[Shruti Kunisetty is a III Year B.A. LL.B. (Hons.) student at the National Law School of India University, Bangalore]
Section 29A of the Insolvency and Bankruptcy Code, 2016 (the “IBC”) bars certain entities from submitting a resolution application in insolvency proceedings. Broadly, there are four categories of entities that are barred under this provision: (i) ineligible persons, (ii) persons connected to the ineligible persons, (iii) related parties, and (iv) persons acting “jointly or in concert with” ineligible persons. This provision was introduced by way of an amendment to the IBC for ensuring that persons responsible for the management of the company do not benefit from the insolvency. The primary assumption that underlies this provision is that promoters are responsible for the failure of the business. While this is a rather bold assumption, there is some merit in the apprehension that promoters could orchestrate transactions to push the company into insolvency and thereafter benefit from the undervalued transactions and thereby evergreen their loans. Thus, section 29A acts as a sieve to sift out all potential fraudulent applicants – or does it? In this post, I shall argue that achieving the objective of section 29A comes with an obvious cost, which is not off-set. This is because the section leaves open a wide loophole which defeats the salutary object of the provision.
Faulty Assumptions and the Cost of Section 29A
In the landmark case of ArcelorMittal India Pvt. Ltd. v Satish Gupta, the Supreme Court decoded section 29A(c) of the IBC and held that entities are ineligible under section 29A if they have ‘positive control’ over the company. This is an exceedingly low threshold for disqualification. In Swiss Ribbons Pvt. Ltd. v Union of India,the petitioners challenged section 29A as unconstitutional and violating article 14 of the Constitution as it imposes a blanket ban on all promoters and related parties of the company and consequently treats those acting fraudulently and otherwise on par with one another. The Supreme Court, however, upheld the constitutionality of the provision on the ground that the object of section 29A is not solely to target malfeasance. It is also to disqualify people who controlled the transactions that led to the financial downfall of the company.
It is important therefore to understand the nuance of section 29A and the assumptions necessary for its conception. There exist two assumptions for persons in control and other related parties respectively. First, the provision assumes that all promoters and managerial persons are necessarily responsible, not only individually but also collectively, for the financial state of the company. An extension of this assumption is that persons who failed once at sustaining the company are incapable of restoring the business. Second, insofar as ‘related parties’ are concerned, the disqualification is necessarily based on the assumption of malfeasance. This is a rather bold assumption.
More often than not, it is logical to presume that the person who has structured a company a certain way and has incurred losses is in the best position to restructure the business and flip the performance. Often, the failure of a business is owing to extraneous factors such as delay in regulatory approvals, challenges in material sourcing, unforeseen competition, etc. Therefore, this sweeping disqualification imposed by the statutory provision comes with a cost of losing out on the opportunity of having a credible promoter revive the company and duly discharge the creditors in the most effective manner. The only explanation for such far-reaching disqualifications is the claim that such blanket bar will eliminate all possible fraud and incapacities. It is my limited contention that such a claim is not always true due to an obvious loophole posed by section 29A.
Object Sought After and the Existing Loophole
X is the promoter of his company X Ltd. His father Y is the owner of 100% shares of Y Ltd. X Ltd. is insolvent and the insolvency professional invites resolution applications. Under section 29A(c), X is disqualified. Y is disqualified under section 29A read with section 5(24A). However, Y Ltd. is not disqualified under section 29A read with section 5(24A). This is a simplistic illustration of how the section can be circumvented and persons can evade the provision by using the company or any financial entity as a vehicle of fraud. This would be sufficient for the promoter or other managerial personnel to sidestep the provision and benefit from deliberately manipulating transactions and thereafter conveniently evergreen their loans and retain the company with a significantly lower liability.
Therefore, the initial justification of the blanket ban on resolution applications of the persons mentioned in section 29A(c), (f), (i) and (j) that such restriction would prevent all potential misuse of the insolvency procedure stands failed. One would argue that every time the restricted persons use the loophole to escape restriction under the section and fraudulently benefit from the insolvency procedure, the court could pierce the corporate veiland restrict fraud. This is not unprecedented as the Supreme Court held that Numetal was disqualified in the resolution procedure of Essar Steel India Ltd. (“ESIL”) because one of the promoters of ESIL was a shareholder of Numetal and the Supreme Court pierced the corporate veil. A similar situation occurred in Chitra Sharma v Union of India.
Primarily, there are two issues with this approach. First, the object of the introduction of section 29A was to ensure that the widely-worded mandate of the statute minimizes the intervention of the courts to decide the credibility of the applicant every time a resolution application is made. This object stands defeated if the stakeholders are at the mercy of the court’s decision to pierce the corporate veil every time a company is sought to be used as a vehicle of fraud. Alternatively, if the courts were to accept this as a default rule and necessarily bar all entities, the shareholders of which are barred under section 29A, it will lead to an indefinite widening of an already far-reaching section. Therefore, in any event, the purpose of the section stands defeated.
Section 29A or Not: A Cost-Benefit Analysis
Having discussed the lacunae in the operation of section 29A as it currently exists, it is useful to consider a scenario wherein section 29A did not exist and explore the possibility achieving the objective of section 29A through more efficient means. In furtherance of the same, it is important to weigh the benefits of the provision against its cost. The cost of section 29A can broadly be classified into three prongs. First, the use of a wide language and a blanket bar on persons precludes the company of a potential effective revival by an entity that is familiar with the business and consequently impedes the maximization of the creditors’ benefit from the resolution procedure, which is in fact one of the primary objective of the IBC in the first place. Second, once an exhaustive list of restrictions is enumerated, the implication is to allow all but the enumerated entities. Therefore, the provision specifically allows the use of corporate entities for the purpose that was sought to be plugged by the section. Third, if the aforementioned practice is to be curbed, the need for increased court intervention to pierce the corporate veil arises. This leaves all the stakeholders at the mercy of judicial discretion to pierce the corporate veil.
The assumed benefit of section 29A – to eliminate all potential fraud and repeat mismanagement – does not exist due to the exception provided to corporate entities and the consequent creation of the loophole by the provision. In the absence of section 29A, the burden of proving the mala fide intention of the applicant would lie on the contester. With the loophole, the burden of showing the need to pierce the corporate veil again lies on the party contesting the qualification of the resolution applicant (the corporate entity). Therefore, the burden sought to be removed by section 29A is not entirely eliminated and a failure to discharge the burden would allow the disqualified applicant under the section to evade the provisions by using a corporate entity as a corporate vehicle for fraud.
Thus, section 29A creates a paradoxical situation wherein the object sought to be achieved is defeated by the creation of an obvious loophole. Further, in addition to being self-defeating, the section is accompanied with a cost that is not worth the negligible benefit, if any, provided by the section. The costs would be spared from being incurred in the absence of the section as such promoters and entities who are prima facie benefiting from their own wrongs can be disqualified by the committee of creditors who have the final discretion. Alternatively, in any event, the court under section 447 of the Companies Act can undertake the disqualification, which will in fact act as a greater deterrent for persons to employ dishonest means to circumvent liabilities towards creditors.
In conclusion, the resolution procedure and the interests of the creditors are better protected in the absence of section 29A and better utilization of existing provisions, as the section comes with high costs that are ultimately borne by the creditors.
– Shruti Kunisetty