Thursday, July 27, 2017

Layering of Subsidiaries: The Phoenix Rises Again?

[The following guest post is contributed by Siddharth Raja, Senior Partner & National Executive Director, Argus Partners, Solicitors & Advocates.  Monica Umesh and Divya Mirlay, Associates of the Firm, assisted in the preparation of the “Note on Objections” referred to below.  Views are personal and do not reflect or incorporate the views or positions of the Firm. Comments are welcome.]

On 28 June 2017, the Ministry of Corporate Affairs (“MCA”) issued Public Notice No. 3/3/2017-CL-I, containing a draft notification proposing amendments – chiefly, the insertion of Rule 5 (the “Proposed Amendments”) – to the Companies (Specification of Definitions Details) Rules, 2014 (the “Rules”). 

The Proposed Amendments restrict the prescribed class or classes of holding companies from having subsidiaries beyond two layers.  In other words, as the Public Notice states, “[b]ased on suggestions received, the [MCA] is considering commencing” the proviso to Section 2(87) of the Companies Act, 2013 (the “Companies Act”).  The Public Notice, which also contains a background or explanatory note, invites suggestions and comments on the Proposed Amendments from stakeholders. 

The authors of this post have prepared and submitted to the MCA a detailed note of their objections to the Proposed Amendments.  This post is a summary of their “Note on Objections”.  The issue of the layering of subsidiaries had first caught critical attention at the time such a restriction was first suggested in the Companies Bill, 2011 (here).

The thrust of the objections to the Proposed Amendments in their entirety is a principled one. In other words, the proposed amendments ought not to be implemented in full as, at the very threshold, we believe they are destructive of the ability of companies to structure their affairs entirely from a commercial perspective, while still maintaining their compliance with anti-abuse, prevention of the siphoning-off of funds or money laundering objectives or other legal provisions.  We believe that the Proposed Amendments are neither salutary nor necessary to achieve the MCA’s principal objective stated in paragraph 4 of the “Background / Explanatory Note” accompanying the Public Notice: namely, the creation of shell companies for the diversion of funds or money laundering.

In 2005, the J Irani Committee Report on a proposed new companies’ legislation for India strongly opposed the move to have any restrictions on the number of subsidiaries that a holding company may have.  This opposition was principally founded on two threads of analysis: firstly, as the Irani Committee Report itself very succinctly states, in paragraph 8.1 of its Report (emphasis added): 

The Companies Act should not pre-empt the decision as to what structure is appropriate for controlling businesses.  Such prescriptions will make the environment rigid and put Indian companies at a disadvantage vis-a-vis their competitors internationally. Such restrictions would also not facilitate sound corporate planning, formation of joint ventures, international operations or restructuring of companies.”

Secondly, while recognising the need to control the misuse of funds through multiple layers of subsidiaries, the Irani Committee had also opined in paragraph 8.3 of its report that “the phenomenon of siphoning off funds may not be caused solely on account of holding-subsidiary structure” and went on to observe (emphasis added): 

“[I]solated instances of misuse of the holding-subsidiary structure should not result in doing away with this very important business model [namely, the holding-subsidiary structure] for investment and corporate planning.  Instead of prohibiting formation of subsidiaries, there should be adequate disclosure obligations as to utilisation of the funds raised or loans and advances given by the coming to other entities.  Strict disclosure and compliance norms in respect of holding and subsidiary company structures should be provided for.

Indeed, the Companies Act has proper and strict disclosure requirements as suggested in the Irani Committee Report, including the mandatory consolidation of financial statements.  All such existing provisions address the concerns (principally, the diversion of funds) attendant to the purported lack of transparency in the holding-subsidiary structure.  Directed by the need for financial transparency and to root out misuse, the Companies Act has stringent requirements with respect to disclosures and related party transactions to snuff out any such potential abuse.

