agree on a resolution plan. This is a process designed to avoid the liquidation of the company.
2. Liquidation: If a resolution plan cannot be found within a prescribed period (typically 180 days, extendable by 90 days), liquidation may be the last resort, but it is not automatic.

Therefore, bankruptcy doesn’t mean an automatic end. The focus is on finding a solution that benefits both creditors and debtors, with liquidation being an option only after all other avenues are explored.

3. Bankruptcy Is Only for Individuals, Not Companies

Myth: A common misconception is that bankruptcy law only applies to individuals and not businesses. Many believe that companies, especially large ones, cannot file for bankruptcy.

Reality: The IBC applies to both individuals and corporate entities. Companies facing financial distress can file for insolvency proceedings under the Corporate Insolvency Resolution Process (CIRP), whereas individuals and partnerships can file for bankruptcy under the Insolvency and Bankruptcy Code as well. The IBC applies to:

• Corporate Persons (Companies, LLPs, etc.)
• Individuals and Partnership Firms

The IBC has made it easier for both individuals and companies to approach insolvency proceedings, ensuring that corporate and personal insolvencies can be resolved in a more systematic and efficient manner.

4. Bankruptcy Will Ruin Your Credit Score Forever

Myth: Another prevalent myth is that bankruptcy will permanently destroy a person or company’s credit score, making it impossible to recover or secure future credit.

Reality: While it is true that declaring bankruptcy will negatively affect an individual’s or company’s credit score in the short term, it does not mean a permanent ruin. The IBC provides mechanisms for the debtor to recover from insolvency, and in time, the credit score can improve, especially if the debtor works to rebuild their financial standing post-bankruptcy.

In fact, companies going through CIRP may emerge stronger and more viable, which could improve their creditworthiness once they have settled their debts and are on a path to recovery. Individuals can also rebuild their financial life over time by demonstrating responsible credit behavior after their debts are discharged.

5. Only Big Businesses Need to Worry About Bankruptcy

Myth: Many people believe that bankruptcy only concerns large corporations or businesses with substantial debt. Small businesses and individuals are not usually considered to be at risk of insolvency under the IBC.

Reality: Bankruptcy law in India is applicable to all businesses, including small and medium enterprises (SMEs). In fact, SMEs are one of the most vulnerable sectors when it comes to financial distress, and the IBC offers a mechanism for them to either resolve their debts or undergo a more structured liquidation process if necessary. Additionally, individuals and partnerships can also utilize bankruptcy proceedings to manage their debts effectively.

The IBC is designed to cater to businesses of all sizes, from the largest multinational corporations to small family-owned businesses, ensuring that any entity in financial distress can access appropriate solutions.

6. Bankruptcy Law Only Applies When a Business Fails

Myth: Some believe that bankruptcy law should only be invoked when a business is completely failed and can no longer function.

Reality: Bankruptcy law is not meant to punish failure but to provide a path for restructuring and recovery. In fact, the IBC encourages companies to take early action when they face financial difficulties, allowing them to resolve issues before insolvency becomes a full-blown crisis. The earlier a business recognizes that it’s struggling and seeks help, the better the chances of recovery and preserving value for stakeholders. The law provides for preventive measures, including debt restructuring and negotiations with creditors, which can help the company avoid total failure.

7. Filing for Bankruptcy Is a Lengthy and Complicated Process

Myth: There is a widespread belief that the bankruptcy process in India is time-consuming, bureaucratic, and filled with red tape.

Reality: The IBC was designed to streamline and expedite the insolvency process. In fact, the law imposes strict timelines to ensure that insolvency proceedings are completed within a relatively short period. For corporate debtors, the resolution process is designed to be completed within 180 days, with a possible 90-day extension. This is a marked departure from previous laws, which were seen as slow and inefficient. The IBC focuses on speed and efficiency to prevent the prolonged financial distress of debtors and creditors.

8. Bankruptcy Law is Too Harsh for Debtors

Myth: Many individuals and businesses are afraid of filing for bankruptcy because they believe the law is too harsh on debtors and provides little protection or relief.

Reality: IBC aims to strike balance between protecting interests of creditors and offering a fair opportunity for debtors to recover. It provides several safeguards for debtors, including the possibility of a “fresh start” after the completion of insolvency proceedings. While creditors are given priority in recovering their dues. The process also includes a restructuring framework to help businesses continue their operations and preserve value. Debtors, whether individuals or companies, are not left without any support. And the focus is on resolving issues rather than punishing them.

9. Only Secured Creditors Can Recover Their Dues

Myth: People often believe that only secured creditors (those with collateral) can recover their dues in insolvency proceedings. While unsecured creditors (like employees, trade vendors, etc.) get nothing.

Reality: Under the IBC, all creditors—both secured and unsecured. Are given a fair chance to recover their dues based on the priority of claims. While secured creditors have a higher priority than unsecured creditors, unsecured creditors are not left empty-handed. The Code ensures that a structured process is followed, with a focus on equitable distribution and resolution for all stakeholders.

10. Once Bankruptcy Proceedings Are Started, There Is No Way to Exit the Process

Myth: There’s a common belief that once an individual or company enters bankruptcy proceedings. They are stuck and cannot exit the process unless it’s completed.

Reality: The IBC allows for several exit options. For example, a debtor may propose a resolution plan to creditors to avoid liquidation. If the creditors accept the plan, the company can exit the process successfully. In some cases, individuals may also negotiate settlements or payment plans with creditors. That allow them to exit bankruptcy proceedings before liquidation becomes necessary.

Conclusion

Understanding the true scope of bankruptcy law in India is essential for individuals and businesses facing financial difficulties. The Insolvency and Bankruptcy Code provides a structured process that helps address insolvency issues. Offers debtors a fresh start, and ensures that creditors have a fair chance of recovering their dues. By dispelling these common myths and misconceptions. We can encourage more people to use the system as intended—to resolve financial difficulties in a constructive manner.

If you or your business is facing financial distress. Consulting a professional insolvency expert can help navigate complexities of IBC and find the most suitable solution for your situation.