This article is written by Suparvo Dey, pursuing a Certificate Course in National Company Law Tribunal (NCLT) Litigation from LawSikho.
What is distress debt?
Distress Debt means when a company is in a state of incapacity to repay its dues or is going to become a defaulter or bankrupt in the near future and when such a company invites other investors to invest in such unpaid debts as secured parties, such debt is called distress debt. According to Black’s law dictionary Distress Debt means “a debt instrument issued by a company that is financially troubled and in danger of defaulting on the debt, or in bankruptcy, or likely to default or declare bankruptcy in the near future” this definition from Black’s law dictionary is also referred in a judgment “Avenue Asia Advisors Pvt. Ltd. vs Assessee on 22 January 2016 by Income Tax Appellate Tribunal – Delhi” where the learned Appellate Tribunal used this definition while stating the difference between distress debt and loan syndication.
Brief history of IBC
Prior to IBC there was no proper insolvency & bankruptcy law in India and generally the debtors were always in better positions than the lenders since, during insolvency proceeding, the companies still used to hold control over the management and operations of the company. For distressed or sick industries it was quite difficult for them to recover when they were in financial distress and availability of no proper forum for such process which results in delay and complex proceedings.
Due to result of this in 2013 a Committee of Financial Sector Legislative Reforms submitted a draft to Indian Financial Code, which included a “resolution corporation” for resolving distressed financial firms and as a result Insolvency and Bankruptcy Code, 2016 was introduced. For investors who invests in such debts, it was quite a boon for them also since after the commencement of IBC 2016 the investors can now recover their investments to some extent if the company goes bankrupt.
The history of IBC was discussed quite in detail in a judgment “Mobilox Innovations Private Ltd vs Kirusa Software Private Ltd on 21 September 2017” by Supreme Court of India, in this case the rights of operational creditors in respect of operational debt owed to them is challenged and before pronouncing the judgment the Supreme Court of India quoted a brief history of IBC as follows:
“It was for the first time, in 2001, that the L.N. Mitra Committee of the RBI proposed a comprehensive Bankruptcy Code. This was followed by the Irani Committee Report, also of the RBI in 2005, which noted that the liquidation procedure in India is costly, inordinately lengthy and results in almost complete erosion of asset value. The Committee also noted that the insolvency framework did not balance stakeholders’ interests adequately. It proposed a number of changes including changes for increased protection of creditors’ rights, maximization of asset value and better management of the company in liquidation. In 2008, the Raghuram Rajan Committee of the Planning Commission proposed improvement to the credit infrastructure in the country, and finally a Committee of Financial Sector Legislative Reforms in 2013 submitted a draft Indian Financial Code, which included a “resolution corporation” for resolving distressed financial firms.
All this then led to the Bankruptcy Law Reforms Committee, set up by the Department of Economic Affairs, Ministry of Finance, under the Chairmanship of Shri T.K. Viswanathan. This Committee submitted an interim report in February 2015 and a final report in November of the same year.
It was, as a result of the deliberations of this Committee, that the present Insolvency and Bankruptcy Code of 2016 was finally born.”
Procedure for recovering distressed debt under IBC
Nature of distressed debt
The nature of distressed debt is financial debt since it is issued as a debt instrument generally as bonds and section 5A (8(c)) of IBC, 2016 includes debt which is disbursed against any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument as financial debts.
Recovery procedure of distressed debt
The recovery procedure of distressed debt is same as recovery procedure for any other financial debt by financial creditor under section 7 of IBC, 2016.
Following will be the necessary steps in a recovery proceeding for distressed debt under section 7 of IBC in case of default:
- The lender (Financial Creditor) will have to send a demand notice under section 7 & of IBC, 2016 demanding the due amount to the borrower (Corporate Debtor).
- If the borrower disputes the claim under demand notice the lender can approach National Company Law Tribunal (NCLT) for initiation of Corporate Insolvency Resolution Process (CIRP) of the Corporate Debtor.
- First, the Financial Creditor have to file an application under section 7 of IBC 2016 in Form – I of IBC Rules 2016 along with relevant documents for initiation of CIRP of the Corporate Debtor.
- After filing the application by the Financial Creditor the Corporate Debtor will be given a chance to defend itself that as to why the application should not be admitted.
- If the Corporate Debtor is able to establish his defense, the application for initiation of CIRP of the corporate debtor will be dismissed or else the adjudicating authority will order for initiation of CIRP of the Corporate Debtor.
- After the admission of application for CIRP the adjudicating authority (NCLT) will appoint interim resolution professional (IRP) on the insolvency commencement date as per the provision of section 16 of IBC, 2016 and moratorium will be declared as per the provision of section of 14 of IBC, 2016.
Meaning & effect of moratorium
Moratorium means temporary suspension or prohibition of an activity.