Even assuming, for a moment, that the situation of the Indian economy in general, and the corporate world in India in particular, is vastly different from what existed when the Irani Committee submitted its report, despite the passage of time and drastic changes in circumstances, two subsequent learned and distinguished official committees of experts have underscored and endorsed (or, in any event, not entirely gone against) the views and approaches of the Irani Committee on this issue of the layering of subsidiaries under a holding company structure.

The Companies Law Committee Report of February 2016 (the “CLC Report”) that formed the basis of the Companies Amendment Bill, 2016, presently pending before Parliament, was especially clear in reiterating the objection to having any stipulation as to such layers; so much so, that the Companies Amendment Bill, 2016 based on the CLC Report, expressly and specifically suggests the removal of the proviso to Section 2(87) of the Companies Act.  Paragraph 1.24 of the CLC Report states as follows (emphasis added):

The Committee noted that this provision [Section 186(1)] was included to address practices of creating subsidiaries aimed at making it difficult to trace the source of funds and their ultimate use, and reduce the usage of multiple layers of structuring for siphoning off of funds and that the same was incorporated in the [Companies Act] in the wake of various scams in the country........The Committee, therefore, felt that while the proviso to Section 2(87) has not yet been notified, it was likely to have a substantial bearing on the functioning, structuring and the ability of companies to raise funds when so notified and hence recommended that the proviso be omitted.

On merits, Section 186(1) of the Companies Act already effectively restricts the layering of subsidiaries, in particular investment companies, so as to prevent the siphoning-off of funds through such multiple layers – thereby making it clear that the introduction of genuine, operational subsidiaries, which are not principally mere investment vehicles, is a permitted exercise of corporate investment structuring between holding companies and as many layers of operating subsidiary companies as may be commercially justified.  That latter structuring is, on a reading of the scheme of the Companies Act, entirely legal and ought not to be subject to the unnecessary restrictions currently proposed. 

It is, therefore, clear that the CLC Report was mindful of the issue of abuse and siphoning-off of funds, but agreed with the Irani Committee so strongly that they recommended the very omission of the enabling power to make rules in that behalf contained in Section 2(87) proviso.  

In these circumstances, we argue that while the Companies Amendment Bill, 2016 which contains the suggested omission of the proviso to Section 2(87) is pending in Parliament, this attempt to enforce such proviso by these Proposed Amendments to the Rules, would be tantamount to flying in the face of legislative wisdom, should the omission of the proviso be passed by Parliament.   The Companies Amendment Bill, 2016, however, appears to be floundering in Parliament and may well have been put into cold storage, as a result of a change in the MCA’s mind, as the current proposal seems to suggest.  At the very least it appears that the MCA is less than enthusiastic in moving ahead with that amendment bill in its current form.

That said, the Companies Amendment Bill 2016 would need to change if this proposal from the MCA comes through and it insists on it. Otherwise, any “commencement” of the said proviso in the interregnum (such as currently proposed) may lead to the anomalous position that some companies would have been impacted by the proscription on having more than the permitted layers of subsidiaries, while those who acted in a situation without, or in the absence, of such a proscription would not be under any such disadvantage. It would potentially lead to a situation where two equal and similarly situated holding companies would be placed under dissimilar legal requirements leading to the infringement of the equality of treatment among them.  Any such position, apart from being potentially legally untenable, would also be patently disingenuous and disadvantageous to some companies merely because they had acted at a time when the rules may have proscribed such layering of subsidiaries.

Even assuming that the Companies Amendment Bill, 2016 is amended in Parliament to omit the deletion of the proviso to Section 2(87), the very making of the Proposed Amendments, would run contrary to learned and well-held opinion that such a restriction is not warranted in law as well as in genuine, legally compliant commercial practice, given business realities. 

Even the Parliamentary Standing Committee Report on the Companies Bill, 2011 (that eventually became the Companies Act) reveals that while stakeholders (primarily, the MCA) had represented the need for a restriction on layering of subsidiaries on the basis of prevention of abuse, other stakeholders had emphasised that imposing such restrictions could be construed as restrictive of the conduct of business, a point elegantly stated by the Irani Committee, as noted above.  The Parliamentary Standing Committee’s proposal to introduce a register of beneficial owners of a company to address the need to know the ultimate beneficial owners in complex corporate structures is all the more reason that all such considered opinions from the various committees recommend not having such layering restrictions in place.

