The NCLAT Decision in Hystone Merchants: Conferring Unruly Discretion

[Shubhansh Thakur is a fourth-year student at the Symbiosis Law School, Noida. The author wants to thank Mr. Deepak Joshi for his comments on the draft version]

The National Company Law Tribunal (“NCLAT”) in Hytone Merchants Pvt Ltd v. Satabadi Investments Consultants Pvt. Ltd. has held that the Adjudicating Authority (“AA”) can refuse to admit an application that is otherwise complete in all respects under section 7 of the Insolvency and Bankruptcy Code, 2016 (“IBC”) if there are visible signs of fraud, collusion or malicious intent under section 65 of the IBC. Interestingly, the NCLAT decided to reject the application on its own motion under section 65meaning thereby, the corporate debtor never averred that the application was fraudulent or motivated with malice. 

This post intends to critically analyse the decision on the settled jurisprudence of section 7 vis-à-vis section 65 of the IBC.

Case Before the Adjudicating Authority

The Financial Creditor approached the AA with an application under section 7 of the IBC to recover its unsecured loan of three lakhs. The Corporate Debtor (“CD”) cited pandemic-induced recession in its failure to pay back the loan, thus not contesting the existence of default under section 7. 

The AA considered the application to be complete in all respects. The default crossed the threshold limit as specified under section 4 of the IBC at the appropriate time (2019). Despite this, the AA, by referring to the Ministry of Corporate Affairs’ master data and financial statement of the CD, held that it was impossible to presume that a company with a net worth of over Rs. 153 Crores and with a Corporate Guarantee of over Rs. 482 Crores cannot pay a meagre amount of three lakhs. Thus, the AA rejected the application. It is pertinent to note that the AA did not allow the parties to contest the said position before dismissing the application.

The Appeal in NCLAT

The Creditor appealed against the order on the ground that AA was motivated by extraneous considerations beyond the purview of section 7(5) of IBC. It was argued that the financial statements relied on by AA were for the financial year 2018-19, while the application was filed in the subsequent cycle of 2019-20. The financial condition of the CD worsened in a year, giving rise to the default. It was also contended that CD invested its money in companies that were now either under liquidation or going through the Corporate Insolvency Resolution Process, causing the impugned debt’s default. Still, due to the standard accounting practices, the CD was bound to depict the amounts as receivables, although there remained grim prospects of actually receiving the money. 

Rejecting the arguments, the NCLAT upheld the order of AA by relying on section 65 of the IBC. The NCLAT held that section 65 could not mean the imposition of penalties alone. The AA has the inherent power to restrict the perpetuation of applications motivated by fraud or malice. The tribunal held “section 65 explicitly says that if any person initiates the insolvency resolution process or liquidation proceedings fraudulently or with malicious intent for any purpose other than for resolution of Insolvency or liquidation, as the case may, the Adjudicating Authority may impose a penalty”.

Analysis

Critique on the anvil of section 7

Textually, section 7(5)(a) imposes three conditions before admitting an application, i.e., first, the existence of default; Secondly, completeness of application under Form I and thirdly, there are no pending disciplinary proceedings against the Resolution Professional(“RP”) proposed to be appointed. The AA in the present case was concerned with the existence of the first two conditions, while the RP’s appointment was not contested. The law concerning section 7(5) of the IBC has been lucidly laid in the authoritative pronouncement of Innoventive Industries Ltd. v. ICICI Bank, where the Apex court has held that “the moment the adjudicating authority is satisfied that a default has occurred, the application must be admitted unless it is incomplete, in which case it may give notice to the applicant to rectify the defect within 7 days of receipt of a notice from the adjudicating authority.”

Additionally, the NCLAT in Shobhanath v. Prism Industries has held that the AA is merely required to see whether there is a debt and a default, and it cannot take any other irrelevant or extraneous consideration into account. Thus, in the present case, it can be safely argued that when the application fulfilled the profile under section 7, the AA, while rejecting the application, was motivated by extraneous consideration beyond section 7, something which is impermissible.

The NCLAT in the present case has also held that using the word “it may” in section 7(5)(a) itself leaves ample scope for the AA to exercise its discretion before admitting or rejecting the application. Thus, NCLAT held there was nothing wrong with the decision of AA to decline the application. It is true to argue that a certain amount of discretion has been vested with the AA under section 7 when seen in contrast to section 9(5), which uses the word ‘shall‘; however, this difference is not conclusive for such a finding.

