Corporate Insolvency Law Reform By Half Measures?

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1 Corporate Insolvency Law Reform By Half Measures? It was beginning to be almost unanimously felt that India s law on industrial Sickness- The Sick Industrial Companies (Special Provisions) Act 1985 (SICA) was not quite right. Ultimately, Justice V. Balakrishana Eradi (Rt.) was appointed by the Government to suggest what should be done. Following the recommendations of Eradi committee, The Sick Industrial Companies (Special Provision) Repeal Bill, 2001 was introduced in the parliament in August 2001, which provided for abolition of BIFR and AAIFR as a part of a package whereby SICA would be repealed. As per this bill, the provisions in respect of rehabilitation and revival of sick industries stood merged in the Companies Act, 1956, by inserting a new Chapter VI A therein. New provisions thereof propose to set up a National Company Law Tribunal (NCLT), which would undertake the responsibility for nursing and resuscitating sick industrial companies. Is this a complete overhaul of Indian bankruptcy laws? Today Industrial Reformation laws and Industrial Insolvency or Bankruptcy laws have attained increasing importance and attention in the developing economies throughout the world. These laws are perceived as parameters and important indicia of the economic health of a country. It would be difficult to distinguish between industrial bankruptcy and industrial sickness. The later one is an extreme case where firms chronically make losses to a point where accumulated losses exceed their net worth and yet continue to be in operation. High incidence of industrial sickness has the effect of blocking of scarce financial resources and loss of employment, loss of production and loss of government revenue. It is important that corporate insolvency laws match up to their underlying policy objectives. Insolvency cannot be completely cured - but that is OK In India, the problem of the industrial sickness has been a long standing one and the sizable magnitude and incidence of sickness has been a serious concern for the government. The bane of industrial sickness not just affects the industrial concern but also leads to accumulation of Non-Performing Assets with the banks and labour problems. In the past, various efforts were made by the government in consultation with the Reserve Bank of India (RBI) to tackle the problem of sick units and to find out the solution for the revival of sick industrial units. In 1981, RBI appointed a committee headed by T. Tiwari (Chairman, Industrial Reconstruction Corporation of India), to examine the legal and other problems faced by

2 the banks and financial institutions in rehabilitation of sick industrial units and to suggest remedial measures for effectively tackling the problem of sickness. The committee, in its report stressed the need for comprehensive 1egislation to deal with the problems of sick industrial units. Following the recommendations of the Tiwari Committee, the Government of India enacted the Sick Industrial Companies (Special Provisions) Act, 1985, (SICA). The Act, inter alia, provided for setting up of the Board for Industrial and Financial Reconstruction (BIFR) and Appellate Authority for Industrial and Financial Reconstruction (AAIFR). The Act was enacted in the public interest and the object of the legislation was to provide for timely detection of sickness in industrial companies and for expeditious determination by a body of experts of the preventive, ameliorative, remedial and other measures that would need to be adopted with respect to such companies and for enforcement of the measures considered appropriate with utmost practicable dispatch. Although, the object of the Act was laudable, the Act contained several sections that were capable of and were factually misused by the erring promoters' to defeat the object of the Act, the most notable of such provisions was the protection under Section 22 of the Act. Due to such inherent defects of SICA, BIFR failed to fulfill the purpose and mandate as envisaged therein. While the causes of the sickness remained circumspect in many cases, at times even resulting from management deadlock or even shareholder disputes, the effects of the sickness proved to be disastrous for the banking system affecting the investment climate and prospects. SICA Repeal The main drawback of the SICA scheme is that it seemed to be so heavily loaded in favour of the debtor company that it created an asymmetry and imbalance between the interests of the debtor company and that of its creditor. Therefore, its restructuring had become necessary to undo this imbalance in keeping with the banking reforms. The definition of sick industrial company in S.3(1)(o) and S.22 (i.e. suspension of legal proceedings against sick companies) of SICA and its judicial interpretation again in favour of debtor company, also contributed to create a situation, which culminated in repeal of SICA. As per S. 3(1)(o) 'sick industrial company' means an industrial company which has at the end of any financial year accumulated losses equal to or exceeding its entire net worth and is registered for not less than three years. The concept of 'sick industrial company' has been used, in many cases, by promoters and company management for preventing