The Proposed Amendments are both untenable as well as improperly timed. Improperly timed because assuming there is a felt need for such layering restrictions to be in place, the proper approach would have been first to seek the continuing retention of the proviso to Section 2(87)).  The stand of the MCA appears untenable because to seek the introduction of these Proposed Amendments to the Rules not only goes against the grain of the various committees that have examined this matter threadbare, it also exposes companies to the very real possibility of prejudice if the layering restrictions were subsequently to be entirely done away with by Parliament.  It is however clear that the MCA’s approach seems to be in line with the apparent push from the Government to crack down on shell companies; it remains to be seen whether the MCA’s view will prevail and the Companies Amendment Bill, 2016 changed to accommodate the MCA’s and, indeed, the Government of India’s perceived perspective on this matter.

While the objective of preventing abuse and siphoning-off continues to be capable of being achieved through other provisions that have more than ample strength and teeth in law and in practice, the other very real and stated objective of Government to promote Indian industry, including the “Make In India” programme, ought not to suffer by such unnecessary and unwarranted restrictions, which in our view, fetters Indian companies to their detriment and that of the Indian economy, including as regards overseas entities who may not be subject to any such restrictive layering stipulations.  That last aspect is a moot and important issue, requiring further analysis: would any such restriction on the layering of subsidiaries apply to overseas holding companies on a proper interpretation of the (existing and proposed) definitions of “holding company” and “subsidiary”?  This interpretational aspect is made all the more nuanced because the Companies Amendment Bill, 2016 proposes to clarify that for the purposes of the definition of “holding company” the expression company includes anybody corporate.

- Siddharth Raja (assisted by Monica Umesh and Divya Mirlay)

More on RBI’s Intervention in Matters of Corporate Insolvency

The Gujarat High Court judgment discussed in a post yesterday by a guest contributor, Saurav Roy, brings to the fore several tricky issues and questions relating to the extent to which the Reserve Bank of India (RBI) ought to be involved in matters relating to the resolution of corporate insolvency. While matters of insolvency are essentially within the purview of the National Company Law Tribunal (NCLT) under the Insolvency and Bankruptcy Code, 2016 (the Code), RBI’s intervention is not surprising given the eagerness to use the Code process to deal with the non-performing loans (NPAs) that have been plaguing the banking sector. RBI’s powers in this regard have been strengthened by way of the Banking (Regulation) Amendment Ordinance, 2017.

The manner in which the RBI went about the process of exercising its powers has caused a great deal of consternation, much of which has been the subject matter of the Gujarat High Court judgment mentioned above. However, both in the run up to the Court’s ruling as well as before that, there has been considerable debate and discussion surrounding the jurisdictional considerations surrounding corporate insolvency and possible turf wars plaguing the resolution process. The purpose of this post is to merely point readers to some of the extensive commentary that already exists on this issue. As noted by the commentators, while the Gujarat High Court may have shone the green light in respect of the Essar Steel case that is now before the NCLT, it may have ended up circumscribing the new found powers that RBI has exercised in respect of corporate insolvency involving the largest NPA cases.


- Shyamal Majumdar in Business Standard

- Editorial in the Economic Times

- Andy Mukherjee in Bloomberg Gadfly

- Somasekhar Sundaresan on his blog

- Pratik Dutta on Ajay Shah’s Blog

- Cyril Shroff in conversation with Menaka Doshi on BloombergQuint

Wednesday, July 26, 2017

Gujarat High Court Rules on RBI’s Powers Relating to Corporate Insolvency

[Guest post by Saurav Roy, IV B.A.LL.B, ILS Law College, Pune.] 


