The Corporate & Commercial Law Society Blog, HNLU

Author: HNLU CCLS

  • IBC Ordinance: A Double-Edged Sword for MSMEs

    IBC Ordinance: A Double-Edged Sword for MSMEs

    BY JUBIN MALAWAT AND BHAVYA KALA, SECOND-YEAR STUDENTS AT RGNUL, PUNJAB

    Introduction

    CoVID-19 has created worst ever recessional conditions in the markets worldwide leaving everyone in distress. In light of the prevalent market conditions and the anticipated future contraction in the market, the government of India has introduced a few stabilizing and corrective measures keeping in mind the vulnerability of the Micro, Small and Medium Enterprises (‘MSMEs’) in these challenging times. One of the best examples of the measures adopted by the Union Government is the vision of making India self-reliant, ‘Atmanirbhar Bharat’. The government has also introduced a few changes in the Insolvency and Bankruptcy Code, 2016 (‘IBC’) with an intent to safeguard the MSME sector from the leash of CoVID-19 and improve the ease of doing business.

    Although the intent of the government behind the promulgation of ordinance dated 5th June 2020 was to amend the IBC to provide some breathing space to the MSME sector, the measures have had some unintended effects on the sector. This piece analyses the impact of the recent ordinance to amend the IBC on the MSME sector and highlights the gaps which are to be bridged. Bridging of these gaps would not only make MSMEs sustainable in the times of economic downturn but also help India become ‘Atmanirbhar’. 

    Highlights of the ordinance introducing sec. 10A to the IBC:

    1. Suspension of S. 7, 9 and 10 of the IBC for default arising on or after 25.03.2020 till 25.09.2020 and extendable up to 25.03.2021.
    2. No new application shall be allowed to initiate fresh CIRP from 25.03.2020 for a minimum period of 6 months extendable up to 12 months as and when notified.
    3. No application shall ever be filed for the initiation of CIRP of a corporate debtor concerning any default arising during disruption period starting from 25.03.2020.
    4. An application seeking initiation of fresh CIRP shall be allowed only if the following two conditions are fulfilled:
      • The default arose before 25.03.2020.
      • The said default amount is greater than Rs.1 Crore. 

    Impact on MSME Sector

    Micro, Small and Medium Enterprises, as defined in S. 7 of MSMED Act 2006, contribute significantly to the economy of the nation. It employs around 111 million people and accounts for approximately 48% and 28% of the nation’s export and GDP respectively. Hence, it is clear the MSME sector remains the backbone of the nation’s economy and deserves to be protected in these unprecedented times. The legislators with a similar intent promulgated an ordinance amending the IBC but the letter didn’t seem to match to the authority’s intent.

    Recent changes in the IBC, including the rise in the default threshold under S. 4, suspension of S. 7, 9, and 10, and insertion of the proviso in S. 10A providing blanket protection to the debtors defaulting during the disruption period starting from 25th March have raised debates as to whether the ordinance helps MSMEs or harms them. Owing to the recent ordinances, MSMEs have been impacted in two ways, i.e. being a creditor and being a debtor.

    MSMEs being the Operational Creditors

    As per the study by the Brickwork Ratings, MSMEs have approximately Rs.303 lakh crore of their funds stuck with large corporates in the form of receivables. Hence, it can be asserted that MSMEs play a vital role in the economy being operational creditors to the large corporate houses. In the times of CoVID-19 when the whole economy is struggling to escape from the rippling effect over the economy, it becomes all the more important to ensure that the smaller firms contributing to the nation’s economy on such a large scale are duly paid back.

    • Suspension of S. 9 adding to the plight of MSMEs

    The un-amended IBC framework facilitated negotiating leverage to the smaller firms against the mighty corporates as the MSMEs could enforce S. 9 of the IBC to recover their dues in a time-bound manner. But the recently introduced ordinance, although passed to provide breathing space to the distressed firms, has made the MSME firms helpless by disabling them to invoke insolvency proceedings for the recovery of their dues. In numerous cases, it has been that the corporate houses, fearing wide-ranging ramifications, settled their debts against the smaller firms after the application for insolvency proceeding was filled but before the same was taken up by the tribunals.

    According to the data provided by the Insolvency and Bankruptcy Board of India, up to March 2020, 157 applications for corporate insolvency resolution process were withdrawn under S. 12A of the IBC, of which 64 cases involved amounts less than Rs.1 crore. The reasons for early withdrawal of cases were full settlement with the applicant and other settlement with creditors.

    Now under the garb of amended IBC framework, the corporates who earlier feared harsh consequences of the insolvency proceedings would now fearlessly strong-arm the smaller firms by defaulting the repayment of their dues. Furthermore, the redressal forums other than NCLT fail to provide timely redressal adding to the plight of the creditors.

    • Proviso incentivizing corporate debtors to default

    Apart from the above-stated problems, the proviso in the newly introduced S.10A has placed the MSMEs in a vulnerable position by allowing complete amnesty to the corporate debtors who default during the disruption period. The expression “no application shall ever be filed” has opened the flood gates of varied interpretation.

    Recently, the Hon’ble National Company Law Tribunal, Chennai Bench in Siemens Gamesa Renewable Power Private Limited v. Ramesh Kymal interpreted the proviso to S. 10A and held that there shall be no insolvency proceedings ever against the defaults which arise after 25.03.2020. This interpretation allows an exemption to the defaulting debtors whether or not such default has arisen due to the economic downturn in the times of the pandemic.

    If such an interpretation is taken up, it would incentivise the non-payment of dues by the corporates and would lead to the MSMEs turning up into non-performing assets. In these trying times when the economy is struggling to move out of the rippling effect, fall of MSME sector would adversely impact the nation’s economy. Among other things, a decline in MSME sector would cause a steep rise in the unemployment rate and set off India’s ambition of becoming self-reliant. 

    MSMEs being the Corporate Debtors

    Objectives of IBC include maximization of the value of assets, to promote entrepreneurship, availability of credit and balance the interests of the stakeholders. In consonance with the objectives, S.10 facilitates an exit route to a corporate debtor wherein the loss-making business is transferred to a prospective resolution applicant based on a resolution plan to revive the sick enterprise. The resolution plan is sanctioned by the adjudicating authority keeping in mind the interests of all the stakeholders.

    Blanket suspension of S.10 defeats the core objective of the IBC to revive and not to liquidate the enterprise. Suspension of the section would lead to a slow death of the business enterprises which could be revived with a prospective plan. The ordinance would not only deprive the corporate debtor of rehabilitating the business but also force him to continue the distressed business. This would not only deplete the value of assets rather than maximizing them but also lead to the winding-up of a potentially viable business.

    Conclusion

    In the testing times of this pandemic, although the government has tried to modify the provisions of the IBC with a bonafide intention to provide safeguard to the MSMEs, it has ended up worsening the situation for them. The recent ordinance adding S. 10A in the IBC and the notification has created loopholes which would act against the interest of the MSMEs. These would make the smaller businesses vulnerable in the hands of larger corporates.

    Furthermore, these additions and modifications to the IBC would act as a barrier for MSMEs to pull off under the government’s “Atmanirbhar Bharat” initiative. The liquidity crunch faced by the MSMEs owing to the suspension of S. 7 and 9 of IBC would compel the MSMEs to avoid further payments of their debtors and undergo unnecessary litigation which would certainly raise the burden of the MSMEs in the near future. Moreover, blanket suspension of S. 10 of IBC will destroy every hope of reforming viable MSMEs.

    Keeping in mind the flickering market conditions and the upcoming competition in domestic as well as international market, more focused actions are called for on the part of the authorities. As pointed out by the Hon’ble Finance Minister in her press note, a special insolvency framework needs to be introduced under S. 240A of IBC accompanied with other focused initiatives. This would not only provide leverage to the MSMEs against the powerful corporates but also help India holdup its ambition of self-reliance.

  • Material Influence Test – A Convoluted Approach For Determining Control

    Material Influence Test – A Convoluted Approach For Determining Control

    By Priyashi Chhajer, fourth-year student at NLU, Jodhpur

    The concept of control has been laid down in various statutes and defined differently as per their requirements. Competition Act, 2002 (‘Act’), Companies Act, 2013, SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, Foreign Direct Investment policy are a few examples. ‘Control’ is defined in explanation of section 5 of Act, which reads as “Controlling the affairs or management by one or more ‘enterprises’ or ‘groups’, either jointly or singly, over another enterprise or group.” Acquiring control of enterprise may lead to appreciable adverse effect on competition and is therefore required to be notified to the Competition Commission of India (‘CCI’).

    An uncertain and wide definition was adopted in the Act as the legislature intended to determine acquisition of control on factual basis. However, because of an absence of clear and specific guidelines the scheme of control continues to be ambiguous. The uncertain boundaries of control have also led to inconsistency in interpretation resulting in improper imposition of penalties.

    Recently Ministry of Corporate Affairs introduced Draft Competition (Amendment) Bill, 2020 in February wherein; material influence over the affairs of business and management has been proposed as a standard to determine control. This test on one hand will put large number of transactions under scrutiny and help in monitoring competition in market; but at the same time it will give excessive power to CCI thereby hampering the ease of doing business.

