Hytone Case: Mala Fide Intention as a Ground for Dismissal

  September 7, 2021

(The second prize winning entry by Abhinandan Sharma, a fourth year law student at SLS, Noida, in IBC16’s first edition of the blog writing competition.)

Introduction

The Insolvency & Bankruptcy Code, 2016 (code) provides a mechanism for financial and operational creditors to recover their dues from corporate debtors promptly. This is done by triggering the Corporate Insolvency Resolution Process (CIRP) against the corporate debtor if they fail to pay the dues. On the occurrence of a default by a corporate debtor, a financial creditor can make an application for initiating CIRP on its own or together with other financial creditors under Section 7 of the code. Generally, the Adjudicating Authority must ascertain, within fourteen days of the receipt of the application, the existence of a default from the records of an information utility or based on other evidences furnished by the financial creditor. It implies that if the existence of default is proved, the Adjudicating Authority is required to accept the application and initiate CIRP against the corporate debtor. However, recently, the National Company Law Appellate Tribunal(NCLAT) in Hytone Merchants Pvt. Ltd. v. Shatabdi Investments Consultant Pvt. Ltd. No. 258 of 2021(Hytone Case) held that the Adjudicating Authority under Section 65 of the code has the power to reject admission of an application on the ground that the application has been filed collusively and not to initiate the corporate insolvency resolution process. Even though all the prerequisites of Section 7 of the code were satisfied, the NCLAT held that the Adjudicating Authority at the admission stage has to carefully evaluate the application to avoid and safeguard the corporate debtor from being drawn into the CIRP with mala fide intent. The NCLAT expanded the scope of Section 65 of the code, observing that when a statute punishes any wrongdoing, it also includes a presumed power to prevent the wrongdoing. Furthermore, the NCLAT asserted that under Section 65 of the code it can exercise this discretion even before the initiation of CIRP, i.e. at the stage of admission, and it cannot be said that Section 65 of the code applies only after the initiation of CIRP. The Hytone Merchants decision has thus established a new precedent. The author’s aim with this post is to examine the judgement and its implications. The author will argue that the NCLAT decision is a positive step forward in preventing the potential abuse of the code.

Facts of the case

Hytone Merchants had advanced an unsecured loan of Rs. 3 lakhs for a period of six months @ 15% interest to Satabadi Investment Consultant Pvt. Ltd. (Satabadi Investment). Shatabdi Investment failed to repay the loan and as a result, Hytone Merchants issued a demand notice to Satabadi Investment for repayment of the unsecured loan. The default of Rs. 3 lakhs was acknowledged by Satabdi Investment; however, the amount was not paid. Hytone Merchants decided to initiate insolvency resolution process against Satabadi Investment under Section 7 of the code. Although Hytone Merchants had satisfied all the conditions of Section 7 of the Code, National Company Law Tribunal (NCLT)  decided to dismiss the application. In its order, NCLT stated that Satabadi Investment’s 2018-2019 financial statement reveals that the business has a net value of approximately Rs. 15 cores and owes a corporate guarantee of approximately Rs. 482 crores. Relying on the financial statement, NCLT decided to dismiss the petition on the ground that it is difficult to believe that a corporation with a net worth of Rs. 15 crores would be unable to repay a small sum of Rs. 3 lakhs. Consequently, the NCLT established that the application by Hytone Merchants had been filed in collusion with Satabadi Investment to avoid the liability of Rs. 482 crores as a corporate guarantor. Aggrieved by the order, Hytone Merchants decided to file an appeal before the NCLAT.

Issue before the NCLAT

The question before the NCLAT was whether the Adjudicating Authority, relying on Section 65 of the code, has the power to reject a Section 7 application because it was filed collusively with malicious or mala fide intent and not for the purpose of Resolution or Insolvency, even if the application complied with all the Section 7 requirements.

The NCLAT’s Decision

The NCLAT upheld the NCLT’s decision and held that the Adjudicating Authority has the power to reject an application if it is of the belief that the application is filed collusively with mala fide or malicious intent and not for the purpose of insolvency resolution. The NCLAT noted that –

  1. Hytone Merchants has a net worth of Rs. 15,36,39,015.
  2. Hytone Merchants has given a corporate guarantee of Rs. 4,82,42,000,00.

