In this article, the author has analyzed whether there is a need to alienate the incumbent promoters from the corporate debtor entirely and whether the present classification is fair and equitable. Further, the article also sheds some light on what was the mischief sought to be addressed by Section 29A and how effective it has been while addressing the same. Lastly, the article delves into whether Section 29A is harmonious with the objectives of the Code.
Introduction to the Code and Need for Section 29A
The Insolvency and Bankruptcy Code, 2016 (“the Code”) was brought in to replace the SICA regime where the debtor-in-possession system was prevalent which had made rehabilitation of a corporate debtor a severe challenge for various reasons, leading to an almost collapse of the Indian economy. Theobjectives of the Code have been to “consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time-bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders.”
The first case of resolution under the Code was ofSynergies Dooray Automotive Limited wherein a related party of promoters (Synergies Castings Ltd.) of the Corporate Debtor (Synergies Dooray Automotive Ltd.) filed a resolution plan with a 94% haircut to the creditors, which was subsequently confirmed by the CoC and NCLT. Edelweiss ARC being one of the financial creditors with 9.8% voting right in the CoC challenged the NCLT order approving said resolution plan. The main contention was that Synergies Castings had sidestepped restrictions placed on related parties of the corporate debtor to be on the CoC by transferring 90% of its debt to Millennium Finance Ltd giving it a 76% voting share on the CoC and thereby gaining a backdoor entry. This immediately rang alarm bells in the minds of all stakeholders, including the creditors and the Government of India (“the Government”). This cast doubtson the integrity of the Code’s process and suggestions to amend the Code’s clawback provisions to apply to the transfer or assignment of debts byrelated parties before the insolvency process.
This was followed byPhoenix Arc where although the financial creditors were not related parties at the time of CIRP, they were related parties at the time when the transactions giving rise to the claims arose. Although not analogous to the Synergies Dooray case, in both instances, one could find a common pattern of negating the principles of the Code.
The most remarkable features of the introduction of section 29A were – firstly, the speed with which it was conceptualized – barely a year and a half from the commencement of the Code. Secondly, it took a rather drastic measure to curb the issue at hand by barring an entire class of persons from participating in the resolution process although there wereother provisions existing under the Code relating to undervalued or preferential transactions.
Borrowing from the UK model and its skepticism to let the incumbent management manage theaffairs of the corporate debtor during insolvency resolution, India has adopted a ‘creditor-in-control’ resolution mechanism where the control of the corporate debtor is undertaken by a resolution professional. However, the Code goes one step further to systematically exclude the participation of incumbent promoters entirely.
The Code when first introduced under the recommendations of theBankruptcy Law Reform Committee (“BLRC”), did not contain any bar on who could propose a Resolution Plan. However, within a year and a half, the Code was amended by the way of anordinance and lateran amendment act to include section 29A barring several persons from proposing resolution plans. For this article, the focus shall be on section 29A(c) which disqualifies anyone who is a promoter, director, or key managerial person and persons connected to them, of a company holding a non-performing asset (“NPA”) account for over a year. The 2018 Amendment of section 35 also barred the liquidator from selling any assets to those persons barred under section 29A.
While the bare reading of section 29A does not suggest that it singles out the promoters of the Corporate Debtor as opposed to general prohibitions applied to filter persons who can submit resolution plans, some of the criteria laid down in section 29A are almost always met by such promoters.
Judicial Interpretation and Growing Ambit
The judiciary plays an integral role as under the Code it is entrusted with the duty to confirm a resolution plan or the liquidation order. The courts – NCLT, NCLAT, and Supreme Court – have consistently upheld section 29A.
InChitra Sharma, the Supreme Court blatantly rejected the validity of a resolution plan which was approved by the CoC of the corporate debtor on the grounds that the plan was hit by section 29A, referring to the object of the 2018 Amendment preventing unscrupulous promoters from being rewarded and thereby asserting the 2018 Amendment over the commercial wisdom of the CoC.
The validity of section 29A was challenged in the case ofSwiss Ribbons on the grounds of retrospective application, treatment of unequal as equal, the section was contrary to the object of the Code pertaining to maximization of the value of the assets of the Corporate Debtor and arbitrary timelines. The Supreme Court upheld section 29A to be valid under law of the land and seemingly prevented the erstwhile promoters from regaining control over the Corporate Debtor whom the said promoters have allegedly driven to the ground.
