Insolvency Tests Under Indian Law: Implications And Developments

Introduction

The determination of the insolvency of a company is essential for the company’s proceedings for insolvency and bankruptcy. Amid all the jurisdictions there are primarily two tests used for the determination of the company’s insolvency, namely cash flow test (commercial insolvency test) and test of balance sheet. Throughout history we have seen varying nature of the judgements given by the Indian courts towards their preference of test in the insolvency determination. In this article the evolving nature of the insolvency test under the Indian law is discussed along with the recent developments brought to it.

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Understanding The Concept Of Insolvency Tests

Disparity in using one of the balance sheets or the cash flow test arises from the position of the creditor for the debt recovery on or before the date of maturity. The cause of prevalence of the cash flow test is, it being easier to ascertain. In a cash flow test for determining insolvency the company should not be in a state to pay the dues to the creditor on a demand notice before a stated period of time. Balance sheet insolvency is more of an accounting test wherein the liabilities reported of a company is less than the reported assets. The committee set up by the government for bankruptcy reforms suggested that both the tests should be considered in separate ground in order to avoid clash between the two. The reason behind this being, there can be a state in which the company is insolvent by the cash flow test but solvent as per the balance sheet test and vice versa. Based on this reasoning the dual test was used initially. But the IBC’s final report didn’t find the mention of the BLRC suggestions.

Inconsistency Of The Indian Courts (Conflicting Judgments)

Before IBC 2016 came into being there was inconsistency in the insolvency test used by the courts to reach a judgement. In the Megabyte consultancy services case[i], the judgement given by the Bombay High Court highlighted that insolvency should be proved by the test by creditors for submitting a winding-up application. Further, contrasting to this the Bombay High court in Karpara Project Engineering v Ballarpur Industries Ltd.[ii] evidenced in the judgement about the non dependance of the company’s solvency based on some other test instead of the cash flow test (commercial solvency). This inconsistency was prevalent in the Supreme court judgements as well. In the Info Drive System case[iii], the Supreme court pointed out the perils of solely relying on any one of the insolvency tests whilst in Jignesh Shah[iv] case it asserted the genesis of the cash flow insolvency solely mentioned in the IBC. Liquidation is rendered ineffectual disciplinary tool consequent to the widely divergent approaches taken by various courts in India. It can be argued that uniformity is sustained now through the cash flow approach included in the IBC, however in a recent judgment there was deviation observed by the court from the IBC rules.

Vidarbha Industries Power Ltd. V. Axis Bank (Recent Development)

There was a divergent approach adopted by the Supreme court in the Vidarbha case[v] from existing precedents as in the judgment it was held that even if the company’s debt to the creditor is proved, other relevant factors may be considered by the NCLT in established whether the insolvency proceedings should be admitted against the debtor.

Diverse stakeholders voiced strong disagreements by granting wide discretion the process of resolution would drag longer causing the asset depreciation and creditors recovery lowering.

Facts of the case are that a power purchase agreement between the debtor, Vidarbha Industries, a power generating business, and Reliance Industries was involved. The rate set by the regulator in relation to the agreement was protested by the debtor and contested before the appellate. Amount of INR 1730 Cr. was to be compensated to the debtor. The appellate tribunal’s decision was challenged by the regulator before the Supreme Court. Axis Bank Ltd, one of the debtor’s creditors, submitted an application to start bankruptcy proceedings against the debtor while the appeal was pending before the Supreme Court. Further, it was contended by the debtor that because the sum owed under the award would easily enable it to fulfil all of its current financial commitments, bankruptcy proceedings should not be started prior to the Supreme Court’s decision on the appeal. The NCLT may take into account elements other than the appearance of debt and default, such as the general financial health of the debtor under its current management, before starting insolvency procedures, according to the Supreme Court, which upheld the debtor’s claim and returned the case to it.

The influence of this judgement is already observed in the insolvency adjudication in the lower courts, like in the Anita Jindal case[vi], Reliance Commercial Finance case[vii], etc. One side to this judgement as argued by many enhances the creditor’s difficulties against the debtors. The process of establishing the company as insolvent gets elongated with lowering the recovery of the creditors. The average time required for admission of an application by an operational creditor under Section 9 is 650 days, according to a discussion paper by the Insolvency and Bankruptcy Board of India, India’s insolvency regulator, greatly beyond the statutory time limit of 14 days. Any attempt at debt resolution may be substantially hampered by a similar delay in the admission of applications by a financial creditor under Section 7.

On the other side, the Vidarbha judgement provides security to debtor’s current management and stockholders. After the beginning of the bankruptcy proceedings until the liquidation a resolution specialist takes over and manages the debtor. Under the approach used in the judgement the goal of insolvency legislation is to safeguard a variety of interests, including those of the debtor, its creditors, stockholders, employees, and the general public.

Conclusion

The debt relief process and external circumstances are inextricably linked. As emphasized, under the absence of another test of insolvency under IBC there is enormous scope for the present determination of insolvency problem in order to avail effective resolution of the debtor because role of the insolvency diagnostic does not restrict itself to insolvency determination. Adding to it, for the time being, the Vidarbha judgement seems to drastically change India’s insolvency scene. Before being admitted into insolvency, creditors now have a new defense. It would be interesting to observe if, in the long run, this ruling signal a turning point in how we perceive the function and character of Indian insolvency law.

Author: Zainab Fatima, a student at Hidayatullah National Law University, Raipur, in case of any queries please contact/write back to us at support@ipandlegalfilings.com or   IP & Legal Filing.

References

[i] Gujarat State Financial Services Ltd. v. Megabyte Consultancy Services Pvt. Ltd., 2003 115 CompCas 165 Bom.

[ii] Karpara Project Engineering v. Ballarpur Industries Ltd., C.P No. 8 of 2006.

[iii] IBA Health v. Info-Drive Systems, [2010]159 CompCas 369(SC).

[iv]  Jignesh Shah v. Union of India, (2019) 10 SCC 750. In this case, under the CA, 2013 a winding up petition against the debtor was brought before the Bombay HC, after the IBC was passed, it was further referred to the NCLT.

[v] Vidarbha Industries Power Ltd. v. Axis Bank Ltd., 2022 SCC OnLine SC 841.

[vi] Anita Jindal v. Jindal Buildtech (P) Ltd., 2021 SCC OnLine NCLAT 1644.

[vii] Reliance Commercial Finance Ltd. v. Darode Jog Builder Pvt. Ltd., MANU/NL/0833/2022.