In the previous part (click here), we gave you a general background to the Insolvency and Bankruptcy Code, 2016 (IBC) and tried unpacking some specific concepts crucial to its functioning. We introduced you to the central actors of the IBC regime: Adjudicating Authority (AA), Committee of Creditors (CoC) and financial creditors, including the latest addition to the group—homebuyers. Additionally, we briefly analysed some of the more advanced concepts such as 'cross-border insolvency', 'group insolvency' and 'timely resolution'—topics that the IBC (and the country) is still warming up to. We also explained how Courts have interpreted 'default' and 'dispute', which are important events which can trigger or stall a corporate insolvency resolution process (CIRP).
In the second part, we take a closer look at the IBC's most fundamental features (terms starting with alphabets I-P).
I – Information Memorandum (IM)
The IM is one of the four important documents in an insolvency process along with the evaluation matrix, request for resolution plans and the resolution plan (RP) itself.
Put simply, the IM is nothing but a document spelling out the details of the corporate debtor (CD) to assist the resolution applicant (RA) in preparing the RP. Section 5(10) of the IBC defines an IM as a memorandum prepared by a resolution professional and then directs the reader to Section 29 which spells out, with greater granularity, what 'relevant information' an IM should contain.
This information is intended to provide an all-around picture of the CD and to help stakeholders make informed decisions w.r.t the future of the CD; broadly, it includes information relating to CD's financial position and disputes by or against it. Insolvency and Bankruptcy Board of India (IBBI) is empowered to lay down what exactly constitutes 'relevant information.' The IBBI has done so in Regulation 36 of the IBBI (Insolvency Resolution Process For Corporate Persons) Regulations, 2016 (IBBI Regulations, 2016) where it has added on to the constituents provided in Section 29. These include : the audited financial statements, the list of creditors and the amounts claimed by them, assets and liabilities of the CD, details of guarantees given for the debts of the CD, the number of workers and employees and liabilities towards them, amongst a host of other things.
J – Judicial Review of the decision of the Committee of Creditors
However, judicial review has not been completely ruled out. The AAs/NCLATs have to still ensure that the decision of the CoC reflects a plan to maximise the value of assets and takes into account the interest of all stakeholders, which includes the operational creditors. In providing a narrow scope of scrutiny, the Supreme Court has, therefore, struck a balance. This is important because any company cannot survive merely off financial creditors; it needs a constant supply of goods and services from operational creditors. A complete disregard of their interests can never be in the long-term interests of the company because this may have the effect of handicapping a newly revived company who may rendered a pariah and left with no operational creditors to provide goods and services to it.
Even the 2019 amendment to Section 30 of the IBC, which we have discussed in the previous part, has taken a balanced view by stipulating that the RP has to provide a minimum pay-out to the operational creditors and that the CoC can take into account the hierarchy between creditors in deciding the manner of distribution from an RP. However, a vaguely worded explanation has also been introduced to Section 30 which states that: [f]or the removal of doubts, it is hereby clarified that a distribution in accordance with the provisions of this clause shall be fair and equitable to such creditors.
Before the judgment of the Supreme Court in Essar Steel, there were two possible interpretations of this explanation which rendered it ambiguous. One interpretation was that if the RP provided for the minimum pay-out to the operational creditors, it would be deemed to be a fair and equitable distribution and thereby, eliminate any possibility of judicially review of the 'fairness' of the distribution. If it was truly in the character of a deeming provision, that would mean that the Parliament had omitted to insert the words 'deemed to be.' Another view was that the explanation had cast a duty on the AAs/NCLATs to determine the 'fairness' of the distribution to operational creditors and, thus, opened up the floodgates for litigation on the fairness of distribution. However, the latter view brought the IBC back to square-one and defeated the intent of the amendment which is to limit judicial review of distribution under RPs. In Essar Steel, the Supreme Court seems to have endorsed the first interpretation; it clarified that Explanation 1 has been inserted to preclude the AA/NCLAT's from entering into the merits of the decision of the CoC, once the RP ensures the minimum pay out to operational creditors. This means that the scope of judicial review of the CoC's decision is circumscribed by the IBC and can no longer be tested on untrammeled subjective notions of just and fair.
