The Corporate & Commercial Law Society Blog, HNLU

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  • 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.

  • 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.

  • The Requirement of ‘Intention’ in Special Resolutions

    The Requirement of ‘Intention’ in Special Resolutions

    By Gunjan Bahety and Tanmay Joshi, fourth-year students at MNLU, Nagpur

    Introduction

    Under the Companies Act, 2013 (‘Act’), decisions are taken and executed with the consent of the shareholders through resolutions. The consent of the shareholders is duly taken by the casting of votes. Special Resolution under the Act has been defined as:

    “A resolution shall be a special resolution when

    1. the intention to propose the resolution as a special resolution has been duly specified in the notice calling the general meeting or other intimation given to the members of the resolution; 
    2. the notice required under this Act has been duly given; and 
    3. the votes cast in favor of the resolution… are required to be not less than three times the number of the votes, if any, cast against the resolution by members so entitled and voting.”[i]

    The very first requirement that the section provides is for “intention to propose the resolution as a special resolution” which needs to be “duly” mentioned in the notice. Going by the literal text of the statute, prima facie it seems that the requirement of intention is mandatorily an element for classification of a resolution as a special resolution. However, the courts have interestingly taken an opposite view of the same. 

    Is Intention Really a Mandatory Requirement?

    The Courts have time and again held that the requirement of “intention” under clause (a) of section 114 is not a mandatory requirement.[ii]

    The Andhra Pradesh High Court had held in a case:

    “requirement of setting out the intention to move a resolution as a special resolution in the notice could not be said to be such a mandatory requirement, that the failure to comply with it would invalidate the resolution.”[iii]

    The Court then differentiated between a directory requirement and a mandatory requirement. The Court held:

    “There is no general rule for determining whether a particular provision in a statute is mandatory or directory. The court must look at the purpose of the provision, its nature, and intention of the Legislature to find out whether it is directory or mandatory.”[iv]

    The Court was of the view that even the use of the word “shall” is not decisive of the matter and many other aspects have to be looked into.[v] However, there are other aspects that the Courts need to consider while reaching this conclusion. The Supreme Court (‘SC‘) recently has stated that:

    “the Legislature inserts every part of a statute with a purpose & the legislative intention is that every part thereof should be given effect to. If the words used are capable of only one construction, it is not open to the court to adopt any other hypothetical construction on the ground that it finds it more consistent with the alleged object and policy of the Act.”[vi]

    Parallelly, the SC had held in a case that “the first and primary rule of construction is that the intention of the legislation must be found in the words used by the legislature itself.”[vii] Citing various case laws, the Apex Court had concurred, “when the Legislature has employed a plain and unambiguous language, the Court is not concerned with the consequences arising therefrom”[viii] and construal is to be done only when the text is incomprehensible. The Court further held that “it is a cardinal principle of interpretation of statutes that the words of the statute is to be given prima facie meaning, irrespective of the consequences”. However, equally it is important to look at the interpretation from another perspective, as cited by the SC:

    “In matters of interpretation one should not concentrate too much on one word and pay too little attention to other words. No provision in the statute and no word in any section can be construed in isolation. Every provision and every word must be looked at generally and in the context in which it is used.”[ix]

    The above-mentioned method of interpretation would obviously make it reasonable to give effect to the legislative intent and the purpose of the provision while keeping in mind to not focus much on the wordings of the section so as to defeat the purpose of the legislation. In light of the above analysis, even the court opined that the inconveniences which would arise if the resolution would fail even after being passed as a special resolution were certainly not the intention of the legislature.[x] Hence, the requirement of intention under section 114 cannot be said to be a mandatory requirement but only a directory requirement. Further, the Court held that the decisions which require a special resolution to be adopted are mandatory but the notice convening the meeting and implying the intention that the resolution is to be passed as a special resolution is only directory. The Court thus, adopted harmonious construction in practice. 

    Hence, what would be of material importance would be the contents of the resolution and the consent of the members and certainly not what the irregularities in the notice would say. Therefore, it would be sufficient if the provision is only substantially complied with. The Gujarat High Court had also observed that the requirement of intention in the notice under section 114 to move a special resolution could not be said to be such a strict and necessary requirement that the failure to comply with it would invalidate the resolution.[xi]