Last week, the Gujarat High Court ruled on some interesting issues under the Insolvency and Bankruptcy Code 2016 (“IB Code”) while adjudicating upon a writ petition filed by Essar Steel Ltd., (“Essar”) against the Reserve Bank of India’s (“RBI”) decision to initiate insolvency proceedings against Essar and 11 other companies.  


In light of the growing concerns surrounding non-performing assets (“NPAs”), the RBI had issued a press release in June 2017, wherein it decided to initiate insolvency proceedings against certain companies that had high exposure to NPAs based on certain criteria laid down by the RBI. Accordingly, 12 companies (including Essar) came within the purview of the criteria. It is pertinent to note that approximately 25 per cent of the total NPA value of banks was owing to the accounts of the aforementioned 12 companies.

The RBI had also clarified that a consortium of lenders (led by the State Bank of India (“SBI”)) had decided to initiate proceedings under section 9 of the I&B Code, as there was a clear failure to effectively implement the debt restructuring scheme that was approved by Essar’s board of directors.

Soon after the lenders, led by the SEBI initiated insolvency proceedings before the National Company Law Tribunal (“NCLT”), Essar approached the Gujarat High Court seeking to quash the press release of the RBI issued in June 2017 calling upon the banks to initiate proceedings against the 12 borrowers, based on which the SBI had initiated insolvency proceedings against Essar.

Contentions as raised by Parties

1.         Essar

Essar primarily contended that the rationale, process and justification provide by the RBI in determining which cases are to be referred to the NCLT is arbitrary and unjust. Another concern raised by Essar was that if an Insolvency Resolution Professional (as mandated by the I&B Code) were to be appointed to take over the management of the company, it would place the company at great risk, particularly given the extent and magnitude of the business operations of Essar.

Moreover, Essar contended that the RBI had completely ignored the fact that the debt restructuring scheme as planned and agreed by Essar was in its final stages of negotiation and would be ready soon, thus negating the need for RBI intervention.

2.         RBI

The RBI’s contentions relied on the contextual scenario with regard to the Indian economy. As of 31 March 2017, the gross NPAs of Indian banks was over Rs. 728,768 crore (almost 5% of India’s Gross Domestic Product).

The RBI further contended that Section 35AA of the Banking Regulation Act, 1949 (“Banking Act”) (introduced by way of the Banking Regulation (Amendment) Ordinance, 2017 (the “Banking Ordinance”)) empowered it to initiate insolvency proceedings before the NCLT and there is no restriction on initiation of proceedings even if negotiations between the borrower and the financial creditor were ongoing (as was the case in the present dispute).

The RBI informed the Court that the NPAs of Essar rose from Rs. 31,671 crores till 31 March, 2016 to Rs. 32,864 crores till 31 March, 2017. Through it arguments, the RBI sought to clarify that it will seek to focus on cases which have the profile of being the largest and longest-standing NPAs.

Court’s Decision

Through its order, the Court dismissed the petition filed by Essar by stating that Section 35 AA of the Banking Act empowered the RBI to intervene in cases wherein it deems initiation of insolvency proceedings to be the most practical solution, and that there was nothing wrong with the RBI’s decision to initiate insolvency proceedings.

However, the Court was quick to observe the carelessness and haphazard construction of the RBI’s press release, by noting that the usage of the phrase “such cases will be accorded priority by the National Company Law Tribunal…” was a serious issue, as “nobody is entitled or empowered to advise, guide or direct the judicial or quasi-judicial authority in any manner whatsoever”. The Court, thus, demanded a more cautious approach to release of official RBI documents and press releases, which led to the RBI releasing a corrigendum on 8 July 2017 to delete the sentence in question.

As an important issue was one of the commencement of insolvency proceedings before the NCLT, the Court clarified that Essar must be given a fair and equal opportunity to be heard, and that the substantive issues of the case would be dealt with by the NCLT itself. In other words, the insolvency petition cannot be admitted mechanically.


