In this article, Brihan Madhav, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses on Corporate Insolvency Resolution Process.

Introduction

Before we begin a critical analysis of the various grounds on which the insolvency resolution process can be initiated, it would be necessary to get acquainted with some of the key terms in the project.

Going Concern

The first important concept we should be aware of is the ‘Going Concern’ concept. The Going concern concept is a fundamental concept that is followed while preparing the accounts and other financial papers of the company. The concept essentially states that the entity will be assumed to continue with the business and will not shut down or go into the process of liquidation in the foreseeable future.

This means that when the creditors lend money to the Company they expect that the Company will continue to function in the future and the company in due course of time will repay the debt that it has acquired. Next we come to terms such as insolvency, bankruptcy and liquidation. To a certain extent all these terms are interrelated. They are sometimes used interchangeably.

Insolvency

Every entity has assets and liabilities. Insolvency is a scenario in which the liabilities outweigh or outnumber the assets.

Let us take an example, imagine a company ‘A’ has assets worth INR 100 and liabilities worth INR 200. In this case the company has more liabilities than assets and it is difficult for the company to carry on day to day operation.

However, it is not compulsory that all insolvency should lead to a shut down or bankruptcy. It is very much possible that an insolvent company receives a cash influx or some other aid and is again in a position to carry out day to day activities.

Bankruptcy

Bankruptcy is a legal term. Insolvency sometimes may become very extreme and the people who head the firm may decide that there is no other option but to file for bankruptcy. The important aspect of bankruptcy is that bankruptcy option is available to both individuals as well as companies. Famous individuals such as President of America Mr Donald Trump have filed for bankruptcy.  An insolvent company files for bankruptcy. It is not automatically assumed to be bankrupt. The bankruptcy will be filed by a creditor or the company themselves.

So when bankruptcy is filed, the functioning of the company becomes the responsibility of the Official Receiver generally. They decide what actions have to be taken, what assets are to be sold and creditors are to be paid back in what ratio. Bankruptcy is not the end however and may come as a relief. Major companies such as General Motors and Kodak have filed for bankruptcy and have come back stronger eventually.

This means that essentially bankruptcy tries to provide the party filing a second chance and at the same time helps in paying of its debts.

Liquidation

Liquidation process is similar to bankruptcy but the effects are different. Unlike Bankruptcy the option of Liquidation is not available to an individual. Only a company can file for liquidation. The essential purpose of liquidation is to collect and as much money as possible so that the same can be paid to the creditors. When the liquidation process finishes the Company ceases to exist. Herein lies the biggest difference between Bankruptcy and Liquidation, while the first one tries to give a second chance to the individual or company involved, liquidation is the end game and the Company ceases to exist.

Insolvency and Bankruptcy Code, 2016

The Insolvency and Bankruptcy Code (hereinafter known as IBC) was passed in 2016. The cases of Bankruptcy were governed previously by Presidency Towns Insolvency Act, 1909 and Sick Industrial Companies Repeal Act, 2003 in addition to certain other provisions of the Companies Act.

It might be pertinent to note that the term ‘stakeholder’ has not been defined in the Code. The IBC is considered to be more creditor friendly in its operation.  Creditor has been defined in section 3(10) of the Code. A creditor is anyone who is the owner of a debt. There are two types of creditor

1. Financial creditor as per Section 5(7) is a person who is the owner of a financial debt.
2. Operational creditor as per Section 5(20) is, a person who is the owner of an operational debt.

Corporate Insolvency Resolution Process

The Corporate Insolvency Resolution Process can be initiated by either the financial creditor or the operational creditor.

By financial creditor

The financial creditor can initiate the process under section 7 of the IBC. It is an imperative condition of filing the application that the debt should not be less than INR 1 lakh. In a situation in which the company has defaulted the creditor can file an application. Default would typically mean that there has been a non-payment of and a certain amount has become due. It is not necessary that the amount of debt be ascertained by the authority in charge, they must simply inspect if a default has occurred or not.

Criteria that needs to be examined

1. The Adjudicating Authority shall firstly examine if the default has taken place. This can be done through the records or the evidence that have been provided by the Financial creditor.
2. The Adjudicating Authority will check if there exists any disciplinary proceeding pending against the resolution.
3. The Adjudicating Authority will check if the application is complete.