The erroneous combination of malfeasance with defaults, in general, has clubbed two different categories of promoters when evaluating resolution applicants. It was held that the disqualification under section 29A pierced the corporate veil and is thus extensive.
InArcerlormittal the Supreme Court ventured into explaining section 29A and highlighted the need to use purposive interpretation. The court had rejected two resolution plans of the corporate debtor (Essar Steel Ltd.) from two resolution applicants on the grounds that they were ineligible under section 29A. The judgment delved into the legislative history of section 29A and allowed the judiciary to expand its ambit to instances not strictly within the text of the Code.
A common theme across the decisions of the Supreme Court and NCLAT is that the incumbent promoters should not be allowed to regain control of the corporate debtor.
Critical Analysis of Section 29A
The Government to fill in the gaps it had left in the Code quickly sought to rectify it. The 2018 Amendment was introduced with theobject to prevent the “persons who, with their misconduct contributed to defaults of companies or are otherwise undesirable, may misuse this situation due to lack of prohibition or restrictions to participate in the resolution or liquidation process, and gain or regain control of the corporate debtor.”
The notion of section 29A and the judgments that have followed through is based on the reasoning that those who have contributed to the downfall of the corporate debtor should be barred from continuing any involvement in its future. The assumption is further based on the presumption that behind every downfall of a corporate debtor is the mismanagement of it.
The underlying principle is that unless the incumbent management is barred, it “may undermine the processes laid down in the Code as the unscrupulous person would be seen to be rewarded at the expense of creditors. In addition, in order to check that the undesirable persons who may have submitted their resolution plans in the absence of such a provision, responsibility is also being entrusted to the committee of creditors to give a reasonable period to repay overdue amounts and become eligible.”
Although section 29A and its proviso provide some relief to the incumbent management by allowing “reasonable” time to be given to the promoter to repay “all overdue amounts with interest thereon and charges” and no longer be in control of an NPA, it is pertinent to note that financially distressed companies are fraught with liquidity issues and are not always in a position to pay the overall dues.
Revaluating the Solution offered for a Peculiar Problem
Failure of Business – Whom to Blame?
There may be internal as well as external reasons involvedin the failure of business and the formation of an NPA. These can be divided into three categories, namely – internal, external, and other factors.
- Internal factors include “diversion of fund for expansion, diversification, modernization or for taking up new projects, diversion of fund for assisting or promoting associate concerns, time or cost overrun during the project implementation stage, business failure due to product failure, failure in marketing, etc, inefficiency in bank management, slackness in credit management and monitoring, and inappropriate technology or problems related to modern technology”or even late payment cycles leading to cash flow issues – these may be due to poor management of the corporate debtor or the unfortunate consequences of certain risks taken while conducting business.
- Theexternal factors have been said to “include recession in the economy as a whole, input or power shortage, price escalation of inputs, exchange rate fluctuations, and change in government policies.”
- Other factors can be categorized as “include liberalization of the economy and the consequent pressures from liberalization like several competitions, reduction of tariffs, etc, poor monitoring of credits and failure to recognize early warning signals shown by standard assets, the sudden crashing of capital market and inability to raise adequate funds, mismatching of funds i.e. using loan granted for short term for long term transactions, granting of loans to certain sectors of the economy on the basis of government directives rather than commercial imperatives.”
Even before the introduction of the Code or its subsequent amendments, the BLRC in its Reportdistinguished between malfeasance and business failures. It elaborated that in a “weak insolvency regime, the stereotype of “rich promoters of defaulting entities generates two strands of thinking: (a) the idea that all default involves malfeasance and (b) the idea that promoters should be held personally financially responsible for the defaults of the firms that they control.” Further, the BLRC also recognized that “some business plans will always go wrong” and that it is conducive to a growing economy that entrepreneurs aim for high rewards by taking risks; higher the risk, higher the chances of such plans inducing default. However, equating the unfortunate consequences of a business risk to malfeasance will hamper economic growth.
Miles to go Before Achievement of Objects of the Code
1.1. Maximization of Value of Assets
The central theme of the Code is the value maximization of the corporate debtor. It aims to keep the corporate debtor as a going concern as far as reasonably possible under the CIRP and even allows for the creditors to decide to sell the corporate debtor as a going concern during liquidation. It is believed that true maximization of value is only possible when the corporate debtor continues as a going concern, although allowing for its corporate death in the form of liquidation when it can no longer function effectively.