Keeping in mind the ballooning NPA problem that has confronted India’s economic growth, the faith reposed by the Gujarat High Court on the I&B Code in general and the specific insolvency process pertaining to Essar would be welcomed by the banking community. The Court’s recognition of the importance of the Banking Ordinance reaffirms its status as an effective legislative tool to counter the menace of bad loans. At the same time, the Gujarat High Court was not called upon in the Essar case to rule on the constitutionality of the I&B Code or the Banking Ordinance. Whether any of the affected debtors would venture that far remains anybody’s guess, although it cannot be ruled out.

- Saurav Roy

Tuesday, July 25, 2017

Activism through Directors Elected by “Small Shareholders”

Recent news reports (here, here and here) have highlighted a shareholder proposal that has been initiated in preparation for the annual general meeting of Alembic Limited to be held on 28 July 2017. The shareholder in question is Unifi Capital Private Limited who is said (though not verified) to be holding 3% shares in Alembic. The proposal involves the election of a “small shareholder” director for which Unifi Capital put forward the name of Mr. Murali Rajagopalachari. Although the company has since withdrawn the item from the agenda for the shareholders meeting, the developments have raised the possibility that activist investors could potentially use the “small shareholder director” route in order to get their voice heard by resistant boards. Proxy advisory firm IiAS has a detailed memo on the impact this episode will have on shareholder activism. In this post, I outline some of the issues pertaining to the “small shareholder director” and conclude that its utility is likely to be limited, if at all, as a tool of shareholder activism.

Background and Purpose

The concept of a “constituency director” is not novel, either in India or elsewhere. Such a director’s election is attributable to a predefined constituency. A nominee director (proposed by a controlling shareholder or private equity investor) is a paradigmatic instance of a constituency director. Similarly, in the Indian context, directors nominated by banks through powers set forth in specific banking legislation are another example. However, the idea of small shareholders as a distinct constituency electing directors is not common around the world, and India appears to be an honourable exception in providing for a director to be elected by small shareholders.

To be sure, the concept of small shareholder director existed even under the Companies Act, 1956, although it was introduced into the legislation by way of an amendment in the year 2000. It is presently contained in section 151 of the Companies Act, 2013 (the “Act”). The idea seems to be premised on the need to provide representation and a voice to the small shareholders who are otherwise passive and apathetic. While it has been on the statute book for a decade and a half, it has hardly been used. Given that its potential use as a tool for shareholder activism has been highlighted, it is useful to consider some of the other features and issues surrounding the concept.

Election of a Small Shareholder Director

The bar for the election of a small shareholder director has been set quite high. Rule 7 of the Companies (Appointment and Qualification) of Directors Rules, 2014 (the “Rules”) provides that the lower of 1,000 shareholders or one-tenth of the total number of shareholders of a listed company may propose the election of a director. Alternatively, a listed company may, of its own accord, opt to have the small shareholders elect a director. The Companies Act, 2013 in section 151 defines “small shareholders” as those holding shares of nominal value of not more than Rs. 20,000.

It would certainly be a tall order for an activist investor to garner the support of such a high number of small shareholders. It not surprising at all, therefore, to find that small shareholdings could be “created”, as reported in the Alembic case. This can be done by orchestrating sales of shares to several small shareholders so as to generate the constituency required for the election of such a director. While it is not clear as to who has been behind the process of disaggregating the shareholding of the company, both an activist investor as well as incumbent management (or promoter) may indulge in the process, which will lead to an all-out proxy war. Whether the artificial creation of such constituencies in the run up to the election of a small shareholder director is legally permissible is an interesting question. On the one hand, it may be argued that there is nothing illegal about such disaggregation of shareholdings, as long as the sales and purchases of shares are otherwise legitimately carried out. But, on the other, the question arises as to whether this amounts to vote manipulation. A similar effort in Hong Kong in the context of a scheme of arrangement was clamped down by a court in the case of Re PCCW Limited ([2009] HKCU 720). But, the exercise of powers under section 151 neither involve court approval nor are they through a scheme of arrangement, thereby creating a legal vacuum regarding the legitimacy of such an approach.

