Contesting Section 66(1) application in IBC

Contesting Section 66(1) application

1. Section 66 of the Code under which petitions are being filed by the IRP/RP/Liquidator reads as under;

• # Section 66. Fraudulent trading or wrongful trading. -

• (1) If during the corporate insolvency resolution process or a liquidation process, it is found that any business of the corporate debtor has been carried on with intent to defraud creditors of the corporate debtor or for any fraudulent purpose, the Adjudicating Authority may on the application of the resolution professional pass an order that any persons who were knowingly parties to the carrying on of the business in such manner shall be liable to make such contributions to the assets of the corporate debtor as it may deem fit.

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• Explanation. – For the purposes of this section a director or partner of the corporate debtor, as the case may be, shall be deemed to have exercised due diligence if such diligence was reasonably expected of a person carrying out the same functions as are carried out by such director or partner, as the case may be, in relation to the corporate debtor.

2. Section 66(1) has the following ingredients;

1. Business of the corporate debtor has been carried on with intent to defraud creditors of the corporate debtor. (Doctrine of “Mens Rea”)

2. business of the corporate debtor has been carried on for any fraudulent purpose

3. Any persons who were knowingly parties to the carrying on of the business in such manner shall be liable to make such contributions to the assets of the corporate debtor as it (Adjudicating Authority) may deem fit. This provision makes it imperative to assess the adverse impact of such fraudulent business on the interests of creditors, along with identification of beneficiaries of such alleged fraudulent business/trading.

4. A director or partner of the corporate debtor, as the case may be, shall be deemed to have exercised due diligence.

3. Thus an application under 66, to succeed, applicant (IRP/RP/Liquidator) has to satisfy all the ingredients under section 66. ;

1. Intention to defraud the creditors.

2. Business/Trading of the CD  has been carried out fraudulently.

3. Assessment for extent of impact of such Fraudulent Business/Trading on the interests of the creditors, subject to the challenge by the respondents. Undue benefit has to be quantified to establish that fraud has taken place. In absence of any undue benefit at the cost of creditors, the business cannot be classified as fraudulent business/trading.

4. Identification of persons who were knowingly parties to the carrying on of the business in such manner (fraudulent business).

5. Identification of beneficiaries of  such Fraudulent Business/Trading, who are required to be made respondent in the petition.

6. Rebuttal to deeming provisions of the section 66, that a director or partner of the corporate debtor has exercised due diligence. 

7. Explanation to section 66 reads as “a director or partner of the corporate debtor”  signifies that the liability of a director under section 66 is not a collective liability with other directors, necessitating filing of separate applications against individual directors. Provisions of Section 66 are devoid of the concept of “Vicarious Liability”.

4. From the provisions of section 66, it is clear that the concept of “Related party” does not find any place in provisions of section 66. Even otherwise,  transactions/dealings etc  with “Related Party” are not illegal. Only certain rights of a related party are restricted under IBC, i.e. membership of CoC, eligibility to submit resolution plan etc. On the other hand “Related Party” do have equal rights as creditor, for distribution of funds in Resolution plan or under section 53, equally with other similarly placed secured/unsecured or financial/ operational creditors respectively.

4.1. Undue benefit has to be quantified to establish that fraud has taken place. In absence of any undue benefit at the cost of creditors, & identification of beneficiaries of such undue benefits, the business cannot be classified as fraudulent business/trading.  

4.2. From the above it is very clear that the averments made in the application have to satisfy all the caveats of the  provisions of section 66. Further the applicant has to submit his report of his opinion & determination as required under the provisions of the Code & Regulations [Regulation 35A r/w 40B of Liquidation Regulations],

4.3. It is trite law that the avoidance applications will survive the dissolution of CD  or closure of liquidation process [Regulation 44A of Liquidation Regulations]. As such the avoidance applications are not covered or decided under summary proceedings..

5. Reliance can be placed on the following judgements of various courts;

1. NCLAT (06.03.2024) in Md Sadique Islam & Ors. Vs. Niraj Kumar Agarwal & Ors. [Company Appeal (AT) (Ins.) No. 1081 of 2022 & I.A. No. 3178 of 2022]

2. NCLAT (04.08.2023) In Mr. Tenny Jose & Ors. Vs. Mr. Prathap Pillai Resolution Professional of M/s. Tenny Jose Limited, [Company Appeal (AT) (CH) (INS.) No. 95 / 2023]

3. NCLAT (05.06.2023) In Renuka Devi Rangaswamy,IRP of M/s. Regen Infrastructure and Services Pvt. Ltd. Vs. Mr. Madhusudan Khemka [Company Appeal (AT) (CH) (INS.) No. 356 of 2022]

4. High Court Tripura (18.01.2023) in Smt. Sudipa Nath Vs. Union of India [WP(C) (PIL) 04 of 2023].

5. NCLAT (23.09.2022) in Regen Powertech Pvt Ltd Represented by Erstwhile RP Vs. M/s. Wind Construction Private Limited, & Ors. [Company Appeal (AT)(CH)(Ins) No.349/2022]

6. NCLT, Mumbai (29.11.2021) in Venkatesan Sankaranarayanan, the Resolution Professional for RTIL Limited v. Nitin Shambhukumar Kasliwal & Ors. (CP No. 382 / I & B / MB/2018)

