The Interplay of Section 66(2)(b) with Sections 10 and 43 of the IBC: Directors’ Duties in Incipient Insolvency

The Interplay of Section 66(2)(b) with Sections 10 and 43 of the IBC: Directors’ Duties in Incipient Insolvency

The Insolvency and Bankruptcy Code (IBC) equips Resolution Professionals and Adjudicating Authorities with the authority to hold directors accountable when a company approaches insolvency. Section 66(2)(b), in particular, imposes vital duties on directors when a corporate debtor’s financial health declines. This blog explores how Section 66(2)(b) interacts with Sections 10 and 43 of the IBC, highlighting directors’ responsibilities and relevant legal precedents.

Understanding Section 66(2)(b) of the IBC

Section 66 addresses Fraudulent or Wrongful Trading. It permits the Adjudicating Authority to direct directors or partners to contribute to the corporate debtor’s assets if they:

• Knew or should have known, before the insolvency commencement date, that insolvency was unavoidable; and

• Failed to exercise due diligence to minimize creditor losses.

# Section 66. Fraudulent trading or wrongful trading. -

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• (2) On an application made by a resolution professional during the corporate insolvency resolution process, the Adjudicating Authority may by an order direct that a director or partner of the corporate debtor, as the case may be, shall be liable to make such contribution to the assets of the corporate debtor as it may deem fit, if-

• (a) before the insolvency commencement date, such director or partner knew or ought to have known that the there was no reasonable prospect of avoiding the commencement of a corporate insolvency resolution process in respect of such corporate debtor; and

• (b) such director or partner did not exercise due diligence in minimising the potential loss to the creditors of the corporate debtor.

Negative Net Worth: A Red Flag for Directors

A negative net worth clearly signals impending insolvency. This should place directors on notice, triggering their duty to act under Section 66(2)(b) by evaluating the company’s situation and considering insolvency proceedings under Section 10 of the IBC.

Directors’ Decision-Making Upon Negative Net Worth

When net worth turns negative, directors should make a conscious, documented decision - ideally by board resolution or AGM - to:

• File for insolvency under Section 10; or

• Continue operations based on credible prospects of profitability.

NCLAT (10.10.2022) in Mrs. Renuka Devi Rangaswamy, RP of M/s. Regen Infrastructure and Services Pvt. Ltd. Vs. M/s. Regen Powertech Pvt. Ltd. [Comp. (AT) (CH) (Ins) No. 357 / 2022 & IA/814/2022] held that;

• “# 30. It must be borne in mind that whenever a ‘Fraud’ on a ‘Corporate Debtor’ is committed, in the course of carrying ‘business’, it does not necessarily mean that the ‘business’ is being carried on with an intent to ‘defraud’ the ‘Creditors’. In this connection, this ‘Tribunal’ pertinently, points out that if the ‘Directors’ of a ‘Company’ had acted on a bona-fide belief that the ‘Company’ will recover from its ‘Financial Set Back’ / ‘Difficulties’ / ‘Problems’, then, it will not be liable for the ‘Act’ / ‘Offence’ of ‘Fraudulent Trading’, in the considered opinion of this ‘Tribunal’.

• XXXX

• 34. At this juncture, this `Tribunal’ worth recalls and recollects the decision of the Hon’ble High Court of Kerala, in the matter of South India Paper Mills Pvt. Ltd. v. Sree Rama Vilasam Press Publications (P) Ltd., reported in (1982) 52 Comp Cas 145 (Ker.), whereby and whereunder at Paragraph 10, it is observed as under:

• “ . . . . .  A company may actually be insolvent at a given time; but its directors may bona fide hold a different view. Even in a case where they are aware of the true position, they may still think that all was not lost and that they would be able to stem the rot by further borrowings and improving the business.  . . . . .  . “

• XXXX

• # 36. No wonder, the ingredients of Section 66 (1) and 66 (2) of the Insolvency & Bankruptcy Code, 2016, operate in a different field. It must be borne in mind, that for `Fraudulent Trading’ / `Wrongful Trading’, `Relevant Facts’ / `Acceptable Materials’, are to be pleaded by a `Party’, by providing requisite `details’ / adequate `facts, to fall within the parameters of Section 66 of the I & B Code, 2016.”

• [ Link Synopsis ]

Preferential Transactions and Section 43

During the period of negative net worth, any payments or refunds made to directors, shareholders, or related parties within the “lookback” period are subject to scrutiny under Section 43 of the IBC (Preferential Transactions).

Preferential transactions are those that unfairly favor certain creditors above others just before insolvency. Courts look at:

• Whether the transaction benefits a creditor preferentially;

• Whether it relates to antecedent debts; and

• The timing within the statutory lookback period.

For example, in Anuj Jain v. Axis Bank, the Supreme Court introduced a structured test to determine preferential transfers, protecting creditors’ equal rights in insolvency resolution.

Practical Viewpoint and Recommendations

Given the legal framework:

• It is advisable to mandate that management and/or auditors initiate insolvency proceedings within 60 days of audited financials showing negative net worth and absence of fresh capital infusion.

• Directors should avoid running the company on creditor funds during incipient insolvency.

• Any payments to related parties should be closely monitored and justified to avoid allegations of preferential treatment.

Voluntary Initiation of Insolvency under Section 10

Section 10 allows the corporate debtor itself to voluntarily initiate insolvency proceedings. This proactive option:

• Grants the company protection from creditor actions through a moratorium;

• Provides breathing space to restructure and revive the business; and

• Helps directors demonstrate timely actions to mitigate liability for negligence or fraud.

The process under Section 10 is governed by strict timelines, including a 60-day window recommended for initiating proceedings after negative net worth is confirmed, will prevent misuse and ensure creditor protection.

Conclusion

Directors must act responsibly when a company shows signs of financial distress. Section 66(2)(b) enforces their duty to minimize losses and act diligently during incipient insolvency. Timely initiation of proceedings under Section 10, careful decision-making, and avoidance of preferential transactions under Section 43 are crucial tools to uphold creditor interests.

Disclaimer

This blog is intended for informational purposes only and should not be relied upon as legal advice. Readers are encouraged to consult professionals before making decisions related to insolvency matters.

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