In any event, such directors are to be elected by way of a majority of small shareholders, with no other shareholders eligible to vote for the purpose. Moreover, such election ought to be conducted through a postal ballot.

Qualification of a Small Shareholder Director

The Rules provide that the person proposed as a small shareholder director must satisfy all the requirements for appointment as a director, and ought not to be disqualified under section 164 of the Act. Moreover, the small shareholder director may be considered an independent director if the requirements under section 149(6) and (7) are satisfied. This issue may come to the forefront in case of the appointment of a person who is put up by a significant shareholder such as an activist investor (as experienced in the Alembic case). Questions could arise whether the board could have the discretion to determine the suitability of the person for appointment as a director even if she otherwise satisfies the qualification criteria. At one level, if the election by the constituency of small shareholders is to act as an investor protection mechanism, the board must be left with a fait accompli once a person is elected to the board by the small shareholders. On the other hand, section 178 of the Act provides for a broader role for the Nomination and Remuneration Committee regarding the composition of the board as a whole, and as to the qualifications and competencies of individual directors. The topical question would be whether the Nomination and Remuneration Committee can exercise power under section 178 to determine the suitability of a person proposed to be a small shareholder director. Arguably, this will come within the ambit of the Committee’s roles and responsibilities, although how this will interact with the minority’s choice of director to represent their interests is unclear. Only a test case will determine how a conflict (or an apparent one) between the appointment of a small shareholder director (under section 151) can be reconciled with the terms of reference of the Nomination and Remuneration Committee to shape the composition of the board (under section 178).

These issues are not merely within the hypothetical realm. Take a case where a company has just the minimum number of independent directors as required by the Act. If a person proposed by the small shareholders for appointment under section 151 does not satisfy the “independence” requirements, her appointment to the board will bring the number of independent directors below the statutory minimum, thereby resulting in non-compliance. Can the board (or the Nomination and Remuneration Committee) in such circumstances refuse to facilitate the appointment of such a person as a small shareholder director? Alternatively, will it be under any form of compulsion to appointment the small shareholder director, and follow that up with the appointment of additional independent directors to bring about the requisite balance and to comply with the independence requirements? Companies that face activism through the small shareholder route will have to prepare for such scenarios.

Whose Interests to Serve?

Like the case of nominee directors, there could be considerable ambiguity if the small shareholder director is required to serve two masters, namely the company (as an entity) on the one hand and the small shareholders (collectively as the constituency) on the other. While the Act makes provision for the election of the small shareholder director, it does not explicitly lay out the roles, responsibilities, duties and liabilities of such director. In that sense, the small shareholder director is no different from other directors, and will be foisted with the array of duties under company law as applicable to all directors. While there is some level of segmentation among the director body when it comes to appointments, which creates a specific mode of appointment for the small shareholder director, no distinction exists in relation to the roles and responsibilities. The small shareholder directors’ duties are like that of other directors. Hence, such a director, once appointed by the small shareholders, cannot simply advance the interests of her constituents at the cost of the broader interests of the company and other shareholders. Directors’ duties under Indian law (albeit under common law and not expressly in statute) are owed to the company and not to individual shareholders. Hence, while the small shareholders are entitled to appoint a director, ostensibly protect and advance their interests, in the end the director so appointed cannot prefer the interests of the constituents over and above the broader interests of the company. Individuals being proposed for election as small shareholder directors must be fully cognizant of the unenviable position they are likely to be placed in. Discharge of such a role will require a great deal of sophistication and experience.

Impact on Shareholder Activism

What motivated this post was the enthusiasm displayed by the media and commentators regarding the use of the small shareholder director provision in the Act to stimulate greater shareholder activism. The excitement surrounding the Alembic case is emblematic of the euphoria, even though in that case the proposal itself may not be put to vote at the shareholders’ meeting. Given that the Indian company legislation is somewhat rare in providing for small shareholder directors, the possibility of its use as a tool of shareholder activism cannot be ruled out. At the same time, there are considerable limitations with its design and operation.

