Uncovering Vulnerabilities: Examining the flip side of Insolvency and Bankruptcy Code, 2016

February 4, 2024

Gaurav Pimple

Introduction

India is witnessing a momentous era of economic growth and financial prosperity. In order to fulfill the objective of Ease of Doing Business, the Government of India is constantly pushing for credit-driven stimulus to the economy. To ensure apposite credit supply, the Indian Government introduced new credit fostering institutions such as Non-Banking Financial Companies (NBFCs) as an alternative to traditional banks, burdened with a plethora of Non-performing Assets (NPAs).

In this ever-evolving landscape of easily accessible credit facilities, effective management of insolvency and bankruptcy is the most crucial element to maintain the financial health of a nation. The need for a comprehensive insolvency and bankruptcy framework in India became increasingly evident as the country witnessed a surge in NPAs and long-lasting legal proceedings of insolvency resolution. As existing legislation was insufficient to resolve these evolving issues, the Insolvency and Bankruptcy Code, 2016 (IBC) was introduced as a game-changer legislation to resolve insolvency instead of being a debt recovery statute.

However, as with any legal framework, its application has not been immune to misuse. IBC was introduced with the noble intent of speedy insolvency resolution of sick companies^[1], but emerging unfair practices have raised pressing concerns. Some entities, individuals and legal practitioners have found ways to manipulate the legislation for personal gain, often at the expense of the broader economic ecosystem. This article delves into the facets of the misuse of the IBC, shedding light on the various loopholes and unfair practices that have emerged recently.

IBC: As a Recovery Mechanism

As a successor of the Sick Industrial Companies Act of 1985, the purpose of IBC is to identify the inability of companies to repay their liabilities and facilitate the resolution of insolvency. IBC cures the financial sickness of companies, motivates the continuation of operations by insolvency resolution and maximizes asset valuation to protect the interest of various stakeholders. Yet, the actual situation on the ground is utterly distinct, as creditors^[2] often misuse IBC as a debt recovery tool, subverting its main objective.

Section 4 of IBC applies to matters related to insolvency where the minimum amount of default is ‘one crore rupees’. If the threshold in this section gets triggered, it becomes the prerogative of creditors to initiate a Corporate Insolvency Resolution Process (CIRP) against the ‘Corporate Debtor’^[3], including small creditors as well as short-term lenders. There has been a rising trend among creditors to file frivolous complaints against Corporate Debtors with the mere intention of damaging their reputation.

In addition, Section 12A of IBC provides for the withdrawal of insolvency applications. As of the end of March 2023, 19% of total cases have been withdrawn under Section 12A^[4]. Such a significant number of cases withdrawn suggests that completing CIRP was never the motive of the creditors. Creditors often employ insolvency applications to forcefully induce Corporate Debtors to arrive at private settlements through negotiations, thus defeating the objective of the code.

Adjudicating Authorities under IBC, the National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT) have from time to time clarified that IBC is not a debt recovery law but a revival mechanism. Recently, in the case of Maulik Kirtibhai Shah v. United Telecom Ltd^[5], NCLAT (Chennai Bench) upheld the order passed by NCLT (Bangalore Bench), dismissing the plea moved by the Operational Creditor^[6] claiming default of interest amount of Rs. 8.46 crore against United Telecom Ltd, stating that the petition is filed with only the intention of recovery of interest amount and hence it is not maintainable. Further, the Appellate Tribunal held that the spirit of IBC is a ‘Resolution of Debt’ and not a ‘Recovery of Debt’^[7].

With this, the NCLT plays a crucial role in ensuring that insolvency law doesn’t turn into a bare mechanism of debt recovery. Section 65 of IBC provides for action by NCLT in case of fraudulent initiation of CIRP. NCLT has taken significant steps in this direction by imposing penalties for the malicious initiation of proceedings.

Haircuts and Deceptive Valuations

In the context of the IBC, a “Haircut” refers to the reduction in the value of a debtor’s assets or the amount creditors will recover as part of the resolution process. It signifies a loss in the face value of the debt owed to creditors. Creditors must accept a haircut as a compromise to facilitate the insolvency resolution and revival of the sick entity.

Research and Rating Firm CareEdge, in its latest report, stated that the overall recovery rate in CIRP till the second quarter of FY23 was 30.8%, implying a haircut of approximately 70%^[8]. That means if creditors owe Rs.100, only Rs. 30 is recoverable through the insolvency resolution process. Creditors have to sacrifice almost 70% of the amount due. This scenario primarily arises due to deceptive valuations determined by valuers. In the process of insolvency resolution, acquirer entities frequently present lower valuations for the assets of sick companies they aim to acquire. Moreover, valuations are sometimes lowered through bid rigging or collusive bidding among acquirer entities. Since the Government’s approach is to revive these ailing companies, resolution plans with lower valuations often receive approval from the NCLT.

Lately, in the case of Raj Infrastructure Pvt Ltd v. Lavasa Corporation Ltd^[9], the NCLT (Mumbai Bench) approved the Resolution Plan proposed by Darwin Infrastructure Ltd, which outlines a staggered payment of Rs 1,814 crore to lenders in response to the total admitted liabilities of Rs 7,965 crore^[10]. In this scenario, secured creditors could recover only 20% of their dues with a sacrifice of 80% of receivables. This situation highlights the urgent need for government intervention, perhaps by introducing a minimum threshold limit on the percentage of haircuts.

