Debt Restructuring Mechanism for MSMEs

MSMEs occupy a unique position within the credit ecosystem. They are not only borrowers but also critical intermediaries in larger industrial and governmental value chains. Their cash flows are frequently contingent upon payments from large corporate and public sector undertakings, delays in which are beyond the MSMEs’ control. In such a context, equating temporary liquidity stress with insolvency, or treating MSMEs as fungible corporate borrowers for recovery purposes, undermines both economic efficiency and public interest. The RBI’s MSME-specific Directions, read in light of judicial pronouncements, therefore serve an important corrective function, mandating that banks prioritise early engagement, restructuring, and settlement before resorting to coercive legal mechanisms.

This paper proceeds on the premise that MSME protection, credit discipline, and recovery are not mutually exclusive objectives. A calibrated regulatory and judicial approach, rooted in RBI’s Master Directions, supported by non-discretionary restructuring and OTS mechanisms, and mindful of the limits of insolvency as a recovery tool—is essential to ensure that viable MSMEs are preserved, public funds are safeguarded, and the insolvency framework is not reduced to a blunt instrument of enforcement.

The RBI’s Master Direction, lending to Micro, Small and Medium Enterprises (MSME) Sector, as updated on February 9, 2026[1], is a consolidated regulatory framework aimed at balancing prudential discipline with developmental imperatives. The Directions seek to ensure that MSMEs are not subjected to abrupt withdrawal of credit or coercive recovery actions at the first sign of stress, but are instead provided structured opportunities for revival, rehabilitation, and sustainable restructuring.

The Directions integrate the Debt Restructuring Mechanism for MSMEs (DRM-MSME), non-discretionary One Time Settlement (OTS) principles, and the Framework for Revival and Rehabilitation of MSMEs notified by the Ministry of MSME in 2015, thereby institutionalising a recovery-with-continuity approach rather than a liquidation-oriented response.

Judicial developments over the last decade have reinforced this regulatory philosophy. Courts, including the Supreme Court and High Courts, have repeatedly emphasised that RBI circulars and master directions are not merely advisory in nature but constitute binding regulatory norms, particularly for public sector banks and regulated entities. In cases such as Sardar Associates v. Punjab & Sind Bank[2] and subsequent decisions, the judiciary has underscored that MSME-specific restructuring and OTS frameworks are intended to be non-discretionary and non-discriminatory, thereby preventing arbitrary exclusion of eligible borrowers or selective application based on subjective assessments of recovery potential.

At the same time, experience has shown that the Insolvency and Bankruptcy Code, 2016 (IBC), has increasingly been deployed as a pressure tactic and recovery mechanism, including against MSMEs. Initiation of insolvency proceedings at early stages of financial stress, without meaningful exploration of restructuring or settlement under RBI-mandated MSME frameworks, has resulted in erosion of enterprise value, loss of employment, and disruption of supply chains. For MSMEs, the consequences of insolvency are often irreversible, as access to working capital, market confidence, and promoter capacity deteriorate sharply once insolvency proceedings are triggered.

[1] Master Direction FIDD.MSME & NFS.12/06.02.31/2017-18 July 24, 2017 (as updated)

[2] Sardar Associates v. Punjab & Sind Bank- AIR 2010 SUPREME COURT 218, 2009 (8) SCC 257

The Debt Restructuring Mechanism for MSMEs (DRM–MSME) is the RBI-recognised, bank/NBFC-implemented stress-resolution pathway for eligible MSME borrowers, intended to preserve viable units, prevent avoidable slippages into NPAs, and provide a time-bound and standardised approach for corrective action (including restructuring / rehabilitation, and where needed, recovery / settlement). The 2026 Master Direction positions this within the broader MSME credit-policy architecture (loan policy, rehabilitation/restructuring policy, and OTS policy) and links the rehabilitation framework to the RBI’s MSME revival/rehabilitation guidelines.

Eligibility is typically anchored on (i) MSME status, and (ii) stress recognition (incipient stress or default), with the Revival & Rehabilitation framework being a primary route for structured intervention. The RBI Master Direction expressly points to the Framework for Revival and Rehabilitation of MSMEs as the governing structure for restructuring/rehabilitation policy for potentially viable sick units.

Practically, the DRM–MSME universe generally splits into:

• Incipient-stress accounts (early stress flags / SMA-type classification under bank monitoring); and
• NPA accounts (where restructuring/rehabilitation may still be explored if viable, or recovery/OTS becomes the primary route).

