Section 7 Application of IBC cannot be allowed if Petition filed collusively

INTRODUCTION

Section 7: Initiation of corporate insolvency resolution process by the financial creditor:

7. (1) A financial creditor either by itself or jointly with [other financial creditors, or any other person on behalf of the financial creditor, as may be notified by the Central Government] may file an application for initiating corporate insolvency resolution process against a corporate debtor before the Adjudicating Authority when a default has occurred.

On the occurrence of a default, Section 7 of the Insolvency and Bankruptcy Code, 2016 (Code) grants a financial creditor the statutory authority to commence the corporate insolvency resolution procedure of a corporate debtor. The above-mentioned default is in relation to a financial debt owing to any financial creditor. The Adjudicating Authority must simply be satisfied with regard to the presence of default and ensure that the application is complete and that no disciplinary actions against the suggested resolution professional are underway under the Code in order to allow an application. The Adjudicating Authority is not obligated to consider any additional criteria when deciding whether or not to accept the application. However, because declaring a company insolvent has such serious consequences, it has been held that a corporate debtor cannot be condemned without being heard, and the Adjudicating Authority must give the corporate debtor a reasonable opportunity to contest the claim of default by filing a written objection. Prior to accepting the petition filed under Section 7 of the Code, the Adjudicating Authority may require that the corporate debtor be provided with a reasonable chance to be heard.

In a recent case, the NCLAT ruled that if an insolvency application is filed in a collusive manner, it might be dismissed.

The National Company Law Appellate Tribunal (NCLAT) dismissed an appeal against an order of the National Company Law Tribunal (NCLT) at Kolkata Bench, which dismissed the application under Section 7 of the Insolvency and Bankruptcy Code, 2016, on the grounds that the Respondent - Corporate Debtor colluded with the Appellant - Financial Creditor to avoid its liability as a corporate guarantor. If a person begins the insolvency resolution process or liquidation proceedings illegally or with malicious intent, the Adjudicating Authority may impose a penalty, according to the Tribunal.

The case of Hytone Merchants Pvt. Ltd. v. Satabadi Investment Consultants Pvt. Ltd., REED 2021 NCLAT Del 06591, was placed before the Division Bench of NCLAT at New Delhi comprising of Justice A.I.S. Cheema and V.P. Singh. Even if the petition meets all of the provisions of section 7 of the Insolvency and Bankruptcy Code, 2016, the bench found that it was filed collusively, not with the goal of resolving the insolvency, but for other reasons. As a result, admitting the Application to prevent the Corporate Debtor from being dragged into the Corporate Insolvency Resolution Process with mala fide is not required. In the conditions described above, the Hon'ble thought the appeals were without merit and rejected them.

BACKGROUND

The Appellant (Hytone Merchants Private Limited) filed this appeal after being aggrieved by the Adjudicating Authority's 'AA' (NCLT-Kolkata Bench) judgement rejecting the Application submitted under Section 7 of the IBC, 2016. The Appellant had granted the Respondent/ Corporate Debtor (Satabadi Investment Consultants Private Limited) an unsecured loan of Rs. 3.0 lakhs for six months with interest at 15% per annum in response to the Respondent's request for financial help. The Appellant, as the Respondent's Financial Creditor (FC), filed a Section 7 Application against the Respondent due to the Respondent's failure to repay the loan amount provided by the Appellant.

The Respondent acknowledged receipt of the unsecured loan money and issued a demand promissory note in addition to acknowledging receipt of the unsecured loan amount. The Respondent, on the other hand, failed to return the debt. The Appellant then sent a demand letter recalling the unsecured loan, but the Respondent ignored it and failed to pay the outstanding debts. The Section 7 Application submitted was comprehensive in every way and satisfied all of the standards set out in the IBC, 2016 and its rules. Despite finding and ascertaining that there was indeed a default and that the Application was complete in all respects, the Adjudicating Authority dismissed the Application, stating that upon examination of the Corporate Debtors’ master debt, it has a corporate guarantee of Rs. 480 crore approx. and upon examination of the Corporate Debtor's financial statements, and it has networks of Rs. 15 crore approx. As a result, it is difficult to believe that a company with a net worth about Rs. 15 crore would be unable to make a payment of Rs. 3.0 lacs. The petition in question appears to have been submitted in conjunction with the CD.