At the outset, as discussed earlier, the bar has been set too high for the proposal and election of small shareholder directors. Several aspects of the appointment and role of such director suffer from considerable ambiguity. Even assuming an appointment is successful in a given case, the small shareholder director is only one among several directors, and cannot affect the outcome of a board decision. Such director can be privy to information placed before the board, and can express views and opinions and seek to convince other directors on matters being discussed, but would not be in a position to veto any decision. To that extent, the utility of such a position is to make the voice of various stakeholders (including the electorate consisting of small shareholders) heard and to infuse a higher level of transparency in board decision-making.

More importantly, while the small shareholder director is an important tool for the protection of “small” shareholders, necessary care and caution must be exercised to ensure that the position is not used by one or more large institutional investors who have an axe to grind with the management or promoters. Without appropriate checks and balances, the small shareholders may end up acting as pawns in larger corporate battles amongst groups of influential shareholders (such as a large institutional investor and the promoters). This will end up compromising the interest of passive retail shareholders rather than protecting them, which was the reason for the small shareholder director in the first place.

Insolvency & Bankruptcy Code: Arbitral Proceedings and Bona Fide Dispute

[Guest post by Puneet Dinesh, is a IV year student at the National Law University, Delhi. He can be reached at]

The Insolvency and Bankruptcy Code, 2016 (the ‘Code’) has given rise to some interesting legal questions. As previously discussed on this Blog (here and here), the interpretation of the term ‘dispute’ under section 5(6) of the Code has arisen multiple times before the National Company Law Tribunal (‘NCLT’). In this post, I intend to cover the aspect concerning a dispute raised by way of an arbitral proceeding.

The scheme of an insolvency proceeding under the Code initiated by an operational creditors run as follows. The operational creditor, upon the occurrence of a default, delivers a notice to the corporate debtor under section 8 of the Code. A period of ten days is provided for the debtor to respond to the notice proving the existence of a ‘dispute’. In this regard, section 5(6) defines the meaning of the term ‘dispute’:

"dispute" includes a suit or arbitration proceedings relating to—

(a) the existence of the amount of debt;

(b) the quality of goods or service; or

(c) the breach of a representation or warranty;

The existence of an arbitral proceeding is sufficient to stall the entire proceedings under the Code. In order to determine whether an arbitral proceeding exists or not, it would be necessary to refer to the Arbitration and Conciliation Act, 1996 (the ‘Arbitration Act’). Section 21 of Arbitration Act provides that ‘the arbitral proceedings ...commence on the date on which a request for that dispute to be referred to arbitration is received by the respondent’. Further, section 3(2) of the Arbitration Act provides that ‘the communication is deemed to have been received on the day it is so delivered’. Reading sections 21 and 3(2) in conjunction, an arbitral proceeding is commenced the moment the debtor sends a written communication requesting the reference to arbitration, which is received by the creditor. Therefore, all that a corporate debtor needs to do to stall the proceedings under the Code is to merely send an email requesting for arbitration, and any efforts of the creditor to resort to protection under the Code is instantaneously stalled.

The interesting question that emerges here is to ascertain if the NCLT can scrutinize any abuse of process by the debtor in seeking to stall insolvency proceedings. Section 9(5) of the Code confers power on the NCLT to admit or reject the application by the operational creditor on listed grounds. Section 9(5) as it stands is extremely formalistic and provides limited flexibility for the NCLT to adjudicate.

In these circumstances, it would be useful to analyse analogous situations in other legislation where courts or other adjudicating authorities have had to ascertain the existence of a dispute, and standards they have employed to determine whether such dispute was bona fide. Indian courts have faced similar questions under the Arbitration Act. Section 8 of the unamended Arbitration Act, which provided for reference of disputes to arbitration was extremely formalistic requiring the courts to refer the matter, except when formal conditions provided in the Act were not met. The parallel between these two provisions has not gone unnoticed before the tribunal. The National Company Law Appellate Tribunal (‘NCLAT’) in Kirusa Software Pvt. Ltd. recently observed:

It may be helpful to interpret Sections 8 and 9 and the jurisdiction of the Adjudicating Authority being akin to that of a judicial authority under Section 8 of the Arbitration & Conciliation Act, 1996 amended up to date, which mandates that the judicial authority must refer the parties to arbitration.