Special Mention Account (SMA) Classification

• Under the RBI’s credit monitoring framework, SMAs are early-warning classifications used by banks to identify incipient stress in loan accounts before they become Non-Performing Assets (NPAs). The SMA system is preventive in nature and enables timely corrective action such as restructuring, rectification, or recovery.
• An account is classified as SMA-0 when principal or interest payments are overdue for 1–30 days, SMA-1 when overdue for 31–60 days, and SMA-2 when overdue for 61–90 days. Once the overdue exceeds 90 days, the account is classified as an NPA.
• The purpose of SMA classification is not punitive, but monitoring-oriented. It triggers closer supervision, borrower engagement, and consideration of remedial measures, especially critical for MSMEs, so that stress is addressed early and slippage into NPA can be avoided.

For the Framework for Revival and Rehabilitation of MSMEs, the RBI Master Direction explicitly notes that the framework applies to MSME loan accounts where the aggregate exposure of lenders is up to INR 25 crore (as of March 17, 2016, guidelines, rooted in the GoI framework).

This “INR 25 crore aggregate exposure” threshold is important as it determines when the formal, committee/CAP-based revival & rehabilitation architecture must be followed; and shapes how early-stress identification and corrective action are operationalised across lenders for that MSME borrower.

The debt restructuring and revival framework for Micro, Small and Medium Enterprises (MSMEs) is rooted in a composite statutory and regulatory architecture comprising Section 9 of the Micro, Small and Medium Enterprises Development Act, 2006, the Ministry of MSME’s Gazette Notification dated May 29, 2015 on the Framework for Revival and Rehabilitation of MSMEs, and binding directions issued by the Reserve Bank of India under Sections 21 and 35A of the Banking Regulation Act, 1949, as consolidated in the RBI Master Directions on Lending to MSME Sector. The framework was conceived as a remedial and corrective mechanism to address early financial stress in MSMEs through structured engagement between

lenders and borrowers, prior to the account slipping into non-performing asset (NPA) classification and coercive recovery measures being triggered.

Judicial scrutiny of this framework has, over time, crystallised several core legal questions, including whether the MSME revival framework is mandatory or merely directory, whether banks are required to suo motu identify and extend restructuring benefits to eligible MSMEs, how eligibility, particularly the INR 25 crore loan threshold, is to be computed, and how the framework interfaces with creditor enforcement mechanisms under the SARFAESI Act, 2002 and the Insolvency and Bankruptcy Code, 2016.

The Supreme Court, in Pro Knits v. Canara Bank[3] (2024), settled the question of the binding nature of the MSME revival framework. The Court held that the framework is not a discretionary or optional policy but has statutory force, having been issued pursuant to Section 9 of the MSMED Act and Sections 21 and 35A of the Banking Regulation Act. It was held that banks are under a mandatory obligation to examine whether a borrower qualifies as an eligible MSME and to consider revival and rehabilitation measures before classifying the account as an NPA. The Court further clarified that initiation of SARFAESI proceedings without compliance with the MSME framework, in cases where the borrower is eligible, would be legally unsustainable. At the same time, the Supreme Court underscored that the burden of establishing MSME eligibility lies on the borrower, who must furnish authenticated and verifiable documentation; mere assertion or registration under the MSMED Act is not sufficient.

The scope and limits of Pro Knits were subsequently examined by the Bombay High Court in Vardhan Agro Processing v. Union of India (2026)[4]. In this case, the borrower sought protection under the MSME revival framework on the basis that its outstanding dues were below INR 25 crore, despite its sanctioned loan limits exceeding that threshold. The High Court rejected this contention and held that eligibility under the MSME framework is determined by the sanctioned loan limits or aggregate credit facilities, and not by the fluctuating outstanding amount. The Court emphasised that the INR 25 crore ceiling is a jurisdictional eligibility condition, deliberately incorporated to restrict the framework to smaller MSMEs, and cannot be diluted by importing broader RBI concepts of “exposure” applicable in other contexts. The Court clarified that Pro Knits applies only to borrowers who satisfy the threshold eligibility criteria under the MSME framework, and that MSME registration alone does not confer restructuring rights where the loan limits exceed the prescribed ceiling.

Subsequent clarifications by the Supreme Court, have further refined the legal position by holding that banks are required to act suo motu only where MSME eligibility is apparent or has been duly disclosed. Where the borrower fails to assert MSME status with supporting documentation at the appropriate stage, banks are not precluded from proceeding with NPA classification and enforcement. The Court also clarified that MSME protections cannot be invoked belatedly after issuance of a SARFAESI notice merely as a delaying tactic.

Insofar as the interplay with SARFAESI and the Insolvency and Bankruptcy Code is concerned, the settled position is that compliance with the MSME revival framework is a condition precedent to valid NPA classification and SARFAESI action in eligible cases. Once such compliance is either completed or rendered inapplicable due to ineligibility or borrower default, creditor remedies under SARFAESI remain unaffected, with Section 35 of the SARFAESI Act conferring overriding effect. Similarly, initiation of proceedings under Section 7 of the IBC is not barred merely because the borrower is an MSME; however, failure to adhere to mandatory MSME restructuring requirements in eligible cases may expose the creditor’s action to judicial scrutiny.