    Ambit of Control – Asymmetrical Interpretation Leading to Confusion

    As a matter of practise, CCI  has attempted to assess control by the yardstick of “decisive influence” over the affairs of another enterprise or group by way majority shareholding, veto rights or contractual agreements. However, these boundaries have diluted over the period of time.

    In Multi Screen Media Private Limited Case,  veto rights over strategic commercial decisions were exercised. CCI in this order extended the ambit of control to  not only proactive rights but also negative and affirmative rights. In subsequent RB Mediasoft/ IMT order, mere right to convert zero coupon optionally convertible debentures into equity share,  was  considered as control. Threshold was further lowered in case of Jet- Eithad, where  Eithad acquired 24% stake without any veto or quorum rights, along with the right to appoint 2 out of 12 directors.  CCI took into account  Eithad’s ability to control the managerial affairs of business and considered the transaction as acquisition of control.

    Later on, CCI started shifting the threshold towards material influence for determining ability to exercise control. In Argium Inc. and Potash Corporation of Saskatchewan, Inc., it was observed that although Potash Corp. held 14% interest, it still had the capacity to control the affairs as it was leading in production in global market and thus might exercise influence.

    In the recent  Ultratech/Jaiprakash Order , CCI defined material influence as “the lowest level of control, implies presence of factors which give an enterprise ability to influence affairs and management of the other enterprise including factors such as shareholding, special rights, status and expertise of an enterprise or person, Board representation, structural/financial arrangements etc.” CCI expanded the ambit of control to include material influence and not just de facto and de jure control (acquiring more than 50% of voting rights by way of shareholding).

    Later in 2018,  this expansive threshold was reiterated in Meru Travel Solutions vs. ANI Technologies and Ors, where CCI ruled that Softbank has ability to exercise  material influence even though it is a minority shareholder in Ola and Uber. Therefore, even the acquisition of  minority shareholding, for investment purposes may attract section 5 and section 6 under competition Act.

    The scope of  policies is left wide and inclusive, so as for the CCI to interpret it in a manner favouring competition law objectives. The strict definition may impede promotion of social and economic cause. However, inconsistent factual determination of control by regulatory body has clearly lead to dysfunctionality, as it has breed vagueness for business entities and lack of clear legislative guidance has vested excessive discretionary power with CCI.  

    Complexities  that are Propagated by “Material Influence” Test

    Firstly, unavailability of codified guidelines and the open-ended interpretation of ‘control’ adopted by CCI will empower them with unrestricted power to take up suo-moto cognizance of any transaction. For instance, in Jet – Eithad Case where there was acquisition of mere 24% stake without any significant rights; CCI still took the matter into its hands and reviewed the deal. Not only this, disparity amongst different regulators makes compliance unmanageable  for the businesses . As was seen in abovementioned case where affected by the CCI’s orders, SEBI reopened the case and ordered to investigate the matter again.

    Secondly, even when there is likeliness of appreciable adverse effect on competition, the transaction needs to be notified in accordance with section 6(2) of Act. Sporadic definition and lack of precedential clarity will result in ambiguity pertaining to determination of transactions that needs to be notified. There have been instances wherein the CCI took 60-90 days to conclude prima facie inquiry, which in turn should be completed in 30 days. Open ended test of control will bring more transactions under review which will lead to delay in execution of  transactions and deterrence in ease of doing business.

    Thirdly, expansion of definition of control has also led to expansion of the meaning of ‘group’ under explanation (b) of section 5. In this explanation group is considered to be formed when “two or more enterprises are directly or indirectly in position to control the management or affairs of another business”. The new threshold will affect the applicability of  numerous exemptions available to intra group dealings. Also, it will be difficult to determine horizontal and vertical overlaps during merger filings.

    Fourthly, many financial investments and private equity transactions will now come under the review of competition commission as because of the expansive definition the pure minority protection rights can also now be seen as negative control triggering mandatory notifying obligation under section 6 of the Act.

    Position of Law in other Jurisdictions

    Indian regime is similar to that of the EU. However unlike in India, EU provides detailed guidelines for interpretation of control. Article 3(2) of ‘Council Regulation (EC) No 139/2004 on the control of concentrations between undertakings’ defines control as the ‘possibility of exercising decisive influence on an undertaking’. It implies that one may or may not actually exercise decisive influence but even a slightest possibility of exercising effective decisive influence is ample enough to bring it under the ambit of control. There are no particular thresholds specified to assess when there is change of control. However, European Commission issued a Consolidated Jurisdictional Notice, which acts as a guide and tool for interpretation. It anticipates and provides for all possible instances when merger regulations can be triggered. Possibility of exercising decisive influence can be on the basis of right, assets or contracts, or any other means, either separately or jointly.

    In the US, the concept of control is defined in Hart-Scott-Rodino Regulation (‘HSR’). Section 7 of Clyton Act  provides for three tests – the commerce test, the size of transaction test and the size of person test. For the transaction to fall under HSR filing obligation, above tests must be fulfilled. Generally, acquisition of voting rights and assets is looked into to determine change in control.

    CCI has failed to remedy the indefiniteness surrounding the concept of control. International organisations such as  OECD endorse global uniformity for the definition of control. Unfortunately, the domestic inconsistency has resulted into cross-border disparities for the understanding of control.

    Conclusion

    A transaction can be reviewed under section 5 of Act only if there is change in control. Earlier it was decided by way of decisive influence over management or affairs of business by way of majority shareholdings, veto rights and contractual agreements.  By virtue of this threshold those transactions comprising acquisition of non-controlling powers, however having appreciable adverse effect on competition were left unchecked. To alter the situation Competition Law Review Committee, 2019 proposed to lower the threshold of control so as to include those minority shareholdings that can affect competition.

    Material Influence test is the lowest threshold of control. As a consequence of this, majority of combination transactions will come under review process. It will increase the load of the CCI with insignificant notifications and will also be onerous for the parties involved in transactions. Moreover, lack of guidance and inconsistency in precedential trail adds to the existing confusion on kinds of transactions that are eligible for notification.

    Therefore, there is pressing need to make the market investor friendly for economic growth. Sizable problems posed by the proposed amendment weighs down the benefits that it purports. Cues must be taken from other jurisdictions so as to promote certainty in domestic regime. CCI must tread with caution so that ease of doing business is not affected and market entities do not get caught in clutches of cumbersome notifying process, unforeseen penalties and vagueness.

  • Converting Preference Shares into Debts: Tax Evasion or Tax Planning?

    Converting Preference Shares into Debts: Tax Evasion or Tax Planning?

    BY YASH MORE AND HITOISHI SARKAR, THIRD-YEAR STUDENTS AT GNLU, GANDHINAGAR

    In December 2019, the National Company Law Appellate Tribunal (“NCLAT“) in Joint Commissioner of Income Tax v. Reliance Jio Infocomm Ltd. & Ors., while approving a demerger under s. 230-232 of the Companies Act, 2013, allowed the conversion of preference shares of a company into debt during the scheme of arrangement. However, the tribunal failed to adjudicate and determine the legal validity of such a transaction. The ramifications of such conversion include a considerable reduction in the profitability of the demerged company and a consequent estimated loss of Rs 258.16 crores to the public exchequer which would otherwise have received such payment in the form of dividend distribution tax under s. 2(22)(a) of the Income Tax Act. 

    The main thrust of the argument before the NCLAT was that by the scheme of arrangement, the transferor company sought to convert the redeemable preference shares into loans, i.e., conversion of equity into debt, which is contrary to the principles in s. 55 of the Companies Act, 2013. However, the NCLAT dismissed this contention stating such a determination is not a subject matter of the Income Tax Department. It noted that such an objection could be raised only by the competent authorities, i.e., Regional Director, North Western Region and the Registrar of Companies.

    This article aims to determine the legality of such a conversion of preference shares into debt under the scheme of the Companies Act. In doing so, the authors have first expounded on the nature of preference shares and delineated on the vanishing line of distinction between tax evasion and tax planning. The authors have concluded the discussion by highlighting the problems faced in law while such conversion transactions are carried out.

    Preference Shares under Companies Act

    As per Explanation (ii) to s. 43 of the Companies Act, 2013, preference share capital refers to those shares which carry a preferential right with respect to (a) payment of dividend, either as a fixed amount or an amount calculated at a fixed rate, and (b) repayment, in the case of a winding-up or repayment of capital, of the amount of the share capital paid-up or deemed to have been paid-up.

    The problem that arises when preference shares are converted into a loan is that the shareholders turn into creditors of the company. This leads to two main consequences – firstly, the shareholders who are now creditors can seek payment of the loan irrespective of whether there are accumulated profits or not and secondly, the company would be liable to pay interest on the loans to its creditors, which it otherwise would not have had to do to its shareholders.

    Tax Evasion v. Tax Planning

    S. 2(22)(a) of the Income Tax Act, 1961, taxes any distribution of accumulated profits by a company to its shareholders, if such distribution entails the release of all or any part of the assets of the company. By way of converting preference shares into loans, there is an “indirect release” of assets by the demerged company to its shareholders without appropriating funds from the accumulated profits of the company. Thus, the conversion aid companies to circumvent payment of dividend distribution tax which would have otherwise been attracted in light of s. 2(22)(a). Further, the payment of interest on such vast amounts of loans would lead to a reduction in the company’s total income in an artificial manner.

