Vidarbha Judgment | Assignments International Business

Research Note on Vidarbha Judgment

InVidarbha Industries Power Limitedv.Axis Bank Limited,1the Supreme Court,inter

alia,held that Section 7(5)(a) of the Insolvency and Bankruptcy Code ("Code"/"IBC")

confers discretionary power on the Adjudicating Authority to admit an application of a

financial creditor under Section 7 of the Code for initiation of CIRP. The Apex Court with its

aforesaid finding thus differed from the long-settled view that the moment the Adjudicating

Authority is satisfied that a default has occurred, the application must be admitted unless it is

incomplete.2

What will be the likely outcome of the latest ruling by the top court? Does this

weaken the IBC regime in India?

Yes the Supreme Court’s ruling in this case likely to radically weaken the IBC regime in

India. To substantiate this we need to look at some previous judgement of court:

Innoventive Industries Decision:

The Supreme Court in the case ofInnoventive Industries Limited Vs. ICICI Bank, while

dealing, inter-alia, with a question whether a notification issued under a state enactment

suspending debts of a Corporate Debtor will stand in the way of initiation of CIRP under the

IBC, analyzed Section 7(5) of IBC and held as under:

"30.On the other hand, as we have seen, in the case of a corporate debtor who commits a

default of a financial debt, the adjudicating authority has merely to see the records of the

information utility or other evidence produced by the financial creditor to satisfy itself that a

default has occurred. It is of no matter that the debt is disputed so long as the debt is "due"

i.e. payable unless interdicted by some law or has not yet become due in the sense that it is

payable at some future date. It is only when this is proved to the satisfaction of the

adjudicating authority that the adjudicating authority may reject an application and not

otherwise."

It is clear that the Supreme Court has categorically held that the NCLT cannot reject an

application for initiating CIRP unless it is either satisfied that the debt does not exist or if the

debt is not due. In other words when the twin conditions of existence of debt and default are

established it is mandatory for the NCLT to initiate CIRP.

The Supreme Court was aware of its earlier decision in Innoventive Industriesas certain

portions of the decision have been referred to in this decision. However, specific finding in

the earlier decision does not form part of the discussions.

Cash Flow Test Vs. Balance Sheet Test:

On a literal interpretation of Section 7(5)(a) the Supreme Court held that the NCLT has the

discretion to reject an insolvency application even after satisfaction of the twin conditions.

The Court has further held that using the discretion the NCLT has to examine the expediency

1 Civil Appeal No. 4633 of 2021, Judgment dated July 12, 2022

2 Innoventive Industries Ltd. v.ICICI Bank Ltd.,[2017] 84taxmann.com320.

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Research Note on Vidarbha Judgment In Vidarbha Industries Power Limited v. Axis Bank Limited ,^1 the Supreme Court, inter alia, held that Section 7(5)(a) of the Insolvency and Bankruptcy Code ("Code"/"IBC") confers discretionary power on the Adjudicating Authority to admit an application of a financial creditor under Section 7 of the Code for initiation of CIRP. The Apex Court with its aforesaid finding thus differed from the long-settled view that the moment the Adjudicating Authority is satisfied that a default has occurred, the application must be admitted unless it is incomplete.^2  What will be the likely outcome of the latest ruling by the top court? Does this weaken the IBC regime in India? Yes the Supreme Court’s ruling in this case likely to radically weaken the IBC regime in India. To substantiate this we need to look at some previous judgement of court: Innoventive Industries Decision: The Supreme Court in the case of Innoventive Industries Limited Vs. ICICI Bank , while dealing, inter-alia, with a question whether a notification issued under a state enactment suspending debts of a Corporate Debtor will stand in the way of initiation of CIRP under the IBC, analyzed Section 7(5) of IBC and held as under: "30. On the other hand, as we have seen, in the case of a corporate debtor who commits a default of a financial debt, the adjudicating authority has merely to see the records of the information utility or other evidence produced by the financial creditor to satisfy itself that a default has occurred. It is of no matter that the debt is disputed so long as the debt is "due" i.e. payable unless interdicted by some law or has not yet become due in the sense that it is payable at some future date. It is only when this is proved to the satisfaction of the adjudicating authority that the adjudicating authority may reject an application and not otherwise." It is clear that the Supreme Court has categorically held that the NCLT cannot reject an application for initiating CIRP unless it is either satisfied that the debt does not exist or if the debt is not due. In other words when the twin conditions of existence of debt and default are established it is mandatory for the NCLT to initiate CIRP. The Supreme Court was aware of its earlier decision in Innoventive Industries as certain portions of the decision have been referred to in this decision. However, specific finding in the earlier decision does not form part of the discussions. Cash Flow Test Vs. Balance Sheet Test: On a literal interpretation of Section 7(5)(a) the Supreme Court held that the NCLT has the discretion to reject an insolvency application even after satisfaction of the twin conditions. The Court has further held that using the discretion the NCLT has to examine the expediency (^1) Civil Appeal No. 4633 of 2021, Judgment dated July 12, 2022 (^2) Innoventive Industries Ltd. v. ICICI Bank Ltd., [2017] 84 taxmann.com320.

