Back to Basics: Missing the Point in Companies Act and the I&B Code – Ms. Muskaan Gupta

Back to Basics: Missing the Point in Companies Act and the I&B Code

In the recent judgment of UKG Steel Pvt. Ltd. v. Erotic Buildcon Pvt. Ltd. (2021) ibclaw.in 64 NCLT, the National Company Law Tribunal, Principal Bench, New Delhi gave an interesting decision. The existence of a financial debt was accepted by the corporate debtor, yet the financial creditor failed to recover its dues due to missing a basic tenet of company law.

Case Summary

UKG Steel Private Limited (“Financial Creditor”) is a company incorporated under the Companies Act, 1956. The Financial Creditor is not a bank, non-banking financial company or body corporate recognized by the Reserve Bank of India for carrying out financial business. Erotic Buildcon Private Limited (“Corporate Debtor”) was also incorporated under the Companies Act, 1956. A loan agreement was executed between them on 16.03.2019, pursuant to which the Financial Creditor advanced a loan of Rs. 3,76,45,000 at 6.5% per annum to the Corporate Debtor. As per the agreement, the Corporate Debtor had to repay the entire loan, in eight installments, starting from 30.06.2019 to 31.03.2021. The Financial Creditor provided evidence that loan amount was disbursed in five consecutive installments. However, the bank statements in this regard were smudged and illegible.

The Corporate Debtor defaulted in repayment of principal and interest amount installment, as per the terms of the loan agreement. The Financial Creditor sent a demand notice on 10.07.2019, to which the Corporate Debtor replied that it was unable to pay the amount due to a financial crisis. The Financial Creditor sent another demand notice dated 07.10.2019, and subsequently recalled the total loan amount, including interest, of Rs. 3,91,91,522 by a letter dated 02.01.2020. The Corporate Debtor did not reply to this letter. Finally, the Financial Creditor sent another demand notice on 25.06.2020 but the Corporate Debtor still did not repay the amount, causing the Financial Creditor to file a Corporate Insolvency Resolution Petition (“CIRP”) under Section 7 of The Insolvency & Bankruptcy Code, 2016 (“I&B Code”). The Corporate Debtor replied to the petition on 03.12.2020 claiming that a financial crisis is preventing them from repaying the loan. They stated that they intend to repay the loan and requested for more time to resolve their financial stress.

The issue before the National Company Law Tribunal, Principal Bench, New Delhi (“NCLT”) was whether the Financial Creditor, who is not a bank, non-banking financial company or body corporate recognized by the Reserve Bank of India for carrying out financial business, was authorized to extend the loan. It should be noted that even though the bank statements regarding disbursal of loan amount by the Financial Creditor were illegible and the Financial Creditor’s balance sheets did not reveal sanctioning of any loan, the Corporate Debtor had not denied the financial debt via correspondence. Therefore, NCLT presumed that the loan had been disbursed.

NCLT referred to Section 186 of The Companies Act, 2013 (“CA 2013”), that deals with inter-corporate loans. As per Section 186(2) of CA 2013, companies cannot extend loans exceeding 60% of its paid-up share capital, free reserves and securities premium account. NCLT recorded that the aggregate of the Financial Creditor’s paid-up share capital, reserves and surplus amounted to Rs. 1,64,33,092, and 60% of that amounted to Rs. 98,59,855.2. No information regarding securities premium account was provided by the Financial Creditor. Evidently, the loan amount disbursed by the Financial Creditor was significantly more than the limit allowed under Section 186(2) of CA 2013.

However, as per Section 186(3) of CA 2013, this limit could be extended via a special resolution passed in a general meeting by the company. NCLT noted that the Financial Creditor had neither disclosed the inter-corporate loan granted to the Corporate Debtor in its balance sheet, nor had it passed a special resolution in an extraordinary general meeting of its shareholders. The loan agreement also did not recognize any special resolution authorizing the Financial Creditor to extend the loan. Thus, the Financial Creditor failed to fulfil the requirements under Section 186(3) of CA 2013.

Based on the evidence provided and interpretation of Section 186 of CA 2013, NCLT held that the loan extended by the Financial Creditor was beyond the limit prescribed under CA 2013, resulting in an ultra vires act committed by them. Therefore, the loan advanced by the Financial Creditor was not a legally enforceable debt, and the petition was dismissed by NCLT.

It’s Rudimentary Dear Company

This article will argue that NCLT was correct in its reasoning. It also contends that there are some inalienable principles of company law that the judiciary cannot obliterate, as was apparent from this judgment. The decision provides a stark contrast to judiciary’s recent trend of trumping enshrined principles of law in favor of allowing primacy of the I&B Code and fostering an arguably efficient debt recovery system in India. An instance of this troubling trend can be gleaned from the Supreme Court diluting the well-established principle of corporate criminal liability by unconditionally upholding s.32A of the I&B Code. Thus, an answer to the conflict of laws question and jurisprudential labyrinth of the I&B Code is imperative for an efficient business and judicial ecosystem.

NCLT’s decision in the present case was correct because of the foundational company law doctrines it protects, instead of allowing proceedings under the I&B Code to continue unhindered, as done in many other cases mentioned below. A basic tenet of company law is that shareholders are the owners of a company. However, they do not always have the business acumen to make correct decisions, which is why proficient agents or directors are appointed to manage the affairs of the company. The company and its shareholders have consented to the Articles of Association (“AOA”) and Memorandum of Association (“MOA”) of the company, and their agents are expected to follow them.

