[Akhil Kumar is a fifth year BA LLB (Hons.) student and Ayushi Singh a fourth year BA LLB (Hons.) student, both at NUALS, Kochi]
The Ministry of Corporate Affairs has been considering the introduction of a pre-packaged insolvency process to the Insolvency and Bankruptcy Code, 2016 and has invited comments from stakeholders. The proposal is in line with the objectives of the code to ensure resolution of corporate debtors in a time bound manner and liquidation being an option of the last resort. In this post, the authors seek to highlight some of the drawbacks associated with pre-packaged insolvency process and provide suggestions to tackle the same for its effective implementation in India.
Introduction
The purpose of a pre-pack is to strike a balance between safeguarding the interests of the creditors and maintaining the business and assets of the debtor company by facilitating a swift transition of such assets and business. It provides prompt and efficient means for effectuating the sale of a business without considerable costs. Pre-packs are also considered to be the only viable option for selling a business as a going concern, particularly in cases in which the company does not have access to sufficient funding to enable it to continue trading.
Liquidation is a grave threat perceived on failure of the corporate insolvency resolution process (CIRP). Frequent instances of liquidation may not be a viable or desirable solution in the long run in terms of promoting the welfare of the economy. This problem becomes worse in cases of micro, small and medium enterprises (MSMEs), which are mostly at the receiving end due to a lack of investor interest in their assets during CIRP. Time and costs, even for big companies undergoing corporate insolvency resolution process, are huge factors which create an aversion towards it. It has been argued that the stringent timelines under the Code are a primary reason that calls for the introduction of the pre-packaged insolvency process.
Effect on the unsecured creditors
Unsecured creditors typically contend that, contrary to the insolvency process as it currently stands, the process of entering into pre-pack arrangements is opaque. These arrangements are usually agreed in consultation with the management of the corporate debtor and, therefore, places the interests of the management and the secured creditors at a higher pedestal than that of the unsecured creditors. Furthermore, the lack of open marketing in many of these cases ensure that the value agreed upon in the plan are not maximised.
Pre-packs involving undervalued transactions
The wealth maximisation model rests on the idea that, with any given set of entitlements, creditors would prefer a system that keeps the size of the pool of assets as large as possible. It is often observed that potential actions for avoiding undervalued and preferential transactions are not taken into consideration under the pre-packaged regime.
Certain objections have been raised that the terms of a pre-pack may give a company an unfair market advantage by allowing the new company to leave behind its unwanted debts. There remain real doubts as to whether pre-packs lead to wealth maximisation owing to the lack of transparency and open marketing of the business. It may not consider the interests of the creditors and other stakeholders, and has an element of risk that the assets of the debtor company. There may also be instances where the business of the corporate debtor may be transferred to entities without keeping in mind the interests of the creditors or other stakeholders.
While entering into a pre-pack agreement, there is a possibility that the corporate debtor might enter into preferential or undervalued transactions for the purpose of transferring its assets or business to another entity. It is to be noted that such a transaction would not carry the seal of approval of a court (unless the same is undertaken as a court approved scheme such as a scheme of arrangement under the Companies Act, 2013) and would, therefore, to that extent, be open to challenge by creditors if they were to object to such a transaction and require clawback,[1] which is a safeguard provided to creditors under the Code.
Entry of errant promoters
One of the reasons for the directors of a corporate debtor to undertake a pre-pack is to regain control of its business or assets, however, under a different identity. It is arguable that this roundabout manner of regaining control of the debtor company can result in circumvention of the insolvency laws. This particularly becomes an issue where a company is facing huge losses primarily due to promoter or managerial inefficiency.
Pre-packaged insolvency process is a debtor-initiated process by a pro-active company in distress which is willing to negotiate the terms of insolvency with its lenders, before the initiation of a formal CIRP under section 7 or 9 of the Code. Hence, section 29A of the Code will not be applicable to the pre-packaged insolvency process.[2] Therefore, taking the aforesaid premises into consideration, it may be inferred that if a provision similar to section 29A is made applicable to the entities willing to go for pre-packaged insolvency, it may tend to defeat the very objective of such a scheme.
Conclusion and suggestions
For a pre-pack to be successful it is necessary to ascertain the tangible value of the corporate debtor to ensure that a balance is struck between corporate resolution of such company and the use of a pre-pack as a means to escape inconvenient debts. In our opinion, wide marketing of the assets, calling for expressions of interest from parties interested in taking over the business or assets of the debtor company by inviting the bidders to quote their price for such assets would be crucial for a successful pre-pack.
The risk of a clawback may not arise if pre-packs are approved by the adjudicating authority (NCLT) itself. By proposing mandatory NCLT approval for execution of a pre-pack, a common fear which might hold back investors, creditors and other stakeholders regarding their rights against the debtor company in recovery, would be allayed to a great extent and confirm the finality and binding nature of such transactions. This will also be helpful in preventing unjust enrichment of the corporate debtors who have entered into preferential and undervalued transactions under the Code.
The introduction of a pre-pack insolvency pool will further help to tackle the problem. It was established in line with the recommendations of Graham Committee to ensure wealth maximisation and to strike a balance between safeguarding the interests of the creditors and the corporate debtor. The committee is an independent body that consists of ‘experienced business persons who offer an opinion on the purchase of a business or its assets by connected parties to a company where pre-packaged sale is proposed.
It is pertinent to note that in Lokhandwala Kataria Construction Pvt. Ltd. v. Nisus Finance and Investment Managers LLP, the Supreme Court used its power under Article 142 of the Constitution to accept the out of court settlement for the benefit of all the stakeholders and for meeting the ends of justice. Therefore, it can be inferred that under the current framework the practice of pre-packaged insolvency and out of court settlements can only be entered into for meeting the ends of justice under Article 142 of the Constitution. Furthermore, many cases before the NCLT for the corporate insolvency resolution process have resulted in liquidation primarily because of the absence of resolution plans. In our opinion, pre-packaged insolvency in India is an idea that must be implemented soon in order to achieve the larger goal behind the Code.
– Akhil Kumar & Ayushi Singh
[1] Under section 44 of the Code, the National Company Law Tribunal (NCLT) possesses the power to pass an order, if approached by the resolution professional, declaring any transaction entered into by the debtor company prior to the insolvency commencement date as a preferential transaction, undervalued transaction or an avoidance transaction.
[2] Section 29A, inter alia, provides safeguards from related parties and defaulters from submitting resolution plans under the Code.