7. NCLT Chennai (06.02.2019) in The Resolution Professional for M/s. Orchid Pharma Limited  Vs. M/s. Hospira Healthcare India Pvt. Ltd & Others  [MA/87/IB/2018 in CP/540/IB/2017]

8. NCLT Chennai (10.01.2019) in Mr. Ramkumar SV Vs. M/s. Serum Institute of India Limited  [MA/92/ 1B/2018 in CP/540/IB/CB/2017]

9. Supreme Court (1975.12.09) In Union Of India vs M/S.Chaturbhai M. Patel & Co.  [Civil Appeals Nos. 972- 973 of 1968]

5.1.  NCLAT (06.03.2024) in Md Sadique Islam & Ors. Vs. Niraj Kumar Agarwal & Ors. [Company Appeal (AT) (Ins.) No. 1081 of 2022 & I.A. No. 3178 of 2022] held that;

• When we look into the aforesaid paras, it is clear that the Adjudicating Authority has recorded only its conclusions and that too without considering the preferential, undervalued and fraudulent, each transaction separately and there is general observation that the transactions are undervalued transactions as well as preferential and fraudulent transactions. 

• The ingredients of preferential, undervalued and fraudulent transaction are entirely different and there has to be application of mind to the ingredients of each transaction to come to conclusion that ingredients are satisfied and the transaction falls in the said category adverting to the given pleadings in the application. 

• The Adjudicating Authority ought to have adverted to the said pleadings and returned the finding regarding the fulfilment of ingredients of each provision.

5.2. NCLAT (04.08.2023) In Mr. Tenny Jose & Ors. Vs. Mr. Prathap Pillai Resolution Professional of M/s. Tenny Jose Limited, [Company Appeal (AT) (CH) (INS.) No. 95 / 2023]

• # 40. In `Law’, a `Fraudulent Intent’, is to be `proved’, after a careful examination of all materials / evidence, as the case may be. If a `Fraudulent Intent’ or `Fraudulent Purpose’, is made out, the `Liability’, must follow. An action can also lie, when there is a `Fraudulent Purpose’, upon the `Customers’ of the `Company’. The `Burden of Proof’, is the same as in a `Civil’ case, where `Serious Allegations of Misconduct’, such as, `Fraud’ are in `issue’. In an `isolated fraud’ case, an `Individual Tort Action’ (`Civil Wrong’), will lie.

5.3. NCLAT (05.06.2023) In Renuka Devi Rangaswamy,IRP of M/s. Regen Infrastructure and Services Pvt. Ltd. Vs. Mr. Madhusudan Khemka [Company Appeal (AT) (CH) (INS.) No. 356 of 2022] held that;

• # 37. `Dishonesty’, is an essential ingredient of `Fraudulent Trading’. The `Aspect of Dishonesty’, is to be established and it cannot be inferred in any manner. Whether a `Director’, had exercised his skill, experience and general knowledge, to be expected of a person, in carrying out the `duties of his functions’, is to be determined for a `Liability’, in the considered opinion of this `Tribunal’.

• # 38. The Appellant has a `duty’, to establish to the satisfaction of this `Tribunal’, that a `person’, is knowingly carrying on the business with the `Corporate Debtor’, with an `dishonest intention’, to `defraud’, the `Creditors’. For a `Fraudulent Trading’ / `Wrongful Trading’, necessary materials are to be pleaded by a `Litigant’ / `Stakeholder’, by furnishing `Requisite Facts’, so as to come within the purview of the ingredients of Section 66 of the I & B Code, 2016. Suffice it, for this `Tribunal’, to pertinently point out that the ingredients of Section 66 (1) and 66 (2) of the I & B Code, 2016, operate in a different arena.

5.4. High Court Tripura (18.01.2023) in Smt. Sudipa Nath Vs. Union of India [WP(C) (PIL) 04 of 2023]  held that;

• However, under section 66(1) of the IBC, only an application filed by resolution professional can be entertained by NCLT.

• However, under Section 66(1) of IBC, the NCLT can pass an order holding such person liable to make contribution to the assets of the corporate debtor or it may deem fit.

• firstly It {section 66) confers no jurisdiction but declaring any transaction as void, even if fraudulent, but confers jurisdiction on NCLT to fix the liabilities on the persons responsible for conducting business of corporate debtor which is fraudulent or wrongful. 

• Secondly section 66(1) contemplates an application thereunder only by the resolution professional and by none other.  

• Thirdly section 66 (1) also restricts the power of NCLT subject to being satisfy with pre-requisite that any business of the corporate debtor has been carried on with intent to defraud creditors or the corporate debtors or for any fraudulent purpose and if satisfied it powers to pass an order is only against such person who are responsible for the conduct of such fraudulent business of the corporate debtor with mens rea to make them personally liable to make such contributions to the assets of the corporate debtor as it may deem fit.

5.5. NCLAT (2022.09.23) in Regen Powertech Pvt Ltd Represented by Erstwhile RP Vs. M/s. Wind Construction Private Limited, & Ors. [Company Appeal (AT)(CH)(Ins) No.349/2022] held that;

• # 33. Be it noted, this ‘Tribunal’, significantly, points out that, whenever ‘Fraud’ on a ‘Creditor’ is perpetrated in the course of ‘carrying on Business’, it does not necessarily follow that the ‘Business’ is being carried on with an ‘Intent to Defraud’ the ‘Creditor’. 

