Corporate Insolvency- Extension of Liability on Directors and Parent Company

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Introduction

Corporate insolvency
and bankruptcy has been the subject matter of various legislations in India, some
of which are the Companies Act 2013/1956, SARFAESI Act 2002 and Sick Industrial
Companies Act 1985. However, these legislations failed to comprehensively address
the issues surrounding the insolvency process specifically amongst others the time
taken to resolve insolvency, investor confidence and the situation of
non-performing assets.  The implementation
of the Insolvency and Bankruptcy Code 2016 (“IBC 2016”) is a significant reform which provides for a robust
framework and time-bound road map to deal with distressed or failed businesses;
a welcome contrast from the previous, seemingly never-ending process.

While for the layman
the words insolvency and bankruptcy may be interchangeable, these stand as two
different financial conditions in the legal world. Insolvency can be mere short
term inability of the company to meet its liabilities during the course of
their business whereas bankruptcy takes place when the courts get involved to
determine insolvency and gives an order to resolve the same. IBC 2016provides a very clear distinction
between both the processes. A corporate entity faces insolvency on account of cash
flow insolvency or balance sheet insolvency. In case of cash flow insolvency the
company is unable to pay debt as it falls due and in balance sheet insolvency
the total liability exceeds its realisable assets.

IBC 2016 prescribes new
approach towards insolvency which helps in early determination of insolvency by
moving from erosion of net worth to payment defaults. Thus, default of payment
of more than INR 1 Lakh can invoke the insolvency process against the debtor
under IBC 2016. Further, IBC 2016 seeks to reorganise corporations within the
prescribed timeframe, failing which the entity shall be liquidated and wound
up. During the insolvency resolution process there may arise circumstances pointing
towards dubious transactions conducted by the corporate debtor which may seem
to contribute towards its own insolvency

IBC 2016 vests power in
the resolution professional to question such transactions of the corporate
debtor and inform the NCLT accordingly. Further, NCLT has the power to
scrutinize the questioned transaction and extend liabilities as arising from
such transaction on any person so involved. This article focuses only on the
extension of liability on directors and parent company, therefore only such
statutory provisions have been analysed.

Statutory Extension of Liability

IBC 2016 ensures to safeguard the interest of the creditors and in
doing so it extends the liability to the persons involved in transactions
leading otherwise. IBC 2016 extends the liability on two kinds of transactions
namely, preferential transactions undertaken before the commencement of
insolvency but during the twilight period and fraudulent or wrongful trading
carried out during the corporate insolvency resolution process.

General extension of liability

As per Section 48 read with Section 45 and Section 46, if the
liquidator or resolution professional on an examination of a preferential
transaction of the corporate debtor held during the twilight period determines
that such transaction was undervalued, in that case it shall inform the
adjudicating authority. Adjudicating authority in case of such applications
shall make an order to declare the transaction void and reverse the effect of
such transactions.

Twilight period as detailed out in Section 46 shall mean such
transaction made with any related party within two years and with any other
person within one year preceding the insolvency commencement date. Section
5(24) of the IBC Code 2016 provides for broad and extensive definition of
related party which includes the director of the corporate debtor and a body
corporate which is a holding company of the corporate debtor.

As per section 48(1)(c), the adjudicating authority may direct any
person to pay such sums, in respect of benefits received by such person, to the
liquidator or the resolution professional as the case may be. Thereby, it is
evident that the order of the adjudicating authority is aimed at reversing the
effect of the undervalued transaction and requiring the person who benefits
from such transaction to pay back any gains made as a result of such
transaction. Section 48(1)(c) uses the word “such person” wherein there seems
no distinction between natural and legal person. Therefore, both directors and
parent company can be brought in the ambit of the order passed under this
section in case it is established that either of them have made benefits from
such preferential transaction.

In the case of Tristar
Consultants vs. M/s. VCustomer Services India Pvt. Ltd. & Anr.[1]
the Delhi High Court has clearly held
that directors are agents of the company to the extent they have been
authorized to perform certain acts on behalf of the company. They owe no
fiduciary or contractual duties or any duty of care to third parties who deal
with the company and liability would arise only if they derive any personal
benefit while purporting to act on behalf of the company. Therefore, the
judiciary has accepted the extension of liability as a general norm in cases
where the directors obtain personal gain/benefit from any transactions while acting
on behalf of the company.

Section 66 deals with the second transaction under scrutiny by this
Code i.e. fraudulent or wrongful trading during the corporate insolvency
resolution process. As per section 66(1), if during the corporate insolvency
resolution process or liquidation process, it is found that any business of the
corporate debtor was carried out with the intention of defrauding creditors or
for any fraudulent purpose then, the resolution professional shall make an
application to the adjudicating authority informing the fraudulent transaction.
Adjudicating authority upon receiving such application may pass an order that
any person 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 debtors as it may deem fit. Section 66(1) extends liability on “any
person” who were knowingly party to such transaction, thereby bringing both
directors and parent company under its ambit if it is proved before the
adjudicating authority that either of them were knowingly party to such
fraudulent/wrongful transaction. In case the same is proved, they may be called
upon to make “such contribution” as the adjudicating authority deems fit. The
word “such contribution” has been left to the discretion of the adjudicating
authority thereby not limiting the liability in any manner.