    The order of the NCLAT reminds one of the Supreme Court’s landmark verdict in Vodafone International Holdings BV v. Union of India wherein the Court had frowned upon artifice, which leads to tax avoidance. However, this has to be read in consonance with the ruling of the Gujarat High Court in Vodafone Essar Gujarat Ltd. v. Department of Income Tax, where it was held that the mere fact that a scheme may result in a reduction of tax liability does not furnish a basis for challenging the validity of the same.

    The Supreme Court in McDowell & Co. Ltd. v. CTO had acknowledged and dwelled upon the fine although significant distinction between tax planning and tax evasion and expounded that ‘tax planning may be legitimate, provided it is within the framework of the law.’ Therefore, in order for us to determine the validity of the scheme of arrangement, we must look into the legality of the conversion of equity into debt under the scheme of s. 55 of the Companies Act.

    Legal Validity of the Conversion under the Companies Act, 2013

    The pertinent question that needs to be addressed is whether such a conversion of preference shares to a loan is in contravention of s. 55 of the Companies Act, 2013. It deals with the issue and redemption of preference shares. However, it does not state anything about the conversion of preference shares. In fact, in the event where a company is not in a position to redeem any preference shares or to pay dividend, it may either (a) further issue redeemable preference shares equal to the amount due, including the dividend thereon, or (b) convert the preference shares into equity shares.

    S. 55(2)(a) of the Companies Act, 2013, necessitates the requirement that preference shares cannot be redeemed except out of the profits of the company. Likewise, s. 80(1) of the Companies Act, 1956, provided a similar requirement. Thus, when the preference shares are converted into loans, the problem lies in the fact that shareholders who would now have become the creditors of the company will have to be paid irrespective of the availability of profits, thereby presenting a prima facie conflict with provisions of the Companies Act, 2013.

    However, the courts have refused to construe such a conversion as a contravention of company law. In PSI Data Systems Ltd., the Kerala High Court while adjudicating upon a conversion held that the requirement under s. 80(1) of the Companies Act, 1956, is to protect the preference shareholders from a company’s unilateral action. However, if the preference shareholders consent to such a conversion of preference shares into loans, no contravention of s. 80(1) can be established. The same has been affirmed by the Andhra Pradesh High Court in In Re: SJK Steel Plant Ltd., where the Court refused to read a conversion of preference shares into Funded Interest Term Loan (FITL) as a contravention of the law.

    Did the NCLAT erroneously sanction the Scheme of Arrangement?

    It is beyond doubt that any scheme of arrangement needs to satisfy the requirements of s. 230-232 of the Companies Act, 2013, so as to be sanctioned by a competent court. The corresponding provisions of the erstwhile Companies Act, 1956 in this regard were s. 391-394 of the Companies Act, 1956. Thus, for a scheme of arrangement to be denied sanction, a violation of the aforementioned statutory provisions must be established.

    It is a well-settled position of law post the Supreme Court’s ruling in Miheer H. Mafatlal v. Mafatlal Industries that a scheme of compromise and arrangement which is in violation of any provision of law cannot be sanctioned and the Court has to first satisfy itself that any scheme of arrangement does not contravene any law or such compromise is not entered into in breach of any law. However, juxtaposing the legal pronouncements in PSI Data Systems Ltd. and SJK Steel Plant Ltd., it is evident that s. 55 nowhere prohibits conversion of the preference shares into a loan.

    A pertinent objection which was raised before both the NCLT and NCLAT was that the conversion of preference shares by canceling them and converting them into a loan would substantially reduce the profitability of the demerged company. The Andhra Pradesh High Court in In Re: T.C.I. Industries Ltd., laid down that while exercising powers under s. 391 and 394 of the Companies Act, 1956 the Court cannot sit in appeal over the decision arrived at by the shareholders or the secured creditors or the unsecured creditors, and minutely examine whether the proposed scheme as approved by the shareholders should be sanctioned or not. Thus, it is beyond the powers of a court under s. 230-232 of the Companies Act, 2013, to examine the implications of a particular scheme on the profitability of the company.

    Conclusion

    The authors duly acknowledge that conversion of preference shares into loans may lead to a massive loss to the public exchequer as the payment of loans to the creditors (who were formerly preference shareholders) cannot be taxed as opposed to payment of dividend under s. 2(22)(a) of the Income Tax Act. However, as detrimental as it may be to the exchequer, the courts have not found any explicit or implicit statutory provision that prohibits such transactions. The opposite, i.e., conversion of loan into shares, although, has statutory recognition under s. 62(3) of the Companies Act, 2013 by way of issuance of convertible debentures.

    Nevertheless, the NCLAT should have been careful while allowing such conversion and must not have dismissed the contention of Income Tax Authorities merely on the grounds of locus standi. The NCLAT alone is empowered and responsible for ensuring that no scheme of arrangement is carried out in contravention of any law even though shareholders or creditors agree to such terms. At the same time, there is a need to further deliberate upon the legality of such conversion and courts must not approve of such transactions merely because they have not been expressly prohibited.

  • Suspension of IBC: Is India ready for pre-packaged insolvency?

    Suspension of IBC: Is India ready for pre-packaged insolvency?

    by Swapnil singh, a student of fifth year at rmlnlu, lucknow

    Implementation of Insolvency and Bankruptcy Code, 2016 (“IBC”) has shown favorable outcome with India’s rank improving from 136 to 108 in 2018 to 52 in 2019 in the ‘Resolving Insolvency’ bracket of the Ease of Doing Business ranking, released by World Bank. IBC has exponentially reduced the time taken for an insolvency resolution. However, in the current crisis and lockdown, the resolution process will undoubtedly suffer an inexorable delay.

    The Central Government’s decision to suspend any fresh filing under Section 7, 9 and 10 for next six months which may be extended up to a year is seen as step in the positive direction but the fact that instead of solving a lot of issues, it is putting them on a back burner which will ultimately lead to a greater number of cases and increased burden on the Tribunal.

    Considering this and the persistent resolution delay in cases under IBC by NCLT, without any alternative mechanism for resolution of distress could lead to rapid depletion in asset value and huge losses for a number of stakeholders. Pre-packs are seen as a desirable solution to be incorporated to solve this issue and there are certain issues which will pose a challenge to smooth implementation of pre-packs within the existing regulatory system.

    The concept of pre-packaged insolvency

    Pre-packaged insolvency, often referred to as “pre-pack sale”, has been defined by the Association of Business Recovery Professionals (a trade association for the United Kingdom’s insolvency, restructuring, advisory, and turnaround professionals) as “an arrangement under which the sale of all or part of a company’s business or assets is negotiated with a purchaser prior to the appointment of an administrator and the administrator effects the sale immediately on or shortly after his appointment”. It is different from traditional bankruptcy because in a case of a pre-pack the restructuring takes place prior to filing of application before the adjudicating authority.

    With the suspension of IBC, it becomes pertinent that alternative solutions to address the stress in the system be explored and pre-packs are a promising option due to its strongly built around the tenets of value preservation and timely resolution, which form the lifeblood of any insolvency law. In the Indian scenario, if introduced, it will be a subset of the existing pre-insolvency resolution instruments therewith providing financial creditors and corporate debtor a platform to negotiate in advance on the resolution strategy of the corporate debtor with the advice of an Insolvency Professional, before the filing application under IBC.

    The possibility of pre-packs to be introduced under IBC has always been a topic of debate in the Bankruptcy Law Reforms Committee (BLRC) and it was advanced that Indian market is not developed enough to go for pre-packs. However, NCLT has time and again recognised that the corporate insolvency resolution proceeding(“CIRP“) is broad enough to include a discussion and negotiation done beforehand, about the resolution plan. In the case of Essar Steel Ltd an objection was raised on the that application for commencement of CIRP pointing out that admitted Essar was already negotiating with its lenders. NCLT rejected the objection stating that these negotiations can later become basis of resolution plan under IBC. It is pertinent to note that in Lokhandwala Kataria Construction Pvt. Ltd. v. Nisus Finance and Investment Managers LLP, the Supreme Court used its power under Article 142 of the Constitution to accept the out of court settlement for the benefit of all the stakeholders and for meeting the ends of justice. 

    India has taken some steps in the direction of outside restructuring when Reserve Bank of India introduced Bank-led Resolutions through Prudential Framework for Resolution of Stressed Assets wherein a bank can try resolution before formally filing for insolvency but it only covers RBI-regulated creditors. The Ministry of Corporate Affairs has also invited comments from stakeholders regarding the introduction of pre-packs in India.

    Challenges in India

    Introduction of pre-packs in India will require developing a robust jurisprudence to address the number of challenges that will arise thereafter. To safeguard and protect interest of each stakeholder while maintaining transparency, following challenges will have to be worked upon:

    Role of Insolvency Resolution Professional and Shield of Moratorium

    Currently under IBC, Interim Resolution Professional (“IRP”) is appointed as soon as the application is admitted and is given the responsibility to manage the business of the debtor during the whole CIRP process. However, during a pre-pack process, the role of IPR will be performed by the debtor as he would ensure that interests of all stakeholders are taken into consideration similar to the ‘Debtor-in-Possession’ concept in US. There have been a lot of objections regarding debtor managing the whole process without any interference from NCLT.