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• # 35. As a matter of fact, the ‘aspect’ of ‘Fraudulent Trading’ requires a very ‘High Degree of proof’, which is attached to the ‘Fraudulent Intent’. To put it emphatically, a more compelling ‘Material’ / ‘Evidence’ is required to satisfy the conscience of this ‘Tribunal’, ‘on a preponderance of probability’. Apart from that, an ‘isolated’ / ‘solo fraud’ case, against the person, then, action in ‘tort’ can be resorted to, as opined by this ‘Tribunal’. No wonder, a ‘Creditor’, who was defrauded, will have ‘recourse’ to an ‘alternative remedy’, under ‘Civil Law’.

5.6. NCLT, Mumbai (2021.11.29) in Venkatesan Sankaranarayanan, the Resolution Professional for RTIL Limited v. Nitin Shambhukumar Kasliwal & Ors. (CP No. 382 / I & B / MB/2018) held that;

• 6. ``The Bench observes that it is a fact that management of company have taken certain decision which has not worked out as intended by the management and eventually loss occurred. However, such bad commercial business decision cannot be considered to be fraudulent or wrongful trading under provisions of Section 66 of the IBC.’’

5.7. NCLT Chennai (2019.02.06) in The Resolution Professional for M/s. Orchid Pharma Limited  Vs. M/s. Hospira Healthcare India Pvt. Ltd & Others  [MA/87/IB/2018 in CP/540/IB/2017] held that;

• # 6. Before going into the factual matrix, we must make it clear that the word “fraud “coined in the section requires to reflect an element of intention to deceive another party by making a false promise without any intention to perform it or any such act or omission as the law specifically declares to be fraudulent. The elementary difference between section 66 and other avoidance transactions is, fraudulent intention to defraud the creditors has to be proved by the person asserting such allegation. Intention is the element of difference in this section. 

• # 8. But to prove that the answering Respondents 1-3 indulged in fraudulent trading or wrongful trading so as to defraud the creditor as enunciated u/s 66 of the Code, it is pertinent to note that the person filing this kind of application, with an imputation of fraud, has to give all the details disclosing how these Respondents have committed fraud in respect to the transaction impugned before this Bench, not only that, the RP has to prove that these answering Respondents committed fraud as detailed in the application. Here, in the application, it has been categorically stated that the information triggered the RP to file this application is the observation made by the forensic auditor. 

• # 15. . . . . . . .One more aspect that should not be ignored from reading of section 66 is, it is a qualified section with multiple caveats to invoke this subject matter jurisdiction, first, transaction shall be entered into with an object to defraud the creditors, second, such parties shall be in know of such intention, and to pass an order under this section, it has to be seen that director/partner of the corporate debtor is for sure aware of the fact that commencement of CIRP is inevitable and lastly, it has to be proved that such director or partner has not exercised due diligence in minimising the potential loss to the creditors of the Corporate debtor. On the top of it, in explanation to section 66 of the Code, it has been laid down that presumption lies in favour of the director/partner that he has exercised due diligence as expected from a person carrying such function, to rebut this statutory presumption, sufficient material has to be placed. One thing is evident from this section that burden is cast upon the RP to prove that fraud is committed by the director/partner, unless it is proved the presumption remains in force in favour of the director/partner. We know it is not a case goes by pleadings; it is the duty of the person asserting a fact shall prove it by showing material indicating that the business of the corporate debtor is carried out to defraud the creditors.  . . . . . . .

5.8. NCLT Chennai (10.01.2019) in Mr. Ramkumar SV Vs. M/s. Serum Institute of India Limited  [MA/92/ 1B/2018 in CP/540/IB/CB/2017] Held that;

• To say it is a preferential transaction, it has to be  tested u/s.43 of the Code, to say it is fraudulent trading, it has to be  tested u/s.66 of the Code.

• As to Section 66 is concerned, here the case is that R1 is creditor to the  Corporate Debtor company, therefore the Corporate Debtor was under  obligation to make payment to R1 herein. If at all payment has been made  other than in ordinary course of business, at the most it could be  considered as a preferential transaction but not as a fraudulent transaction  because payment was made towards the Creditor.

• Payments made to the creditors and such payments cannot be  brought under the caption of either fraudulent trading or wrongful  trading, moreover legislature normally will not provide overlapping  jurisdiction under two heads,

5.9.Supreme Court of India (1975.12.09) In Union Of India vs M/S.Chaturbhai M. Patel & Co.  [Civil Appeals Nos. 972- 973 of 1968] held that;

• It is well settled that fraud like any other charge of a criminal offence whether made in civil or criminal proceedings, must be established beyond reasonable doubt; per Lord Atkin in A. L. N. Narayanan Chettyar v. Official Assignee, High Court Rangoon.

• However suspicious may be the circumstances, however strange the coincidences, and however grave the doubts, suspicion alone can never take the place of proof.

6. Template pleadings;

1.  It is settled law that while alleging fraud, the burden of proof is on the party alleging the same. It has been laid down by the Supreme Court in the case of Union of India v. Chaturbhai M Patel & Co (Supra) that fraud must be established beyond reasonable doubt and the mere suspicion, however may be the circumstances, however strange the coincidences, and however grave the doubt, suspicion alone can never take the place of proof. It is therefore stated that the burden of proof lies on the person who alleges it and the same does not shift on the Respondents until the burden cast on the person alleging the same has discharged it.  

