This article is written by Jai Anant Dehadrai, an advocate based in Delhi & Arnav Sinha, Associate, Chambers of Jai Anant Dehadrai, New Delhi.
Table of Contents
Introduction
The Insolvency and Bankruptcy Code (“the Code”) was enacted as a major financial sector reform which sought to consolidate and amend the laws relating to reorganization and insolvency of Corporate Persons, in a time bound manner. The Code has been instrumental in tackling the problem of non-performing assets in the country with nearly 61% of the total non-performing assets under-going the recovery mechanism under the Code recovered pre-COVID-19 pandemic in 2019-2020.
On a micro-level, the Code has greatly influenced the conduct of the management in companies even prior to the start of the insolvency resolution process through the implementation of ‘creditor-in-control’ mechanism. However, it is pertinent to note that despite the management of the Corporate Debtor not being at the helm of affairs during the insolvency process, the Code imposes retrospective penalties which can be imposed upon the erstwhile Directors. This, while paving way for efficient corporate governance practices in companies, exposes directors and key managerial personnel to potential civil and criminal liabilities.
Historical perspective: recommendations by the Bankruptcy Law Reforms Committee
The Bankruptcy Law Reforms Committee setup in August 2014 (“Committee”) in its report, which formed the basis of drafting of the Code, sought a clear and transparent flow of information from the management of the Corporate Debtor to the Resolution Professional, the Creditors and other stakeholders in the Resolution Process. The Report observed that there is an obligation of “honest behavior” upon the debtor who has the “information advantage” over the creditor to ensure a better symmetry of information between the creditors and the debtor. Thus, it is crucial that the debtor is honest in all disclosures and does not make false representation or conceal facts about the assets or transactions in these disclosures.
The Committee sought to ensure this honest behavior from the Corporate Debtor by bestowing wide powers upon the Resolution Professional to identify and reverse “vulnerable transactions.” These are defined as transactions that fall within the category of wrongful or fraudulent trading by the entity, or unauthorised use of capital by the management etc. This recommendation culminated in the drafting of special provisions for “Preferential Transactions” under Section 43, “Undervalued Transactions” under Section 45, “Transactions to defraud creditors” under Section 49 and “Extortionate Credit Transactions” under Section 50.
These provisions empower the Resolution Professional (or the Liquidator as the case may be) to approach the National Company Law Tribunal (“NCLT”) and reverse fraudulent transactions which may be covered under the ambit of the aforementioned sections.
The Committee further recommended that specific powers be conferred upon the Resolution Professional to file petitions before the NCLT against fraud by the management of the debtor. If the NCLT finds sufficient evidence of fraudulent transactions on the part of the management, or the promoter, or the directors, it can impose directions upon the personnel to repay those amounts to the Corporate Debtor out of their personal assets and estate.
This specific recommendation was incorporated under Section 66(2) of the Code. Section 66(2) imposes a liability upon the director by the way of disgorgement for ‘wrongful trading’ as defined in the Section. A key difference between Section 66(2) and the abovementioned sections is that Section 66(2) makes directors personally liable to disgorge the ill-received gains back to the corporate debtor unlike the abovementioned sections which empower the NCLT to ‘reverse’ such fraudulent transactions.
Disgorgement based liability under section 66(2)
Section 66(2) of the Code imposes a liability on partners or directors of the Corporate Debtor if:
- The director knew or ought to have known that there was no reasonable prospect of avoiding the commencement of the corporate insolvency resolution process of the Company.
- The director/partner failed to exercise due diligence in minimizing the potential losses to be incurred.
Section 66(2) empowers the adjudicating authority (i.e. the NCLT) to pass an order directing a director of a Corporate Debtor to personally make such contributions to the assets of the Corporate Debtor (disgorgement) as deemed fit by NCLT. However, the explanation provided under Section 66(2) lays down a general presumption in favour of the director and it is presumed that they have exercised due diligence.