A recent decision of the Supreme Court has thrown further light on the issue of commercial wisdom and the limits of judicial review. In Maharasthra Seamless Limited vs. Padmanabhan Venkatesh, the Supreme Court approved a RP where the bid amount was lower than the liquidation value (notional value of assets if the CD was to be liquidated; more on this later). While the NCLAT had ordered the RA to increase the upfront payment to match the liquidation value, the Supreme Court felt that the NCLAT had overstepped its boundaries of judicial review in doing so. It observed that NCLAT's decision was based on an equitable perception and, was an improper attempt to substitute its own decision for the CoC's commercial wisdom.
This judgment may come under fire for promoting an unquestionable use of commercial wisdom to defeat any objections against palpably unfair RPs, such as the one in this case, one may argue. However, a close reading of the judgment belies this perception. The Supreme Court itself acknowledged the fact that an RP which provides an amount lesser than the liquidation value appeared inequitable, but also noted that the RA planned to infuse more funds once it began running the company. In other words, the RA's decision to invest in a staggered manner rather than make a significant upfront payment was based on what the CoC and the RA itself considered to be commercially viable. The judgment reinforces the view that the seemingly impenetrable wall of commercial wisdom is not to enable downright arbitrary RPs to pass muster but is intended to avoid excessive intereference in what are otherwise commercially viable decisions.
K – Kreative Destruction
Yes, creatively spelled. This is at the heart of IBC. The term 'creative destruction' was first devised by the economist, Joseph Schumpeter in 1942, in his work titled 'Capitalism, Socialism, and Democracy.' He explained it in the following words: ". . . the same process of industrial mutation . . . that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism." To Schumpeter, the process of constant evolution in the kind of technology, products and services people use, undergirds economic growth and productivity. At its heart, creative destruction requires challenging the status quo and introducing reformative ideas and processes to destroy the existing ones, for the better.
Closer to home, we have our very own proponent of creative destruction in the form of Lord Shiva (also known as Lord of Destruction), who destroys and creates the world anew in a more perfect form.
Regulation 2(k) of the IBBI Regulations, 2016 defines 'liquidation value' as the estimated realizable value of the assets of the CD, if the CD were to be liquidated on the insolvency commencement date. This has to be determined by two registered valuers who have to appointed by the resolution professional within seven days of his appointment. But what exactly is the purpose of determining the liquidation value at a stage when the CD is commencing its journey to recovery, something which is fundamentally opposed to the idea of liquidation.
In fact, the first set of amendments in 2019 has amended Section 30(2)(b) to further benefit the operational creditors by mandating the payment of the resolution value, if it is higher than the liquidation value. This is the amount that the operational creditors are entitled to receive if the bid amount is distributed in accordance with the order of priority under Section 53 of the IBC. In simple terms, the amendment has pegged the value of the minimum pay-out in relation to the amount given in RP, rather than the liquidation value, since the former is likely to generate a higher pay out for the operational creditors. However, a persistent difficulty continues to plague both liquidation value and the amount given in the RP: the amount to be paid under the RP will have to be a significant amount for it to be distributed to the operational creditors in the order of priority under Section 53 of the IBC. This is because they are at a lower priority than other categories of persons under the provision and the amount is likely to be exhausted by the time their claims can be satisfied.
A reading of the IBBI Regulations, 2016 reveals another term which accompanies liquidation value : fair value. This is the estimated realizable value of the assets of the CD if they were to be exchanged on the insolvency commencement date between a willing buyer and willing seller in an arm's length transaction, after proper marketing and with knowledge, prudence, and without compulsion. Note that the italicized terms radically change the circumstances of the hypothetical transactions from the ones that would have to be taken in determining the liquidation value. The determination of fair value is expected to yield a higher valuation than liquidation value, because the former proceeds on the assumption that the CD will continue as a going concern and not be liquidated. The determination of fair value became a requirement only from 2018, when it was added by way of an amendment to the IBBI Regulations, 2016. This change was prompted by low bids being submitted by RA's, which took liquidation value to be the base for their bids, ignoring the fact that the assets had to be valued in the context of revival and not liquidation.
M – Moratorium
Akin to a 'closed door' which does not provide any access to the assets of the CD, the moratorium under Section 14 of the IBC is imposed to keep the CD's assets together so that the interests of all stakeholders can be addressed, and piecemeal recoveries through multiple proceedings do not minimize the value of the CD. A seemingly uncontroversial provision has, however, run into trouble in its implementation when it comes to imposing a moratorium on legal proceedings, in the form of suits and arbitrations, by or against the CD.