2. Secondly undue benefit has to be quantified to establish that fraud has taken place. In absence of any quantification of undue benefit at the cost of creditors, & identification of beneficiaries of such undue benefits, the business cannot be classified as fraudulent business/trading.  Thus, as in the instant case as there are no pleading whatsoever or material particulars submitted to establish the fraudulent business committed by the Respondents herein, the application is liable to be dismissed.

3. Thus, as in the instant case as there are no pleading whatsoever or material particulars submitted to establish the fraudulent business/trading committed by the Respondents herein. 

4. In this regard Section 66 of the Code vide explanation contained therein has set up a rebuttable presumption in favour of the erstwhile directors of the Corporate Debtor. This presumption can only be rebutted by providing adequate, material proofs and pleadings so as to establish fraudulent intent and knowledge of the fraudulent intent at the very inception of the transaction and no later. 

5. Respondent state that in the instant case, a mere perusal of the application would establish beyond an iota of doubt that no such averments mandatorily required to establish fraud under Section 66 of the Code have been made in the application under reply, for which reason alone this application deserves to be dismissed. For all of the reasons set out above, the present Petition requires to be dismissed in limine, without further enquiry.

6. The respondent is entitled to know the documentary basis on which serious allegations under section 66 are sought to be proved. If the applicant has no admissible evidence to establish the statutory ingredients of Section 66, the application should fail on its merits.

Collateral Issues;

7. RP/Liquidator is required to place evidence to satisfy all of these criterias/caveats specified under section 66. Hon’ble Adjudicating Authority (NCLT Mumbai-II) in Mr. Anuj Bajpai, RP of Tollways (Ujjain) Private Limited.  Vs. Surendra Lodha, Suspended Director & Anr.. [IA/2874/2021 In CP(IB)4106/MB/2018] held that to prove the transaction to be fraudulent in nature, the degree of proof and evidence required should be of unimpeachable nature and a transaction cannot be dubbed as fraudulent, on the basis of inadequate and tentative findings, as recorded in the forensic audit report.

• We are of the view that the Applicant/RP has placed no proof on record to satisfy the ingredients of Section 66. 

• It is settled proposition of law that to prove the transaction to be fraudulent in nature, the degree of proof and evidence required should be of unimpeachable nature and 

• A transaction cannot be dubbed as fraudulent, on the basis of inadequate and tentative findings, as recorded in the forensic audit report relied upon by the applicant. 

7.1.  Further, no report can ever form the only basis for convicting a person of an offence. The prosecution has to prove the offence, by adducing evidence. Reliance is being placed on the following;

a. High Court Madras (23.02.2021) in M.Suresh Khatri & Anr. Vs. Directorate of Enforcement Rep. by the Deputy Director GOI. [CRL.O.P.Nos.20127 & 25688 of 2018] held that;

• It is these words which amply suggest that an opinion is to be formed only after due application of mind that there is sufficient basis for proceeding against the said accused and formation of such an opinion is to be stated in the order itself. The order is liable to be set aside if no reason is given therein while coming to the conclusion that there is prima facie case against the accused, though the order need not contain detailed reasons. A fortiori, the order would be bad in law if the reason given turns out to be ex facie incorrect.

• No report can ever form the only basis for convicting a person of an offence. The prosecution has to prove the offence by adducing evidence and this opportunity has to be given to the prosecution in this case too.

8. Report of opinion & determination by RP/Liquidator. It has been observed that in majority of cases the avoidance application filed by RP/Liquidator is without the report of RP/Liquidator of his opinion & determination as required under Regulation 35A of CIRP Regulations. Provisions of the Code & Regulations do not recognize any such Transaction/ Forensic Audit Report to form the basis of avoidance application under section 66 of the Code, and in no case third party (Forensic/Transaction Auditor)  opinion, even if submitted, can substitute the mandatory report of opinion & determination by Resolution Professional/ Liquidator required under provisions of the Code & Regulations (Regulation 35A of CIRP Regulations). In absence of the said report of opinion & determination by Resolution Professional/ Liquidator, the avoidance application filed by RP/Liquidator is not maintainable. Reliance is being placed on the following;

1. NCLT Kolkata (06.05.2022) in Jitendra Lohia vs. Nikhil Chowdhury and others [I.A.(IB) No. 208/KB/2021INC.P (IB) No.204/KB/2019]

2. NCLT Kolkata (30.06.2022) in Kshitiz Chhawchharia vs. Madhumalati Merchandise Private Limited & Ors [I.A. (IB) No. 346/KB/2019 In CP(IB) No. 349 /KB/2017

8.1. CIRP Regulations

# Regulation 35A. Preferential and other transactions.

(1) On or before the seventy-fifth day of the insolvency commencement date, the resolution professional shall form an opinion whether the corporate debtor has been subjected to any transaction covered under sections 43, 45, 50 or 66.

(2) Where the resolution professional is of the opinion that the corporate debtor has been subjected to any transactions covered under sections 43, 45, 50 or 66, he shall make a determination on or before the one hundred and fifteenth day of the insolvency commencement date .

(3) Where the resolution professional makes a determination under sub-regulation (2), he shall apply to the Adjudicating Authority for appropriate relief on or before the one hundred and thirtieth day of the insolvency commencement date. 