Furthermore, in addition to this, the concept of “Moratorium” presents another significant concern. A moratorium refers to the prohibition on the institution of legal actions during the continuation of the ongoing CIRP and the transfer or disposal of assets throughout the insolvency resolution procedure. Freezing of assets for a substantial period can lead to the degradation of assets and a significant reduction in valuation. As per IBC, the statutory time limit for completion of CIRP is 180 days^[11] (extendable by up to 90 days). On the contrary, the reality is quite distinct, the timeline for completion of CIRP is far more than the statutory provisions. The time limit for completion of CIRP observed in the first quarter of FY24 is 635 days for Operational Creditors and 643 days for Financial Creditors^[12], posing a threat of degradation of assets, inducing a reduction in valuations.

Fraudulent initiation of CIRP

The core objective of the IBC is to expedite insolvency resolution cases and support struggling companies by enabling the continuation of operations, ensuring the nation’s economic growth. However, in recent times, Corporate Debtors have been exploiting the IBC by maliciously defrauding creditors and shareholders.

Section 10 of IBC provides initiation of CIRP by Corporate Debtors itself in case of financial crisis in the company. This section bestows liberty to a Corporate Debtor to admit liability and obtain necessary remedy from the Tribunal. However, as per the latest developments in the CIRP proceedings, corporate debtors are seen initiating CIRP, solely or by a collusive petition with creditors, either to defraud creditors or shareholders or to evade financial fraud. In this situation, Corporate Debtors get an undue advantage to run away from liabilities easily.

In the case Infinity Infotech Parks Ltd. v. Electroparts (India) Pvt Ltd^[13], NCLT (Kolkata Bench) issued an order against the Corporate Debtor terminating CIRP. In this case, some shareholders filed an application under Section 65^[14] claiming that the Financial Creditor engaged in fraudulent practices in collusion with the Corporate Debtor. The applicant argued that the Corporate Debtors admitted liabilities supported by fake documents and false transactions despite non-existent liabilities. Further, NCLT referred the matter to the Ministry of Corporate Affairs (MCA) to investigate corporate fraud.

Section 65 of the IBC is a penalizing provision, imposing sanctions against the fraudulent initiation of CIRP, protecting stakeholders’ interests. Despite Section 65 being a safeguard, it is insufficient to deal with such intricate issues. It does not specify how to identify these fraudulent commencements of CIRP, thereby creating a grey area. This lack of clarity leaves room for interpretation by the courts and creates uncertainty about who can file an application under this section.^[15]

Conclusion

Despite several loopholes in the Insolvency and Bankruptcy Code 2016, it still stands as a revolutionary statute facilitating instant resolution of insolvency compared to pre-IBC legislation. In the past, it used to take decades to successfully resolve insolvency or complete the liquidation process. Even though the significant reforms the IBC has brought to the insolvency landscape, its execution has encountered difficulties. Addressing multiple challenges, including the use of the IBC as a debt recovery tool, dealing with a higher percentage of haircuts, combating the fraudulent initiation of CIRP, addressing delays in IBC proceedings, and resolving the lack of clarity about several provisions, is crucial for the successful implementation of the code.

To achieve the objectives of the IBC, it is imperative to clarify legal interpretations through the issuance of guidelines, ensure strict and effective implementation of Section 65 with the imposition of heavy penalties and the classification of fraudulent initiation of CIRP as a criminal offense, regulate the significant percentage of haircuts, and expedite the resolution of insolvency cases through the enhancement of the existing judicial infrastructure.

^[1] Section 2(o) of the Companies Act 2013

^[2] Section 3(10) of IBC, 2016

^[3] Section 3(8) of IBC, 2016

^[4]https://www.google.com/amp/s/m.economictimes.com/news/economy/policy/since-launch-ibc-has-resolved-72-of-distressed-asset-cases/amp_articleshow/101348409.cms

^[5] CP (IB) No.131/BB/2021 https://www.google.com/url?sa=t&source=web&rct=j&opi=89978449&url=https://nclt.gov.in/gen_pdf.php%3Ffilepath%3D/Efile_Document/ncltdoc/casedoc/2903111021002021/04/Order-Challenge/04_order-Challange_004_16850949901571086896470824e7646c.pdf&ved=2ahUKEwiUyIO1sYeCAxVFe2wGHQhrCA8QFnoECA0QAQ&usg=AOvVaw0bCqKCErMJsdIhG-NvmHuV

^[6] Section 5(20) and Section 5(21) of IBC, 2016

^[7]https://www.google.com/amp/s/m.timesofindia.com/business/india-business/ibc-is-not-a-recovery-mechanism-says-nclat/amp_articleshow/103742205.cms

^[8]https://www.google.com/url?sa=t&source=web&rct=j&opi=89978449&url=https://www.careratings.com/uploads/newsfiles/17112022055714_IBC_Remains_Popular_Despite_Haircuts_of_Around_70_pc_and_Delayed_Resolution_Time.pdf&ved=2ahUKEwiXy7SDuYmCAxW-TmwGHZp0BEIQFnoECAoQAQ&usg=AOvVaw17DbtfDn2yU_cA-uZymshv

^[9] C.P. (IB) – 1765/2018

^[10]https://www.google.com/amp/s/m.economictimes.com/news/company/corporate-trends/bankruptcy-court-approves-darwin-platforms-resolution-plan-for-lavasa-corporation/amp_articleshow/102020853.cms

^[11] Section 12(1) of IBC, 2016

^[12]https://www.google.com/amp/s/www.thehindubusinessline.com/news/average-time-taken-for-debt-resolution-under-ibc-at-a-three-year-high/article67251174.ece/amp/