Clean Slate When Not In Clean Hands – Need For Checks And Balances In IBC

In a set back to the successful resolution applicant, the Madras High Court, in its recent ruling in "The National Sewing Thread Co. Ltd Vs The Superintending Engineer TANGEDCO" [W.P. No. 29845/2022] decided on June 7, 2024 held that the protection of the clean slate theory can only be fully claimed when there is a change in management or control of the corporate debtor. If the erstwhile directors or promoters of the corporate debtor continue to be in the management of the corporate debtor or control it post resolution under the corporate insolvency resolution process, then the protection of the clean slate theory can be claimed provided information about all the creditors of the corporate debtor have been disclosed.

BRIEF FACTS

The National Sewing Thread Co. Ltd, the Petitioner in this case, is a public limited company registered under the Micro, Small and Medium Enterprises Development Act, 2006 ("MSME Act, 2006"). It had availed financial assistance from a bank, which it was unable to repay due to business losses. This led to its account being declared as a non-performing asset. Thereafter, the lender moved the NCLT by filing an application under Section 7 of the Insolvency and Bankruptcy Code, 2016 ("IBC"), to initiate the Corporate Insolvency Resolution Process ("CIRP") against the Petitioner company. The application was admitted and the Committee of Creditors ("CoC") was constituted comprising the sole lender/applicant as the member of the CoC. A resolution plan was received from the suspended directors/ promoters of the Petitioner company. This was permissible owing to Section 240A of the IBC which enables the suspended directors/ promoters of micro, small or medium enterprises registered under the MSME Act to submit a resolution plan as a resolution applicant notwithstanding the restrictions contained under Section 29A (c) & (h) of the Code.

The CoC approved the resolution plan submitted by the suspended directors/ promoters of the corporate debtor. The plan also received a nod from the NCLT under Section 31 of the IBC on December 06, 2021. Effect of the above was that the erstwhile directors/promoters became the successful resolution applicant and the Petitioner company came out of the CIRP.

On January 19, 2022, the Respondent, TANGEDCO (Tamil Nadu Generation and Distribution Corporation Ltd) being the operational creditor to the Petitioner company issued a demand notice claiming the unpaid electricity charges from June, 2019 (i.e., pre CIRP dues) to a tune of more than INR 32 Lakhs. The Petitioner company replied to the said notice stating it had already gone through the CIRP and as per the resolution plan approved by the NCLT, all the outstanding dues of the Petitioner company not covered in the resolution plan stood extinguished. Dissatisfied with the reply, TANGEDCO disconnected the electricity connection of the Petitioner company on account of the non-payment of the outstanding electricity dues pertaining to the pre-CIRP period.

Aggrieved by the same, the Petitioner company through the successful resolution applicant challenged the impugned notice issued by TANGEDCO, seeking direction to forthwith provide electricity connection.

Findings and observations of the Court:

The Madras High Court found that every claim of an operational creditor involves a right to its property under Article 300A of the Constitution of India, which the Supreme Court now reads it as a facet of human rights and an integral to the right to life under Article 21 of the Constitution.

Relying on the case of M.K. Rajagopalan v. Dr. Periasamy Palani Gounder [(2024) 1 SCC 42], where the Hon'ble Supreme Court has watered down the concept of commercial wisdom of the CoC. In that case, the Apex Court held that the commercial wisdom of a CoC would operate only when all the relevant information is available before it. The Madras High Court held that the commercial wisdom of a CoC is not a tag that the CoC may conveniently paste on a resolution plan and be used to override all other considerations. Explanation I to Section 30(2) of the IBC creates a statutory obligation on the CoC to be just, fair and equitable in dealing with the rights of the operational creditors.

The Madras High Court further held that clean slate theory cannot be used to reject the claim of an undisclosed creditor on the ground that, he who had not responded with his claim pursuant to public announcement, might have to necessarily lose his right to recovery. This position was based on two aspects. First, an operational creditor, that loses its right to claim which affects its commercial existence would be deprived of its right to engage in business under Article 19(1)(g) of the Constitution, and second, the failure of the resolution professional to gather the relevant information by exercising due diligence would vitiate the CIRP. Hence, the interpretation of the IBC cannot be oblivious to the fact of a claim to money of the creditors being their constitutionally protected right to property under Article 300A.Thus, such a right cannot be destroyed merely because the creditors have not preferred any claims pursuant to the public notice.