Banks (both public and private sector), NBFCs, and other financial lenders have taken a cumulative haircut of Rs. 3.22 lakh crore roughly 61.2% of their admitted claims since the advent of the Code. Although the Code is positioned as a resolution framework as opposed to a method of recovery, there are several pitfalls to achieving its objectives. Between 1 December 2016 and 31 March 2021, financial and operational lenders have filed for the CIRP of 4,376 companies under the Code. Further, 79% of the total cases under CIRP have been pending for longer than 270 days leading to a huge loss of value, and a resolution plan has only materialized in 7.9% of the total cases i.e. 348 cases have.
A recent example includes the resolution plan submitted by Twin-Star Technologies (controlled by Vedanta group) for 13 Videocon companies. While approving the resolution plan, the NCLT (Mumbai bench) raised questions over the Vedanta Group’s Rs. 3 crore bid for. The CoC-approved plan will account for only 4.98% of the debt to assenting secured financial creditors and 4.56% to dissenting secured financial creditors. Leaving assenting unsecured financial creditors to a meagre amount of 0.62% and operational creditors a 0.72% of their respective claims. It may also be noted that several of the operational creditors, in this case, happen to be MSMEs who will be able to recover less than 1% of their claims,which will lead to a highly detrimental effect on these small entities.
Given the plummeting economy post-Covid-19 pandemic, “the general economic downturn will make bidders more skeptical about the RoI (return on investment)that they will get even if the corporate debtor is available for very little.” With potential resolution applicants backing away due to discouraging risk-taking, cases of liquidation are on the rise. “The highest number of liquidation orders of 155 came in the second quarter of 2020, against 33 resolution plans cleared by tribunals, data from the Insolvency and Bankruptcy Board of India (IBBI) showed. In the second quarter of 2021,68 companies faced liquidation against 22 businesses stitching together revival plans.”
1.2. Balancing the Interests of all Stakeholders
Analysis of the present recoveries made by the creditors of corporate debtors undergoing CIRP would suggest a highly differential treatment of the various stakeholders of the corporate debtor – especially financial and operational creditors. Out of the total 348 cases of approved resolution plans in 58, operational creditors have recovered nothing even though financial creditors have been able to secure a portion of dues owed to them andin cases where admitted claims are exceeding Rs. 5000cr, the operational creditors have recovered only 12.5%. With large haircuts, the absolute numbers which are ultimately conferred upon the operational creditors are comparable to proverbial peanuts.
The push towards liquidation due to the failure of the creditors to find a successful resolution applicant also damages the corporate fabric holding the corporate debtor together. The shareholders, both private and public, suffer from the overall depletion of the failing entity.
1.3. Promoting Entrepreneurship
The BLRC in its report recognizes thatthe ability to take risks is essential to economic growth. It also emphasizes the importance of limited liability being a key feature of the companies in India. The concept of the development of corporate structures which separate a company’s managers and owners from the corporate legal entity ultimately comes from the recognition that all businesses involve a certain degree of risk and the advantages of encouraging these riskswithin a sound corporate governance framework that works on checks and balances.
The clubbing of all promoters regardless of the reason for the downfall of the corporate entities, under one head as under section 29A discourages the present batch of entrepreneurs from taking risks and is thus contrary to the objective of the Code and economic policy of the country.
The resolution of a distressed company’s debts can be conducted through a settlement between the debtor and creditors outside the courts or through a formal CIRP under the Code. Currently in India, the out-of-court settlement regime is provided under the RBI’s Prudential Framework for Resolution of Stressed Assets (“June 2019 circular”) which is riddled with its own issues and has seen very few corporate resolutions since its introduction. Further, it also does not provide the corporate debtor with any regulatory benefits such as a moratorium and clean slate.
Expecting a rise in potential insolvency cases as an effect of the COVID-19 pandemic, the Indian economy is presented with a challenge to keep afloat. The World Bank and the International Monetary Fund have also recommended a three-step plan to aid the economy transition smoothly towards the green. First, ample interim measures are to be taken to pause insolvency and debt enforcement processes. Second, to deal with a huge wave of insolvencies, transitional methods such as special out-of-court settlements be used to “flatten the curve”. Lastly, use regular debt resolution tools to address pending debt hangovers and preserve economic growth in the medium term. As a result, a pre-packaged insolvency resolution process (“PPIRP”) for MSMEs has beenintroduced to the Code.