    A shield of moratorium helps the debtor once proceeding is started under Section 7 and Section 9 of IBC. In absence such an automatic stay on the legal proceedings for pre-pack under IBC, nothing would stop the creditors from approaching the tribunal at any stage of the negotiations. This will put the company in a vulnerable position as the creditors can enforce their rights and remedies anytime while the corporate debtor is negotiating a pre-pack resolution.  

    Involvement of Promoters

    One of the reasons for the directors of a corporate debtor to undertake a pre-pack is to regain control of its business or assets, however, under a different identity. It is arguable that this roundabout manner of regaining control of the debtor company can result in circumvention of the insolvency laws. This concept is very popular as ‘phoenixing’ in the UK. This can raise a problem in cases where the company is facing huge losses primarily due to promoter or managerial inefficiency.

    Pre-packaged insolvency is a debtor-initiated process by a go-ahead company in distress which is willing to negotiate with its lenders, before the initiation of a formal CIRP under Section 7 or 9 of the Code. Hence, Section 29A of the Code will not be applicable as it to the pre-packaged insolvency process. Therefore, taking into consideration the aforementioned premises, it may be inferred that if a provision similar to Section 29A is made applicable to the entities willing to go for pre-packaged insolvency, it may tend to defeat the very objective of such a scheme as it would act as a barrier in a pre-pack process where the debtor is mainly in charge of management and negotiations.

    Lack of Cooperation and Sale of Assets

    Pre-packs are supposed to work on a degree of cooperation from side of both the corporate debtor and the creditors. The management of the debtor having the control of the process, if doesn’t share all the information with the creditors or if creditors are unable to come together due to their varied interest, it will be difficult to come to a conclusion.

    Further, sale of assets by debtor to another company before filing insolvency application can be one of the tools of pre-pack restructuring. The earning from these sales goes to the creditors, this helps in keeping the company afloat without any hassle arising due to dilution of assets’ value or loss of clientele. Sometimes due to contractual terms, creditors possess the right to give consent before debtor can dispose-off any asset. If the creditors become apprehensive, either in the divestment or because of the fact that the debtor is facing bankruptcy, it will jeopardise the whole process. Moreover, unsecured creditors will be left outside the picture, having absolutely no say in the matter as they wouldn’t have any contractual right.

    Lack of transparency and the plight of Operational Creditor/ Unsecured Creditors

    Pre-pack processes are usually confidential and do not involve open bidding process. These arrangements are usually agreed by the management of the corporate debtor and, therefore, there may be a possibility that the interests of the management and the secured creditors will be placed at a higher pedestal than that of the unsecured creditors/operational creditors. The independent Graham Review Report into Prepack Administration of June 2014 noted that the “lack of transparency disenfranchises creditors, especially unsecured creditors particularly where the purchase is being made by a connected party.”

    The potential harm of lack of transparency also comes into picture if undervalued transactions are involved. The wealth maximisation model focuses on the idea that creditors would prefer a system that keeps the size of the pool of assets as large as possible. This raises real doubts about the objective of wealth maximisation owing to the lack of transparency and open marketing of the business. There may also be instances where the business of the corporate debtor may be transferred to entities without keeping in mind the interests of the creditors or other stakeholders.

    Such a transaction would not carry the seal of approval of a court (unless the same is undertaken as a court approved scheme such as a scheme of arrangement under the Companies Act, 2013) and would, therefore, to that extent, be open to challenge by creditors if they were to object to such a transaction and require clawback, which is a safeguard provided to creditors under the Code. IBC provides for a claw-back in cases where any transactions are found to be preferential, undervalued, extortionate or undertaken to defraud creditors. An avoidance application is filed before the NCLT for appropriate relief, including for the transaction to be set aside.

    Conclusion

    With the suspension of any fresh filing under IBC, it is time to strengthen the outside restructuring process in India. This will make sure that instead of piling up of cases, there will actually be timely resolution of any insolvencies and bankruptcies. Pre-packs will have far reaching impact on corporate rescue in India but it has to be done with correct implementation, keeping in mind the Indian market and stakeholders. It is pertinent to note that this model has been there in the UK and the US for quite some time, for this reason there needs to be an in-depth study of both the jurisdictions to see what lessons can we learn from them.

    The system does come with its own challenges but if implemented well, it will help in smoothening the resolution plans while promoting the idea of keeping company as a going concern. This will help in retention of jobs and repayment of dues to the creditors. With the current ongoing crisis, it is safe to assume that it will have far more benefits and yield more fruitful outcomes.

  • SEBI in the Shoes of CCI: the Jurisdictional Tussle Continues

    SEBI in the Shoes of CCI: the Jurisdictional Tussle Continues

    By Deepanshu Agarwal, a fourth-year student at UPES, Dehradun

    Introduction

    The Securities & Exchange Board of India (‘SEBI’) and the Competition Commission of India (‘CCI’) are separate independent regulatory bodies which often jurisdictionally overlap with each other. This happens due to the commonality in their objectives of ensuring the protection of consumers and promoting a healthy market.

    In the case of Advocate Jitesh Maheshwari v. National Stock Exchange of India Ltd. (2019) (‘NSE Case’), CCI refused to deal with the matterregarding abuse of dominance by National Stock Exchange (‘NSE’) and allowed SEBI to continue with their practice. This was a drastic turn taken by CCI to allow a sectoral regulator to deal with the abuse of dominance, which is an issue majorly dealt with by CCI under section 4 of the Competition Act, 2002.

    In the instant case, the informant alleged that for almost four years (i.e. 2010-2014), NSE had been giving preferential treatment and unfair access to some of the traders by communicating to them price feed and other data. According to the informant, this was a discriminatory practice followed by NSE towards other traders on the same footing & thus resulted in ‘denial of market access’. Moreover, the informant proposed the relevant market as the ‘market for providing services of trading in securities’ and contended that NSE is a dominant player in the market as it holds a huge market share, consumer dependency and entry barriers for the new stock exchanges.

    Though CCI noted that such discriminatory practices exist in its jurisdiction, the case was dismissed without going into its merits. The reasoning of CCI was that: (i) the allegations against NSE were not final and are yet to be established in appropriate proceedings; and that (ii) there was a lack of evidence to form a prima facie opinion about the role of NSE. However, CCI mentioned that it could examine the discriminatory and abusive conduct independently, based on cogent facts and evidence after the completion of investigation by SEBI. But the question that remains unanswered here is that if SEBI does not reach an adverse finding on the question of NSE’s role, can CCI then still examine NSE’s conduct? To answer this question, it becomes imperative to analyse this order in the light of the Supreme Court’s judgment in the case of CCI v. Bharti Airtel Ltd. & Ors. (2019) (‘Bharti Airtel’).

    The jurisdictional tussle in Bharti Airtel

    Though this case revolves around the jurisdictional fight between Telecom Regulatory Authority of India (‘TRAI’) and CCI, yet it is a landmark judgment when it comes to the jurisdictional overlap between CCI and other sectoral regulators, apart from TRAI.

    Reliance Jio Infocomm Ltd., a new entrant in the telecom market, approached CCI against the Incumbent Dominant Operators (or ‘IDOs’ namely Bharti Airtel, Idea Cellular and Vodafone) for forming a cartel to deny market entry and thereby causing an adverse effect on competition in the telecom market. While the case was already under investigation by TRAI, CCI found out a prima facie violation against the IDOs. The Bombay High Court, in the appeal made by the IDOs, set aside the order of CCI on the grounds of lack of jurisdiction as the matter was already under investigation by TRAI.

    The Supreme Court while confirming the findings of the Bombay High Court did not deny the jurisdiction of CCI altogether but made its investigation subject to the findings of TRAI. It did so by giving CCI a secondary jurisdiction over the matter. In this regard, the court held that “Once that investigation is done and there are findings returned by the TRAI which lead to the prima facie conclusion that IDOs have indulged in anti-competitive practices, the CCI can be activated to investigate the matter going by the criteria laid down in the relevant provisions of the Competition Act and take it to its logical conclusion”.

    Applying the reading of Bharti Airtel to the NSE case, it can be concluded that the jurisdiction of the CCI begins only when there are adverse findings returned by SEBI. Similar to TRAI, SEBI is also a sectoral regulator and will have primary jurisdiction in dealing with the abuse of dominance/adverse competition in the capital markets. Therefore, it can be concluded in the instant order that the CCI was justified in not going into the merits, by accepting itself as a regulator having a secondary jurisdiction in such cases.

    Since the instant order passed by CCI is in line with Bharti Airtel, it also suffers from similar criticisms.

    Criticism of the NSE Case

    Since both SEBI and CCI have a common objective to ensure consumer protection and fair market competition, it is clear that there may be jurisdictional overlaps. Both the Securities and Exchange Board of India Act, 1992 and the Competition Act, 2002 provide for jurisdiction in addition to and not in derogation to other laws. However, neither of the two acts provide the remedy in case of a jurisdictional overlap. This ambiguity paves the way for concurrent jurisdiction of both the regulators which further leads to conflicting decisions and legal uncertainty.

    In such a scenario, putting CCI at a lower pedestal by giving it secondary jurisdiction (as evidenced in Bharti Airtel and the NSE case) may not be the optimal solution for jurisdictional issues. Rather, the CCI being an independent competition watchdog should be allowed to deal with the competition matters freely and irrespective of the findings of the sectoral regulators. It has to be noted that CCI is a specialized body created solely with the purpose to prevent abuse of dominance and adverse effect of competition. Therefore, subjecting CCI’s jurisdiction to the findings of any other sectoral regulator would only hamper the object for which it was created, thereby weakening its authority.