8.2. NCLT Kolkata (06.05.2022) in Jitendra Lohia vs. Nikhil Chowdhury and others [I.A.(IB) No. 208/KB/2021INC.P (IB) No.204/KB/2019] wherein it was held;

• # 16. ``We have carefully seen the averments of the application and corresponding reply of the respondents. We have noticed that the allegations made in application do not constitute anything actionable against the respondents. It was the duty of the RP to come to conclusive determination before filing an application with the Adjudicating Authority. Simply by repeating the extracts or observations made in the forensic auditors report, the RP could not make an independent determination about the nature of transactions as required by Regulation 35A (2) of the CIRP Regulations.’’

8.3. NCLT Kolkata (30.06.2022) in Kshitiz Chhawchharia vs. Madhumalati Merchandise Private Limited & Ors [I.A. (IB) No. 346/KB/2019 In CP(IB) No. 349 /KB/2017] held that;

6.7. ``According to regulation 35A(1) of the CIRP Regulations, the Resolution Professional shall form an opinion whether the corporate debtor has been subjected to any transaction covered under sections 43, 45, 50 or 66 on or before the seventy-fifth day of the insolvency commencement date. According to the regulation 35A(2), on or before the one hundred and fifteenth day of the insolvency commencement date, the Resolution Professional is also required to make a determination to that effect.

6.8. Further, Regulation 35A(3) of the CIRP Regulations provides that upon making such determination under regulation 35A(2), the Resolution Professional shall apply to the Adjudicating Authority for the appropriate relief on or before the one hundred and thirty-fifth day of the insolvency commencement date. In this case, the one hundred and thirty fifth day is on 23 May 2018. The instant application being IA. (IBC) 346/KB/2019 has been filed on 20 March 2019, thus making it clear that the Applicant has not complied with the provisions of regulation 35A within the timeline provided therein.

6.9.  . ., we do not see any “determination” within the meaning of regulation 35A of the CIRP Regulations. Therefore, we will not act as court of first instance to determine the nature of the transactions mentioned hereinabove.

6.1 In light of the above facts and circumstances, the adjudicating Authority is satisfied that the instant application is not maintainable and the same is therefore rejected. “

9. Checklist to determine whether the applicant (RP/Liquidator) has complied with the parameters/caveats laid down under the provisions of the Code & Regulations.

S. No.	Parameter / Caveat	Yes/No
	Whether the applicant (RP/Liquidator) has submitted the report of his opinion & determination of Fraudulent Business. [Regulation 35A of CIRP Regulations].
	Whether the applicant (RP/Liquidator) has submitted the avoidance application (Section 66) within limitation as per the timeline provided under Regulations. [Regulation 35A of CIRP Regulations]
	Whether the applicant (RP/Liquidator) has filed separate applications against individual directors of the CD, as Code does not provide for collective or vicarious liability. (Explanation to section 66 of the Code - “For the purposes of this section a director or partner” ………)
	Whether the applicant (RP/Liquidator) has established the intentions of the respondents to defraud the creditors. [Section 66(1)]
	Whether the applicant (RP/Liquidator) has established that Business/Trading of the CD  has been carried out fraudulently. [Section 66(1)]
6.	Whether persons who were knowingly parties to the carrying on of the business in such manner (fraudulent business) have been identified
7.	Whether the applicant (RP/Liquidator) has submitted the evidence of fraudulent business and have satisfied the burden of proof. Law laid down by the Hon’ble Supreme Court in Union Of India vs M/S.Chaturbhai M. Patel & Co. (supra)
8.	Whether the applicant (RP/Liquidator) has assessed the  extent of impact of such Fraudulent Business/Trading on the interests of the creditors. [Section 66(1)]
9.	Whether the applicant (RP/Liquidator) has identified the beneficiaries of such Fraudulent Business/Trading done by the CD. [Section 66(1)]
10.	Whether the applicant (RP/Liquidator) has  submitted Rebuttal to deeming provisions of the section 66, that a director or partner of the corporate debtor has exercised due diligence. (Explanation to section 66 of the Code)

For avoidance application under section 66 to succeed, all the checkboxes are to be answered in affirmative. 

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.

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Claims of a Creditor during Insolvency of Corporate Guarantor

Claims of a Creditor during Insolvency of Corporate Guarantor

Query: A Corporate Guarantor (CD) to a credit facility goes into CIRP. During its CIRP the Principal Debtor defaults and now the creditor wants to go after the Corporate Guarantor/CD. In the background of Ghanshyam Mishra and Sons Private Limited’ Vs. ‘Edelweiss Asset Reconstruction Company Limited’, (2021) 9 SCC 657, two questions arise: 

1. Can the creditor invoke a guarantee as against a CD/CG which is under CIRP (i.e) covered by a moratorium? 

2. Can a claim be accepted by the RP of CD/CG without invocation of the  guarantee?

The questions have to be answered ensuring that the creditor is not left remedy-less.