    It would be of relevance to discuss here the Duomatic Principle as was laid down in In Re Duomatic Limited 1969[xii]. Buckley J. held that given the shareholders who had a right to attend and vote at a general meeting, had informally assented to a decision in the meeting, that assent is binding and a formal meeting cannot be insisted upon.[xiii] The English Court took the view of In re Express Engineering Works Ltd.[xiv] and other cases[xv], wherein it was held that “where all the corporators in fact approve, the mere absence of the technicality of a formal resolution in general meeting is immaterial”. The Court accordingly held that “the agreement between all shareholders of the company had the effect of overriding the articles so far as was necessary.”[xvi] However, for the application of this principle, the existence of consensus-ad-idem among all the shareholders of a company for a particular course is a condition precedent.[xvii] The scope of this principle has been defined in various foreign cases. In Stakefield (Midlands) and others v. Doffman and another[xviii], it was held that “the principle cannot be applied for a transaction amounting to an unlawful return of capital”. In some cases, it has been held that the principle can be employed to alter the company’s articles.[xix] It has also been accepted as a defense for violation of fiduciary duties.[xx] It is to note that, “the Duomatic principle does not permit shareholders to do informally what they could not have done formally by way of written resolution or at a meeting.”[xxi]

    In India, there have been numerous cases wherein the learned counsels have taken the aid of the Duomatic Principle.[xxii]The Indian Courts too applied the principle, for example in Darjeeling Commercial Co. Ltd. v. Pandam Tea Co. Ltd.[xxiii] the court while applying the principle concluded that the company adopted the loan in its annual general meeting through its members and now cannot take the defense that the said loan is fictitious or fraudulent. Even the Delhi HC had applied this principle and cited various English cases to back its view.[xxiv] Additionally, the Andhra Pradesh High Court in another case held that the principle in essence provides that if a statute provides that a course can be taken by the sanction of a certain number of members which is to be given in accordance with the prescribed procedure under the statute, then provided that the required number of members of that group sanction the decision, the prescribed procedure is not normally treated as being essential.[xxv]  However, extending the proposition, the Court concurred that “this should be the case when the Court is satisfied that the purpose of the given procedure is for the benefit of the members” of that group and enables a majority of that group to bind the minority in relation to the course in question.

    Conclusion

    Hence, what can be said is that the requirement of intention setting out in the notice under section 114 of the Companies Act, 2013 though not mandatory, but to avoid future instances of disputes, it would be better to declare such a notice as convening a meeting for the passing of a special resolution as there is no Supreme Court judgment to that effect. As we have seen the different approaches that the courts adopt while interpreting a statute and there is no straight-jacket formula to that, at times even plain text of the statute requires interpretation to mark it as “plain”. What is necessary to understand is to read the purpose of the section and not to fuss about the procedural requirements when can be easily resolved given the sanctions of the members.

    Endnotes:

    [i] Section 114, Companies Act 2013.

    [ii] In Re: Novopan India Limited 1997 88 Comp Cas 596 AP, Brilliant Bio Pharma Limited v. Company Petition No.91 Of 2012; In Re: Maneckchowk And Ahmedabad [1970] 40 Comp Cas 819; C. Rajagopalachari v. Corporation of Madras [A.I.R. 1964 S.C. 1172].

    [iii] In Re: Novopan India Limited 1997 88 Comp Cas 596 AP.

    [iv] Ibid.

    [v] Ibid.

    [vi] N Sampath Ganesh v. Union of India (2020) Cr. Writ Petition NO. 4144 OF 2019.

    [vii] Kanai Lal Sur vs Paramnidhi Sadhukhan 1957 AIR 907.

    [viii] N Sampath Ganesh v. Union of India (2020) Cr. Writ Petition NO. 4144 OF 2019.

    [ix] Illaichi Devi v. Jain Society, Protection of Orphans India, (2003) 8 SCC 413.

    [x] In Re: Novopan India Limited 1997 88 CompCas 596 AP.

    [xi] Maneckchowk and Ahmedabad Manufacturing Co. Ltd. [1970] 40 Comp Cas 819.

    [xii] In Re Duomatic Ltd. [1969] 2 Ch 365.

    [xiii] Re Duomatic, Buckley J at page 373.

    [xiv] In re Express Engineering Works Ltd. [1920] 1 Ch. 466.

    [xv] In Re Newman (George) & Co. Ltd. [1895] 1 Ch. 674, C.A.; Parker & Cooper Ltd. v. Reading [1926] Ch. 975; Salomon v. Salomon & Co. Ltd.[1897] A.C. 22, H.L.

    [xvi] Ibid.

    [xvii] Euro Brokers Holdings Ltd. v. Monecor (London) Ltd. [2003] 1 BCLC 506.

    [xviii] Stakefield (Midlands) and others v. Doffman and another [2010] EWHC 3175.

    [xix] Cane v. Jones [1980] 1 WLR 1451, The Sherlock Holmes International Society Ltd. v. Aidiniantz [2016] EWHC 1076 (Ch). 

    [xx] Sharma v. Sharma [2013] EWCA Civ 1287.

