Fraudulent Initiation of Insolvency Proceedings

[Richa Saraf is a Legal Advisor at Vinod Kothari & Co.]

Section 65 was incorporated in the Insolvency and Bankruptcy Code, 2016 (the “Code”) so that the provisions thereof cannot be misused by any person who has initiated the insolvency resolution process or liquidation proceedings with a fraudulent or malicious intent, and for any purpose other than for the resolution of insolvency or liquidation, as the case may be. This post will be particularly focusing on the effect of this provision on persons who have fraudulently or maliciously initiated insolvency proceedings. It will also be relying on a recent case law, wherein the National Company Law Tribunal (“NCLT”) has advanced a broad and sweeping interpretation in consonance with the spirit of law.

In Shobhnath v. Prism Industrial Complex Ltd., the NCLT Allahabad (in an order dated 5 July 2018) discussed a very pertinent question: whether an insolvency petition can be entertained in a case where financial fraud exists. The petitioner, being a financial creditor, contended that the petition is complete in all aspects, and in conformity with section 7 of the Code. There was existence of a debt duly acknowledged by the corporate debtor, and subsistence of default duly fulfilling the conditions laid down under sections 3(11) and 3(12). In addition, the financial creditor filed an affidavit stating that the proceedings will be in the interest of the stakeholders (debenture holders/ depositors, in the instant case) and the corporate debtor. A similar affidavit was also filed by the corporate debtor stating that the insolvency proceedings will be in the best of interests of the corporate debtor as well as its stakeholders, as the claims of various classes of creditors can only be satiated by disposing the assets of the corporate debtor. However, considering the adverse market position, the value derived from the asset may not be sufficient to repay all the debts.

Consideration of the Issues Involved

While examining the matter, the considered several aspects:

(a) Report of Amicus Curiae: The Bench relied on the report of the Amicus Curiae appointed in another matter (against the same corporate debtor) and considered the possibility of diversion of funds to group companies and/ or directors and/ or associates, and also raised suspicion that all the properties and assets of the corporate debtor might have been sold or disposed of illegally.

(b) Perusal of financial statements of the corporate debtor:The NCLT relied on the balance sheet of the corporate debtor for determination of several issues:

(i) The recent updated balance sheet of the corporate debtor was not available; hence, it was difficult to ascertain the current state of affairs of the corporate debtor and its properties.

(ii) On perusal of the last available balance sheet, it was observed that land is the sole tangible asset of the corporate debtor, which was highly inadequate to quench all the claims.

(iii) The fact that there was no information available about the area, location or market value of the land was taken on record.

(iv) Odds of diversion/ siphoning of funds: It was also evident from the study of the balance sheet that, having raised money from numerous investors, the promoters and directors have siphoned the funds out into various affiliated companies.

(c) In the instant case, the interests of a large number of retail investors was involved; however, none of these retail investors could be intending to be benevolent to consider a resolution or revival of the corporate debtor.

(d) The after- effects of admission of petition: The consequential impact of commencement of insolvency proceedings was analysed:

(i) Initiation of moratorium: This means the creditors will not be able to take legal action against the corporate debtor.

(ii) Constitution of committee of creditors and the system of voting on the basis of majority in value: The NCLT could not rule out the probability that the corporate debtor might have created creditors with high value, who may care least for the interest of retail investors, from whom money has been raised, and hence, the so- called resolution plan may harm the interest of such investors.

The intent of the corporate debtor was regarded as suspicious, mala fide and intended to divert the attention of the NCLT from the main issue and to prolong the proceedings. The NCLT further went on to state that on perusal of the report of the Amicus Curiae, it appears that the corporate debtor has committed a financial fraud.

The enactment of insolvency resolution process under the Code is a step towards resolution or rectification of an insolvency, wherein a company is under financial distress and the creditors are proposing to collectively bail the company out. The intent of insolvency proceedings cannot be to interfere in cases where there are financial irregularities, illegalities or indication of a financial fraud. Considering the object for which the Code was formulated, public interest involved, and for meeting ends of justice, it was held that the petition cannot be admitted only on the ground that the corporate debtor has not opposed the petition.

The NCLT regarded that while section 65 only stipulates punishment for fraudulent and malicious initiation of insolvency proceedings, the intent is very clear that while a petition is filed under the Code fraudulently with malicious initiation of insolvency proceedings, then in that case, the petition should not be admitted. Thus, the petition was dismissed and a show cause notice was issued under section 65 of the Code against the financial creditor as well as the corporate debtor.


There may be several instances where the application is filed at the behest of the corporate debtor itself, or the applicant is a mere puppet in the hands of the corporate debtor. The adjudicating authority in such cases should place the matter under strict scrutiny and declare that the parties are acting hand-in-glove.

Suppose the corporate debtor has availed funding from its related party and paid the dues of the workmen and secured financial creditors, who are to get priority during liquidation (or during resolution for that matter), and has instead created another class of secured financial creditors, replacing all the other secured financial creditors. In such a situation, the operational creditors and the unsecured financial creditors may not be paid. However, it might so happen that due to some unavoidable circumstances, the very new category of secured creditors, who are also related party to the corporate debtor, initiate insolvency proceedings against the corporate debtor. The intent may be for resolution of the corporate debtor, however, there will only be either of the two consequences:

(a) a resolution plan be submitted as regards the corporate debtor: in such a case, operational creditors and dissenting unsecured financial creditors will be obtaining only liquidation value, which is equivalent to nil in most cases; or 

(b) the corporate debtor goes into liquidation: again, the operational creditors and unsecured financial creditors will not be able to recover anything, since the liquidation estate might not be sufficient and there might not be anything left for the unsecured financial creditors and the operational creditors, after discharge of liabilities towards the secured creditors.

Can the above scenario be consider to be round- tripping of funds? Consider another situation, where the loan agreement itself states that the corporate debtor is in distress, and the loan is needed for making urgent payments required to be made by the corporate debtor. Considering that the corporate debtor was admittedly in financial distress, such a lending, and that too by way of an unsecured loan, would not be intuitively expected from an arms-length lender. Therefore, there is a natural reason to explore whether there existed a relationship between such lender and the corporate debtor, more so if the amount is payable on demand and there is no tenure for claiming back the amount. Now, if such a distress lender seeks repayment by way of a demand notice within few months of granting of such loan, and thereafter on non- payment within stipulated time, initiates insolvency proceedings under Section 7 of the Code, whether such an application can be considered to be one in good faith or whether the case will be considered to be a fit case for fraudulent initiation of insolvency proceedings according to section 65 of the Code is an open question.

Even if the applicant is able to demonstrate that the application complies with all the requirements of law, and regardless of whether the corporate debtor has acknowledged the debt and is not resisting the insolvency proceedings, the adjudicating authority, before admitting any such application, should examine the prima facie facts and material available on record. Whether the loan amount was transferred via proper banking channels or was the debt only a balance sheet entry, with no nexus to actual lending, is another point, which should be considered while framing a decision.

Richa Saraf

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