In the interlude between Part I of this article and the current Part, the "proposed suspension of the IBC" has crystallised as law through the IBC (Amendment) Ordinance, 2020, promulgated on June 5, 2020. The Ordinance has notably added Section 10A, which has suspended insolvency filings for defaults arising on and after March 25, 2020 for six months (this period is extendable for up to one year). This may impair the utility of the moratorium in keeping the CD's assets together. This is because Section 14 of the IBC comes into play only when an application is filed under the IBC, and not otherwise. Therefore, the suspension of filings under IBC has now made it easier to peel off the protective layer over the CD's assets, both by the CD in transferring its assets and by others in instituting legal proceedings, enforcing security interests or recovering any property occupied by the CD.
N – Non-Obstante clause
The first one relates to the conflict with the Securities and Exchange Board of India Act, 1992 (SEBI Act) which is presently pending before the Supreme Court in SEBI v. Rohit Sehgal. The case has arisen from an illegal Collective Investment Scheme floated by HBN Dairies Pvt. Ltd., which was being run in non-compliance with the SEBI Act. In view of this, SEBI ordered the attachment of properties of the company in 2017. Apart from the SEBI taking action, even the investors who had grown impatient with the recovery process, approached the NCLT as financial creditors to initiate the CIRP of the company. The NCLT accepted the application and declared a moratorium under Section 14 of the IBC. Armed with the NCLT order, the RP approached the SEBI for de-attachment of properties which refused to budge, citing the primacy of the SEBI Act. Things ultimately wound up at the NCLT which ordered de-attachment of the property by reason of the overriding effect of IBC over the SEBI Act, which was subsequently affirmed by the NCLAT. This decision has been appealed by SEBI in the Supreme Court which has stayed the order of the NCLT directing SEBI to hand over the title deeds to the RP and ordered SEBI to not create any encumbrance on these properties.
Coming back to the caveat we had inserted before we began discussing this; the issue of an inconsistency between IBC and PMLA stands resolved, more or less, under the Insolvency and Bankruptcy Code (Amendment) Act, 2020. The Act has added Section 32A to the IBC which provides the CD complete immunity from prosecution for any offence committed prior to the CIRP, once the RP is approved. This amendment will certainly affect attempts to attach properties by the ED under legislations like the PMLA and has impliedly given the IBC an overriding effect over the PMLA, in that sense. However, the NCLAT's decision, based on the new Section 32A, to disallow the ED from attaching the assets of Bhushan Steel and Power Limited (CD) for which JSW Steel had bid (RA), has been appealed to the Supreme Court. This means that the IBC-PMLA conundrum, inspite of the legislative amendment, is here to stay, atleast till the Supreme Court endorses the NCLAT's view on this. More on this – in the next part.
O – Operational Creditor
The fact that the operational creditors do not have voting rights in the CoC does not mean the financial creditors can ride roughshod over their interests. As we have noted earlier, the IBC requires that the RP approved by the CoC must provide for higher of the two amounts specified in Section 30(2)(b) of the IBC. This protection has been affirmed by the Supreme Court in the Essar Steel judgment, where it has held that the AA must review the RP to assess whether it has taken the interests of operational creditors into account.
One grouse that operational creditors have always put forth is about the unfair treatment they receive in a CIRP. RPs typically, negotiated by the financial creditors in the CoC, are not geared towards safeguarding the interests of operational creditors. Even the minimum statutory payment of liquidation value (after the 2019 amendment, this is to be considered along with the resolution value provided in Section 30(2)(b)) is often negligible for reasons we have noted above. In fact, this was acknowledged by the Insolvency Law Committee in its 2018 report, which also discussed replacing liquidation value with fair value or resolution value, both of which were eventually discarded for being unsuitable. It also dismissed claims of unfair treatment for lack of empirical evidence.