The National Company Law Tribunal (NCLT Kolkata's) bench had dismissed Hytone's plea under Section 7 of the IBC, citing Satabadi Investments Consultants' net worth of more than Rs.15 crore. 

"…on perusal of the master debt of the corporate debtor, it is seen that the corporate debtor has given a corporate guarantee of Rs 482,42,00,000. On further enquiry and on perusal of the financial statements for the financial year 2018-19 of the corporate debtor, it has come to light that the net worth of the corporate debtor is Rs. 15,36,39,015. It is hard to convince oneself that the Company has a network of Rs. 15, 36, 39,015 is not able to make a payment of Rs 3 lakhs. It appears that the petition at hand has been filed in collusion with the corporate debtor." the NCLT noted. 

This NCLT order from February 2021 was subsequently challenged before the NCLAT.

ANALYSIS

The Insolvency & Bankruptcy Code, 2016 (as modified in 2019) was enacted with the goal of bringing insolvency procedures to a close in a timely and effective way. On account of a debt default, the IBC permits several parties (i.e. corporate debtors, financial creditors, and operational creditors) to begin an insolvency resolution procedure.

The term "financial creditor" is defined broadly in Section 5(7) to include any person to whom a debt is due, including those to whom the debt has been transferred or legally assigned. Any corporate person who owes the aforementioned obligation to the financial creditor is referred to as a "Corporate Debtor."

The procedure under Section 7 is, on the other hand, designed specifically for financial creditors, who, under clause (1) of the provision, may file an application with the National Company Law Tribunal to initiate the Corporate Insolvency Resolution Process either individually or jointly with other creditors. To that end, Section 7 of the IBC gives financial creditors the power to commence insolvency proceedings against corporate debtors. The Explanation to Section 7(1) broadly defines ‘default' – in respect of which the application is made – to encompass both obligations owing to the applicant and debts owed to other financial creditors. This means that even if a default occurs with regard to debt owing to the financial creditor a, financial creditor B can submit an application under Section 7 as a result – even if no default occurs with respect to debt owed to him.

In the present case, the Financial Creditor filed an application with the Adjudicating Authority to reclaim a three-lakh unsecured debt under section 7 of the IBC. The Corporate Debtor (hereafter referred to as "CD") claimed that its failure to repay the loan was caused by a pandemic-induced slump, and so did not contend that a failure under section 7 had occurred. The Adjudicating Authority found the application to be thorough in every manner. The default surpassed the threshold limit set out in section 4(6) of the IBC at the appropriate time (2019). Despite this, the Adjudicating Authority maintained that relying on the CD's master data and financial statement from the Ministry of Corporate Affairs to assume that a company with a net worth of over Rs. 153 crores and a Corporate Guarantee of over Rs. 482 crores could not pay a minuscule amount of three lakhs was unattainable. As a result, the Adjudicating Authority rejected the application. It's worth mentioning that the Adjudicating Authority didn't give the parties a chance to contest the AA's stance before dismissing the petition.

The Creditor appealed the order, arguing that Adjudicating Authority was motivated by reasons outside the scope of the IBC section 7(5). The financial figures used by Adjudicating Authority were for the fiscal year 2018-19, while the petition was filed in the following cycle of 2019-20, according to the statement. Over the course of a year, the Corporate Debtor's financial position worsened, culminating in default. Corporate Debtor was also accused of investing in companies that were either in liquidation or going through the Corporate Insolvency Resolution Process, causing the disputed debt to default. Nonetheless, the Corporate Debtor was required to account for the funds as receivable accounts under generally accepted accounting standards, despite the fact that the chances of obtaining the funds are still slim.

The NCLAT dismissed the objections and affirmed Adjudicating Authority's decision under IBC section 65. Section 65 could not be construed simply in terms of imposing fines, according to the NCLAT. The Adjudicating Authority has the authority to halt the processing of applications based on fraud or malice. The tribunal considered “section 65 explicitly cites that any individual stimulates the insolvency resolution process or winding – up negotiations with the intention of deceiving or with malevolent purposes for any motive apart from resolution of Insolvency or liquidation, though as the case may, the Adjudicating Authority might indeed perpetrate punitive measures”.