Conclusion:

Madras High Court held that clean slate theory will be applicable depending upon whether the creditor is a disclosed creditor or undisclosed creditor and whether the resolution process has resulted in a change in the management or control of the corporate debtor. In the case of a disclosed creditor who had the opportunity to participate in the resolution process, the clean slate theory would apply. However, if the rights of an undisclosed creditor are eliminated under clean slate theory, owing to the negligence of the resolution professional as well as the deliberate silence of the suspended board of directors in not revealing them, clean slate theory will not apply. Hence, after a successful completion of a resolution process, if the same promoters or substantially the same set of directors of the corporate debtor continue to be in management, the clean slate theory will not forfeit the rights of the undisclosed creditors when the suspended management had an opportunity to disclose all its creditors during the resolution process.

Further, if after a successful resolution process, a third-party resolution applicant takes over the corporate debtor, the clean slate theory will apply to extinguish the rights of the undisclosed creditors but only against the successful resolution applicant and not against the promoters or the suspended board of directors. It should not be forgotten that clean slate theory is a judicial coinage to protect the third-party successful resolution applicant from the uncertainties of future claims, and not invented to protect the fraud and suppression of the suspended board of directors of the corporate debtor. In view of the above, the Madras High Court rejected the Writ Petition filed by the successful resolution applicant.

Critique of IBC:

However, what is very interesting about this judgment is the thought provoking critique of IBC and the observations of the Court on the IBC which are reproduced below so as to not lose its punch:

1. Para 6 - And, the petitioner being a MSME, the same promoters or the Board of Directors of the petitioner continued to be in the management of its affairs, but significantly free of all its liability, with its only financial creditor walking away with the chunks, and the operational creditors forced to settle for the crumbs which the IBC regime generously feed them with.
2. Para 8 - TANGEDCO, very innocently demanded its dues, but the petitioner has a prompt response to it: "We had one great holy dip in the IBC, and all our sins are washed away. Today, we are a new born, with a clean-slate balance sheet, with all assets and no liability. Hence, we owe TANGEDCO nothing. And if there are any doubts, read Ghanashyam Mishra case."
3. Para 14.1 - One noticeable difference which is instantly visible on a broader comparison of SICA and the IBC is that while SICA was debtor driven, the IBC is financial creditor driven. In effect the soul of the IBC appears to be that which the Parliament has junked vis-à-vis the SICA
4. Para 14.2 - In that sense IBC may be acclaimed as a path breaking legislation, but it is doubtful if it has broken the path without breaking the back of some of the stakeholders – more particularly the Operational creditors.
5. Para 16 - ......... In that sense IBC has been truly path-breaking. But has not the Parliament unwittingly reduced the operational creditors with lesser insurance against economic uncertainties, to a sacrificial goat to feed the financial creditors, essentially the banking sector, which has greater and better shock-absorbers in-built within its structure against economic turbulences, with the RBI sitting to audit its operational efficiency?
6. Para 25.1 - The legislature, consciously, has not provided any ground to challenge the "commercial wisdom" of the individual financial creditors or their collective decision before the adjudicating authority. That is made non justiciable.
7. Para 31.2 - .... The IBC has however, placed the interest of the operational creditors on the lap of the CoC and authorized the latter to decide what the operational creditor might get.
8. Para 35.2 - Hitherto, clean slate theory was lavishly used to reject the claim of the undisclosed creditors ............. This view overlooks two aspects: a) The right to a claim of the operational creditors, whose loss to them will affect their commercial existence and their right to engage in business under Article 19(1)(g) and the right to life of the promotors and the workmen associated with the operational creditors, an aspect which did not obtain necessary occasion for an adequate consideration of the Supreme Court.
9. Para 50 – .... But the charm and the temptation in invoking the IBC is that, unlike the regime it has created, SARFAESI does not have a clean slate theory inbuilt in its statutory scheme nor has the advantage of any judicial pronouncements to bring it out, with the result the MSME debtor will still be under an obligation to pay the liability to all its other creditors.
10. Para 51 - Another aspect which is intriguing is that when the IBC contemplates a Committee of Creditors, it uses a plural and a not singular, and hence is it permissible within the scheme of IBC to recognize one member CoC? This requires examination but may have to be tested in another case
11. Para 52.1 -This is for the Parliament. Before winding up, this Court intends to persuade the Parliament to evaluate the working efficiency of the IBC. Here it would be apposite to refer to the candid review of the IBC by Shri V. Ramasubramanian J., (former Judge of the Supreme Court of India) "An impact assessment study of IBC has now become necessary, for more reasons than one. Of late, cases of misuse of the provisions of the Code by all stakeholders such as (i) debtors (ii) creditors (iii) resolution professionals and (iv) resolution applicants, have started attracting the attention of courts. For instance, NCLAT highlighted in a case very recently, that large business houses with multiple business arms cannot be allowed to disrupt small businesses. Cases of (i) misconduct on the part of the Resolution Professionals (ii) highhandedness on the part of some of the creditors (iii) abuse of the Code by debtors, through collusive CIRPs and (iv) vultures eyeing for takeover of healthy companies are actually on the rise. The percentage of hair cuts have increased to such an extent that in some cases, they appear as close shave. Therefore, it will be worthwhile to have a thorough study conducted at the earliest so that there is a timely cure. Otherwise, we may land up in a situation where IBC itself may need a resolution plan.
12. Para 52.3 -........ The larger question therefore, is why should the Parliament bend backwards to protect one corporate debtor at the risk of exposing the public interest to peril? The present case, a case-study merely, illustrates how IBC could be manipulated to defeat the interests of the undisclosed creditors of the corporate debtor.