Section 8: Dispute and its bona fide nature

Section 8 of the Arbitration Act, as interpreted through landmark decisions such as P. Anand Gajapathi Raju and Pinkcity Midway Petroleums have consistently guarded against judicial interference at the reference stage. However, in a recent decision the Delhi High Court in M/S Fenner (India) Ltd. vs M/S Brahmaputra Valley ventured into finding whether there was a valid ‘dispute’ in the first place. While it is arguable whether an adjudication of the existence of the dispute (and the extent thereof) is permitted under section 8, the decision also makes observations to the effect that a dispute must be a bona fide dispute in the first place. In making reference to several provisions of Code of Civil Procedure, 1908 (‘CPC, 1908’) the court made some important observations with regard to the dispute being one with bona fide motive. While the NCLT is not bound by the procedure laid down by CPC, 1908, section 424 (2) of the Companies Act, 2013 vests the tribunal with the same powers of a civil court. Although the nature of section 8 of the Arbitration Act and section 9(5) of the Code are vastly different in their subject-matter, it is useful to bear in mind that the court under section 8 with similar formalistic powers as section 9(5) attempts to navigate through the ‘intention’ of the dispute raised.

Section 9 of Arbitration Act: Commencement of Arbitration

As previously noted, an insolvency proceeding under the Code can be brought to a complete halt by the debtor by merely sending a notice of arbitration. In theory, it is possible that the debtor does not intend to participate in the arbitration proceeding and exercises this option as a dilatory tactic. Can the tribunal examine whether the debtor truly intends to commence arbitration?

In this regard, useful parallels can be drawn from the jurisprudence under section 9 of the Arbitration Act. Section 9 empowers the court to grant interim relief ‘before or during’ the arbitral proceedings. The looming concern was that parties may attempt to seek interim relief even before the commencement of an arbitral proceeding without intending to commence arbitration in the first place! Sundaram Finance (1999) caught on to this mischief early on and held that the parties must show a manifest intention to arbitrate while seeking a relief through section 9 of the Act. Later, the Supreme Court in Firm Ashok Traders (2004) extended Sundaram Finance’s logic to hold that ‘....the Court may also while passing an order under Section 9 put the party on terms and may recall the order if the party commits breach of the terms’. Even apart from section 9, nothing in the Arbitration Act confers such a power on the court. All this was read into section 9, given the ‘… scheme in which Section 9 is placed’. While both these cases serve as classic examples of judicial legislation, in the current analysis, it serves as suitable examples regarding the implicit powers the court has exercised to verify the bona fide conduct of the parties in the proceeding.

Winding up of Company: IBA Health on Bona Fide Nature of Dispute

The courts interpretation under winding up cases also provides some guidance in this regard. While the Companies Act, provided for winding up ‘if the company is unable to pay its debts’, the court in IBA Health v. Info-Drive Systems (previously covered here) held that if there is a bona fide dispute regarding the debt, the creditor cannot file a winding up petition. This is one more instance, wherein the court implicitly read in the bona fide nature of the dispute to check if the parties engage in abuse of process. This post highlights that through multiple instances, the court implicitly required the parties to engage in good faith without a specific legislative mandate. In Kirusa Software, NCLAT made a passing reference in this regard:

(Dispute) must be raised in a court of law or authority and proposed to be moved before the court of law or authority and not any got up or malafide dispute just to stall the insolvency resolution process.

It is hoped that the scheme of the Code which seeks to create a time bound insolvency resolution process is protected by developing internal mechanisms to check such abuse of process by corporate debtors. In the absence of clarity in the legislation, much will depend on the jurisprudence developed by the adjudicating authority, and the analogous circumstances discussed above will likely provide some guidance.

- Puneet Dinesh