    [xxi]  Madoff Securities International Ltd v Raven & Ors. [2013] EWHC 3147 (Comm).

    [xxii] Urban Infrastructure Trustees Ltd. v. Joyce Realtothers Pvt. Ltd. LNIND 2015 Bom 776; Dr. Renuka Datla And Others Versus M/Biological E Limited And Others Lnindord 2017 Ap 258; Advansys India Private Limited & Others Versus M S Ponds Investment Limited & Others Lnind 2014 Bom 434.

    [xxiii] Darjeeling Commercial Co. Ltd. vs Pandam Tea Co. Ltd. 1983 54 CompCas 814 Cal.

    [xxiv] Adobe Properties Private Limited vs Amp Motors Private Limited CO.APPL.(M) 150/2016.

    [xxv] In Re Torvale Group Ltd. [1999] All ER (D) 944, In Re Brilliant Bio Pharma Limited [2013] 180 Comp Cas 168 (AP).

  • IBC And The Homebuyers’ Debacle: One Step Forward and Two Steps Back

    IBC And The Homebuyers’ Debacle: One Step Forward and Two Steps Back

    BY srihari gopal and vedant malpani, fourth-year students at GNLU, gandhinagar

    In the latter half of the last decade, the Real Estate (Regulation and Development) Act, 2016 (‘RERA’) and the Insolvency Bankruptcy Code, 2016 (‘IBC’) have arguably been the two most revolutionary legislations in India. While IBC replaced a broken system of corporate resolution and restructuring under disparate laws with a comprehensive self-contained code, RERA introduced accountability to the opaque real estate sector, which over the years had gained infamy for its severe delays, irregularities and unfair practices. The legislations also provide for the constitution of two regulatory bodies, i.e. the Insolvency and Bankruptcy Board of India (‘IBBI’) and the Real Estate Regulation Authority respectively to protect the interest of the stakeholders. Over the years, RERA and IBC have come to be recognized as complementary legislations. However, their interplay has resulted in significant overlapping issues which cannot be ignored.

    So far, the biggest issue concerning the two legislations has been the result of a recent amendment to the IBC in March 2020 (‘the Amendment’), which has left the homebuyers nearly remediless. This Amendment takes the homebuyers, who were only recently recognized as creditors under the IBC, a step backwards. The amendment’s constitutional validity has been challenged, and on 15th June 2020, the Supreme Court (‘SC’) has ordered the government to respond to the petitioner’s claims.

    Before delving into the issues with this Amendment and the judgement, it would be relevant to briefly touch upon the status of homebuyers under these legislations over the years.

    Position of homebuyers under the IBC before 2018

    Under Section 2(d) of the RERA, a homebuyer is an allottee who acquires a property through sale, transfer or otherwise but does not include a tenant. Before the enactment of RERA, a homebuyer had no remedy against a real estate developer to receive a monetary compensation in case of default and had to resort to the Consumer Protection Act (‘CPA’). Even after enactment of RERA, there were no provisions for a time-bound resolution, which left homebuyers in dire need of an effective, speedy remedy.

    Prior to the 2018 Amendment to the IBC, homebuyers could not file for insolvency of real estate developers as there was no clarity as to the nature of debt owed to a homebuyer. Since the IBC classified debts as either operational or financial in nature, homebuyers, whose transactions were in the nature of a ‘sale and purchase’, did not fall under either categories.

    The issue of classification of homebuyers under IBC resurged  in decisions like Nikhil Mehta v. AMR Infrastructure, where the NCLT Delhi considered that homebuyers could be brought under the definition of financial creditor due to the nature of their transactions having the ‘commercial effects of a borrowing’. Further, in Chitra Sharma v. Union of India, the Supreme Court   attempted to protect the interest of homebuyers by appointing an Advocate on Record to represent their interest in the Committee of Creditors. Nonetheless, courts could only grant limited protection without a change in legislation.

    Further, it became all the more important to resolve this issue, considering that once an insolvency petition is initiated, a moratorium under Section 14 of the IBC is imposed on all legal proceedings, including those under the RERA (essentially leaving homebuyers out of the process). It was in this light that the IBC Amendments of 2018 and 2020 were introduced.

    Issues with the 2020 Amendment: You can have an apple, but you cannot eat it

    Through the 2018 Amendment to the IBC, homebuyers were recognized as financial creditors, with the amount owed to them coming within the definition of a financial debt having the commercial effects of a borrowing. This came as a huge respite to homebuyers, who often made substantial investments into real estate projects, both in terms of loans and EMIs. The Amendment also survived a constitutional challenge in the decision of Pioneer Urban Land and Infrastructure Ltd. and Anr. v. Union of India and Ors.