of initiation of CIRP taking into account the overall financial health and viability of the corporate debtor. The Supreme Court has now tasked the NCLT with the assessment of the overall financial health and viability of the Corporate Debtor, which is nothing but determination of insolvency. Insolvency regimes across the globe have largely adopt the cash flow test or the balance sheet test or sometimes a combination of both to determine insolvency. A cash flow test is where the insolvency of a company is determined on the basis of its ability to pay its debts as and when it falls due. On any default in payment of the dues the company will be deemed to be insolvent. The balance sheet test in its simplest form would be to determine if the assets of the company are sufficient to pay off its liabilities. It is very much possible for a company to be solvent as per the balance sheet test but insolvent as per the cash flow test and vice versa. With the introduction of the IBC in India the Parliament has chosen to adopt the cash flow test. Some other jurisdictions like the UK have incorporated both the cash flow test and the balance sheet test in their insolvency law. Satisfaction of one of the tests can result in trigger of insolvency. There is no doubt that the cash flow test has at least in the Indian context proved to be a tool which has brought in some financial discipline, in the process inviting criticism against IBC being used as a recovery tool. Apart from the existing task of determining existence of debt and default of such debt (Cash Flow Test), the Supreme Court has now additionally tasked the NCLTs with examining the financial health and viability of the Corporate Debtor. Now this in effect is the balance sheet test being introduced. The effect of the Supreme Court decision is such that the NCLTs can initiate CIRP only on both the cash flow test and the balance test being satisfied. It is also pertinent to note that the Supreme Court even in Vidarbha Industries (supra) has maintained that when an Operational Creditor files an application for initiation of CIRP if the conditions are satisfied, i.e. the existence of an undisputed debt and a default of such debt, the NCLT has to mandatorily initiate CIRP. So as far as initiations by Operational Creditors are concerned the Supreme Court has envisaged only a cash flow test. There cannot be inconsistency in the tests applied for determining insolvency between petitions filed by Financial Creditors and Operational Creditors. The approach has to be unified. One cannot lose sight of the fact that the IBC is not a recovery tool. Further, after initiation the insolvency resolution process is a proceeding in rem. The creditor who initiated insolvency will have no distinct role to play in the resolution process. The debts of all the creditors are taken into consideration in the resolution process as a whole and no individual creditor will independently benefit from the resolution process. As a policy the Parliament has chosen to adopt the cash flow test. Now, after this decision on the scope of Section 7(5)(a), the position has changed. Further, it is likely to be a complex exercise as there are no guidelines.  Does it make it harder for banks/financial creditors to initiate insolvencies?