    The Way Forward

    The best way through which the jurisdictional tussle can be resolved is following the mandatory consultation approach. This means that if a situation of jurisdictional intersect arises, then both the regulators should consult with each other as to who can deal with the matter more effectively and efficiently. This can be a credible solution to remove all defects from such jurisdictional matters and ensure some technical input is also given by the sectoral regulator.

    Under the current regulatory framework, India follows a non-mandatory consultation approach. Section 21 & 21A of the Competition Act incorporates a mechanism for consultation between the statutory authorities and the commission. However, consultation under these sections is neither mandatory nor binding.

    Lessons should be drawn from other countries which are successfully following the mandatory consultation approach. For example, in Turkey, under the Electronic Communications Law No. 5809, the Competition Board has the statutory duty to receive and take account of the opinion of the relevant regulatory authority (the Information Technologies and Communications Authority) when enforcing the competition law in the telecommunications sector. Moreover, Turkey’s competition authority also sends its opinion to the Information Technologies and Communications Authority regarding draft regulations in the consultation process.

    The mandatory consultation process is also followed in other countries like Argentina and France. This process was also suggested in India by the National Committee on National Competition Policy and Allied Matters in 2011. Therefore, it is the need of the hour that this change be implemented.

    Considering the existing legislative framework, substituting the word ‘may’ with ‘shall’ in Sections 21 and 21A of the Competition Act and making the opinion of CCI or the sectoral regulators binding upon the other will leverage the expertise of both the entities and will enable the initiation of a cooperative regime.

    Conclusion

    Abuse of dominance/adverse effect on market is specifically the area that CCI deals with, it is erroneous for SEBI to encroach upon the same. Both the technical aspects and the competition matters in a case have to be viewed separately. SEBI being a sectoral regulator and a lex specialis in the capital markets can deal with the technical matters more effectively than CCI. Whereas, on the other hand, CCI being a lex specialis in competition matters can deal with the same with more proficiency. Therefore, in cases involving jurisdictional conflict, it is fallacious to place CCI at a secondary stage. Rather, the mandatory consultation approach should be followed by the regulators in such cases to solve the conflict in a more harmonious and effectual manner.

  • One Size Does Not Fit All: Effect of the IBC Ordinance on the Airline Industry

    One Size Does Not Fit All: Effect of the IBC Ordinance on the Airline Industry

    By Vatsalya Pankaj and Likhita Agrawal, third-year students at MNLU, Nagpur

    The COVID-19 outbreak has caused great economic predicament, with many financial institutions and companies on the verge of bankruptcy. With the backdrop of the nationwide lockdown, the Indian government has introduced an ordinance suspending provisions of the Insolvency and Bankruptcy Code (‘IBC‘) to protect the industries from the effect of the pandemic. The airline industry is among those worst hit due to the current situation. Although the ordinance seeks to protect the interest of companies, it may cause an unforeseen impact on the creditors.

    The current condition can be demystified as a no output; still interest, sort of scenario in many cases. The companies have obligations towards their creditors and the prevalent recrudescence makes them unable to meet their financial requirements in terms of the value of money on the credit sanctioned. If this continues, then it could bring the business entity in a state where its liabilities exceed its assets. The same is perilously known as the concept of Insolvency.

    Thus, to provide a cushioning effect for vulnerable industries, the President of India promulgated an ordinance adding Section 10A to the IBC. The section essentially suspends Sections 7, 8, 10 and 14 of the IBC for a period of at least six months (extendable up to a year) from 25 March 2020. Through this ordinance, the Government has provided for a blanket ban of any Corporate Insolvency Resolution Proceedings (‘CIRP’) against any company. It aims to provide some relief to the corporate debtors by preventing the creditors from initiating any form of resolution process against the company. This provides the company with some breathing space to get things back in order which were disturbed because of the pandemic.

    The suspension of CIRP provides for a variety of consequences on the different sectors of the economy, in particular the airline industry. The researches shall be attempting to trace how the finances of the airline industry work and what would be the consequences of the suspension of IBC on this industry.

    The Peculiarities of Airline Industry

    The Aviation Industry is one of the worst affected industries due to the spread of COVID-19 as it has resulted in the grounding of flights both locally and internationally. The Ministry of Civil Aviation had suspended all flight operations on the 24th of March, 2020 to prevent the spread of the epidemic. The Aviation Sector has always been high risk- high return. However, even the most successful airlines are under the threat of bankruptcy. Kingfisher Airlines and Jet Airways serve as examples having gone insolvent, while Air India is struggling to survive. With ever-increasing operational costs coupled with rising fuel prices, there is evidence that operating a consistently profit-making airline is a tough business. Further, reference can be made to an IATA report  (‘Report’) which estimated the losses that the airline industry has suffered globally, due to the COVID-19 pandemic which is expected to be around $84.3 billion in 2020.

    The main assets of airlines are their aircrafts. However, airlines in India are modelled around sale and leaseback transactions. If we analyse the data, airlines in India are rarely ever owned by the airline operator, they are majorly leased from international companies such as Avolon (62), Aircastle (30), BOC Aviation (24) & BBAM (29).

    Lease agreements in the aviation sector work with the principle of “come hell or high water” i.e. the lessee must pay the lessor the charges for the aircraft in all circumstances, without exceptions. It may be argued that in such cases, the defense of force majeure can be claimed to defer the payment of the lease. However as most of the lease agreements are modeled around Common Law, there is no direct assumption of force majeure. To not follow the contract, it must be proven in a court of law, that the situation precluded the performance of the contract. This implies that airlines need to approach a court of law, prove that the current situation provides substantial grounds to them to not follow the lease payment dates and then defer the payment. Thus, it would seem that airlines have no option but to pay the lessors for their aircrafts albeit they may be grounded.

    It is an established principle of aviation law that if the lessee is in possession of the aircraft, the lessee holds the responsibility to pay for it along with the responsibility of maintaining it as per the manufacturing standards and other regulations that may have been set to preserve the airworthiness of the aircraft.[1] Thus, despite no income, the airline would have to pay the dues to the lessors. Additionally, they have to maintain the aircraft up to airworthy standards and incur other expenses to maintain their fleet and crew.

    All of this comes in the backdrop of the fact that most of the airlines had a tough previous financial year with passenger demand decreasing and increasing prices. The pandemic has only worsened the problem. India’s carriers may have to make requests to their respective lessors for deferral of payments till they can make ends meet. However, that is entirely dependent on a host of factors including the airline’s creditworthiness, future business framework, past payment history with the lessor, present financial situation and the competency to pay deferred rentals in the future.

    With the current situation in mind and estimations that air travel demands, would fall significantly in the months succeeding the lockdown airlines undoubtedly, would like to reduce their fleet size. Most lease agreements do provide for the option of invoking “Early Termination Option” or ETO. It means that the lessee will terminate the contract before the due date and return the aircraft to the lessor. However, considering the principles on which lease agreements are made, this option is usually coupled with a hefty fine on the airlines, thereby meaning, that it becomes economically non-viable for the lessee to do so.

    With all the problems culminating into one, the major airlines in the world including those in India are on the verge of bankruptcy. There is the option of bailing out the airline industry. This would require providing economic support to the industry so that it can make ends meet in the short run. This can be done through an economic package which may include tax exemptions, and waiving off landing and parking charges at airports. The Government may also follow the example of the United States and directly infuse cash into the industry. Airline enthusiasts might argue that there is an urgent need to bail out the industry, but keeping in mind Air India’s struggles wherein the Government has already signed off crores in debt, pouring public funds into the already struggling industry would not be advisable or indeed viable.

    The Ramifications of the Suspension of IBC

    The airline industry suffers because of the pandemic and mounting losses makes the situation seems grim for the industry. Further, as most aircrafts are leased from foreign countries, the provisions of the Cape Town Convention govern the lease agreements. The aircrafts which are owned by foreign companies and leased in India, would be deemed to be “International Assets” and India’s international obligations would mandate the return of the aircraft if the lessor demands.[2] The return of aircrafts would render airlines with insufficient aircrafts to operate when air traffic rises again, limiting their chances of recovering losses. This would also lead to excess ground and flight crew and would eventually lead to layoffs in the company. There would be a domino effect and one thing would lead to another, thereby harming the airline industry as a whole.

    In the given scenario restructuring of debts under IBC is required. The ordinance, pose a series of problems to the airline industry as the option of approaching the NCLT for default in payment of lease dues is no longer available.

    Before the IBC came into force, most of resolution and liquidation proceedings were carried out through Sick Industrial Companies (Special Provisions) Act, 1985 and the Companies Act 1956 which were subsequently repealed.[3] Section 230 and 231 of the Companies Act, 2013 (‘Act‘) provides for the arrangements of the companies as an alternative to IBC. However, Section 230 and 231 of the Act does bind all the creditors of the debtor and hence does not serve the purpose.

    The ordinance, however, precludes what would have been best for the airline industry by adding Section 10A to the IBC. It imposes a blanket ban on all Insolvency Proceedings and does not allow creditors to initiate CIRP. While this would have been positive for the national context, but as most lessors are international parties, they would have the right to retake the aircraft. Thus, the airlines would be forced into a situation where the lessors are likely to demand repossession of aircraft which has often been allowed by Indian Courts.[4] This is an unwanted scenario and harms the industry as a whole and it would lead to unintended consequences as discussed above. It is up to the industry to wither the storm and get through this crisis.

