Respite To Operational Creditors by Inclusion of Solvent Entities in Group Insolvency

Debarchita Pradhan*

Introduction

The development of jurisprudence in insolvency law is no longer limited to the resolution of an individual insolvent company. There exist unique challenges in the insolvency of group companies due to the interlinkages between them. While the Insolvency and Bankruptcy Code, 2016 (‘the Code’) does not specifically address such challenges, courts have provided various mechanisms, including procedural coordination and substantive consolidation, for dealing with them. Different scholars have supported the necessity of creating a framework surrounding the problems as well as opportunities of group insolvency.[1] However, none of them adequately address the specific problems faced by operational creditors when a group company fails to pay the debt owed to them.

This paper argues for extending the mechanism of substantive consolidation to solvent companies in certain instances to avoid prejudice to operational creditors. To this end, it first explains the prevailing discussion around group insolvency. Second, it argues for the inclusion of assets of solvent group entities in the consolidated pool of assets formed through the mechanisms of substantive consolidation. Third, it explains the challenges faced by operational creditors due to the conditions imposed on them by the Code and the interlinkages between the group companies. Consequently, it explains how consolidating the assets of solvent entities would be justified and beneficial to the interests of operational creditors.

Position In Group Insolvency

The Code provides various mechanisms for the resolution of an insolvent company while keeping the creditors’ interests in priority. It ensures that the creditors have sufficient information regarding the accounts of the company; It gives them the opportunity to initiate the insolvency proceedings and the ability to recover a reasonable amount in respect of their claim by emphasizing on the maximization of value of assets of the insolvent company.[2] However, there is uncertainty regarding how such mechanisms would work when one needs to deal with the insolvency of more than one member company of a corporate group.

In light of such confusion, and courts being faced with matters involving insolvent members of a group, the Working Group on Group Insolvency (‘the Working Group’) issued a report discussing the features as well as the issues of the same. It acknowledged the insufficiency of provisions of the Code in dealing with the structural, financial and operational interdependence of these companies. Hence, it is suggested that if the insolvency proceedings take into account such interdependence, it would solve various problems regarding the lack of information and additional transaction costs of conducting separate proceedings. Consequently, this will lead to the maximization of the value of assets[3] 

However, while the report strongly recommended procedural coordination, there was less enthusiasm in favour of substantive consolidation in a group insolvency.  In simple words, procedural coordination refers to the process of coordinating the procedures for the resolution of different insolvent members while keeping their assets separate. On the other hand, in substantive consolidation, all the assets of the group companies are pooled together into a single insolvency estate to satisfy the claims of all their creditors.[4] Since substantive consolidation violates the rule of asset partitioning, the Working Group decided not to implement it at this time.[5] However, as many scholars and courts have demonstrated, there exist compelling reasons to opt for substantive consolidation in certain group insolvencies. The following sections build on these reasons to argue for the consolidation of assets of solvent companies, particularly in cases wherein doing so addresses the significant prejudice faced by operational creditors.

Avoiding Hesitation Against Consolidating Solvent Entities

Before arguing the case for including solvent companies to protect operational creditors in peculiar situations, it is pertinent to placate the broader hesitation against substantive consolidation of solvent companies in a group insolvency.

The major concern for completely denying substantive consolidation for both solvent and insolvent companies is that it disregards the fundamental rules of asset partitioning and strict standards of piercing the corporate veil.[6] However, the doctrine of substantive consolidation is wholly separate from such general corporate principles. When the assets of an insolvent company are combined with those of other companies for distribution to creditors and stakeholders, the limited liability of investors remains intact. They are not held personally responsible for the actions of the corporation, and there is no piercing of the corporate veil.[7] Hence, the arguments of limited liability and veil piercing should also not be used against involving solvent entities in the substantive consolidation.