The jurisprudence thus yields a set of clear principles. The MSME revival framework is mandatory but conditional upon eligibility. Eligibility is jurisdictional and must be satisfied before any protection can be claimed. The INR 25 crore threshold is based on sanctioned loan limits and not outstanding dues. Banks have a duty to examine eligibility, but MSME borrowers have a reciprocal obligation of timely disclosure. MSME protections cannot be invoked belatedly or strategically to stall enforcement. Once the framework is duly exhausted or found inapplicable, SARFAESI and IBC remedies operate in full force.

From a practical standpoint, these rulings require banks to institutionalise internal checks to document MSME eligibility analysis prior to NPA classification, while MSME borrowers must proactively assert their status with credible documentation at an early stage. High-value MSMEs with sanctioned limits exceeding the threshold cannot assume entitlement to MSME-specific restructuring. Judicial interference is unlikely where creditor action conforms to the regulatory design and the settled law.

[3] CIVIL APPEAL NO …. OF 2024 (@ SPECIAL LEAVE PETITION (C) NO. 7898 OF 2024)- M/S. Pro Knits vs The Board Of Directors Of Canara Bank on 1 August, 2024

[4] in Vardhan Agro Processing v. Union of India (2026)- Decided on 29.01.2026

The RBI requires banks to have, Board-approved, a non-discretionary One Time Settlement (OTS) scheme for recovery of NPAs in the MSE/MSME segment.

“Non-discretionary” in this context means the bank’s OTS is rule-based and policy-driven (pre-declared eligibility, process, authority matrix, and settlement computation approach), reducing ad-hoc outcomes and ensuring consistency for similarly-placed MSME borrowers.

The Master Direction’s policy architecture specifically contemplates banks putting in place:

• A rehabilitation / restructuring policy (now read with the 2016 revival/rehabilitation guidelines), and
• A non-discretionary OTS scheme for NPAs in the MSE sector.

Supreme Court: RBI SME-OTS is “non-discretionary / non-discriminatory”; banks cannot arbitrarily deviate

Case & citation: M/s Sardar Associates & Ors. v. Punjab & Sind Bank & Ors. (2009) 8 SCC 257.

Issue: Whether a bank can refuse or alter OTS computation despite RBI’s SME OTS guidelines.

Gist: The Supreme Court examined the RBI SME-OTS framework and the bank’s own communications acknowledging that the scheme was “non-discretionary” and to be applied “without discrimination”. It rejected an approach where a bank sought to demand more than what the RBI formula yielded (e.g., because it believed it had better security), and emphasised that banks (particularly PSBs) cannot treat RBI’s supervisory framework as optional or apply it unequally.

Punjab & Haryana High Court: follows Sardar Associates; “non-discretionary” SME-OTS can be enforced (mandamus possible where right created)

Case & citation: M/s Jindev Shuttering & Anr. v. Bank of Baroda & Anr. (P&H HC, 19 Apr 2022).

Issue: Whether a scheduled bank can decline OTS if borrower falls within the bank’s / RBI OTS policy; and whether courts can grant relief (including extension/implementation) in appropriate circumstances.

Gist: The High Court records (while discussing Sardar Associates) that RBI’s communication implementing the SME-OTS was explicitly framed as non-discretionary and non-discriminatory for PSBs, and holds it would not be open to a bank to deny OTS if the borrower meets the applicable policy criteria, reinforcing the “eligibility + formula” discipline, rather than case-by-case discretion.

• Statutory / policy anchor: The Ministry of MSME, Government of India notified a “Framework for Revival and Rehabilitation of MSMEs” (Gazette Notification dated May 29, 2015). RBI thereafter issued the banking-operational guidelines / operating instructions for lenders (March 17, 2016) to implement it as a standard stress-resolution mechanism for eligible MSMEs.
• Objective and approach: The 2016 operating framework states the objective is to provide a simpler, faster and transparent mechanism to address stress, promote development of MSMEs, and preserve viable MSMEs affected by internal/external factors.
• Core operational design (how it works, in practice): In lender implementation, the framework typically runs as a Corrective Action Plan (CAP) model, where once stress is identified (and the account falls within the framework), lenders evaluate and choose among:
  • • Rectification (quick fixes to bring the account back on track),
    • Restructuring / Rehabilitation (a revised facility structure aligned to cashflows/viability), or
    • Recovery / Exit (including, where appropriate, OTS).

• Step 1 — MSME confirmation + exposure computation

Confirm MSME classification and compute aggregate exposure across lenders to determine whether the ≤ ₹25 crore revival/rehabilitation framework is triggered.