The above questions have many dimensions.

a.	Whether insolvency of Principal Debtor can be initiated only after recall of the loan or it can be initiated on the basis of debt & default only.	Insolvency can be initiated on the basis of debt & default, with or without recall of the Loan.
b.	Whether insolvency of Corporate Guarantor can be initiated without invoking the Corporate guarantee, i.e. on the basis of debt & default of the principal borrower.	Depends upon the terms of guarantee, whether the invocation has been waived in the guarantee contract or not. Guarantor’s liability is co-extensive with that of borrower (Section 128 in The Indian Contract Act, 1872}
c.	Impact of recalling the Loan	Entire amount of the loan becomes due, instead of  overdue repayment instalment.
d.	Whether guarantee can be invoked prior to the recalling of the loan of Principal Debtor. Prior to the recall of the Loan only  instalments due as per the contract can be proceeded against.	Guarantee can be invoked only for the sum which is legally due and recoverable from the principal debtor.
	Supreme Court of India (10.04.2006) in Syndicate Bank vs Channaveerappa Beleri & Ors. [Appeal (civil) 6894 of 1997] held that; # 14. We have to, however, enter a caveat here. When the demand is made by the creditor on the guarantor, under a guarantee which requires a demand, as a condition precedent for the liability of the guarantor, such demand should be for payment of a sum which is legally due and recoverable from the principal debtor. If the debt had already become time-barred against the principal debtor, the question of creditor demanding payment thereafter, for the first time, against the guarantor would not arise.
e.	Whether invocation of the guarantee is necessary before a creditor can file a claim under the guarantee irrespective of the nature/terms of the guarantee/contract.	No - Section 5(8)(i) read with section 3(6)(b)
f.	Can the creditor invoke a guarantee as against a CD/CG which is under CIRP (i.e) covered by a moratorium?	Invocation of a guarantee is a unilateral action & is meaning less during moratorium. Evan after invocation creditor can not proceed against CD/CG during moratorium.

Provisions of Statutes 

Co-existence of liability of borrower & guarantor

Section 128 in The Indian Contract Act, 1872

# 128. Surety’s liability.—The liability of the surety is co- extensive with that of the principal debtor, unless it is otherwise provided by the contract.

Illustration

A guarantees to B the payment of a bill of exchange by C, the acceptor. The bill is dishonoured by C. A is liable, not only for the amount of the bill, but also for any interest and charges which may have become due on it.

Insolvency & Bankruptcy Code, 2016

 # 3(6) “claim” means –

• (a) a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured, or unsecured;

• (b) right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to a right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured;

# 3(11) “debt” means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt;

# 3(12) “default” means non-payment of debt when whole or any part or instalment of the amount of debt has become due and payable and is not 1[paid] by the debtor or the corporate debtor, as the case may be;

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Case Law;

1). NCLAT (26.04.2023) In Archana Deepak Wani Vs. Indian Bank.[Company Appeal (AT) (Insolvency) No.301 of 2023] held that;

• The liability of the guarantor being coextensive with the principal borrower under Section 128 of the Contract Act, it triggers the moment principal borrower commits default in paying the acknowledged debt. This is a legal fiction. Such liability of the guarantor would flow from the guarantee deed and memorandum of mortgage, unless it expressly provides to the contrary.

• A guarantor’s liability depends on terms of his contract. There can be default by the Principal Borrower and the Guarantor on the same date or date of default for both may be different depending on the terms of contract of guarantee.

• It is well settled that the loan agreement with the Principal Borrower and the Bank as well as Deed of Guarantee between the Bank and the Guarantor are two different transactions and the Guarantor’s liability has to be read from the Deed of Guarantee.

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2). NCLAT (12.07.2022) in IDBI Trusteeship Services Limited Vs. Mr. Abhinav Mukherji & Ors.  [Company Appeal (AT) (Insolvency) No. 356 & 358 of 2022] held that;

• # 26. It is pertinent to mention that the aforenoted Judgement ‘Axis Bank Limited’ (Supra) relied heavily upon by the Appellants has been overruled by this Tribunal in the subsequent decision in the case of ‘Edelweiss Asset Reconstruction Company Limited’ Vs. ‘Orissa Manganese and Minerals Ltd.’, 2019 SCC OnLine NCLAT 764. Even ‘Andhra Bank Vs. M/s. F.M. Hammerle Textiles Ltd.’, (Supra) is not applicable in view of the subsequent decision. The Hon’ble Supreme Court in ‘Ghanashyam Mishra and Sons Private Limited’ Vs. ‘Edelweiss Asset Reconstruction Company Limited’, (2021) 9 SCC 657, (Supra), has addressed to this issue. It is pertinent to reproduce the relevant paras with respect to invocation of Corporate Guarantee as hereunder:

• “102. NCLT found that by email dated 6-1-2018 EARC had submitted its claim in Form “C’ for an amount of Rs 648,89,62,395. In response to the said email, RP sought a clarification as to whether the corporate guarantee had been invoked by the applicant. RP had not received any response till 21-2-2018 from EARC. Despite repeated requests made by RP, EARC did not respond to the query made by RP. From the record placed before NCLT, it was clear that EARC had not invoked the corporate guarantee. NCLT therefore posed a question to itself, as to whether an uninvoked corporate guarantee could be considered as matured claim of the applicant. NCLT found that once the moratorium was applied under Section 14 of the I&B Code, EARC was prevented from invoking the corporate guarantee. NCLT further found that the OMML’s guarantee had not been invoked by EARC till the date of completion of CIRP process and once the moratorium was imposed, it could not invoke the corporate guarantee. NCLT therefore found that there is no illegality or irregularity in not admitting the claim of EARC.

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• 119. It is to be noted that in the appeal before NCLAT, EXIM Bank as well as Axis Bank had taken steps immediately after the claim of the said Banks on the basis of corporate guarantee came to be rejected by RP/CoC. After rejection of the claim, the said Banks had filed an application under Section 60(5) before NCLT. On NCLT rejecting the said claim, those Banks had approached NCLAT in appeals which were allowed and the order, as stated hereinabove, was passed.

