Fifteen years ago, when the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (also known as the SARFAESI Act) was passed, first as an ordinance and later as an Act, it took quite some time for borrowers in the country to fathom that the scene has changed drastically. It was not possible any more, after the getting the default notice from the bank, to run to a lawyer to get a stay from a court and then relax for years together. The new law was completely non-adjudicative and, once there was a default on an instalment of interest or principal to a bank, it could simply demand the entire loan within a defined timeline, failing which the bank could come calling to grab the secured property. The country’s borrowers were so used to a regime where there would be hearings, adjournments, elaborate legal arguments, and finally an attachment order, before a repossession – the SARFAESI Act had none of that.
The Insolvency and Bankruptcy Code is another such rude awakening. The business community of the country is so used to the Sick Industrial Companies Act (SICA) regime, where the law could be used as a weapon to drag the process on for years. Borrowers, big and small, are finding to their astonishment that on the mere happening of a default, a lender can file an application to the National Company Law Tribunal (NCLT). The latter can then send the borrower into an insolvency process, which would mean that the business would temporarily come under the control of an insolvency practitioner. All management, in fact even the operation of bank accounts, will come under the control of the insolvency practitioner. The first reaction is: Is this process meeting the basic requirements of natural justice, a concept that is so much a part of our legal system?
Scheme of the law
While the jury is still out on the question as to whether the borrower, having defaulted on a financial obligation, still deserves a hearing before disposal of an application for insolvency, the larger thrust of the law, which is entirely creditor-driven, should be clear.
A financial creditor, essentially including a lender, or debenture-holder, may pull the borrower into insolvency proceeding if there is a default. It is not even necessary that the loan should have become a non-performing asset (NPA) in the books of the lender. A threshold default amount is stipulated (currently Rs1 lakh), but that is too small to be of any consequence. The lender proves the default with reference to records of an information utility, akin to a credit information bureau such as CIBIL. Currently, as information utilities are yet to be registered, the evidence may be of any objective form – including the records of the lender, or the correspondence of the borrower evidencing default. Once a default is proved, the NCLT will, in what appear like autopilot proceedings, pass an order putting the borrower into insolvency proceedings.
The immediate result of the insolvency order is that an insolvency practitioner, called Interim Resolution Professional (IRP), takes over the management of the borrower, sending the existing board of directors into a state of animated suspension. Once this happens, the borrower cannot do any private settlements with any of the lenders. So much so that he cannot even pay up the petitioning creditor to avert the implications of the insolvency proceedings. There is a complete moratorium on all transactions, except in the ordinary course of business. The control over the management of the entity, including on its finances, will come into the hands of the IRP.
Should lenders file for insolvency?
While the law enables the lender to file for insolvency in the event of a default, the larger issue is whether he should choose the insolvency law as his first choice. A lender has to choose his weapon carefully. Insolvency is not self-service; it is service to all, because once the borrower is put into insolvency, the borrower cannot do any settlement with the lender. Also, enforcement of security interests, including SARFAESI proceedings, will be stalled during the moratorium period. Post the moratorium, while SARFAESI action is possible, the lender will have to stay out of the resolution proceedings. In short, the lender has to evaluate whether he would like to enforce security interest on whatever asset is under his exclusive charge, or to join the rest of the creditors in preparing the resolution plan.
Evidently, insolvency proceedings cannot be the first choice, because this is an irreversible process. Once initiated, it either will end up killing the target and sending him into liquidation, or will succeed in reviving the company for the benefit of all. Therefore, insolvency proceedings are necessarily a collective remedy, and generally speaking, the last remedy.
Can a borrower defend a filing for insolvency or, on what grounds can it be defended? The question is being raised in several forums currently. A technical reading of the law seems to suggest that the copy of the application for insolvency that the lender files with the NCLT is served on the borrower as well, but there is no apparent scope for the borrower to put up any defence at the stage of admission, if the default is clear and incontrovertible.
However, the other side of the argument is the principle of natural justice enshrined in section 424 of the Companies Act. Natural justice, a legal concept, necessarily implies an opportunity of hearing. The issue is whether the hearing is limited to whether there is a default or not, or does it go any further? The scheme of the law clearly suggests that the only ground to be verified by the NCLT at the stage of admission is the existence of default. Therefore, even if there is a hearing around admissibility, it has to be on the factual existence of default, and cannot go beyond that.
This is precisely where there may be a cultural shock for borrowers, lawyers, and a new learning for the judicial and quasi-judicial forums. Insolvency is a drastic step, but the insolvency law is a drastic law and, factually, all that it requires for initiating the process is a default. A default on a financial obligation is a breach of promise on the part of the borrower. The underlying philosophy on which the law works is that once such promise is breached, the breach itself is an indicator of inability to pay, which shifts the control from the hands of the owners to those of the creditors. The creditors will take a call on whether the entity should be resurrected, restored, restructured, or simply liquidated. The fact of default deprives the borrower of the right to seek any justice.
When the SARFAESI law was enforced, there were several rulings of the courts, including the Supreme Court, which went into the scheme of the law, holding that there is no adjudication prior to a repossession action. The insolvency law is a collective law, whereas SARFAESI is a law of self-help by creditors. Under the SARFAESI Act, there is no opportunity for the borrower before repossession. Under the insolvency code, there does not seem to be any such right, and the question whether such a straight, undefended action deprives the borrower of some fundamental need for justice, is yet to be answered. But the chances are fairly strong that it is only a question of realisation, much against the impression people would have formed over decades. The default itself is the trigger that leaves the lenders empowered and the borrower powerless.
(Vinod Kothari is a chartered accountant, trainer and author. Mr Kothari, through his firm, Vinod Kothari and Company, is also engaged in the practice of corporate law for over 25 years.)