This presumption in favour of the Director represents an evolution in law wherein the presumption of guilt has shifted from the Directors. For illustration, under Section 27(1) of the Securities and Exchange Board of India Act, 1992:
(1) Where an offence under this Act has been committed by a company, every person who at the time the offence was committed was in charge of, and was responsible to, the company for the conduct of the business of the company, as well as the company, shall be deemed to be guilty of the offence and shall be liable to be proceeded against and punished accordingly: Provided that nothing contained in this sub-section shall render any such person liable to any punishment provided in this Act if he proves that the offence was committed without his knowledge or that he had exercised all due diligence to prevent the commission of such offence.
Similarly worded provisions for ‘Offences by Companies’ have been provided under statutes penalizing white-collar crimes such as the Prevention of Money Laundering Act, 2002 (“PMLA”). Section 70 of the PMLA is identical to Section 27 of the SEBI Act. It clearly stipulates a rebuttable presumption of guilt against every Director of the Company. It is only after the Director or the Key Managerial Personnel categorically showcases his lack of knowledge to the commission of an offence or that he exercised due diligence to prevent the offence being committed, does he discharge this preliminary presumption of guilt against him.
The legal position under Section 27 of the SEBI Act or under Section 70 of the PMLA of is in contrast to the proviso under Section 66(2) of the Code which states that the director shall be deemed to have exercised due diligence. Therefore, by incorporating the proviso to the Section, the Legislature has, to a certain extent displayed its willingness to safeguard the interests of directors and key managerial personnel from criminal liabilities, at least during insolvency.
Looking back at the Committee’s Report of 2015, the Committee was conscious in differentiating between genuine cases of an honest ‘business failure’ from cases of malfeasance from the management of the Corporate Debtor. In a growing economy especially like in India, the top tier management will need to take business risks out of which some may fail and incur credit defaults. Not every default can and should be tainted as a fraudulent transaction as such a scenario would deeply affect the corporate culture in top tier managements of big corporations. This would in turn dampen the Country’s economic growth on a macro level.
As stated in the Committee Report, “Bankruptcy law must enshrine business failure as a normal and legitimate part of the working of the market economy.” Legislation will only be able to treat business failure as a normal part of a bankruptcy law when the directors are given space to maneuver their companies by taking calculated business risks in good faith without being in danger of criminal liability being imposed upon them. This legislative intent has been incorporated under the proviso to Section 66(2) of the Code.
However, despite the general presumption in favour of directors, Section 66(2) maybe tricky for Directors for the following reasons:
- Establishment of a Fiduciary Duty towards Creditors may potentially clash with Directors’ Fiduciary Duty under Section 166 of the Companies Act, 2013
Section 166 of the Companies Act, 2013 is a widely worded provision imposing fiduciary duty upon directors to act in the best interests of the Company. It obligates directors to act in the best interests of the company, its employees, the shareholders, the community and for the protection of environment under Section 166(2). A breach of the same invokes penal repercussions under Section 166(7) of the Code.
However, under Section 66 of the Code, this fiduciary duty witnessed a shift from company and shareholders to creditors when the Company will entering the ‘twilight zone’ i.e. the starting point of the period from the time when the director ‘knew or ought to have known that there was no reasonable prospect of avoiding the commencement of corporate insolvency resolution.’
The Code has been enacted to place the interests of creditors above all else, especially the equity shareholders. For instance, the liquidation process under Section 53 of the Code puts the equity-shareholders at the bottom of the so-called ‘liquidation waterfall.’ Taking an illustration wherein a Director seeks to pass a Special Resolution for a voluntary initiation of Corporate Insolvency Resolution Process (“CIRP”) under Section 10 of the Code at the outset of an imminent payment default.
Passing a special resolution is a requirement under Section 10. The equity-shareholders may not agree for CIRP initiation believing that the same will not be the best outcome for their interests. This conflict of interest between those of the equity shareholders and the creditors of a company showcases the ambiguity in the fiduciary position of Directors towards the creditors and whether they ought to be penalized for the same. A Lack of judicial precedents on Section 66(2) have further put directors in a tight spot with the absence of a standard and ambiguity in the interpretation of ‘due-diligence’
- Ambiguity of any specific timeline under Section 66(2)
The text of Section 66(2) clearly imposes a fiduciary duty upon directors for the interests of creditors in a departure of the fiduciary duty towards the stakeholders under Section 166 of the Companies Act, 2013. However, Section 66 does not establish a timeline for this departure. The vaguely worded section gives the impression that this shift occurs when the circumstances of the company are such that the director “knows, or can reasonably expect”, that any action he takes could result or lead to the insolvency of the company. Practically, this casts a difficult duty upon directors especially in companies operating in volatile business environments.
