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September 11, 2017

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Section 10 to file or not to file


Pooja Mahajan

The article analyzes the evolving jurisprudence around Section 10 and its interplay with other provisions of the IBC

Under the Insolvency and Bankruptcy Code, 2016 (“IBC”), a creditor or the corporate debtor itself, can initiate the Corporate Insolvency Resolution Process (“CIRP”) of the debtor. While financial and operational creditors can initiate corporate debtor’s CIRP by filing an application with the National Company Law Tribunal (“NCLT”) under Sections 7 and 9 respectively, a ‘corporate applicant’ (which includes the corporate debtor) can initiate corporate debtor’s CIRP under Section 10 of the IBC.

Since December 2016, many debtors have initiated their own CIRP under IBC. This right given to the debtor is very welcome as it gives an opportunity to the debtor to bring about resolution of its insolvency in cases where its creditors may be reluctant to do so.

In India, such a right to voluntarily initiate resolution process existed even before the IBC, albeit in very different forms - mainly as the right of an ‘industrial firm’ to make a reference under the Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”), for its revival. Admittedly, SICA was a failed experiment for various reasons. SICA was also routinely abused by the promoters who continued to be in possession of the assets and enjoyed the unending moratorium and protection provided by SICA.

Since admission of CIRP under the IBC also leads to moratorium for the benefit of the debtor, the possibility of abuse of Section 10 of the IBC by corporate debtors cannot be ruled out. Nevertheless, Section 10 needs to be read in light of Section 65 (fraudulent or malicious initiation of proceedings) and Section 66 (fraudulent trading or wrongful trading) of the IBC. This article analyzes the developing jurisprudence around Section 10 and its interplay with other provisions of the IBC.

Section 10 Requirements


Section 10 application can be filed by a ‘corporate applicant’ (which includes the corporate debtor as also its members and individuals in charge/control in certain circumstances). Under Section 11 of the IBC, debtors undergoing a CIRP or whose CIRP was completed 12 (twelve) months preceding the date of the application or who have violated a prior resolution plan or in respect of whom a liquidation order has been made are barred from making Section 10 application.

The trigger threshold for filing Section 10 application is low – a payment default of INR 1 lakh or more by the corporate– a threshold most companies, even if solvent, will not find difficult to cross. However, while the trigger threshold is low, the application requirements under Section 10 are quite cumbersome, as compared to an application by the creditors. To reduce the information asymmetry (between the debtor and the creditors) as a part of triggering the CIRP, the corporate applicant is required to provide extensive information such as details of creditors, evidence of debt and default, books of accounts, balance sheets, statement of affairs etc.

NCLT’s Discretion To Reject Section 10 Application


A question arises that if there is a payment default and the debtor is not barred under Section 11, does the NCLT have discretion to reject the debtor’s application? Admittedly, except for non-completion of the CIRP application, Section 10 does not provide any ground for rejection.

In the context of financial creditor’s application under Section 7, in Innoventive Industries Ltd. v. ICICI Bank1, the Hon’ble National Company Law Appellate Tribunal (“NCLAT”) held that once NCLT is satisfied as to the matters in Section 7, it is required to admit the case and beyond that, it is not required to look into any other factor. If the same rationale is applied, even in Section 10 cases, the NCLT should not look beyond Section 10 requirements (i.e. payment default and application being complete).

However, interestingly, NCLTs are issuing notices to creditors under Section 10 and are hearing their objections to admission of debtor’s application. Section 10 applications are being heard by NCLTs in detail and debtors are being asked to explain why their application should be admitted. And there are at least four cases of rejection of Section 10 application by NCLTs on grounds that the debtor made a filing with an ulterior motive to take advantage of the moratorium provisions of IBC.

In Leo Duct Engineers and Consultants Ltd.2 and Antrix Diamond Exports Pvt. Ltd3, NCLT, Mumbai noted that the admission of Section 10 application will stay/stall the proceedings against the debtor and its guarantors, and this, rather than turnaround of its business, appears to be the motivation of the debtor to approach NCLT. NCLT further held that it is not sufficient to meet the requirements of Section 10 and that it has to consider the merits of each case and see beyond what meets the eye. NCLT dismissed the application on the basis that irreparable loss will be caused to creditors and admission will provide uncalled for protection to the debtor and guarantors.

Similarly, in Unigreen Global Private Limited4, Principal Bench, Delhi, observed that corporate debtors were trying to abuse the IBC for only taking benefit of moratorium on actions against the corporate and its directors. In Krishna Kraftex Private Limited5, NCLT, Delhi observed that it cannot mechanically admit Section 10 applications as it will open a floodgate of people forming companies, incurring expenses and then enjoying the moratorium. NCLT further held that since no claims were made against the company, the company cannot be declared to be in default and that it barely had any assets which needed resolution under IBC.

While Section 10 is an important tool in the hands of corporates for resolving their insolvency, the success of this provision will depend on how jurisprudence around Sections 65 and 66 develops

Section 65


Under Section 65 of the IBC, penalties may be imposed on the applicant if it initiates CIRP ‘fraudulently or with malicious intent for any purpose other than for the resolution of insolvency’ of the debtor. The section is peculiarly worded as it stresses on ‘intent’ of the applicant linked to ‘purpose’ of filing - which, as per Section 65, should be ‘resolution of insolvency’. However, the entire IBC proceeds on the premise that a ‘payment default’ (rather than actual insolvency) should be the trigger point for CIRP admission as non-payment is viewed as an early sign of impending insolvency. Therefore, Section 65 leaves a lot to subjective satisfaction of NCLTs on what may appear to them as the ‘intent’ of the debtor in filing Section 10 application.