Further, the Working Group had cautioned that such consolidation harms the creditors who relied on the separate character of the individual group companies while contracting with them.[8] However, the responsibility falls on the creditors opposing consolidation to show the independent existence of the entities that are the subject of such objection. Even otherwise, any harm caused to a few creditors due to the substantive consolidation would be irrelevant if the benefit outweighs the harm (although in rare circumstances).[9] .Similarly, creditors opposing the consolidation of solvent entities should bear the burden of proving that the degree of independence of such solvent companies justified their reliance on the separate status of these entities. Even if such a burden is satisfied, substantive consolidation of such solvent entities can still be warranted if the benefits to the operational creditors outweigh the harm caused to a few other creditors.

Lastly, it is argued that Indian courts lack the authority under the Code to order substantive consolidation.[10] This differs from Section 105(a) of the U.S. Bankruptcy Code, which empowers courts to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions” of the Code. However, the equitable powers of the court to order substantive consolidation never originated from Section 105(a).[11] Hence, even if the powers of the courts in India are outside the scope of Section 60(5), this does not rule out the possibility of ordering substantive consolidation of any entity based on either principles of equity or the rationale of maximization of the value of assets.

Following a similar line of argument, the inclusion of solvent entities in the insolvency proceedings has been largely denied on the basis that they fall outside the scope of the Code.[12] However, as noted above, the doctrine of substantive consolidation doesn’t arise from the Code. . Moreover, it has been suggested that jurisprudence on substantive consolidation should be developed first through the practice in courts.[13] Hence, the purpose of substantive consolidation and the factors necessary to apply it have to be independently considered while deciding whether the assets of the solvent companies should be included in the consolidated pool of assets.  Limiting the doctrine of substantive consolidation strictly to the provisions of the Code overlooks important factors that may justify such inclusion, particularly the unusual disadvantage that an operational creditor may face due to the interconnected operations of the solvent group companies.

Having addressed the broader objections to consolidating solvent entities, it is now possible to consider the specific context of operational creditors in group insolvency scenarios where such consolidation is both justified and necessary.

Erasing The Prejudice To Operational Creditors In Group Insolvency

Importance of Operational Creditors in Group Insolvency Although operational creditors hold less power than financial creditors under the Code, their significance for the insolvent company undergoing resolution is acknowledged in many cases. It is emphasized that operational creditors are essential for operating the company as a going concern.[14]

This is particularly crucial for group companies that rely on each other for operational services. In such cases, substantive consolidation is recommended because the viability of one company heavily depends on the services of the other.[15] For instance, if insolvent Company A is dependent on insolvent Company B for essential operational services, it would not be able to function without Company B, and hence, finding buyers would be difficult without consolidation. This factor was also acknowledged in Re Axis Bank Ltd. case, where the parent company, LCL, was heavily dependent on its subsidiaries for essential functions, and hence, most resolution applicants willing to bid for LCL insisted on substantive consolidation.[16] Now, since Company A depends on Company B for operational services, operational creditors of Company B become essential for the resolution of both these companies. If they are abandoned, achieving a value-maximizing resolution plan might be difficult, which in turn would also defeat the interests of financial creditors. Hence, it becomes necessary to take into account the unique problems faced by operational creditors in group insolvency cases and explore the possibility of involving solvent entities if necessary.

Anomalies Regarding Operational Creditors in Group Insolvency Firstly, according to Section 8, on the occurrence of a default, the operational creditor “may send a demand notice or a copy of an invoice demanding payment of the amount involved.”  As per Section 9 (5)(i), the application of the operational creditor will be admitted only if such invoice or notice for payment is delivered and there is no dispute regarding the payment.[17] So, there is a condition for operational creditors that needs to be fulfilled for initiating insolvency proceedings.

However, there might be several operational interlinkages among the group companies, for instance, concerning the supply of raw materials or technical services,[18] and little clarity on who is ultimately benefiting from such goods and services. In such instances, there will always be disputes as to who owes what amount of debt to an operational creditor. For instance, Operational Creditor X contracted with one of the group companies, Company A, for supplying some goods and services. However, it is not clear in the contract as to whether Company A is liable to pay, or it might be possible that the benefits of the supplies are actually transferred to another group member Company B. If X would like to initiate insolvency proceedings on account of default against any of these group companies, A and B, both of them might dispute the payment. This would, in turn, lead to rejection of the application of the operational creditor at the initiation stage.