When an application for initiation for CIRP is admitted by the adjudicating authority, the adjudicating authority declares a moratorium upon the corporate debtor as per the provision of section 14 of IBC 2016 for prohibiting the following things:
- It prohibits the institution of any new suits against the corporate debtor or continuation of any proceeding against the corporate debtor before any court or tribunal or continuation of any execution proceeding in respect of judgment, decree or order before any court or tribunal.
- It prohibits the corporate debtor from disposing, encumbering, transferring or alienating any of its assets.
- It prohibits any recovery proceeding against any security interest created by the corporate debtor in respect of its property even proceedings under sarfaesi act.
- It prohibits recovery of any property which is in possession of corporate debtor by the owner or lessor.
- The IRP will make public announcement by inviting claims within three days from his appointment in Form – A of IBBI Regulations 2016 as per the provision of regulation 6(1) IBBI Regulations 2016.
- The claims should be submitted within fourteen days from the date of appointment of IPR as per the provision of regulation 6(2)(c) & 12(1) of IBBI Regulations 2016.
- The creditors who fail to submit their claim within fourteen days should submit its claim with proof within ninety days from the date of appointment of IRP as per the provision of regulation 12 (2) of IBBI Regulations, 2016. The creditors who fail to submit its claim within ninety days from the date of appointment of IRP shall make an application to the adjudicating authority for admission of its claim by showing proper reasons for such delay.
- The claim should be verified by the IRP or by the Resolution Professional (RP) within 7 days from the date of its receipt as per the provision of regulation 13(1) of IBBI Regulations, 2016.
- If there is any requirement for the appointment of an authorized representative (AR) for a class of creditors it should be made within 2 days from the date of verification of claim as per the provision of section 21(6A) (b) of IBC 2016 and regulation 16A of IBBI Regulations, 2016.
- The IRP will file a report regarding certifying the constitution of the Committee of Creditors (COC) within 2 days from the date of verification of claim as per the provision of regulation 17(1) of IBBI Regulations 2016.
- The 1st meeting of COC should be held within 7 days from the date of submission of the report as per the provision of section 22(1) of IBC 2016 & regulation 19 (2) of IBBI Regulations, 2016.
- The COC may appoint the IRP as RP or replace the IRP with another RP with a 66% vote majority as per the provision of section 22(2) of IBC 2016.
- IRP will perform all the functions of RP till RP is appointed or if the RP is not appointed within the 40th day from the insolvency commencement date as per the provision of regulation 17 (3) of IBBI Regulations 2016.
- After RP is appointed registered valuer is to be appointed within seven days from the date of appointment of RP or forty-seven days from the date of CIRP as per the provision of regulation 27 of IBBI Regulations 2016.
- The RP will submit the information memorandum in the electronic form to each member of the COC within 2 weeks From the date of his appointment, but not later than 54 days from the date of commencement of CIRP as per the provision of regulation 36(1) of IBBI Regulations 2016.
- In the mean time if there is any application for withdrawal of application under section 7 of IBC it should be made in Form FA of IBBI Regulations 2016 before issuance of expression of interest with a majority of 90% vote as per the provision of section 12A of IBC 2016 & regulation 30A of IBBI Regulations 2016.
- The RP will make an opinion on preferential & other transactions within 75 days from the date of commencement of CIRP and have to determine preferential & other transactions within 115 days from the date of commencement of CIRP as per the provision of regulation 35A of IBBI Regulations 2016.
- If there is any preferential or other avoidable transactions the RP will make an application before the adjudication authority for appropriate relief within 135 days as per the provision of regulation 35A of IBBI Regulations 2016.
- The RP will publish brief particulars of the invitation for expression of interest in Form G of the Schedule at the earliest but not later than 75 days from the date of commencement of CIRP as per the provision of regulation 36A of IBBI Regulations 2016.
- The expression of interest will be submitted by the RP within 15 days from the last date of issue of invitation of expression of interest as per the provision of regulation 36A of IBBI Regulations 2016.
- A provisional list of eligible prospective resolution applicants will be issued by the RP within 10 days from the last date of submission of expression of interest as per the provision of regulation 36A of IBBI Regulations 2016.
- If there is any objection regarding the provisional list it should be submitted within five days from the last date of issue of the provisional list as per the provision of regulation 36A of IBBI Regulations 2016.
- After considering the objections the RP will issue the final list of prospective resolution applicants within 10 days from the last date of filing objections as per the provision of regulation 36A of IBBI Regulations 2016.
- The RP will issue the information memorandum & evaluation matrix within 5 days from the last date of issuance of the provisional list as per the provision of regulation 36B of IBBI Regulations 2016.
- The final list of prospective resolution applicants will be issued by the RP within ten days from the date from the last date of filing objection as per the provision of regulation 36A of IBBI Regulations 2016.
- After the following process the resolution applicants will submit the resolution plan within thirty days as per the provision of regulation 36B of IBBI Regulations 2016.
- The RP will submit the resolution plan approved by COC to the adjudicating authority within 15 days before the expiry of maximum time limit for CIRP as per the provision of Regulation 39(4) of IBBI Regulations 2016.