PPIRP shall not be available where an application under sections 7, 9, or 10 has already been filed and is pending. Further, section 54C of the Code also deals with how the applications before the Adjudicating Authority will be determined. Approval of 66% of the creditors must be taken for filing an application for PPIRP and the PPIRP must be completed within 120 days from its commencement date. Unlike the CIRP, the control over the corporate debtor remains with the existing management in the case of PPIRP thus allowing for the incumbent promoters a second chance at reviving the corporate debtor and continuing their legacy. The Base Resolution Plan must be submitted by the existing management. Where the Base Resolution Plan is not approved by its creditors, the resolution professional may invite prospective resolution applicants to submit a resolution plan thereby maintaining transparency and competition and aiming towards the realization of the fair value of the assets of the corporate debtor.
However, presently this right is only available to MSMEs in India. It is recommended herein that the PPIRP process be made applicable also to other corporate debtors as well since several such corporate debtors are also victims of the Covid-19 pandemic economic aftermath.
Comparative Analysis of the Treatment of Incumbent Management during Insolvency in other Jurisdictions
a. United Kingdom
A comparison between the CIRP process followed under the Code and the processing of administration followed in the UK will show a lot of similarities. As in the UK, India has also borrowed the skepticism shown towards the incumbent management and promoters continuing to be in control of the corporate debtor. Despite its skepticism, the UK does not go to the extent of barring the said incumbent management from participating in the rescue of the company and subsequent regaining of control. There is a higher degree of concern about incumbent management’s participationin the case of pre-packaged insolvency in the UK which allows the assets of a corporate debtor to be sold by the administrator without the majority creditor’s approval.
The Graham Report, 2014 noted that over 2/3rd of pre-packaged insolvency sales involve connected persons and that this might lead to the disenfranchisement of unsecured creditors. However, despite the concerns, the Graham Report did not suggest barring them. In cases involving financial distress of a company due to an industrial downturn, the corporate debtor might not be able to attract bids from other players in the industry, and the incumbent management is the only ones willing to revive the company as a going concern.
A more recent development is the insolvency service, pre-pack sales in Administration Report, 2020 which recommends empowering the creditors and regulating the connected party sales so as to ensure transparency. Pursuant to the same, the Administration (Restriction on Disposals, etc. to Connected Persons) Regulations, 2021 was introduced to limit the administrator’s ability to alienate substantial portions of the corporate debtor’s property within 8 weeks from when the corporate debtor enters into administration. The administrator may however sell the property if it meets the threshold of reasonability depicted by a qualifying report.
This is a stark contrast with the regime followed in India. The UK’s approach to the issue of foul play by incumbent management is to create ring fences around the issue and transactions therein as opposed to a complete lockdown on the promoters to participate in the revival of the corporate debtor as in India.
b. United States of America
The substantial insolvency laws in the United States of America (“USA” or “US”) is contained in the Title 11 of the US Code (US Bankruptcy Code). It allows a debtor-in-possession insolvency resolution mechanism and shows less skepticism towards incumbent management. Chapter 11 in the US is the counterpart to the Indian CIRP. There are 2 pre-packaged insolvency routes in the US – under Chapter 11 and section 363 of the US Bankruptcy Code. Unlike in India or the UK, in the US shareholders continue to remain interested parties, albeit subordinate to the creditor’s claims.
In the case of section 363 sales, the bankruptcy trustee is allowed to sell, lease or otherwise dispose of the property of the debtor once it hits the Chapter 11 reorganisation proceedings. The trustee must give howevera notice and conduct a hearing before making any sale. The bankruptcy court allows the creditors to bring their objections of record and hears them before determination of the sale,and is not a substitute for the creditor’s voting process under Chapter 11 reorganisation. The bare text does not provide for any standards to determine section 363 applications, hence the courts have devised their own standards.