It is a fact that when the SICA was introduced, it was effective and we had seen companies turning around after implementation of the rehabilitation package. However, after a few years, unscrupulous borrowers and guarantors starting misusing section 22 of SICA to seek immunity from legal proceedings which came into effect immediately upon filing a reference under SICA. It was mandatory to file a reference once the net-worth of a company was eroded. One would also see companies deliberately inflate losses to erode their net-worth and seek protection under Section 22. It did not help that the number of benches of board for industrial and financial reconstruction ("BIFR") were very few, could not cope with the caseload and references were pending for years before BIFR. In the meanwhile, section 22 afforded the borrower and its guarantors legal protection and no legal proceedings could be filed against them by the creditors. All this led to the SICA being repealed.

The problem of failure to set up adequate number of benches of BIFR was a serious problem. The same problem is already seen in the NCLTs where there is huge backlog of cases and some of the matters seem to be proceeding for eternity. There is urgent need to remedy this if we do not want IBC to go the SICA way.

It is very much true that even in case of IBC there are several cases where there is suspected misuse and some checks and balances need to be introduced before it goes out of control and beyond redemption like the SICA. The point raised by the Hon'ble Court about single creditor proceedings is very valid. There are cases where a single creditor acquires all or most of the financial debt of the corporate debtor with a view to acquiring controlling voting rights. In some cases, this has done away with delays by multiple financial creditors in taking approval from their respective boards thereby speeding up the resolution process. However, there have also been cases, where one suspects that there is collusion between the single financial creditor and the erstwhile promoters to either handover control to the erstwhile promoters or any front company of theirs or to sell the corporate debtor at a throwaway price to a particular group with the benefit of extinguishment of liabilities.

The Hon'ble Court draws a very nice comparison between SARFAESI and the IBC. It is a fact that there are several cases where IBC is preferred today qua the SARFAESI on account of the ability to extinguish the debt of several classes of operational creditors and the benefit of the clean slate theory. A very valid point raised by the Hon'ble Court is whether or not anybody has thought about the disastrous effects of IBC on innocent stakeholders. One sees large corporates and groups acquiring smaller companies at throw away prices and the people suffering in the process are many small businesses and their promoters and employees which are operational creditors who have been either offered nothing or peanuts resulting in nearly 100% write off of operational debts. In saving one corporate debtor are we creating multiple stressed companies? Has any study been undertaken of the operational creditors who had to undertake such write-offs and the effect on their survival? A very simple example would be worthwhile. There are several cases of corporate debtors owning flats in housing societies in Mumbai. There is a housing society in Mumbai with 20 members, one of which is a corporate debtor who has not paid maintenance for last few years. Going to the registrar of societies to recover this money can be a long drawn and vexatious process. Under IBC, the pre CIRP maintenance dues to the society can be extinguished. The implication of this is that the 19 honest members who have paid their maintenance regularly and who in most cases are middle income individual members have to subsidise the defaulting corporate debtor for no fault of theirs. To add insult to injury a large corporate who can definitely afford to pay the arrears of maintenance acquires the flat under IBC but does not have to pay the arrears of maintenance because of the extinguishment under IBC. Can there be more injustice to the 19 members than this? Is there not a case to identify such cases of operational creditors and make payments to them mandatory under IBC?

Yet another very valid question referred is whether it is just to grant such extraordinary powers to the committee of creditors? In practice, it is often the case, that one does not find the members of committee of creditors to be a group of commercially wise men but rather a group that is interested in protecting only their own interests. Secondly, the process of granting approvals for a number of these financial creditors is so slow and long drawn that it is impossible to comply with the timelines stipulated in the IBC.

It is perhaps the right stage to address the concerns of some of the categories of operational creditors and amend the IBC to speed up the supervisory and adjudicatory mechanism and to make this legislation fairer and more effective.

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