Small and insolvent? You get a break and will be allowed to keep your company if you repay your debt and give a plan of resurrection, moral hazard be damned. This is the gist of one of a series of recommendations a panel has made to the government to fine-tune the newly minted Insolvency and Bankruptcy Code (IBC).

The 14-member Insolvency Law Committee has recommended that promoters of micro, small and medium enterprises (MSMEs) be allowed to bid for their companies when they are referred under IBC by one or more of their creditors. The intent is fair. After all, MSMEs are the drivers of employment in India (they employed more than 100 million people according to Small Industries Development Bank of India or SIDBI). MSMEs make up more than a third of gross domestic product and contribute as much as 43% to exports.

It would be unfair to toss them to the wolves simply because the conglomerates that owe them money are in trouble. Additionally, since the very companies that would be interested in bidding for MSMEs are hamstrung for cash themselves, many small firms face the possibility of going under liquidation. In many cases, all that will be realized is scrap value, while the employees too could find themselves on the scrap heap. So, the government’s focus on MSMEs by offering them a break under IBC has good intentions.

But the fallout won’t be all that good.

One cannot ignore the moral hazard involved in an exemption based on the size of an enterprise. Where is the guarantee that unscrupulous MSME promoters won’t run their businesses to the ground and then buy them back from the bankruptcy courts at a fraction of the loans outstanding? The fact that MSMEs are more inefficient than large conglomerates will provide plenty of excuses for them. MSMEs are riskier to their creditors than others and the bad loan ratios that banks have seen from this segment are proof enough. About 8.8% of the micro enterprises’ loan book of banks turned bad as of December and the NPA (non-performing asset) ratio for small and medium enterprise loans was 11.2%, according to SIDBI.

The adjoining chart shows that the surge in bad loans of large companies occurred in the last two years, given the push for proactive recognition by banks. But the NPA ratio for MSMEs has always been near double-digits.

At a time when the government wants to formalize the economy through reforms, allowing inefficient firms to proliferate defeats its intent. IBC is a clean way of ensuring that the most productive firms survive, thus leading to overall growth.

So what is the alternative?

Madan Sabnavis, chief economist at CARE Ratings, suggests that the exemption be time-bound and not perpetual. It should be recognized that notwithstanding the size, the promoters of any company should be barred from taking control if the firm’s financial troubles are due to inefficient decisions or malaise. After all, the law should be the same for all.