- After the resolution plan is submitted the adjudicating authority may approve or reject the resolution plan as it thinks proper as per the provision of section 31 of IBC 2016. If the resolution plan is approved the company will be revived according to the plan and pay off its debtors or else the company will go into liquidation to meets its debts.
Time limit for completion of CIRP
As per section 12 of IBC 2016 time limit for completion of CIRP is 180 days which can be extended up to 90 days by filing of an application by the RP which is approved by the COC with 66% majority vote to the adjudicating authority. Section 12 also states that the maximum time limit for CIRP should be 330 days including any extension and time taken in legal proceedings.
Advantages & Disadvantages of recovering distressed debt under IBC
- For the investors : Since after IBC 2016 has come into force, it is now easier for investors to recover the sum to some extent if the company goes bankrupt. More investors will now show a keen interest in companies that are showing financial distress and will invest in such debts due to the provision Insolvency Resolution Process under IBC 2016.
- For the companies : Due to IBC 2016 Distressed companies can now attract more investors for investing in distress debts since if the company goes bankrupt or insolvent the investors will be able to recover their sum to some extent by initiating Insolvency Resolution Process under IBC, 2016.
- For the investors : A company going under financial distress may made the following avoidable transactions classified under IBC 2016 as –
- Preferential transaction as per section 43 of IBC,
- Undervalued transaction as per section 45 of IBC,
- Transactions to defraud creditors as per section 49 of IBC.
To keep the assets of the companies out from the reach of creditors which may hamper the interest of the creditors and it is very difficult to identify such transactions in time.
In a judgment “Phoenix Arc Private Limited vs Spade Financial Services Limited on 1 February, 2021 by Supreme Court of India” it was stated that for the success of an insolvency regime, the real nature of the transactions has to be unearthed in order to prevent any person from taking undue benefit of its provisions to the detriment of the rights of legitimate creditors.
Therefore investors have to be careful before investing in such debts since it will be difficult for them to prove that such transaction was made bona fide and in good faith which may also impose legal obligations upon them.
- For the companies: As discussed above it will also hamper the interest of the companies going under financial distress since if the company invites investors to invests in such debts and later such investments identified as avoidable transactions as per the provisions of section 43, 45, 49 of IBC 2016 during Insolvency Resolution Process it will be a disaster for both the investor and the company.
Avoidable transactions under IBC 2016 and how it may hamper the interests of investors and distress companies
Following are the different types of avoidable transactions under IBC 2016:
- Preferential Transactions (section 43 of IBC 2016): If any transfer of property is made by a corporate debtor for the benefit of a creditor or surety or a guarantor to whom the corporate debtor owes a sum of debt and such transfer puts the creditor or surety or the guarantor in a better position such transfer will be called preferential transactions.
If an investor makes an investment in such a transaction by accident it will not only impose legal obligations upon him but will also hamper the interest of the investor, the company and the creditors.
- Undervalued Transactions(section 45 of IBC 2016): If any transfer of the asset is made by the corporate debtor and the value of such transfer is significantly less than the market value such transaction will be called an undervalued transaction.
Sometimes distress companies issue bonds in a lower amount than the actual value of such bonds and investing in such bonds or securities will not only impose legal obligations upon the investor but will also hamper the interest of both the investor and the company.
- Transactions to defraud creditors(section 49 of IBC 2016): If a company enters into an undervalued transaction for keeping its assets from out of the reach of other creditors such transaction will be called transactions to defraud creditors.
If any investor invests in such transactions it will lead such investor into trouble by imposing legal obligations upon him which will hamper the interests of the investor and creditors also.
From the above discussion about recovery of distressed debts under IBC 2016 it is clear that now distressed debts can be recovered to some extent if the company becomes bankrupt or insolvent by initiating Insolvency Resolution Process under IBC 2016. But there are some merits and demerits also in recovering such debts under IBC 2016 which may hamper the interests of the creditors, investors or the company itself.
- Avenue Asia Advisors Pvt. Ltd. vs Assessee (https://indiankanoon.org/docfragment/125399215/?formInput=distressed%20debt )
- Mobilox Innovations Private Ltd vs Kirusa Software Private Ltd (https://indiankanoon.org/doc/166780307/ )
- Phoenix Arc Private Limited vs Spade Financial Services Limited (https://indiankanoon.org/doc/137461156/ )
- For sections refer The Insolvency And Bankruptcy Code, 2016 (IBC) (https://ibbi.gov.in//uploads/legalframwork/2020-09-23-232605-8ldhg-e942e8ee824aa2c4ba4767b93aad0e5d.pdf )
- For regulations refer Insolvency And Bankruptcyboard Of India(Insolvency Resolution Process For Corporate Persons) Regulations, 2016 (IBBI) (https://ibbi.gov.in//uploads/legalframwork/4779dff9a1f5281cc4f72bb6054225cd.pdf )
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