    Due to the extraordinary number of appeals brought forth by real estate developers challenging the 2018 Amendment, another amendment was introduced in 2019 through an ordinance, which was later inserted in the IBC by an amendment in March 2020. It introduced a minimum threshold for initiation of insolvency proceedings against a builder, requiring that an application for corporate insolvency resolution process should not be filed by less than 100 or 10 per cent of all homebuyers in a project, whichever was lesser. It was also stated that the threshold limit had to be complied with within 30 days of the promulgation of the ordinance. This was largely unfair to the homebuyers, as before this Amendment even a single homebuyer, with a claim of Rs.1 lakh or more could move to NCLT against the defaulting developer. The Amendment placed homebuyers in a disadvantaged position as compared to other financial creditors who were not subject to such a requirement. The constitutionality of this Amendment was challenged before the Supreme Court in the case of Manish Kumar v. Union of India & Anr. At present, the matter is sub-judice.

    In this case, homebuyers have challenged the Amendment claiming that it has rendered them remediless under the IBC. They further contended that the Amendment is unfair, arbitrary and in violation to Article 14 and 21 of the Indian Constitution due to unequal treatment of similarly placed creditors. Interestingly, the idea of a similar threshold was already rejected by the Supreme Court in the Pioneer case, which makes it all the more confusing as to why the amendment was introduced in the first place. The SC, in this case, stated that the objective of keeping the threshold limit at Rs. 1 lakh was to specifically enable small financial creditors (homebuyers) to trigger the Code just like other similarly placed financial creditors such as banks and financial institutions to whom crores of money may be due.

    The threshold requirement has been subjected to critique in several other instances. Mr. T.K. Rangarajan, a Rajya Sabha MP and a member of the Standing Committee of Finance, had written a letter to the chairman of the Committee citing his concerns with the minimum threshold requirement. In his report, he alleged that (a) the legislature has been influenced by a strong lobby of builders in introducing the Amendment, (b) it is unfair to homebuyers, having individual claims of more than the minimum threshold of Rs. 1 lakh (now Rs. 1 crore), as unlike other operational and financial creditors, they cannot file an proceed against defaulting builders without fulfilling the minimum threshold requirement, (c) it is unreasonable to expect the homebuyers to unite for the purposes of an application when they are unaware of each other in most cases, and (d) there is no such requirement placed on other similarly placed financial Creditors, such as creditors who are a part of a joint lenders scheme.

    The Insolvency Law Committee released a report in February, 2020 in an attempt to justify the threshold. The primary reasons stated were that (i) the threshold was imposed so that an application is filed only in the collective interest of the homebuyers (ii) even if an application under the IBC fails for want of the threshold, alternative remedies under RERA are still available, (iii) undue pressure will be exerted on the corporate debtor for even ‘minor disputes’ without the threshold and (iv) RERA disputes are heavily contentious, and this will be a set-back on the time-bound RERA process.

    None of these reasons justifies the requirement. Undermining claims of single homebuyers as ‘minor issues’ irrespective of the claim they are owed is unfair and arbitrary, considering that homebuyers often invest their life savings or incur significant debt in real estate purchases. In fact, the requirement of the minimum threshold will only make the disputes more contentious, considering that homebuyers, with their limited resources, now have to not only gather information about other homebuyers by themselves but also consolidate their individual claims to file the insolvency application, all within a span of 30 days. Further, as discussed above, though the remedies in RERA and the IBC are concurrent, IBC provides the more time-bound and efficacious solution. Therefore, the mere existence of another remedy is no excuse to limit homebuyers’ rights under the IBC.

    Conclusion

    The ailing real estate sector has been drastically hit due to the pandemic. Many experts from the industry have shown concern about the severe reduction in demand in the housing sector. It is also forecasted that homebuyers are among the ones who are going to be the most affected, as real estate constructions have come to a standstill due to the nationwide lockdown imposed by the Government. With the subsequent costs being expected to exponentially increase, it can be reasonably expected that the number of cases relating to insolvencies in the real estate sector will also rise considerably once the IBC comes back into force. This makes it all the more important to provide expansive protections to homebuyers.

    We believe that the current amendment leaves homebuyers without any effective recourse under the IBC. Corporate debtors are already protected against bogus applications through the new increased thresholds under Section 4 of the IBC. The amendment is therefore nothing but an unnecessary obstacle. However, in case the amendment is found to be constitutional, the RERA should be amended to devise a mechanism for homebuyers to be aware of other homebuyers involved in the project. However, the legislature should primarily consider repealing the amendment completely, considering that the Supreme Court had already struck down the idea of such thresholds before.