The recent judgment of Hon’ble Supreme Court in M/s Pro Knits v The Board of Directors of Canara Bank and Others holds far-reaching implications for the rights and treatment of Micro, Small and Medium Enterprises (“MSMEs”) in distress. Though the ruling has bolstered the legal foundation of MSMEs, it has also put a shadow of doubt on the relationship between two critical acts – the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) and Micro, Small and Medium Enterprises Development Act, 2006 (“MSMED Act”).

This judgment can potentially to transform how MSMEs are treated when facing financial stress. However, it also leads to questions such as the conflict of laws as well as the peculiarities that surround the mechanisms of the application of the provisions of the two acts afoot. The analysis of this judgment shows not only new strides in MSME rights protection advancement but also a set of challenges which require the attention of lawmakers to prevent ambiguity and unfair application of the law.

Background and Key Provisions of the MSMED Act and SARFAESI Act

To understand the implications of this case, it’s crucial to first explore the key provisions of the MSMED Act and SARFAESI Act, which govern the treatment of MSMEs in financial distress.

The MSMED Act,  primarily through Section 9 of the  Act, spells out  how the Micro, Small, and Medium Enterprises could be revived and rehabilitated. The Ministry of MSMEs came up with a notification on 29 May, 2015 and,  two other RBI notifications, 17 March 2016 and 21 July 2016 that jointly established the framework for the revival and rehabilitation of the MSMEs. In this framework, banks and financial institutions must recognize the MSME accounts that indicate early signs of stress and   correct them before they are categorized as Non-Performing Assets (“NPAs”). The process entails classifying the distressed accounts into three broad categories of Special Mention Account (“SMA”) that requires a committee to develop a restructuring and/or recovery plan.

While the above recovery of overdue debt can be recovered through the Debts Recovery Tribunal, the SARFAESI Act grants banks and other financial institutions the powers to take control of assets and sell them in the event of default. The Act like any other Indian Act, has a non-obstante clause under Section 35, which makes the Act superior to other Acts, including the MSMED Act.

This results in a conflict of interest when the two are applied when, for instance, an MSME is distressed.

The Supreme Court’s Ruling

The Supreme Court’s judgment in M/s Pro Knits v Canara Bank overturned a previous ruling by the Bombay High Court in the case of M/s A Navinchandra Steels v Union of India. In that case, the Bombay High Court had held that the provisions of the MSMED Act, specifically the mandatory restructuring process, were not binding on banks unless the MSME itself initiated the process.

The Supreme Court, however, ruled that the notification under Section 9 of the MSMED Act is indeed mandatory, and banks must follow it when dealing with MSME accounts showing early signs of financial stress. This decision aligns with the view that MSMEs, especially those in distress, deserve additional protection and that financial institutions are responsible for following a structured and fair process before resorting to harsh measures such as classifying accounts as NPAs.

This judgment marks a significant step in favor of MSMEs by affirming the importance of early identification of financial distress and ensuring that the restructuring framework provided under the MSMED Act is adhered to by banks.

The Conflict of Hierarchy: SARFAESI Act vs. MSMED Act

The judgment of the Supreme Court is quite remarkable how it deals with the clash between the SARFAESI Act and the MSMED Act. Earlier, while dealing with the powers of the SARFAESI Act, we discussed how Section 35 of the SARFAESI Act  specifies that the SARFAESI Act will prevail over any other laws in so far as the provisions of the SARFAESI Act are inconsistent with the other laws. This becomes a paradox when the provisions of SARFAESI are in operation and are contrary to the MSMED Act, especially when MSMEs are in financial trouble.

According to the provisions of the Section 24 of the MSMED Act, Sections 15 to 23 of the Act hold the place of prominence where the provisions related to the identification and resolution of distressed MSMEs are captioned. Nevertheless, this priority only applies to the provisions mentioned and does not cover the whole Act. Therefore, there is undoubtedly a lot of confusion on how the restructuring framework under Sec 9 of the MSMED Act is to be placed in the context of enforcement provisions of the SARFAESI Act, which has provisions of overriding effect.

It is also evident in previous judgments that have addressed this conflict. Earlier, in NP Abdul Nazer v Union Bank of India, the Kerala High Court stated that MSMED Act notification was not mandatory since no penalties were provided for non-compliance.  However, the Supreme Court in the present case rejected this stand on the ground that banks cannot bypass the restructuring provisions detailed in the MSMED Act while the SARFAESI Act is in operation.

This decision brings a new legal regime in the affairs of the MSMEs, especially the status of the viability of their recovery under the SARFAESI Act. Thus, it does not provide a clear picture of how these contradictory laws should be reconciled.

The Role of MSMEs in the Restructuring Process

Another condition also involved in the Supreme Court decision is the role and expectations from MSMEs themselves. Though the Court affirmed that the restructuring process must be followed by the banks as per the MSMED Act, it also put responsibility on the MSMEs to go for this protection.

The Court noted that in restructuring major claims, duly verified and authenticated documents and papers must be produced by MSMEs to qualify for such restructuring. Additionally, the Court called attention to the proposition that if an MSME lacks the merit to follow the laid-down procedures and allow enforcement under the SARFAESI Act to go unchallenged, it cannot stand up to claim the provisions of the MSMED Act restructuring framework.

This aspect of the judgment is, to some extent, a burden on MSMEs to be aware of the issues standing before them and to make sure they do whatever is needed to get in the restructuring process. However, the Court has made it clear that banks have to adhere to the MSMED Act, but it has been equally the responsibility of MSMEs to come forward with documents and to initiate the process wherever needed.

The Ambiguity in the Law: A Shared Responsibility

It might, therefore, be argued that the judgment in question engenders an intriguing dilemma. On the one hand, it also compels banks to create a mandatory restructuring framework concerning MSMEs in stress, which offers a crucial lifeline for struggling businesses. On the other hand, it puts an affirmative responsibility on the side of MSMEs to ensure that they open themselves for this protection by participating in the process.

This results in some unpredictability since it is still unclear how the respective roles of the banks and the MSMEs will be implemented. The process applies to the banks, but the MSME is also required to fulfil the conditions necessary to set off the process. This duality could pose a problem and necessitate court interventions now and then, especially where the MSMEs have limited understanding and knowledge of the framework.

Conclusion

This case. M/s Pro Knits v Canara Bank. is a welcome decision made by the Supreme Court to safeguard the interests of stressed MSMEs. The Court’s decision to uphold the mandatory character of the restructuring framework under the MSMED Act is beneficial for MSMEs since they now have legal protection against the unreasonable behavior of banks. However, the judgment also brings some ambiguity in matters relating to the conflict between the SARFAESI and MSMED Acts to which part of the banks and MSMES play out in the restructuring process.

It can be argued that the legal position of MSMEs struggling with financial issues is much stronger following this decision, but the requirement for a more coherent and easily definable framework is still evident. Lawmakers and the judiciary must shoulder the important task of further fine-tuning the relationship between these two vital laws to adequately protect MSMEs from financial loss while safeguarding the rights and concerns of financial institutions in the process. Without such clarity, the very subjects of the law employed to shield them could end up entangled within a confusing network of legal compliance.