Specific extension of liability

Section 66 (2) unlike Section 48 and 66(1), specifies the extension of
liability to the directors. As per Section 66(2) the adjudicating authority may
pass an order directing the director of the corporate debtor as the case may be
to be liable for making such contributions to the assets of the corporate
debtor as it may deem fit. Such extension of liability is subject to the fact
that the director knew or ought to have known that there was no reasonable
prospect of avoiding commencement of insolvency process and they failed to
exercise due diligence in minimising the potential loss to the creditors. For
the purpose of Section 66 (2), general presumption is in favour of the director
i.e. it is presumed that they have exercised the due diligence as is reasonably
expected out of a person carrying out the same function as are carried out by
such director.

In the case of LIC vs. Escort Limited and Ors[2]
the Supreme Court held that the corporate veil may be lifted where a
statute itself contemplates it or in case of prevention of fraud or improper
conduct. As the provisions of IBC 2016 clearly contemplates the extension of
liability on its director and parent company, therefore the intention of the
legislation would remain unfulfilled if the same is not accompanied with the
power to pierce the corporate veil as and when such case arises.

Further, in the case of IDBI Bank Limited vs. Jaypee Infratech Limited[3]
a petition was filed to declare the transaction entered into by promoters and
directors of corporate debtor creating mortgage of property as illegal. It is
pertinent to mention that when the account of the corporate debtor was declared
as NPA, the directors of the corporate debtor, in utter disregard to their
fiduciary duties and duty of care to the creditors of the corporate debtor,
mortgaged 858 acres of unencumbered land owned by the Corporate Debtor to
secure the debt of the related party i.e. Jaiprakash Associates Ltd (parent
company). The value of the land mortgaged by the corporate debtor was estimated
to be in the range of 5000 to 6000 crores approximately, as per the valuation
report prepared at the time of mortgage of the said land. The mortgage of land
was created without any counter guarantee from a related party. The mortgage of
land is in nature of asset stripping and entered into with the intent to
defraud the creditors of the corporate debtor.[4]
The impugned transactions, was declared as fraudulent, preferential and
undervalued transactions as defined under section 66, 43 and 45 of IBC 2016 as
it was carried on during the period of two year preceding the commencement of
insolvency. Therefore, the Tribunal passed the order for release and discharge
of the security interest created by the corporate debtor in favour of lenders
of the parent company and the properties mortgaged by way of preferential and
undervalued transactions were made to be deemed to be vested in the corporate debtor.

Therefore, the Allahabad National Company Law Tribunal may not have
extended the liability to the directors under Section 48 and 66 however, the
intention to reverse the transaction was definitely fulfilled. It is pertinent
to note that an assumption that the Tribunal may never extend liability to the
directors and parent company shall be an early miscalculation especially when IBC
2016 itself provides such an exclusive right to the Tribunal.

Restriction on extension of liability

It is important to understand whether liabilities extended under
Section 48 and 66 are unlimited and whether the extension of the same can be
avoided by directors and parent company.

The liabilities extended under Section 48 and 66 are made with an
intention to reverse the position of the corporate debtor as it would have
stood had the transaction not taken place. Therefore, it can be safely assumed
that the extension of liability shall be limited to the amount of such reversal
of transaction and not more.

For the purpose of Section 48, in order to avoid the extension of
liability one may have to prove that there were no benefits received by them as
a result of such undervalued transaction. In case of absence of any benefit,
the adjudicating authority cannot pass an order for payment of any amount for
such benefits incurred.

For the purpose of section 66, it is important for the person to prove
the absence of intention of defrauding the creditors or any such similar
fraudulent intentions in relation to such transaction. Further, while the
general presumption under 66(2) is in favour of the directors, in case the same
becomes questionable, the director needs to ensure to evidence the reasonable
due diligence exercised by them in minimising the potential loss and the lack
of foreseeability on the commencement of corporate insolvency.

Conclusion

We observe that IBC 2016 has provided for a crystal clear extension ofliability on the directors and parent company of the corporate debtor as andwhen a transaction involving them is brought under question. Such an extensionof liability can be made to the extent of reversing the transaction or makingreasonable contribution to the assets of the corporate debtor to ensuresafeguarding of the creditor’s interest. However, same can be avoided if thetwilight period is kept in mind and reasonable due diligence is undertaken withlack of fraudulent intention. While there exists no precedent under IBC 2016extending personal liability on directors or parent company till date, it wouldnot be farfetched to see a judgement on these lines in the near future, giventhat the cases of Jaypee infrastructure and Religare are still awaiting averdict.   

By – Sindhuja Kashyap and Mohana Roy, Corporate Associates

[1] MANU/DE/7339/2007

[2] MANU/SC/0138/1966

[3] MANU/NC/5257/2018

[4] id

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