Hence, in such cases, assuming no other stakeholder initiates the proceedings against companies A and B, they would retain the tag of solvent entities and might escape the liabilities to the operational creditors. In such situations, if other members of the group, excluding Company A and Company B, are undergoing substantial consolidation, it can be beneficial for operational creditors to combine the assets of the solvent Companies A and B into the consolidated estate. While other creditors of the solvent companies may object to their inclusion by conventional arguments against the consolidation of solvent entities in group insolvency, such concerns can be addressed through the equitable considerations discussed in the previous section. Even if the operational creditors might get a decreased amount of their claims due to the pooling of assets, it would be better than receiving nothing.

Secondly, even if the insolvency proceeding is initiated successfully by a financial creditor against one of the group companies, say Company A, the existence of a dispute might defeat the interests of operational creditors. Generally, when the claims filed by operational creditors are found to be disputed by the resolution professional, they are admitted only notionally at INR 1.[19] They would receive nothing under the consolidated resolution plan because of the existence of a dispute, which only arises because of the interlinked functioning of the group companies. Hence, in such cases, it would be justified to include the assets of solvent member Company B, provided that there exists a prima facie possibility that it might be responsible for paying the operational creditor X. This would also increase the pool of assets for the distribution of claim amounts and result in maximum recovery. Further, the consolidated group of companies (operationally interlinked) would also provide an attractive option for the resolution applicants.

Conclusion

The doctrine of substantive consolidation can be used to include solvent companies where necessary and justified on appropriate equitable grounds. Such grounds should be developed gradually in the jurisprudence of group insolvency without the textual restriction of the Code.  This piece highlights one of such grounds in the form of the prejudice suffered by operational creditors both due to the interlinkages among the group companies and the requirements in the Code itself. . However, it doesn’t in any way argue for a liberal application of the doctrine of substantive consolidation, where, due to the sole reason of harm to operational creditors, courts have to order substantive consolidation. The required factors for determining the necessity of substantive consolidation[20] should be fulfilled in every case. The paper simply addresses the general reluctance to include solvent entities in any case which stems from a lack of authority to do so and the fear that it would reduce the pool of assets available for the creditors of the solvent entity.

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*Debarchita Pradhan is a B.A., LL.B. (Hons.) student at the National Law School of India University (NLSIU), Bengaluru

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[1] Insolvency and Bankruptcy Board of India (IBBI), Report of the Working Group on Group Insolvency (2019), 13-14.

[2] The Insolvency and Bankruptcy Code, 2016, s. 7, 9, 21(9).

[3] Working Group (n 1) 13, 20-21.

[4] ibid 24.

[5] ibid 22.

[6] ibid.

[7] Douglas G. Baird, Substantive Consolidation Today (2005) 47 BCL Rev 5, 8; J. Stephen Gilbert, Substantive Consolidation in Bankruptcy: A Primer (1990) 43 Vand L Rev 207, 218.

[8] Working Group (n 1) 61.

[9] State Bank of India and Anr. v. Videocon Industries Ltd. and Ors. (2019) SCC Online NCLT 745, [80-83].

[10] In the Matter of Giriraj Enterprises v. Regen Powertech Pvt. Ltd. (2023) SCC Online NCLAT 2546, [77].

[11] Timothy E. Graulich, Substantive Consolidation- A Post-Modern Trend (2006) 14 AM Bankr Inst L Rev 527, 553-554.

[12] Ministry of Corporate Affairs (MCA), Report of CBIRC-II on Group Insolvency (2021), 28.

[13] ibid 22.

[14] Committee of Creditors of Essar Steel India Ltd. Through Authorised Signatory v. Satish Kumar Gupta [2019] 16 S.C.R 275, [45].

[15] Working Group (n 1) 15, 76.

[16] In Re: Axis Bank Ltd. (2020) 162 SCL 67, [18-19].

[17] IBC 2016, s. 8, 9.

[18] Working Group (n 1) 13.

[19] Essar Steel (n 14) [102]; Tata Steel BSL Ltd. vs. Varsha and Ors. 2019 SCC Online Bom 541, [21-26].

[20] Videocon (n 9) [80]