    [1] Bunker D H, International Aircraft Financing, Volume 2: Specific Documents (1st edn, IATA 2005) 123.

    [2] Matthias Reuleaux & Morten L. Jakobsen, ‘The De-registration of Aircraft as a Default Remedy in Aircraft Leasing and Financing Transactions’, (2015) 40(6) Air & Space L 377.

    [3] Nithya Narayanan, ‘Aircraft Repossession in India: Turbulence ahead, Buckle up’ (2013) 38 Annals Air & Space L 445.

    [4] Awas 39423 Ireland Ltd. v. Directorate General of Civil Aviation, 2015 SCC OnLine Del 8177; Corporate Aircraft Funding Co. LLC v. Union of India, 2013 SCC OnLine Del 1085.

  • Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    Rationalizing the Need for Inclusion of Mens Rea in Insider Trading Regulations

    By Sezal Mishra, fourth-year student at NLIU, Bhopal

    Introduction

    Securities Regulations in India prohibit the offence of Insider Trading under the SEBI (Prohibition of Insider Trading Regulations), 2015. (‘PIT Regulations’) Insider Trading is the offence of dealing in the securities of a company on the basis of unpublished price sensitive information (‘UPSI’) in order to gain an unfair advantage over the general public. UPSI refers to any information relating to a company or its securities, directly or indirectly, that is not generally available and which upon becoming generally available is likely to materially affect the price of the securities. In simple words, information which relates to internal matters of a company and is not disclosed by it in the regular course of business can be considered as UPSI. Communication of UPSI by an insider without any legitimate reason is prohibited under Regulation 3 of the PIT Regulations.

    Recently, through a series of orders, SEBI penalized several individuals in the ‘WhatsApp Leak Case’ for the unlawful communication of UPSI relating to several companies like Asian Paints, Wipro, and Mindtree through the popular messaging app. An exorbitant penalty of Rs 45 Lakh was levied upon these individuals who were found to be in violation of Regulation 3. These orders interpret some of the most important aspects of Regulation 3 of the PIT Regulations and have severe implications in deciding the liability of insiders in communication of UPSI. Through this article the author advocates the need of taking cognizance of mens rea while adjudicating liability in insider trading cases to ensure just penalization of offences.

    Communication of UPSI and the Need for Mens Rea

    The PIT Regulations have been enacted in accordance with Section 12A of the Securities and Exchange Board of India Act, 1992 with a purpose of ensuring a level playing field and to prevent undue benefit to any individual at the expense of public investors. Regulation 3(1) of the PIT Regulations prohibits an insider from communicating any UPSI, relating to a company, to any person except for legitimate purposes or in discharge of legal obligations. The aim of the legislature in enacting such regulations is to oblige all insiders to handle sensitive information with care since a leak of such information can lead to an undue advantage to both – the tipper and the tippee. The legislature, however, fails to take into consideration a scenario entailing an accidental leak of information which yields no benefit to the tipper or the tippee. Since it has already been established that the purpose of insider trading regulations is to prevent undue advantage to the tipper or the tippee over public investors, a paradox is created when regulation agencies seek to punish even the accidental communication of UPSI which entails no profit to the parties.

    In India, at present, communication of UPSI without personal benefit or even unknowingly, is a ground for liability under the insider trading regulations. Mens rea or intention of the tipper is considered irrelevant under the PIT Regulations. The only available means of solving this paradox lies in the insertion of the element of mens rea in insider trading regulations. The consideration of mens rea at the time of imposition of liability under insider trading regulations can be justified on the two grounds –

    (i.) Mens Rea is in Consonance with the Objectives of PIT Regulations

    Firstly, the purpose with which the PIT Regulations have been enacted is rendered meaningless by the non-inclusion of mens rea. The basic purpose of insider trading regulations is to prevent undue advantage to individuals engaging in trade on the basis of sensitive information. At present, however, the control of SEBI in such cases has been strengthened to a point where the mere possession or communication of UPSI can be considered as a ground for insider trading.

    The legislature has lost sight of its true purpose and engaged itself in policing information and its spread rather than regulating trading done with the intention of acquiring profits. If an insider is penalized for mere communication of information or for trade in securities with no advantage to him over the general investors, the interest of investors remains unharmed. In such a scenario, penalization of such acts becomes meaningless and is clearly beyond the scope of the purpose of the PIT Regulations.

    (ii.) Punishment without Mens Rea is Unjustified

    Secondly, the penalty levied upon an individual for a violation of the PIT Regulations is often exorbitant. Due to the diverse repercussions entailed by the offence, it is of utmost significance that the market regulations take steps towards prosecuting individuals after ascertaining proper cause. This has lead Securities Regulation Agencies in countries like the USA to consider mens rea as a vital element in imposition of liability in order to avoid imposing large penalties in cases of accidental tipping.

    In India, the opinion of the Supreme Court in SEBI v. Shriram Mutual Fund and the legislative notes to Regulation 4 have made it clear that mens rea cannot be considered as an essential element for penalization under the PIT Regulations since it is neither a criminal nor a quasi-criminal offence. Insider trading proceedings pertain to Section 15G of the SEBI Act which are essentially civil proceedings and so the question of proof of mens rea does not arise. However, the Securities Appellate Tribunal has not always subscribed to the same opinion. Previously in Rakesh Agarwal v. SEBI, SAT decided that if an insider deals in securities based on the UPSI for no advantage to him, over others, it is not against the interest of investors and hence should not constitute an offence. It can be similarly inferred that mere communication of information without any advantage to the insider must not be considered an offence. The position adopted by SAT widens the scope of PIT Regulations by correctly interpreting the purpose for which the Regulations were enacted. 

    Mens Rea as a Requirement for Insider Trading in the UK and US

    For the first time in 1984, the US Supreme Court in Dirks v. SEC established that while adjudicating liability in insider trading cases, the mens rea of the tipper must be considered. The Court arrived at its decision by devising a test to decide whether or not breach of a fiduciary duty had been committed by the insider and consequently, whether or not the tippee had committed the offence of insider trading. This was explained by the Court as,

    “The test is whether the insider personally will benefit, directly or indirectly, from his disclosures. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach by the tippee.”

    Hence, post the judgment in Dirks case, the simple test for insider trading violations was whether the insider has communicated sensitive information with the unlawful intention of earning undue personal benefit. If communication of information was done with a guilty intention, the insider had breached his fiduciary duty and would be liable under the regulations. Additionally, the tippee would be considered liable on the basis of his knowledge of the said breach by the tipper.

    The prosecution of individuals was made much more difficult by the Court in the subsequent case of US v. Newman. Here, the Court reinstated its faith in the personal benefit test by clarifying that a mere breach of an insider’s fiduciary duty to not disclose sensitive information is not sufficient to constitute an offence of insider trading, even if the information was communicated to a friend, unless some improper purpose on the part of the insider is demonstrated.

    Similarly, insider trading is illegal under Section 52 of the Criminal Justice Act, 1993 in the UK. Since the offence entails criminal liability under the Act, the requirement for mens rea is indispensible. Section 53 of the Act lays down three defences that can be used by individuals accused of insider trading. To qualify for a defence, the accused must exhibit that, (i) it was not expected at the time of dealing that the transaction would result in a profit; or, (ii) the accused was under the impression that the information is within the public domain; or, (iii) that transaction would have been undertaken even without access to the sensitive information. 

    In a situation entailing an accidental communication of sensitive information where no personal benefit is derived by the tipper, an application of the personal benefit test or the defences enlisted under Section 53 would lead us to the conclusion that there exists no ground for imposing penalty under insider trading regulations.

    Conclusion

    Over the years, the scope of SEBI’s insider trading norms has been widened in order to protect the interests of the investors and to create a healthy environment for trade in the securities. While recent orders in the WhatsApp leak case provide an impression of SEBI’s tireless efforts in curbing insider trading, upon close scrutiny it becomes evident that these orders establish a new threshold of evidence for liability under the existing PIT Regulations. The orders omit discussion on the issue of mens rea and turn a blind eye to a situation where the sharing of the information is accidental and has not resulted in any insider trading or undue benefit. Evidently, at present, the Insider Trading Regulations operating in India are much more rigid and strict than those operating in other countries of the world. It is, thus, proposed that the tipper-tippee test and other principles relating to mens rea prevalent in other jurisdictions should be incorporated in the Indian jurisprudence at the earliest.

  • U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    U.S. Ruling on Disgorgement of Profits: A Model for Indian Securities Market

    By kartik singh, a second-year STUDENT OF at NLUO, CUttack

    Disgorgement refers to the repayment of unlawful profits earned by an individual arising from unlawful activities. Disgorgement of ill-gotten profits has been a potent tool for global regulatory authorities in preserving the interests of the stakeholders in the securities markets. In spite of having a provision to that effect incorporated under Section 11B of the SEBI Act, 1992, added by an amendment in 2013, the Indian market regulatory authorities have been hesitant in enforcing such powers, primarily due to the lack of clarity in the legislation itself and precedents thereof as to how the amount for disgorgement must be computed. The Indian courts and tribunals, thus, often look to foreign pronouncements on the subject.