The debtor defaulted to the petitioning financial creditor, according to the tribunal, the creditor who filed the insolvency petition, and the debtor. The Tribunal also determines that the petition had no procedural flaws. The tribunal, however, did not trust the debtor's claim that it was unable to repay the petitioning creditor based on a study of the debtor's prior financial net worth. The order, as well as the logic that underpins it, are flawed. The order goes against the word and spirit of the Code and opens the door to subjective judicial discretion when it comes to admitting insolvency cases.

To begin with, there is a prevalent belief that strategically initiating bankruptcy might assist debtors in avoiding payment of their debt. The main assumption here is that once a bankruptcy is filed, a statutory moratorium will prevent the debtor from performing its obligations to its creditors, forcing creditors to negotiate a restructure or write-off of their debt.

Evidence demonstrates, on the other hand, that filing for bankruptcy with the intent of avoiding creditors may not always assist the debtor ‘game' the system. Indeed, it is possible that the debtor will be liquidated. This is due to the fact that once the bankruptcy procedure begins, it is unpredictable, and many aspects of the bankruptcy case's life cycle are outside the debtor's control.

The incentives for a corporate debtor in India to cooperate with a creditor to purposefully induce bankruptcy are extremely minimal. This is primarily due to the lack of a debtor-in-possession model under Indian law. Following the admission of a bankruptcy petition by the NCLT, the board of directors of the corporate debtor is suspended, and the company's affairs are managed by an insolvency professional designated by the creditors. By itself, this element of the law will dissuade debtors in India from declaring bankruptcy as a means of avoiding creditors.

Second, the IBC empowers the debtor to initiate insolvency proceedings on its own. Given this right, it's unclear why a debtor would feel compelled to work with a creditor to activate the IBC.

There are two further aspects of the IBC's construction that attempt to discourage "collusive" bankruptcy filings. First, after the NCLT accepts the insolvency petition, the resolution procedure is a collective action process in which all financial creditors (not just the "colluding" creditor) engage in the corporate debtor's decision-making. Questions such as who will serve as the insolvency professional, if the debtor should seek interim financing, and how the corporate debtor will be handled.

A majority vote of the creditors decides on issues such as who will be the insolvency professional, whether the debtor should raise interim finance, how the corporate debtor should be put up for sale, and whether the corporate debtor should be kept as a going concern or liquidated – all of which are critical to maximizing value.

The IBC also allows creditors to withdraw an insolvency petition by a supermajority vote if they do not believe it is in their best interests to keep the corporate debtor in the resolution process. This means that a collusive insolvency petition that does not benefit all creditors will very certainly be dismissed.

“None of these features of the law have been designed to act as a check against collusive insolvencies. Nevertheless, they significantly lower the probability of a collusive bankruptcy meaningfully leading to creditor avoidance.”

One could argue that the debtor may have conspired to file for bankruptcy in order to avoid operational creditors who do not have a seat on the creditors' committee. While this is logically correct, it may not favour financial creditors in practice. This is because a significant financial creditor, such as a bank, is compelled by law to decrease a loan's bankruptcy classification and account for the obligation. This means a decrease in profitability, which dilutes any incentive to conspire with the debtor solely to avoid operational creditors' claims.

Given that contract enforcement in India is notoriously slow and expensive, operational creditors would have a tough time enforcing their claims, whether or not the debtor firm is bankrupt.

IMPLICATIONS OF THE NCLAT ORDER

The NCLT's order, as well as the NCLAT’s affirming it, has far-reaching ramifications for the judiciary's participation in the resolution process.

A major part of the IBC, as has been repeatedly stated, is to minimize judicial interference in resolving the business financial crises. As a result, the IBC has designated the judiciary with a specific and limited role, namely, oversight of due process in creditors' committee meetings, acceptance and rejection of claims by the resolution professional, replacement of the resolution professional, and approval of creditors' committee-approved resolution plans. Before an application may be approved, it must fulfil three conditions: first, there must be a default; second, the application must be complete under Form I; and third, there must be no pending court procedure against Resolution Professional (RP) recommended to be chaired. Although the RP's appointment was not in jeopardy, the Adjudicating Authority was concerned about the first two criteria in this case. 