3 recovery and to avail of remissions and concessions, merely, by manipulating the accounts of the company in any financial year just to come within the purview of the definition of 'sick industrial company' as provided in SICA, and to escape from any further liability. Section 22 of the SICA provides for suspension of legal proceeding, contracts etc. with respect to the sick industrial company, in circumstance mentioned therein and with incidents specified under the provisions. The object of Section 22 is not to provide protection to unscrupulous persons, however, promoters and management of the companies have used this section as weapon to avoid payment to their creditors. These provisions apart, the elaborate procedure provided under the Act as also the spiraling pendency of the cases before the BIFR/ AAIFR resulted in near nullification of the object of the Act, a case proverbially, of a doctor attending the patient too late. The pendency and endemic delays also caused serious banking and labour concerns and increase in the cost of industrial restructuring/reformation. Section 22 of the SICA accorded protection to the sick company from the legal proceedings both pending and future, if an inquiry in respect of the sick company was pending before the BIFR. This provision was judicially interpreted by the Supreme Court of India to include the protection to a Guarantor in the case of Patheja Brothers vs. ICICI reported in [2000] 26 SCL 404. In an earlier judgment of the Supreme Court in the matter of Real value Appliances reported in JT [1998] 3 SC715, the court held that the protection under Section 22(1) of the SICA became applicable no sooner than the registration of the reference by the BIFR. This view was followed by the Court in another judgment of Rishab Agro Industries vs. PNB Capital Services Limited reported in [2000] 25 SCL 461. While the judicial interpretation was meant to give constructive and meaningful interpretations to the provisions of the SICA, it could not, as indeed it was not meant to, check the misuse of SICA and its usage as per convenience of the erring promoters. Thus, while the courts enlarged the scope of the provisions of the SICA to aid industrial revival, it further incentivised the misuse of SICA by the erring promoters. Proposed changes in the insolvency law Amendments in the provisions of SICA were long over due and this is certainly a step in the right direction. An effort has been made to overcome the defects in the earlier scheme of SICA. Remarkable changes in the new provisions for rehabilitation of sick companies, as incorporated in The Companies (second amendment) Act, 1956, are:?? New definition of Sick Company ;?? Time-bound mechanism to deal the problem of industrial sickness; and?? Section 22 of SICA has been repealed altogether.

4 New Definition of Sick Company Under S.2 (46AA) of the amended companies act, a Sick Company is defined as one whose accumulated losses in any financial year are equal to or more than fifty percent of its average net worth during four financial year immediately preceding such financial year or a company which has failed to repay its creditors for three consecutive quarters on demand. The concept of four years average of net worth for determining the true position may prove to be a wise introduction, which would be more realistic than the provisions of the erstwhile SICA. This has, prima facie, been done to stop the malpractice to book number of items at the end of financial year to make the company look sick. Provision regarding fifty percent of its entire net worth, will result in sick company getting the attention earlier thereby improving the chances of revival. The provision regarding the default in payment by the company for three consecutive quarters will not only allow the board of directors of company but also Banks and Financial Institutions to refer the Company to the Tribunal for its revival even if the company is registered for less than five years. Time Bound Mechanism New Provisions specify time period for completion of enquiry, framing of scheme by the operating Agency and for passing of order for sanctioning of scheme. NCLT is expected to adhere to this faster time-bound mechanism for dealing with the problem of industrial sickness. As regards winding up of sick industrial companies, it is provided that after making inquiry and considering all the relevant facts and circumstances and after hearing the parties concerned, if the Tribunal is of the opinion that the sick industrial company is not likely to become viable, it may record its findings and order winding up of the company. The Tribunal may also have power to sell the assets of the sick industrial company for distribution in accordance with the provisions of Section 529A of the Companies Act, The winding up of a company shall, as far as may be, conclude within one year from the date of the order of winding up. This time bound mechanism may prove to be helpful in providing timely solution to revive the sick companies. Section 22 of SICA There is no provision corresponding to S.22 of the SICA in the new amendment. This Section has been repealed completely. Undoubtedly, this provision was subject to much abuse in the past; however, one must not lose sight of its beneficial effect in a genuine case. This provision was necessary, subject of course introduction of inbuilt and effective

5 checks for curbing its abuse, considering the vast geographical landscape of the country and the likely of a sick company facing legal proceeding in diverse places. Thus, altogether repeal of this provision, may prove to be more baneful than effective in the future. Proverbially, it is a case of altogether severing an ailing limb when an effective operation could have proved to be more beneficial. Outlook Under the new provisions, NCLT is empowered to deal with all company matters which were earlier handled by various High Court, Company Law Board, BIFR and AAIFR. It is apparent that this will lead to over-burdening of NCLT. With this amendment, there is no guarantee as to whether the slow mechanism of BIFR which was observed by the committee would disappear and the NCLT would be able to rehabilitate or wind up the company within 1 year. In other words, shifting the judicial procedure from one body to another gives no surety of speedy revival of sick companies in this judicial system. It is said that the functioning of a system solely depends on its users. A very well intended system may also prove to be the undoing if it is more abused than used. This was the case with the SICA leading to its repeal and passage of The Companies (Second Amendment) Act, 2002, by the Parliament. Even while, the users of the system remain the same, one hopes that the changes effected by this Act would go a long way to curb the historic abuse of the provisions of SICA and would aid timely revival of a sick company. Vasudha Mehta ALG India Law Offices The views are personal vasudha.mehta@algindia.com

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