recovery or a pending appeal in the given case, but rather that the appellant has a right vested in it given by an authority to recover an amount which is more than the debt that the financial creditor is seeking to recover. This means this judgement will be a good precedent only when there are very similar facts. Otherwise the AA may hold that there are other factors which can be categorised as extraneous and deny relief to such corporate debtors. The court ruling that even if the NCLT is satisfied that a financial debt exists and that the corporate debtor has defaulted, it may not admit the case for resolution if the corporate debtor resists admission on any other grounds. Corporate debtors are likely to use this precedent to the fullest to resist admission into IBC. The likely outcome would be more litigation and delay at the admission stage, enhancing the risks of value destruction in the underlying distressed business. Unless the NCLT consciously constrains the use of its own discretion at the admission stage, the IBC may well end up like the SICA.  Will the ruling deter lenders from using the insolvency law/NCLT route for resolution of NPAs? Yes, the decision in Vidarbha Industries seems to deter lenders from using the insolvency law/NCLT route for resolution of NPAs because the ruling broadened the range of possible defences that the Corporate Debtor may put up to establish as to why 'there are good reasons not to admit the petition'. The Supreme Court has also warned the NCLTs not to use its discretionary powers arbitrarily or capriciously. However, the Supreme Court has stopped with just a warning and has not laid down any guidance on when the powers can be used or how it is to be used. The following questions are inevitable: ( i ) How will the NCLT determine the financial health and viability of the Corporate Debtor? ( ii ) Should the NCLT order for an Insolvency Professional to determine the viability of an enterprise? ( iii ) If so, in such determination should the Insolvency Professional go by the books of accounts of a Corporate Debtor? ( iv ) Before determining financial viability, should the NCLT order, forensic audit of the Corporate Debtor, given the fact that past experience shows that in some cases, the liabilities are not recorded or under-reported in books? ( v ) Should contingent and prospective liabilities of the company be considered in accessing the viability of the Corporate Debtor? Perhaps it is for these practical difficulties of adopting a balance sheet test the Parliament thought it fit to only have a cash flow test. It is not that the balance sheet test was never envisaged in the lead up to IBC. The Bankruptcy Law Reforms Committee in its Interim Report of February 2015 made a recommendation as under

'Balance sheet insolvency' and 'commercial insolvency' should be identified as separate grounds indicating a company's 'inability to pay debt' in order to avoid conflicts/confusion with the statutory demand test (as is the case of the IA 1986 where the statutory demand test, the commercial insolvency test and the balance sheet insolvency test are alternate grounds for determining a company's inability to pay debts under Sections 123(1) (a) ,123 (1) (e) and 123(2), respectively). However, in its Final Report of November 2015 the Bankruptcy Law Committee rejected the balance sheet test after observing that the balance sheet test is vulnerable to quality of accounting standards and that India suffers from having both a low average standard of accounting quality as well as wide variations across single entities. It is always recommended that any amendment to a statute more so an economic legislation be made only on the basis of empirical evidence in support of the change. The introduction of the IBC and the subsequent amendments made to it have all been made after deliberations of the Bankruptcy Law Reforms Committee and other Insolvency Law committees set up from time to time. The Parliament on the recommendation of these committees has taken an informed decision to adopt the cash flow test and has kept the balance sheet test out of IBC. On a literal interpretation of Section 7(5)(a) the Supreme Court has added the balance sheet test to the IBC. Though the expression 'may' is used in the statute, it is very clear that the balance sheet test was never envisaged by the Parliament, in fact the Parliament had clearly chosen the cash flow test and rejected the balance sheet test. It would be interesting to see how the NCLTs use their discretionary powers. What is certain is that the discretionary power of the NCLT is going to ensure long drawn litigation. The NCLTs and NCLAT are already burdened with a heavy case load and this new development will further clog the functioning of the NCLTs. Given the fact that the decision of the Supreme Court is the law of the land, amendments in IBC are likely where 'may' could be substituted with 'shall' or an explanation may be added to restore the 'case flow test' as the only test.  What alternatives do financial creditors have? Is IBC the last resort for them? An effective alternate remedy for creditors could be exercised by filing a summary suit (commercial) under Order 37 of the Code of Civil Procedure (CPC), 1908, or a standard commercial suit as amended by the Commercial Courts Act, 2015. The remedy of filing civil suits for recovery of money is often seen as a remedy of last resort, since civil suits have traditionally suffered from the vice of long adjudicatory processes and delays. However, after passing of the Commercial Courts Act, 2015, the said position has changed substantially with relatively quicker adjudicatory processes, as will be seen hereinafter.