Innoventive Industries Limited v. ICICI Bank and Another, REED 2017 SC 08563, one of the first IBC cases before the Supreme Court, the Supreme Court read the rules of the IBC severely to prohibit the possibility of any discretion in accepting insolvency petitions. To paraphrase the court:

“The moment the adjudicating authority is satisfied that a default has occurred, the Application must be admitted unless it is incomplete, and in which case it may give notice to the applicant to rectify the defect within 7 days of receipt of a notice from the adjudicating authority…”

The debtor argued that, while it had defaulted on its debt to the petitioning creditor, the liability had been waived under state law. The Supreme Court found that the existence of the debt and the fact of default had been established and that the tribunal could not dismiss the insolvency case based on state legislation. An examination of the debtor's financial net worth, as the NCLT is doing in this case, appears to be an even more improbable reason for dismissing an insolvency petition.

“More importantly, if the NCLAT's order is used as a precedent, debtors will merely have to demonstrate previous good financial net worth, to deprive the creditors of their right to trigger the IBC on the basis of a debt default.” 

This can't be good for the debtors. While a debtor's financial net worth (assets minus liabilities) may be good, it may not have enough liquid cash flow to meet a debt repayment deadline. The value of my home, for example, contributes to my net worth. A decrease in my monthly earnings, on the other hand, may affect my ability to return my EMI to the bank for that month. The distinction between net worth and cash flows is this. If the NCLT judges firms' bankruptcy eligibility on the basis of their "good financial net worth," the noble goal of enabling creditors to discover and resolve financial hardship in firms at an early stage will be undermined.

This provides the door for the NCLT to use its discretion when it comes to admitting insolvency cases. Worse, it obliges courts to examine the debtor's financial statements, something they are neither qualified nor trained to accomplish. This can't possibly be good.

Furthermore, the NCLAT held in Shobhnath and Others v. Prism Industrial Complex Limited, REED 2019 NCLAT Del 08504, that the Adjudicating Authority is only required to assess if there is a debt and delinquency, and that it cannot look into any other irrelevant or extraneous elements. As a result, even if the application met the profile under section 7, the Adjudicating Authority's denial of the application was based on extraneous factors not covered by section 7, which is illegal. In this case, the NCLAT also ruled that the inclusion of the word "may" in section 7(5)(a) permits the AA to use significant discretion in deciding whether to accept or reject the application. As a consequence, NCLAT ruled that Adjudicating Authority made the proper judgement in rejecting the application. It is true that the Adjudicating Authority has been granted considerable discretion under section 7 as compared to section 9(5), which includes the term "must," but this distinction is not decisive for such a finding.

CONCLUSION

According to the Appellate Tribunal, based on the law laid down by the Hon'ble Supreme Court in Swiss Ribbons Private Limited and Another v. Union of India and Others, REED 2019 SC 01504, it is clear that even if the Section 7 Application meets all of the requirements, the Adjudicating Authority must exercise caution in order to prevent and protect the Corporate Debtor from being dragged into the CIRP mala fide. As a result, Sections 65 and 75 of the IBC impose fines. Furthermore, Section 65 expressly states that the AA may impose a penalty if any individual begins the CIRP or liquidation procedures illegally or maliciously for any purpose other than the resolution of insolvency or liquidation. As a result, the Adjudicating Authority should proceed with caution when admitting the Application to ensure that Corporate Debtor is not dragged into CIRP for any reason other than the resolution of the Insolvency. Before accepting the Application, every care must be taken to ensure that the insolvency procedure is not exploited for reasons other than insolvency resolution.

Even though the petition meets all of the provisions of Section 7 of the IBC, 2016, the Appellate Tribunal believes it was submitted collusively, not with the goal of resolving insolvency but for other reasons. As a result, admitting the Application to prevent the Corporate Debtor from being brought into CIRP with mala fide is not required. Furthermore, in light of the Adjudicating Authority's observations and the fact that the Corporate Debtor is also a Corporate Guarantor who has provided a substantial Corporate Guarantee, such a reasonable claim that the Corporate Debtor conspired with the Financial Creditor to avoid its obligation as a corporate guarantor cannot be ruled out.

The Appellate Tribunal dismissed the appeal stating that the appeal had no merit.

The National Company Law Appellate Tribunal has decided that it has the authority to deny insolvency cases if there are evidence of cooperation and mala fide purpose, in a first-of-its-kind judgement. The decision is a step toward ensuring that the Insolvency and Bankruptcy Code's resolution procedure is not misused by those who come to the tribunal with dirty hands in order to evade their commitments and take advantage of the moratorium provided during the process.