- May force directors to initiate CIRP in a haste
Section 66(2) may deter the management of a Company from any corrective actions and resort to a hastily initiated CIRP in order to safeguard themselves from any liability which may arise under Section 66(2). Premature CIRPs for financially sound businesses may lead to potential losses in stock value, investor relations and cause a disruption in the regular functioning of operations.
Criminal penalties of directors
As is often the case with high profile scams, when a Company approaches default, Directors and Key Managerial Personnel may anticipate this ahead of time and make illicit transfer of Company assets in order to defraud Creditors. The Code is designed with a particular focus on blocking such behavior which is undoubtedly malfeasance and not being a business decision taken in good faith.
The following provisions impose criminal liabilities on the officers of the Corporate Debtor:
|
Sr. No. |
Section |
Offence |
Penalty |
|
Section 68 |
Where a Corporate Debtor, within the twelve months immediately preceding the insolvency commencement date;
At any time after the insolvency commencement date, taken in pawn or pledge, or otherwise received the property knowing it to be so secured, transferred or disposed of. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore.
|
|
|
2. |
Section 69 |
On or after the insolvency commencement date, Entering into transactions defrauding creditors or removing any part of the property of the corporate debtor within two months before the date of any unsatisfied judgment, decree or order for payment of money obtained against the corporate debtor. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
|
3. |
Section 70(1) |
On or after the insolvency commencement date, does not disclose or deliver all or part of the property or, any books or papers to the resolution professional which he is required to be delivered, or fails to provide any information regarding the accounts of the corporate debtor. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
|
4. |
Section 71 |
On and after the insolvency commencement date, destroys, mutilates, alters or falsifies any books, papers or securities, or makes or is in the knowledge of making of any false or fraudulent entry in the accounts with the intention to defraud any person. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
|
5. |
Section 72 |
Where a Corporate Debtor makes any material and willful omission in any statement relating to the affairs of the corporate debtor. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
|
6. |
Section 73 |
Where any officer of the corporate debtor —
|
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
|
7. |
Section 77 |
Where a corporate debtor provides information in the application made by him, which is false in material particulars, knowing it to be false and omits any material fact, knowing it to be material or any person who knowingly and willfully authorized or permitted the furnishing of such information. |
Minimum 3 years up to 5 years.
Minimum one lakh to one crore. Or Both. |
These offences are tried by Special Courts under as established under the Sections 435 to Sections 438 of the Companies Act, 2013.
Conclusion
While the Insolvency and Bankruptcy Code’s creditor centric provisions have largely been successful in developing a sound insolvency regime in the Country, the Code’s imposing of a fiduciary duty upon directors to take creditor-oriented steps may not sit well with the shareholders and other stakeholders of the Company. The interests of the shareholders are not necessarily aligned with those of creditors and initiation of a CIRP will not always be the most logical way forward.
Hence, with the absence of any set standard or judicial precedent, Section 66(2) presents a potential pitfall for directors by incurring liability in the form of disgorgement under the Section. The Code, further, imposes criminal liability of fines and imprisonment on officers of the Corporate Debtor for any malfeasance displayed during and before the CIRP.
However, the Code, while being creditor-centric also recognizes legitimate and good faith risk-taking by a corporation’s management which may potentially lead to defaults in future. The criminal and civil liabilities in the Code were never meant to penalize those Directors who in took risky or even erroneous business decisions without any particular intention of defrauding creditors. The Committee in its discussion on the Code has clearly demarcated between cases of fraud from such cases. This legislative intent is reflected in the Code and is a progression of law from older statutes adjudicating white-collar crimes.
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