If these conditions are not fulfilled the Adjudicating Authority may dismiss the application of the Financial creditor.

By operational Creditor

The procedure is slightly different when it comes to operational creditor. The operational creditor first has to send a demand notice to the debtor. There must be a demand for payment. The Operational debtor has 10 days’ time to respond to the notice or make the payment.

Under Section 9(1) if the Operational creditor has not received payment even after 10 days he can approach the Adjudicating Authority by filing an application for resolution process.

Criteria that need to be examined

1. The Adjudicating Authority must check if the application has been filed in the correct format and the appropriate fee is attached.
2. The Adjudicating Authority will check that there is no disciplinary proceeding is pending.
3. The Adjudicating Authority will check if the operational debt has been paid.

Role of directors in the Liquidation process

As stated above, the director is perhaps the most important person as far as the decision of liquidation is concerned. Until bankruptcy/liquidation, the director thinks from the view of the shareholders, what would benefit them the most and what would give them maximum earnings and returns. However, on bankruptcy the Director has to think from the point of view of the creditors. This aspect has been kept in mind while setting up the IBC.

What needs to be kept in mind is that once the liquidation process begins, the objectives of the Company changes. While earlier the company was moving with the objective of earning maximum profits now the objective is to pay back most of the debts. Hence as soon as the liquidation process begins the Board of Directors stand suspended. This power is now shifted into the hands of the National Company Law Tribunal.

Before we understand the intricacies in such situation we should understand the concept of ‘twilight zone’. Twilight zone is the period between the time where there is no possibility of avoiding the prospect of liquidation and the start of the process of liquidation process. In India the twilight zone period generally extends to the period of 2 years before the date of liquidation. However, it must be kept in mind that the twilight zone has not been defined under the Act.

Simply put the directors are not absolved of responsibility for the decisions that were taken during the twilight zone. We must keep in mind that any action taken by the Director especially the risky decisions will affect the company in a sufficient way.  The major point of inspection that needs to be checked is whether a decision was taken with the intention of defrauding the creditors.

The liabilities of the Directors are essentially of two types:

1. Punitive liability: this is the kind of liability that extends to actions such as defrauding and falsification of books of accounts.
2. Disgorgement based liability: This is the liability that comes into existence due to wrongful trading.  Essentially it means that the Directors did not exercise due diligence while trying to reduce the loss for the creditors of the company.

If it is found by the Adjudication Authority finds that the directors have taken decisions with the intention of defrauding the creditor, then the Adjudication Authority has the power to pass an order to make the concerned parties personally liable for the contribution to assets of the debtor.

The important aspect of the decision is due diligence. If due diligence was not taken or the intention was to defraud then the Directors may be personally liable.

Another aspect of protection is perhaps provided in Section 45 of the Code. If it is found that under the relevant period that the assets were undervalued, then the Adjudication authority has the power to make the transaction void. The Adjudication Authority shall consider the property for undervaluation if

1. Property was given as a gift from the corporate debtor
2. Or a sale of asset for a consideration or price which is far less than its value

The possible defense that the Directors can take is that they exercised due diligence. If the directors have exercised diligence that an ordinary man of reasonable prudence would take. The NCLT will check if the director has taken due diligence while taking decisions.

Conclusion

The IBC has become the authority when it comes to the laws regarding laws of insolvency. The Act has replaced a lot of other acts. The IBC has given two ways of going for liquidation, one is for financial creditors and the other is for operational creditors. In either cases the amount of default does not matter but it is critical that the default occurred. If this condition is taken care of and the notice and complaint is filed in the proper format and the same is complete then the liquidation process should start.

Another important aspect of the IBC is the role of directors. There is shift of objectives when it comes to liquidation as far as the directors are concerned. While earlier it is to provide maximum returns to the stakeholders during liquidation the main objective is to minimize the loss for the creditors.

The directors must keep note of the twilight zone and the actions that have been taken place during the twilight zone. If the Directors commit fraud, wrongful trading or any other actions that are trying to defraud the creditors, they may be held personally liable. To avoid this the Director must exercise caution as that of a man of reasonable prudence would exercise.

It can be clearly seen that the IBC is made with the objective of creditors and paying them back for their debts given.