    The Indian regulatory law for disgorgement has been inspired by the provisions of the US securities law, therefore, the developments in the US securities market are of considerable importance to the Indian regulatory regime. Recently, the US Supreme Court’s decision in Liu v. SEC has thrown light on the issue of the quantum and computation of disgorgement amount by expounding certain guiding principles for the same. Considering the absence of such a computation mechanism in the Indian securities regulations, the ruling serves as an example for India.

    The Securities and Exchange Commission (‘SEC’) charged Charles Liu and Xin Wang with defrauding Chinese investors of a project that the couple falsely claimed met the requirements of the Immigrant Investment Program, following which they diverted the investment funds to overseas marketers and by paying themselves generous salaries. Proceedings were initiated against them and the matter ultimately reached the US Supreme Court.

    Observations of the US Supreme Court: A guiding example for the Indian Framework

    Firstly, the US Supreme Court categorically observed that the power to order disgorgement must not be viewed as a “punitive remedy”, rather it must be considered as an “equitable remedy” i.e. the same must be meant to remedy the wrong and not to punish the wrongdoer. The amount ordered to be disgorged must not exceed the amount of ill-gains gained by the wrongdoer, the contrary of which would fall within the ambit of a “punitive remedy”. The Securities Appellate Tribunal (‘SAT’) in Gagan Rastogi v. SEBI and Shadilal Chopra v. SEBI had too observed the same principle. The US ruling further exemplifies the principle by providing useful direction to enable the courts and tribunals to differentiate between an equitable order and a punitive order.

    Secondly, the Supreme Court noted that the process of disgorgement must be followed by the restitution of such amount to the victims of the wrongdoing. It is often observed that the regulatory authorities disgorge the amount and then claim to have brought justice to the victims. The US Supreme Court depreciated such practice and observed that the true essence of the disgorgement provision would only prevail if the process of restitution of the disgorged amount is followed. Emphasizing the point that mere collection of the disgorged amount and depositing the same in the government treasury would amount to a penalty, the Supreme Court ordered to follow the principle of restitution. To facilitate this, the regulatory authorities must consider the number of stakeholder/victims of the wrongdoing and pass necessary order to protect their interests. A similar approach has been adopted by SAT in Ram Kishori Gupta v. SEBI, wherein it observed the exclusion of principle of restitution in the disgorgement process to be unacceptable, remarking “disgorgement without restitution does not serve any purpose”. Again, the backing of the US Supreme Court on the aforesaid principle augurs well for the Indian securities framework going forward.

    Thirdly, the US Supreme Court noted that the disgorgement of money must be computed based on the net profits earned by the wrongdoer and not from the money earned from the wrongdoing. It must be taken into account that the wrongdoer may have incurred certain legitimate expenses during the course of wrongdoing. It would be unfair to account and extract such legitimate expenses through the process of disgorgement. Depreciating such practice of the regulatory authorities, the court remarked that there have been instances where they have used disgorgement as a tool to shirk their responsibility of applying their mind in order to compute the “actual” amount for disgorgement i.e. by deducting the legitimate expenses incurred by the wrongdoer.

    In the Indian framework too, it is often seen that the authorities order to disgorge the entire amount in question instead of acknowledging the legitimate expenses of the wrongdoer. The US Supreme Court acknowledging such facet said the same can be done by analysing the facts and circumstances of each case, following which the remedy would be truly equitable in nature.

    Lastly, the court also raised concerns about the repeated use of the “jointly and severally liable” principle by the regulatory authorities. Generally, fraudulent activities are committed by several individuals in connivance of each other. Consequently, authorities punish or impose a penalty on one of the wrongdoers for the acts of others using the ‘jointly and severally liable’ principle. The court was of the opinion that although the use of such principle is justified and may be reasonable in circumstances peculiar to a case, however, in cases of disgorgement authorities must be mindful of the person being asked to disgorge the amount unlawfully gained by the wrongdoers as such person may not actually be in possession of the unlawful gains, thereby impeding his ability to disgorge the amount to the regulatory authorities.

    Conclusion

    The US ruling has certainly paved the way for developing a mechanism to ascertain the disgorgement amount from the wrongdoer. While it may be argued that the securities market of the US is different than that of the Indian market, the principles enunciated by the court form the basic structure and the essence as to the computation for disgorgement. Disgorgement differs from a claim of damages, the former being a right in rem and the latter being a right in personam, thus, the method developed by the courts over the years in computing claims for damages must not be applied for the purpose of disgorgement.

    Further, disgorgement, especially in the Indian context, allows the regulators to be more liberal in deciding the quantum since they are themselves the court of first instance. The concept of disgorgement is still at a nascent stage and it is expected that the US ruling would guide the development of the subject in India.

  • Why Lenders are Withdrawing Applications under the IBC and Opting for One-Time Settlement?

    Why Lenders are Withdrawing Applications under the IBC and Opting for One-Time Settlement?

    By Nitya Jain, a fifth-year student at NLU, Jodhpur

    Introduction

    There has been a rising trend of the corporate debtor and the creditor settling their claims out of court after initiating a formal insolvency proceeding in the National Company Law Tribunal (“NCLT”). This has been made possible due to Section 12A of the Insolvency and Bankruptcy Code, 2016 (“IBC”) which provides for withdrawal of insolvency applications. An aggrieved party first files an insolvency application against the corporate debtor in the NCLT but thereafter realises that a private settlement is more feasible and withdraws the application. In fact, data from Insolvency and Bankruptcy Board of India (“IBBI”) shows that out of the 142 cases closed in the second-half of 2018, 63 had been withdrawn under Section 12A. This is 45 percent of the total insolvency cases closed. Thus, it is relevant to understand the laws governing withdrawal of insolvency applications.

    The withdrawal of the application can be done at various stages of the insolvency proceedings. It can be withdrawn before it’s admission by the tribunal, after its admission, before the setting up of Committee of Creditors (“CoC”) or after the CoC has been set up. It can be withdrawn even after the invitation for expression of interest has been issued and the resolution plan has been made. The laws applicable at each stage differs and the approvals required change. These can be divided into four stages.

    Stage 1: Before the admission of the application

    Before the coming of Section 12A, applicants relied on Rule 8 of the Insolvency & Bankruptcy (Adjudicating Authority) Rules, 2016 to withdraw their insolvency applications. This rule provides for “withdrawal of application on a request made by the applicant before its admission.” The term ‘before its admission’ is of relevance here. In Mother Pride Dairy India v. Portrait Advertising & Marketing , the NCLT acknowledged that a private settlement had been reached between the applicant and the corporate debtor. But it held that the application cannot be withdrawn once it has been admitted by the tribunal. The rationale for the same was that other creditors are entitled to raise their claim after the admission of the application and the proceeding has become in rem. Similarly, in Lokhandwala Kataria Construction v. Nisus Finance and Investment Managers LLP, it was held that irrespective of the settlement between the applicant and the corporate debtor, the matter cannot be closed till the claim of all the creditors is satisfied by the corporate debtor.

    Stage 2: After the admission of the application but before the constitution of CoC

    Section 12A of the IBC was introduced via an amendment to provide a mechanism for withdrawal of application after it has been admitted. In order to protect the interest of all creditors, a safeguard was added in the provision whereby such withdrawal is possible only with the approval of ninety percent voting share of the CoC. Here a doubt arises as to what will happen in a case where the application has been admitted but the CoC has not yet been set up. Can such an application be withdrawn? If yes, how?

    This riddle was solved by the Hon’ble Supreme Court in Swiss Ribbons v. Union of India in January 2019, where it stated that “We make it clear that at any stage where the committee of creditors is not yet constituted, a party can approach the NCLT directly, which Tribunal may, in exercise of its inherent powers under Rule 11 of the NCLT Rules, 2016, allow or disallow an application for withdrawal or settlement…….”

    Consequently, in July 2019, an amendment was made in the IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016  (“Regulations”) to accommodate a pre-CoC situation. Accordingly, Regulation 30A (1) (a) of the Regulations provides that before the CoC has been constituted withdrawal may be made by the applicant through the interim resolution professional.

    Stage 3: After the constitution of CoC

    Section 12A will simply apply and the application can be withdrawn provided that such withdrawal is approved by ninety per cent of the CoC. This has to be read with Regulation 30A (1) (b) of the Regulations which states that withdrawal after the constitution of the CoC has to be made by the applicant through the interim resolution professional or the resolution professional, as the case may be.

    Stage 4: After the issue of invitation for expression of interest

    Once the CoC has been set up, the next stage in the insolvency proceeding is invitation for expression of interest. It is an invite to the general public whereby those interested in submitting resolution plans for the corporate debtor can do so. Initially, Regulation 30A of the Regulations did not allow withdrawal of application after issuance of invitation for expression of interest. However, the judiciary still allowed the withdrawal in various cases overlooking the regulation and acting in pragmatic economic terms.

    The Supreme Court in the case of Brilliant Alloys v. Mr. S. Rajagopal  held that the insolvency application for can be withdrawn even after issuance of invitation for expression of interest. The rationale for doing so was that the out of court settlement was more beneficial for all the stakeholders involved. It was considered prudent to ignore the Regulations in this matter to ensure maximum economic benefit to the parties.

    Eventually, the Regulations were amended and the withdrawal of insolvency application was allowed after the issuance of invitation for expression of interest provided there are reasons justifying such withdrawal.