 Four-pillar institutional framework : The IBC consists of NCLT and NCLAT, the adjudicating authorities; the Insolvency and Bankruptcy Board of India (IBBI), the regulator of insolvency professionals and insolvency professional agencies; insolvency professionals, the class of regulated persons responsible for the efficient execution of the IBC processes; and information utilities, a new industry that electronically stores facts about lenders and terms of lending. IBC Objectives  All existing insolvency laws in India should be consolidated and amended.  To make insolvency and bankruptcy proceedings in India easier and faster.  To safeguard the interests of a company’s creditors and stakeholders.  To resurrect the company in a timely manner.  To encourage entrepreneurship.  To provide necessary relief to creditors and, as a result, increase the credit supply in the economy.  To devise a new and timely recovery procedure for use by banks, financial institutions, or individuals.  To establish an Indian Insolvency and Bankruptcy Board.  Maximization of the value of corporate assets. Insolvency and Bankruptcy Code (IBC) Success  The IBC has sparked a cultural shift in the relationships between lender and borrower, promoter and creditor. It was crucial in changing the behaviour of borrowers.  Prior to the IBC, lenders had access to recovery mechanisms such as Lok Adalat, Debt Recovery Tribunal, and SARFAESI Act. While previous mechanisms resulted in a low average recovery of 23%, recoveries have increased to 43% under the IBC regime.  Since the implementation of the IBC, India has improved its ‘Resolving Insolvency’ ranking to 108 in 2019 from 134 in 2014, where it had remained stagnant for several years.  In 2018, India was named the most improved jurisdiction by Global Restructuring Review.  According to a January 2018 IMF-World Bank study, India is moving toward a new state-of-the-art bankruptcy regime.  Insolvency law has resulted in financial system stability. Concerns and Issues

 NCLT hesitancy : Even if the NCLT is convinced that a financial debt exists and that the corporate debtor has defaulted, it may refuse to admit the case for resolution if the corporate debtor objects on any other grounds.  Misuse by debtors : Corporate debtors are likely to take full advantage of this precedent in order to avoid admission into the IBC.  Broader implications : The latest ruling is likely to result in more litigation and delay at the admission stage, increasing the risks of value destruction in the underlying distressed business.  Another failure : Unless the NCLT consciously limits its own discretion at the admission stage, the IBC may end up looking like the defunct Sick Industrial Companies Act (SICA). o SICA Facts: SICA 1985 was a critical piece of legislation enacted in India to detect unviable (“sick”) or potentially sick companies and assist in their revival, if possible, or closure, if not. o Importance : This action was taken to free up investment trapped in failing businesses for productive use elsewhere. The failure of SICA, on the other hand, was an unintended consequence of this pro-revivalist judicial approach. o Tribunal: The SICA established the Board for Industrial and Financial Reconstruction (BIFR) as a specialised tribunal to expedite the resolution of distressed industrial companies. o Failure: The BIFR became a haven for companies seeking years of protection from creditors, with managers syphoning off assets in the interim. o Findings : A study found that a series of judicial innovations aimed at facilitating the rescue of distressed companies benefited some stakeholders at the expense of others, particularly institutional creditors such as banks. Insolvency determination  Balance-Sheet Test : This is a legal procedure used to determine whether a company is insolvent. A court decides how much a company’s prospective and contingent liabilities are worth. This includes deferred payments or potential litigation decisions against a company, allowing for a more precise arrangement.  Downside: This test is vulnerable to the quality of accounting standards. As a result, the Bankruptcy Law Reforms Committee opposed this test in the Indian context.  Twin-test: The Bankruptcy Law Reforms Committee recommended that a filing creditor provide a record of the liability (debt) as well as evidence of the corporate debtor’s default on payments.  Importance: This twin-test was designed to reduce litigation at the admission stage, allowing for faster resolution of distressed businesses. Concerning the Corporate Insolvency Resolution Process (CIRP)

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