In the cases mentioned above, the fact that proceedings were initiated/will be initiated against the guarantors or directors appears to have weighed in heavily on NCLTs’ minds in determining debtors’ intent - NCLTs ultimately held that the intent was only to seek moratoriumrelated protections. However, the question is whether the moratorium really gives protection to the guarantor or directors of the company? Admittedly, a moratorium under Section 14 of the IBC is imposed only for actions against the debtor. In Schweitzer Systemtek India Private Limited6, (where creditors argued that the debtor has filed Section 10 application to thwart their attempts to recover the property of the guarantors), while NCLT, Mumbai recognized that imposition of moratorium has been used to frustrate recovery proceedings in certain cases, it admitted the application on the basis that moratorium would prohibit action only against properties of the debtor (not the guarantors).

Further, even if moratorium applies, it only applies during the CIRP period (which as per the IBC, cannot extend beyond 6 (six) to 9 (nine) months). Failure to approve a resolution plan within such period leads to mandatory liquidation. Importantly, during this period, it is the creditors (and not the debtor) who are in possession and decide the fate of the company. The creditors can take a decision to liquidate the company or approve a resolution plan which could entail sale of company’s assets or change in control. This is very different from debtor in possession regime under SICA where moratorium could be enjoyed forever. Therefore, to a large extent, the threat of abuse of Section 10 seems unwarranted. It is difficult to envisage a situation where promoters would put an otherwise solvent company into CIRP and run the risk of its liquidation or change in control just to enjoy 6 (six) to 9 (nine) months’ moratorium. And if the company is insolvent, then let the creditors who are seeking recoveries decide the fate of the company. The fact that moratorium is sought by the debtor against recovery proceedings cannot itself be a ground to impute fraudulent/ malicious intent – especially when the very purpose of CIRP is to provide a calm period and prevent dissipation of assets of the company during such period.

Section 66


Lastly, Section 10 must be read in light of Section 66 (2) of the IBC. Under this provision, a director can be made personally liable to contribute to the corporate debtor’s assets if before the insolvency commencement date, such director knew or ought to have known that there was no reasonable prospect of avoiding the commencement of CIRP; and such director did not exercise due diligence in minimizing the potential loss to the company’s creditors. To make the director liable under this provision, proceedings may be initiated before the NCLT by the resolution professional.

Therefore, for the first time in India, directors can be made personally liable for what is generally known as wrongful trading or insolvent trading. Section 66 (2) is based on ‘wrongful trading’ provision of Section 214 of the UK Insolvency Act, 1986. Wrongful trading occurs when the directors have continued to trade past the point when they knew, or ought to have concluded that there was no reasonable prospect of avoiding company’s insolvent liquidation and they did not take every step with a view to minimizing the potential loss to the creditors. During this time, the directors need to be extremely careful when considering whether to continue to trade, or not. Importantly, the liability is not for trading during this period but failure to take steps to minimize the losses to the creditors.

Section 66 (2) of IBC will force directors of Indian companies to evaluate what to do in case of impending insolvency. The insolvency may be a temporary issue in which case the directors may determine that it is beneficial to continue trading, or the directors may take some steps to improve trading conditions. However, at a point when they realize that it may not be beneficial to continue trading as is, they must exercise due diligence to minimize losses to creditors. Such due diligence may be in the form of taking steps for turnaround – and it is in this context that the right to initiate CIRP under Section 10 becomes important. If the directors believe that a turnaround process outside IBC is not feasible or proper, then they must question if CIRP under IBC will help in minimizing losses to the creditors. If the answer is yes, Section 10 almost takes the color of a duty cast on the directors to make an application for initiation of CIRP of the company.

It may be noted that in the UK, while deciding wrongful trading cases, the courts place some weight on whether the directors took professional advise (when the company started going insolvent), and if so, what that advise was. Therefore, it would be useful for directors of Indian companies to seek professional advise on turnaround mechanics to help them decide whether to file or not to file under Section 10 of the IBC.

Conclusion


While there is some fear of abuse of Section 10, it is an important tool in the hands of the corporate debtors when deciding how to resolve their insolvency, especially in cases where creditors are not interested or are dragging their feet on deciding an outside IBC resolution plan. However, the success of this provision will depend on how jurisprudence around Sections 65 and 66 develops. While Section 65 provides a disincentive to file (considering the risk of NCLT determining ‘malicious or fraudulent intent’ on the part of the debtor), Section 66 provides an incentive to directors to file (to avoid personal liability for wrongful trading). It may be mentioned that some of the cases referred to above are pending in appeal before NCLAT which is actively looking at the question whether NCLT has discretion to reject debtor’s application on grounds of potential abuse of the moratorium provisions.

Footnote:
1. Company Appeal (AT) (Insolvency) No. 1 & 2 of 2017, Judgment dated 15 May 2017.
2. C.P. No. 1103/I&BP/NCLT/MAH/2017, Order dated 22 June 2017.
3. C.P. No. 1104/I&BP/NCLT/MAH/2017, Order dated 20 June 2017.
4. Company Petition No. IB-39 (PB)/2017, Order dated 08 May 2017.
5. Company Petition No. IB- 78 (ND)/2017, Order dated 15 May 2017.
6. T.C.P. NO.1059/I&BP/NCLT/MB/MAH/2017, Order dated 03 July 2017.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.

 

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