    The judiciary went one step further in the matter of SBM Paper Mills and allowed withdrawal even after the resolution plan was accepted by the CoC. The NCLT acknowledged the value that the one-time settlement was offering the parties which was much better than the resolution plan. However, the tribunal also cautioned against such withdrawals and stated that withdrawal at such a later stage of insolvency proceedings must be discouraged.  Such withdrawals waste the time of the court as well as of the insolvency resolution machinery. Accordingly, the NCLT awarded high costs as a deterrent.

    Conclusion

    Settlement has been sought time and again by creditors in lieu of insolvency proceedings under IBC. Although IBC provides a time limit for resolution of insolvency, it is rarely followed and cases get stretched for more than 500 days which is almost double of the time limit provided in the IBC. In light of this, many lenders opt for withdrawing their application and choose to settle outside court with the debtor. For instance, in January 2020, the Union Bank of India withdrew a couple of insolvency petitions and opted for settlements with the defaulting companies for a much better realisation. The reason for the same was that the bank had not seen any successful resolution for cases referred by it to the NCLT. In a statement the MD and CEO of the United Bank stated that looking at the kind of value that lenders are getting through NCLT and the time taken for resolution, the preferred route is settlement with the corporate debtor. 

    It can be concluded that the judiciary is allowing withdrawal of applications filed under IBC where such withdrawal is economically advantageous to the parties. This practice is in line with the central theme of the IBC i.e. maximization of economic benefit for the lenders. However, it also raises an important question about the effectiveness of IBC in providing maximum fiscal relief.

  • An Inevitable Collision Under The Insolvency Code

    An Inevitable Collision Under The Insolvency Code

    BY PALAK AGRAWAL AND VISHESH JAIN, third-year students at nluo, odisha

    Introduction

    The National Company Law Appellate Tribunal [‘NCLAT’] in its recent decision of SBI v. Metenere held the substitution of Insolvency Resolution Professional [‘IRP’] under the Insolvency Bankruptcy Code 2016 [‘Code’] to be valid. The question dealt with the possibility of unfair and biased Corporate Insolvency Resolution Process [‘CIRP’] since IRP appointed was an ex-employee of the creditor. The author attempts to test the NCLAT judgement against the various provisions of the Code, which is identified as creditor centric, therefore leading to inevitable collision.

    Background of the Case

    In the case of SBI v. Metenere, the Resolution Professional [‘RP’] appointed by the Committee of Creditors [‘CoC’] was an ex-employee of one of the financial creditors i.e., State Bank of India and was also drawing pension from it. M/s Metenere Ltd., the corporate debtor objected to such appointment based on apprehension of bias. The point of deliberation before NCLAT was whether the appointment of an ex-employee of a creditor as RP would render the CIRP process unfair and biased? The NCLAT held that substitution of RP is valid on the basis of apprehended bias. The Adjudicating Authority while dealing with the aforementioned issue acted beyond its jurisdiction and certainly overlooked the literal rule of interpretation.

    Analysis

    • Overstepping of Jurisdiction by the NCLAT

    Entry 8A of the First Schedule of the IBBI Regulation 2016 mandates RP to disclose any association with the financial creditors to the CoC, thereby leaving his appointment on the discretion of the CoC. However, any party to the CIRP aggrieved by the compliance of this provision can approach the Insolvency and Bankruptcy Board of India [‘IBBI’] under Section 217 of the Code. The IBBI is the appropriate authority to take any disciplinary action against the irregular conduct of the RP. A reading of Section 217 elucidates that IBBI shall be the proper authority deciding irregular conduct of the RP, instead of Adjudicating Authority. Therefore, a decision by the Adjudicating Authority on apprehended biasness of the RP, lacks  jurisdiction.

    • Apprehension of Bias

    NCLAT while formulating its decision relied on ‘real danger’ test of apparent bias. The real danger test traces back its origin in the English case of Regina v. Gough, wherein the House of Lords laid the test in term of real danger than likelihood. The court opined that the merits of the case should lead to possibility rather than probability. In the Indian context, the Supreme Court in Kumaon Mandal Vikas Nigam Ltd. v. Girja Shankar Pant also opined, that the surrounding circumstances must be collated and then a conclusion must be drawn, to ascertain that whether there is a mere apprehension of bias or real danger of bias. In the instant case, IRP appointed was merely a pension drawee from the creditor and was not on a panel vested with any decision-making power. Even at a later stage, if the IRP is appointed as the RP, there are certain limitation on the power of RP which require prior approval of the CoC. Therefore, the Adjudicating Authority did not examine the charges of biasness based on any evidence and adopted a lower threshold for determination of biasness.  

    • Disregard to Literal Rule of Interpretation

    Under Regulation 3(1) of IBBI (Insolvency regulation for corporate person) 2016, the IRP shall be eligible to be appointed as RP, if he is independent of the corporate debtor. A bare perusal of Regulation 3(1) shows that it does not prohibit the appointment of RP if related to any party other than the corporate debtor. However, in the present case, NCLAT held the appointment of the RP to be wrong, due to his relationship as ex-employee with the financial creditor. The said finding appears to be inconsistent with the literal rule of interpretation as reiterated by the apex court in Kanai Lal Sur case. In this case, it was held that if the words used were capable of one construction only then it would not be open to the court to adopt any hypothetical construction that is more consistent with the present act. The NCLAT, therefore, on the apprehension of bias took the path inconsistent with the established principle of law and propounded a new judicial principle.

    • IRP/RP as the Custodian of the Corporate Debtor

    IRP/RP acts as a custodian to the corporate persons undergoing CIRP. It has been reiterated by tribunals and courts that the role of IRP/RP is not merely supervisory but also of a negotiator between the creditors and the corporate person to assess and formulate a plan which is best suited for the corporate debtor in keeping his business as a going concern.

    Section 18 of the Code provides for the statutory duties of the IRP which includes carrying every task that is crucial for bringing the insolvency process in motion and collating information on all assets, operations, finance of the corporate person and taking control over the same until the RP is appointed. IRP after assessing the financial position of the corporate person constitutes a CoC under Section 21 of the Code. Once the CoC is constituted, RP under Section 25 of the Code takes over the activities as performed by IRP and carries out further processes involved in a CIRP like preparing information utility and inviting prospective Resolution Applicants. Apart from this, Entries 5 to 9 of the IBBI Regulations provides for the Code of conduct for impartial and independent conduct of the RP.

    Therefore, it is clear from the aforesaid reading, that IRP/RP plays a quintessential role in the whole process of reviving the corporate debtor through CIRP. The IBC scheme and the IBBI Regulation mandates the RP/IRP to be impartial and independent, otherwise it will defeat the very purpose of the Code, which is to balance the interest of all the stakeholders involved in the process.

    • Supervision of CoC over the duties of RP

    During CIRP, the appointment of RP is put-forth before CoC which in its first meeting appoints either the IRP or any other person of their choice as RP by majority ratification of 66%. Apart from this, the CoC is also empowered to change the appointed RP at any point of time during the CIRP process by the majority of 66%. This section makes it significantly clear that the appointment or removal of the RP is directly in the hands of CoC. Putting it differently, if Adjudicating Authority does not endorse the RP as selected by the CoC, then the CoC by the majority vote of 66% can appoint the same person. Therefore, the very independence given to IRP/RP remains to be ambiguous, as its appointment, as well as its removal depends on the CoC. Therefore, the NCLAT’s judgement clearly poses a question on independence of RP.

    Apart from the power of appointment and removal, the CoC oversees and ratifies all the functions undertaken by the RP. Besides, the CoC is called upon to consider the resolution plan vetted and verified by the RP and the RP is not required to express his opinion on matters within the domain of CoC to approve or reject the resolution plan. Therefore, every decision by RP regarding the selection of a resolution plan or liquidation has to be aligned with the commercial wisdom of the CoC. Furthermore, it is a settled principle that RP cannot challenge the commercial wisdom of the CoC unless it is against the very purpose of the Code i.e. it does not balance the interest of all the stakeholders concerned.

    Therefore, it is no harm to mention that a biased action taken by the RP towards CoC at the stage of CIRP has a negligible scope of being checked or corrected. This leads to a bias and may prove to be detrimental towards the corporate debtor. Thus, making RP more dependent on CoC, therefore leading to loss of independence in decision making power.

    Conclusion

    In conclusion, the NCLAT’s decision in Metenere emphasises on the independence of the IRP/RP in order to conduct CIRP in an unbiased and fair manner. But once the Adjudicating Authority assumes the power to adjudicate upon the appointment of IRP/RP, this will open the Pandora box inviting challenges against every appointment and nomination of IRP/RP by the corporate debtor which is against one of the objectives of the Code i.e. the timely completion of the insolvency process.

    Lastly, the author believes that the objective of the Code can be truly achieved when the RP/IRP performs its duties without being influenced by CoC. But it is almost impracticable for the IRP/RP to work independently in the current arrangement of the Code, as the CoC overlooks the appointment as well as functions of the IRP/RP. Therefore, a shift towards institutionalising the appointment of IRP/RP will help break the chain between CoC and IRP/RP and will enable them to work in a more fair and unbiased manner. The aforementioned case has been appealed in Supreme Court and hence, positive changes which align with the Code are awaited.