• Step 2 — Stress identification and internal escalation

Upon early-warning signals (cashflow stress, overdue trends, stock statement irregularities, etc), the account should be escalated under the institution’s MSME stress policy.

• Step 3 — Select the resolution track (Rectification / Restructuring / Recovery)

Based on viability and conduct, select the corrective route, (a) Rectification where stress is temporary and reversible; (b) Restructuring/Revival of viable but needs time/terms reset;
– Recovery/OTS where viability is impaired or borrower response is weak.

• Step 4 — Restructuring package design (if viable)

Design a cashflow-aligned restructuring: tenure reset, moratorium, interest structure, additional finance (if policy permits), security review, monitoring covenants, and governance requirements.

• Step 5 — OTS execution (if chosen)

Apply the non-discretionary OTS policy with documented eligibility, computation logic, approvals, and settlement implementation milestones.

• Step 6 — Monitoring + discipline post-resolution

Implement enhanced monitoring, milestone-based controls and periodic review until the account stabilises.

In the context of MSME restructuring under RBI guidelines, “viability” essentially means that, after restructuring, the enterprise is expected to be commercially sustainable and able to service its debts on the revised terms from its own business cash flows, within a reasonable time-frame. This is not a matter of optimism alone, but of structured, data-based assessment (usually through a Techno-Economic Viability, or TEV, exercise) that examines business, financial and managerial aspects in an integrated way.

Concept of viability under RBI-related frameworks

• Viability assessment is a pre-condition for restructuring or rehabilitation: only viable or potentially viable units are to be restructured; non-viable units are to be exited with focus on recovery.
• Under the MSME “Framework for Revival and Rehabilitation”, the lenders’ Committee is required to assess the techno-economic viability of the enterprise, especially for higher exposures, before deciding on any corrective action plan or restructuring package.
• The framework expects lenders to fix and monitor “viability benchmarks” and “milestones” (for example, target levels for DSCR, current ratio, and capital structure over the restructuring period) and to periodically review performance against these.
• Prudential norms on income recognition and asset classification follow the same principle: restructuring should not be used to evergreen inherently unviable assets; it is justified only when there is a realistic path to restoration of satisfactory servicing.

In short, viability means that after implementing the restructuring package, the MSME is expected to function as a going concern, generate adequate profits and cash flows, and meet its obligations without relying on continuous external support.

• Cashflow sufficiency and serviceability: Viability is fundamentally tied to whether projected cashflows can service the restructured obligations. A robust package therefore maps (i) realistic revenue assumptions, (ii) operating margins, (iii) working capital cycle and churn, and (iv) DSCR-like comfort over the revised tenor (with sensitivity to delays in receivables and cost inflation). The TEV requirement under the MSME framework is aimed at precisely this, restructuring only if the unit is viable post-package.
• Working capital realism (especially receivables dependence): Because MSMEs are often dependent on Government/CPSE/large-corporate payments, viability must explicitly stress-test the receivables cycle: concentration of buyers, ageing, dispute risk, and enforceability. A package that ignores WC friction is “paper viability” and often collapses into repeat SMA/NPA.
• Promoter skin-in-the-game and governance fixes: A credible restructuring package usually includes: minimum promoter contribution (cash/asset infusion), tighter information covenants, periodic stock/receivables audits, escrow/TRA, and negative covenants on related-party leakage.
• Security and enforceability upgrades (without mistaking “security” for “viability”): Security is not a substitute for viability. However, where operational lapses triggered stress, the package often strengthens security monitoring: asset tagging, insurance, collateral top-up, and clearer charge creation/perfection steps—so that rehabilitation does not dilute enforceability.
• Compliance and classification trajectory: A viability-driven package should state the intended monitoring milestones (monthly/quarterly), triggers for review, and the “exit conditions” (upgrade path / curing events). This aligns with the framework’s committee-based CAP logic.

The RBI Master Direction also prescribes a structured approach to improve delivery and monitoring of MSE credit, including, standardised application receipt: borrowers must receive an  acknowledgement for loan applications with a unique application serial number; enabling borrowers to track status online and for banks to conduct monitoring through the same platform; a mechanism to ensure loan applications are not rejected without justification, and to monitor/strengthen credit delivery (the Master Direction treats this as part of the institutional framework for MSE credit growth).

The regulatory and judicial framework governing MSME stress resolution now reflects a coherent and purposive design. The RBI’s Master Directions, the statutory revival and rehabilitation framework notified by the Government of India, and consistent judicial interpretation together establish that restructuring, rehabilitation, and non-discretionary settlement are not discretionary concessions but mandatory first-line responses for eligible MSMEs. Insolvency and coercive enforcement are intended

We trust you will find this an interesting read. For any queries or clarifications please write to us at insights@elp-in.com or write to our authors:
Mukesh Chand, Partner – Email – mukeshchand@elp-in.com