 The NCLT ruling in India Bank v. Varun Resources Ltd though not binding on the NCLAT, can still be considered a directory tool for understanding the scope of discretion vested in AA under section 7The NCLT held in this case that the discretion vested in the AA has to be exercised for admitting the application rather than to deny it, especially when there is ample documentary evidence for debt and default. Based on this, it can be safely concluded that the NCLAT had erred in upholding the order of AA denying the application when there was sufficient documentary evidence indicating the existence of default. 

The discretion is conferred for cases where the prerequisites of section 7 are fulfilled, and still, the CD agrees to settle the claim. In such cases, the discretion can be exercised to reject the application for fostering greater flexibility among parties, which lies at the root of good bankruptcy law. Thus, where there lie more significant objectives of preserving the administrative costs without disrupting the existent corporate entity, discretion can be exercised. However, the AA has failed to indicate any such significant reason to reject the application in the present case. The AA only indicated towards the net worth of the CD and its corporate guarantee, which are extraneous factors while deciding an application under section 7, especially when there are no averments concerning such factors by either of the parties.

Misplaced reliance on section 65

A prima facie reading of section 65 indicates that to fall within the contours of the Section; there is a twofold requirement. Firstly, the application has been filed either fraudulently or with malicious intent, and Secondly, it has been filed for a purpose other than resolving insolvency or liquidation. Both conditions must co-exist because the second part dealing with any other purpose has been qualified by ‘fraud or malicious intent. However, the learned NCLAT seems to be motivated by the second factor alone, while there is nothing in the decision that could have justified the existence of the first condition. Stated straightforwardly, the NCLAT concluded that the application was initiated for a purpose other than insolvency without substantiating its conclusion on the presence of fraud or malicious intent, which is sine-qua-non for section 65.

Apart from this, the proceedings under section 7 are summary proceedings meaning that the AA has to decide the question of default by a short enquiry resulting in a rapid decision. Given this, it has been held by NCLAT in the case of Monotrone Leasing v. PM Cold Storage that in such summary proceedings, it is difficult to determine the applicant’s intent unless shown by way of documentary evidence. In the present case, none of the parties even averred about the fraud or malicious intent, let alone the aspect of laying documentary evidence.

In the present case, AA presumed collusion (a subset of fraud) between the Creditor and CD without even allowing either party to defend their position. However, in doing so, the AA violated section 424 of the Companies Act. The Section requires AA to be guided by the principles of Natural Justice in all its proceedings. Applying this vis-à-vis section 65 of IBC, it has been held by NCLAT in the case of M/S  Unigreen Global Private Limited v. Punjab National Bank that prima facie opinion has to be formed before imposing penalty under section 65. Thereafter, the AA is required to accord a reasonable opportunity of hearing to the person to enable it to explain and defend its case. In the present case, the AA formed a prima facie opinion and gave finality to it based on the net worth of the CD without allowing the parties to explain their respective positions. The NCLAT must have referred back the matter on this ground alone as it prejudiced the parties’ rights in presenting their case.

Thus, it is difficult to discern how the NCLAT concluded that fraud or mala fide intent was present in the Creditor’s application in the absence of any documentary evidence or averment. Moreover, when there are doubts over the existence of fraud and malice, the application of section 65 itself becomes dubious.  

Conclusion

The ruling in the matter enlarges the scope of AA beyond the contours of section 7. It can become an unruly horse in the long run where the AA can reject the applications despite an actual default. As it has compellingly argued and indeed so, it is not a rule of thumb that a company having a good net worth can generate sufficient cash flows to meet its obligations, which is further corroborated by the Bankruptcy Law Reforms Committee (BLRC) report. As per the BLRC report, the bankruptcy is often motivated by either financial failure (mismatch between payment and receivables) or business failure (insufficient revenue to meet the payment obligations), or, in some cases, by both. In the present case, however, the NCLAT, by relying on the net worth and corporate guarantees, presumed that both the failures must co-exist to trigger insolvency, which is fallacious.

The ruling will bring instability and uncertainty in the current bankruptcy law, which is undesirable and against the principles for which the code was brought into place. Suppose the matter is carried forward in appeal. In that case, it is expected that the Hon’ble Supreme Court will set aside this ruling based on its own previous decisions and prevent the exercise of unfettered discretion by the AA while admitting an insolvency application, in line with the objective of IBC to have minimal judicial interference. 

– Shubhansh Thakur

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