In Chapter 11 reorganizations, the involuntary bankruptcy process allows the corporate debtor an exclusive right to submit an insolvency resolution plan within 120 days fromwhen creditors file a bankruptcy application against the debtor. If the corporate debtor’s plan is rejected, the claimants can also propose a plan to be considered by all creditors. In the case of voluntary bankruptcies, the bankruptcy application is usually accompaniedby a resolution plan approved by claimants. This is followed by a disclosure requirement from all claimants, which contains all information material to the said claimant before they vote on the plan. The bankruptcy court then confirms if the reorganization plan meets all the criteria set out in section 1129 of Chapter 11.
The Chapter 11 plansare relatively straightforward and allow more protection to creditors than the regime in the UK. The main ingredient is requiring disclosures prior to the resolution plan’s execution and preserving the creditor’s voting rights. It also allows flexibility to negotiate discreetly and the time frame to obtaincreditors’ approval also increases.
In Sickness and in Health – Mapping the Way Ahead
The ineligibility under section 29A(c) does not require any intentionality. The person holding the NPA account need not be a wilful defaulteras defined by the RBI. For a debt to be considered a “wilful default”, it needs to be supplemented with the siphoning of funds for a purpose not permitted by the creditor, disposal of assets attached as security to creditors, or making the defaultdespite having capacities to honor financial obligations. This is treated as separate ineligibility under section 29A (b). In the present context and the Indian business fabric, the prohibition seems unforgiving as the entities that are in most need of the Code usually happen to be NPAs.
As was held in the matter ofSunrise 14/AS Denmark, the NCLT ordered the corporate debtor to be liquidated because the only resolution applicant was ineligible under section 29A. The point to be noted here is that the corporate debtor never got a chance, the CoC did not even have the opportunity to consider the resolution plan so as to maintain the “integrity of the Code”.
There is a vested interest to revive and replenish the corporate debtor far more in the case of the incumbent promoters who are the most “obvious propounders” of a resolution plan compared to any third-party resolution applicants. Promoters play a central role in navigating and steering the company in Indian family-driven businesses and in their absence, a corporate debtor is left alone to fend for itself and will inevitably get liquidated due to a lack of eligible resolution applicants.
Hence, it is recommended that at least where no resolution plans have been submitted, the erstwhile promoters are given an opportunity. At a time when buyers are scarce in a plummeting economy, alienating the promoter and shoving all struggling entities through the Corporate Insolvency Resolution Process in a system that suffers from liquidation bias would lead to a momentous loss of value. Further, in a case where a promoter submits a resolution plan, the Resolution Professional can adopt a swiss challenge method to ensure transparency and realization of fair value. Thus, relaxing the restrictions under section 29A may not automatically increase creditor recoveries but it will give the CoC another resolution plan to consider.
The existence of a lacuna is undeniable.There is fear of the phenomena of ‘phoenixing’ of companies “whereby companies are successively allowed to run down to the point of winding up, only to rise phoenix-like from the ashes as a new company formed and managed by an almost identical group of persons and utilising a company name similar to that under which the former company was trading.” The underlying concept of section 29A(c) is that the incumbent promoters of corporate debtors are less capable of reviving the company and participating in the rehabilitation. However, this has been challenged and the paper attempts to distinguish and classify the incumbent promoters into two classes i.e. malfeasant and non-malfeasant.
It is further essential that the legislature try to curb the effects of malfeasant promoters through subjective tests such as when there is a wilful default or an intent to act maliciously. Although the Code is still in a relatively nascent stage, there has been a considerable experience in the duration of the last 5 years, with the move towards pre-packaged insolvency in India might lead to a harmonious resolution and revival with a debtor-in-possession regime trusting the erstwhile management. Theobjective of the Code is to “give honest debtors a second chance, and penalize those who act with mala fide intentions in default” stressing the “mala fide intentions in default” being the operative part.
After all, in theimmortal words of Harper Lee, “Shoot all the bluejays you want, if you can hit ’em, but remember it’s a sin to kill a mockingbird.”
The views and opinions expressed by the authors are personal.
About the Author
Ms. Ipshita Dey is the Manager (Legal) of Welspun Group, Mumbai.
Managing Editor: Naman Anand
Editors-in-Chief: Jhalak Srivastav and Akanksha Goel
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Preferred Method of Citation
Ipshita Dey, “IBC v. Promoters: A Study of the Role and Treatment of Promoters in the Indian Corporate Insolvency Regime” (IJPIEL, 15 April 2022)