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• 125. We are therefore of the considered view that the appeal deserves to be allowed by expunging paragraphs 28, 42, 43, 51 and 52 from the judgement of NCLAT dated 23-4-2019. It is ordered accordingly. The judgement and order passed by NCLT dated 22-6-2018 is upheld. No costs.”       (Emphasis Supplied)

• # 27. It is seen from the aforenoted Judgement that an uninvoked Corporate Guarantee cannot be considered as a ‘Matured Claim’. In para 133 of the aforenoted Judgement the Hon’ble Supreme Court has upheld the finding of the Adjudicating Authority that once the moratorium was applied under Section 14 of the Code, a Corporate Guarantee cannot be invoked. Though this is a case where the Resolution Plan has been approved, the fact remains that the Principle that a Corporate Guarantee cannot be invoked once the CIRP has commenced and that an uninvoked Corporate Guarantee as on date of filing of the Claim, cannot be considered as ‘Matured Claim’ has been laid down by the Hon’ble Supreme Court.

Blogger’s comments; The main thrust in IDBI Trusteeship Services (supra) is about the maturity of claim in respect of guarantee which has not been invoked. As per the definition provided in the Code “debt” is a claim which is due (i.e. is matured). One has to distinguish between the Debt for which insolvency can be initiated in case of default, whereas the claim represents right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured; [Section 3(6)] 

The Hon’ble Supreme Court in ‘Ghanashyam Mishra and Sons Private Limited’ Vs. ‘Edelweiss Asset Reconstruction Company Limited’, (2021) 9 SCC 657, (Supra), has upheld the orders of NCLT as EARC filed application after the approval of the resolution plan & claim of EARC if admitted the voting percentage would not have altered the outcome of decision of CoC for approval of the resolution plan.

The purpose of collation of claims during insolvency is to assess the total liabilities of the CD for resolution of the insolvency. 

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3). NCLAT (24.11.2020) in “State Bank of India Vs. Athena Energy Ventures Pvt. Ltd." [(2020) SCC online NCLAT 774] held that,

• # 13. . . . . . . . . .If the above provisions of Section 60 (2) and (3) are kept in view, it can be said that IBC has no aversion to simultaneously proceeding against the Corporate Debtor and Corporate Guarantor. If two Applications can be filed, for the same amount against Principal Borrower and Guarantor keeping in view the above provisions, the Applications can also be maintained. It is for such reason that Sub-Section (3) of Section 60 provides that if insolvency resolution process or liquidation or bankruptcy proceedings of a Corporate Guarantor or Personal Guarantor as the case may be of the Corporate Debtor is pending in any Court or Tribunal, it shall stand transferred to the Adjudicating Authority dealing with insolvency resolution process or liquidation proceeding of such Corporate Debtor. Apparently and for obvious reasons, the law requires that both the proceedings should be before same Adjudicating Authority.” . . . . . . . .

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4). NCLAT (14.08.2018) In Export Import Bank of India and Ors. vs. Resolution Professional JEKPL Private Limited and Ors. [Company Appeal (AT) (Insolvency) No. 304 of 2017,],

• # 54. Therefore, stand taken by the respondents that the claim has not been matured cannot be ground to reject the claim.

• # 55. Section 25 provides the duties of Resolution Professional. As per Section 25(2)(e), the Resolution Professional is required to maintai  updated list of all the claims. Aforesaid fact also suggests that the maturity of a claim or default of debt are not the guiding factors to be noticed for collating or updating the claims. The matter can be looked from another angle. It is only in case of ‘debt’ and ‘default’, a ‘Financial Creditor’ or ‘Operational Creditor’, may file applications under Section 7 or 9. The ‘Corporate Applicant’ has also right to file application under Section 10 for initiation of Corporate Insolvency Resolution Process against itself, if it has defaulted to pay the ‘debt’. It does not mean that the persons whose debt has not been matured cannot file claim. The ‘Financial Creditors’ or ‘Operational Creditors’ or ‘secured or unsecured creditors’ all are entitled to file claim.

• # 56. Therefore, we hold that maturity of claim or default of claim or invocation of guarantee for claiming the amount has no nexus with filing of claim pursuant to public announcement made under Section 13(1)(b) r/w Section 15(1)(c) or for collating the claim under Section 18(1)(b) or for updating claim under Section 25(2)(e). For the purpose of collating information relating to assets, finances and operations of Corporate Debtor or financial position of the Corporate Debtor, including the liabilities as on the date of initiation of the Resolution Process as per Section 18(1), it is the duty of the Resolution Professional to collate all the claims and to verify the same from the records of assets and liabilities maintained by the Corporate Debtor.

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5). NCLAT (13.07.2018) in Andhra Bank vs. M/s. F. M. Hammerle Textile Ltd. [Company Appeal (AT) (Insolvency) No. 61 of 2018] held that;

• # 9. It is not necessary that all the claims as are submitted by the Creditor should be a claim matured on the date of initiation of Resolution Process/admission, even in respect of debt, which is due in future on its maturity, the ‘Financial Creditor’ or ‘Operational Creditor’ or ‘Secured Creditor’ or ‘Unsecured Creditor’ can file such claim. Therefore, the definition of ‘Claim’ as defined under Section 3(6) is to be read along with Section 13 read with Section 15 of the ‘I&B Code’.