With atleast one promising potential change to look forward to, operational creditors have to weather another storm: one brought about by the recently added Section 10A. As noted earlier, Section 10A suspends filings under the IBC by all the three major stakeholders in a CIRP- financial creditors, operational creditors and the CD itself. But it is likely to have a disproportionate impact on the operational creditors. This is because the suspension coincides with the six-month moratorium on repayment of loans being granted by banks, which means that there are no chances of a default occurring, in absence of any obligation to pay on the CD. The financial creditors, therefore, have no reason to file applications under the IBC, atleast during the suspended period. However, operational creditors are perpetually precluded from invoking the IBC for non-payment of amounts due to them. The use of the word perpetually stems from the proviso to Section 10A which bars an insolvency application for a default, in the suspension period, forever. The proviso reads as: . . . Provided that no application shall ever be filed for initiation of corporate insolvency resolution process of a corporate debtor for the said default occurring during the said period. The said period is currently to be counted for six months from March 25th, 2020. With banks expecting repayments (and therefore possible defaults) only after the loan moratorium is lifted, which is likely to coincide with the lapse of Section 10A, it is the operational creditors that stand to bear the major brunt of this. Since the amendment was always intended to benefit the Micro, Small and Medium Enterprises (MSMEs), who are mostly operational creditors, the potential detriment that they may suffer has turned the amendment into a double-edged sword.
(ii) Operational Creditors can also, by virtue of being considered MSMEs, seek protection under the MSME Development Act, 2006. It entitles the operational creditor to receive compound interest if the buyer fails to make the payment and also provides for dispute resolution by the Micro and Small Enterprise Facilitation Council.
P – Preferential Transactions
Normally, a completed transaction between parties is left undisturbed and considered valid, unless it is objected-to by any of the parties to the transaction. However, the IBC empowers the resolution professional and the liquidator to scrutinise certain types of transactions which were entered into in the run-up to an insolvency. Generally referred to as 'vulnerable transactions,' they are subjected to an ex-post facto examination by reason of the circumstances under which they are concluded. Preferential transactions are one type of vulnerable transactions, apart from fraudulent (this has been covered in the previous part), undervalued and extortionate transactions, both of which will be discussed in the next part.
Section 43 of the Code explains in detail when a transaction will be deemed to be a preferential transaction by highlighting two situations: (i) when such transaction is for the benefit of a creditor, surety or guarantor for the satisfaction of a debt owed to such person and (ii) when the aforesaid transaction changes the pecking order given inSection 53 in a way that the beneficiary is put in a more beneficial position than it would have been in the event of a distribution being made in accordance with Section 53. To illustrate, for e.g. Company 'A' is going to go under insolvency pursuant to which all its assets will become part of a common pool which can be used to satisfy the claims of all creditors, in the event of liquidation. But just before this happens, Company 'A' transfers a substantial amount of property in favour of its holding company 'B' which is also a creditor of the company. This transfer has the effect of reducing the amount of assets which can be used to satisfy the claims of other creditors and is a transaction which gives an undue preference to Company 'B'. It further puts Company B in an advantageous position than it would have been under Section 53 as an unsecured creditor.
The provision empowers the liquidator or RP to review any transactions undertaken by the CD in the 'look back period' which is a period of two years preceding the date of insolvency for transactions entered into with a related party and a period of one year for transactions with persons other than a related party. Section 44 empowers the AA to pass a variety of orders to restore the position of the CD, it would have been in had the transactions not been entered into. Not all transactions, however, in the 'look-back' period are hit by the prohibition: transactions which are made in the ordinary course of business or financial affairs of the CD or the transferee are excluded from avoidance. Similarly, are transactions which create a security interest which secures new value to the CD and transactions which are registered with an information utility on or before thirty days after the CD receives possession of such property.
- So long as both the requirements of Section 43(2) along with the relevant look back period are fulfilled, the transaction will be deemed to be a preferential transaction, irrespective of whether it was, and whether it was intended or anticipated to be;
- The look back period can be reckoned from before the commencement of the IBC i.e. even preferential transactions undertaken before 2016 can be scrutinised and doing so will be not be considered a retrospective application of the law.
- The word 'or' appearing in Section 43(3)(a), which contains the ordinary course of business exception, has to be read as 'and'. This rule was necessitated by an argument that in order to be excluded from the purview of Section 43, transactions had to be made in the ordinary course of business or financial affairs of only one of the two parties, the CD or the transferee. This would have shifted the focus from the affairs of the CD and saved it of justifying its unusual transactions, so long as they could be justified from the viewpoint of the transferee's business affairs. Mindful of the disastrous implications of the argument, the Court has held that a transaction has to fulfil the exclusionary requirements of Section 43(3) from both the CD's and the transferee's perspectives.
To be continued…..
(Bharat Chugh, Former Judge & Partner, L&L Partners, Law Offices and Mr. Advaya Hari Singh, 4th-year B.A., LL.B student at National Law University, Nagpur. The views of the authors are personal)
This article was first published here
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