The AOA and MOA are constitutional documents of a company. They include its objects, managerial requirements and permissions granted to directors by the shareholder members. Section 10 of CA 2013 encapsulates that a company and its members are bound by the AOA and MOA. The company and its shareholders are considered as principals with respect to directors, who are their agents. In a principal-agent relationship, an act that the principal themselves cannot do, cannot be done by them through their agent. Thus, no obligations or liabilities can arise from such acts. No one can hold the principal accountable or demand performance or remedy under The Specific Relief Act, 1963. Applying the concept to a company structure, it follows that a company cannot be bound by the actions of its directors for an act that it itself was not allowed to perform as per its AOA and MOA. In the interest of all current and future shareholders, statutory restrictions like these are vital.

The question that then arises is, what can a party that entered into an agreement with the company, believing that the company and its directors had legal competence, do? The answer depends on some fundamental doctrines. The doctrine of ultra vires establishes that an act done by an agent which is contrary to law and against the company’s AOA and MOA is beyond the agent’s legal authority and thus void. The doctrine of constructive notice presumes that a third party knows about the abilities of the company as the primary documents or evidence in question were publicly available. Contrarily, the doctrine of indoor management clarifies that the third party does not have to investigate too deeply into the company’s internal working, unless any actions of the company’s agents arouse suspicion. For instance, a third party should be able to glean that prima facie AOA and MOA, which are publicly available documents, have been complied with. They are not required to look through every single document authorizing the company to participate in any transaction.

The entire company law structure would be destroyed if agents were allowed to make decisions contrary to AOA and MOA, and the company and shareholders were to be held liable for them. Contracting parties must take rudimentary steps to ensure legal competency of companies. If these statutory regulations were absent, shareholders would be skeptical of investing in entrepreneurial ventures and fostering businesses. Thus, one of the prime objectives of the I&B Code would be obliterated if foundational principles are not adhered to. While extinguishment of corporate liability under Section 32A is understandable to assist new promoters, a moratorium making investigation difficult to even quantify liability of corporate debtors is problematic. Bona fide entities lose out on recovering their dues under arbitral awards or cases under Negotiable Instruments Act, 1881 (“NIA”) and Prevention of Money Laundering Act, 2002 (“PMLA”), due to lacuna in law and inefficiency of investigating and judicial authorities. Discriminating between creditors to ensure speedy insolvency resolution proceedings is unjust. Allowing supremacy of the I&B Code to the detriment of proceedings under all other legislations is ill-thought, and a question that the judiciary has been unable to answer satisfactorily even after its myriad of judgments on the I&B Code.

This case, while not being a landmark judgment, forces us to reflect upon foundational principles of company law that we have had to complicate and build upon extensively over time. However, the essence of these principles remains imperative and unswerving.  The most intriguing facet of this case is that the Corporate Debtor accepted that the Financial Creditor had a legitimate claim and that it owed a financial debt to UKG Steel Private Limited, which it defaulted upon. There was absolutely no argument by the Corporate Debtor on these basic points of initiating a valid CIRP against it. It is possible that this precedent is overruled since debts defined under Sections 3(11), 5(8) and 5(21) of the I&B Code do not require any legal sanction. Sections 3(6) and 3(12) of the I&B Code simply require the existence of a claim and a defaulted upon debt for a valid CIRP. Additionally, the judiciary’s inclination towards the I&B Code’s supremacy is well documented. Regardless, the invocation of this provision by NCLT to bar proceedings under the I&B Code is a contemporary example and reinforcement of the concept of agency and legal competence within company structures.

Conclusion

In the present case, NCLT realized the importance and upheld these key principles of company law. It also reminded entities involved in corporate insolvency resolution proceedings that even an agreed upon existence of debt will not be repaid under the I&B Code if the debt was ultra vires and void. It will be interesting to see if these arguments are used in any other cases to strike off significant amount of debt, or if it affects creditors and debtors in a subsidiary and group companies’ structure who have undertaken commonly used inter-corporate loans.

This judgment is an arguably welcome relief to the judiciary’s disruption in established principles of law to facilitate the I&B Code. Section 238 of the I&B Code contains a non-obstante clause establishing that in case of conflict of laws, the I&B Code will prevail. The judiciary has wielded this provision as an indomitable weapon to essentially subdue the liability of corporate debtors under various legislations like NIA, PMLA, Karnataka Protection of Interest of Depositors in Financial Establishments Act, 2004, etc., while declaring the supremacy of the I&B Code. The fact that criminal liability of corporate debtors is being extinguished, via Section 32A of the I&B Code, to facilitate ease of business is troubling. However, to fulfil the imperative objects of the I&B Code, which include maximization of value of stressed assets, increasing availability of credit and promoting entrepreneurship, the judiciary’s reasonings are not gratuitous. The crucial point for consideration is whether in the arena of conflict of laws, the judiciary is truly balancing interests of all stakeholders. Depending on whom you ask, the answer to this differs drastically. What cannot be denied is that there are several open issues that have not been decided upon sufficiently and it seems that the jurisprudence surrounding the I&B Code is only going to grow and become more tumultuous.