• # 11. For example, if there is a default, a ‘Financial Creditor’ or ‘Operational Creditor’ may file application under Sections 7 or 9 for initiation of ‘Corporate Insolvency Resolution Process’. Once it is initiated, order of ‘Moratorium’ is passed and the advertisement is issued all claimants whether his claim is matured or not are supposed to file claim before the ‘Resolution Professional’. The ‘Resolution Professional’ cannot reject one or other claim on the ground that only the person whose claim has been matured can be looked into and other claim not matured cannot be entertained.

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6). Supreme Court of India (10.04.2006) in Syndicate Bank vs Channaveerappa Beleri & Ors. [Appeal (civil) 6894 of 1997] held that;

• # 9. A guarantor's liability depends upon the terms of his contract. A 'continuing guarantee' is different from an ordinary guarantee. There is also a difference between a guarantee which stipulates that the guarantor is liable to pay only on a demand by the creditor, and a guarantee which does not contain such a condition. Further, depending on the terms of guarantee, the liability of a guarantor may be limited to a particular sum, instead of the liability being to the same extent as that of the principal debtor. The liability to pay may arise, on the principal debtor and guarantor, at the same time or at different points of time. A claim may be even time-barred against the principal debtor, but still enforceable against the guarantor. The parties may agree that the liability of a guarantor shall arise at a later point of time than that of the principal debtor. We have referred to these aspects only to underline the fact that the extent of liability under a guarantee as also the question as to when the liability of a guarantor will arise, would depend purely on the terms of the contract.

• # 13. What then is the meaning of the said words used in the guarantee bonds in question? The guarantee bond states that the guarantors agree to pay and satisfy the Bank 'on demand'. It specifically provides that the liability to pay interest would arise upon the guarantor only from the date of demand by the Bank for payment. It also provides that the guarantee shall be a continuing guarantee for payment of the ultimate balance to become due to the Bank by the borrower. The terms of guarantee, thus, make it clear that the liability to pay would arise on the guarantors only when a demand is made. Article 55 provides that the time will begin to run when the contract is 'broken'. Even if Article 113 is to be applied, the time begins to run only when the right to sue accrues. In this case, the contract was broken and the right to sue accrued only when a demand for payment was made by the Bank and it was refused by the guarantors. When a demand is made requiring payment within a stipulated period, say 15 days, the breach occurs or right to sue accrues, if payment is not made or is refused within 15 days. If while making the demand for payment, no period is stipulated within which the payment should be made, the breach occurs or right to sue accrues, when the demand is served on the guarantor.

• # 14. We have to, however, enter a caveat here. When the demand is made by the creditor on the guarantor, under a guarantee which requires a demand, as a condition precedent for the liability of the guarantor, such demand should be for payment of a sum which is legally due and recoverable from the principal debtor. If the debt had already become time-barred against the principal debtor, the question of creditor demanding payment thereafter, for the first time, against the guarantor would not arise. When the demand is made against the guarantor, if the claim is a live claim (that is, a claim which is not barred) against the principal debtor, limitation in respect of the guarantor will run from the date of such demand and refusal/non compliance. Where guarantor becomes liable in pursuance of a demand validly made in time, the creditor can sue the guarantor within three years, even if the claim against the principal debtor gets subsequently time-barred. To clarify the above, the following illustration may be useful :

• Let us say that a creditor makes some advances to a borrower between 10.4.1991 and 1.6.1991 and the repayment thereof is guaranteed by the guarantor undertaking to pay on demand by the creditor, under a continuing guarantee dated 1.4.1991. Let us further say a demand is made by the creditor against the guarantor for payment on 1.3.1993. Though the limitation against the principal debtor may expire on 1.6.1994, as the demand was made on 1.3.1993 when the claim was 'live' against the principal debtor, the limitation as against the guarantor would be 3 years from 1.3.1993. On the other hand, if the creditor does not make a demand at all against the guarantor till 1.6.1994 when the claims against the principal debtor get time-barred, any demand against the guarantor made thereafter say on 15.9.1994 would not be valid or enforceable.

• Be that as it may.

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.

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Interplay of Section 66(2)(b) with section 10 & 43

Interplay of Section 66(2)(b) with section 10 & section 43

# 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.

 

The fact that CD’s net worth has turned negative, should put directors or partners, as the case may be, on notice of the reasonable prospect of the incipient insolvency of the company. Thus the duty is imposed on the management of the CD under section 66(2)(b) to initiate insolvency proceedings under section 10 to minimize the losses to the creditors. Directors or partners, as the case may be, can be asked to contribute towards the assets of the CD, an amount equal to the losses of the CD after the net worth of the CD turned negative. 

 

Whenever the net worth of the CD turns negative, directors or partners, as the case may be, should take a conscious decision, preferably through board resolution/AGM to either file for insolvency proceedings under section 10 or to continue to run the business of CD on profitable prospects. 

 

In my view, it should be made incumbent on the management/auditors to file for insolvency resolution within 60 days, when the net worth of the company turns negative in the audited financials, and the management has not taken any steps to infuse fresh capital. Management should not be allowed to run the company on funds of creditors.

 

Corollary of incipient insolvency

During the period of negative net worth of the CD, any payments/refund of deposits & loan etc. to directors or partners, as the case may be, and shareholders & related parties, should be treated as preferential transactions. Accordingly, “Look back” period for preferential transactions under section 43, is required to be redefined to start from the date the net-worth of the company turns negative.

 

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.

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