NCLAT upheld the reasoning of the NCLT  that it was hard to believe that a company having a net worth of approximately Rs. 15 crores cannot repay a small amount of Rs. 3 lakhs. Relying on the Supreme Court’s decision in Swiss ribbons (P) Ltd v Union of India, NCLAT observed that before admitting the application, the Adjudicating Authority is required to carefully examine the application to avoid and protect the Corporate Debtor from being drawn into the CIRP with mala fide intent. As a result, even if all the requirements of Section 7 are met, the Adjudicating Authority can reject the application and decide not to initiate CIRP against the corporate debtor. It is not required that Section 65 be applied only after the CIRP process has begun. The NCLAT also relied on Arcelor Mittal India Private Limited  v. Satish Kumar Gupta, observing that the concept of lifting the corporate veil in insolvency proceedings has been recognised under Section 29A of the code. The rule of lifting the corporate veil will apply in this case since there is reason to believe that Hytone Merchants colluded with Satabadi Investment to commence CIRP, not for the purpose of the resolution, but to escape its liability as a corporate debtor. The NCLAT also analysed the interplay between Section 29A and Section 65 of the code and noted that although Section 65 of the code provide penalties for fraudulent or malicious initiation of the insolvency proceeding, “it does not mean that Section 65 will not be applicable to prevent such fraudulent or malicious initiation of proceedings. When a statute makes a provision for punishment for any wrong, it also contains deemed power to prevent it.” Recording these reasons, NCLAT decided to dismiss the appeal.

Scope of Section 65 of the Code

In Pioneer Urban Land and Infrastructure Ltd. v. Union of India, (2019) 8 SCC 416 (Pioneer Urban), the Supreme Court held that the corporate debtor can use Section 65 to argue that the bankruptcy resolution process has been initiated fraudulently, with malicious intent, or for any purpose other than insolvency resolution. Relying on Pioneer Urban judgement, NCLAT in Navin Raheja v. Shilpa Jain No. 864 of 2019 held that Before admitting an application for the commencement of the CIRP process, the Adjudicating Authority must consider the Supreme Court ruling in the Pioneer Urban case. As a result, it is reasonable to conclude that Section 65 of the code applies at the time of admitting a Section 7 application. Typically, instances of mala fide have, in the past, been pressed upon by the parties to the insolvency proceedings. However, the present case is the first instance wherein the Adjudicating Authority has suo moto initiated proceedings to determine mala-fide intent and has declined to admit the Section 7 application. The Supreme Court and the NCLAT have previously ruled that an order admitting an application for the commencement of CIRP is a judicial decision that must be made in line with the provisions of the Code and the principles of natural justice, while taking into account the consequences of the order. As a result, the Adjudicating Authority has discretion in deciding whether to accept or reject the application, and this discretion must be exercised carefully. The admission of a Section 7 application should not be done in a routine manner, and the Adjudicating Authority must examine all the details before admitting such application. Section 7(5)(a) of the code also states –

Where the Adjudicating Authority is satisfied that—

(a) a default has occurred and the application under sub-section (2) is complete, and there is no disciplinary proceedings pending against the proposed resolution professional, it may, by order, admit such application

The word “may” clearly gives discretion to the Adjudicating Authority to not admit a Section 7 application even if all the requirements are met. In State Bank of India v. Essar Steel Limited, C.P. No. (I.B) 39/7/NCLT/AHM/2017, the NCLT relying on Gujarat High Court’s judgment held that the Adjudicating Authority has the discretion to accept or reject the application, and this discretionary power must be exercised in a judicious manner. Therefore, in order to admit a Section 7 application, the Adjudicating Authority can go beyond assessing the occurrence of default, and the decision of the Adjudicating Authority must be based on natural justice principles.

Take away from the NCLAT Judgment

Malicious means doing something intended to harm or upset other people. In his book(Insolvency & Bankruptcy Code of India 1st ed), Ashish Mahajan defines fraud as “anything dishonest and intended to deceive.” The moratorium period under Section 14 of the code kicks in as soon as the Section 7 application is approved. Section 14 of the code was intended to relieve corporate debtors of current liabilities in order to keep the business afloat. It gives protection to the corporate debtor to ensure the revival of the business. However, an application for initiating CIRP may be filed to abuse the process under the code so that one might escape his obligations and take advantage of the moratorium period for personal benefit. In such cases, the Adjudicating Authority is required to dismiss the application to prevent the potential abuse of the said provision. The ruling of NCLAT will certainly act as a good precedent.

Conclusion

The admission of section 7 application should not happen in a routine manner and the Adjudicating Authority has to be satisfied that the section 7 application is filed for the purpose of resolution or insolvency. The Adjudicating Authority is required to conclude that the application is not violating any provision of law or is against the objective of the code. Furthermore, Adjudicating Authority has to assert that the application of initiation of CIPR is filled with bona fide intention and not with fraudulent or malicious intent for any purpose other than for the resolution of insolvency. No doubt, the Adjudicating Authority is required to initiate CIRP if it found that a default has occurred. However, Adjudicating Authority is not bound to act mechanically merely because the occurrence of default has been found. The Adjudicating Authority is required to ensure that the application filed is not camouflaged as to take advantage other than for the resolution of insolvency.

In the present case, NCLAT rightly decided not to admit the Section 7 application as both corporate debtor and financial creditors joined hands and colluded to misuse the process under the code to escape the liability as corporate guarantor. To achieve the objective of the code, such application for initiation of CIRP should not be admitted, and a uniform approach should be followed. The corporate debtor cannot be allowed to initiate CIRP fraudulently to take advantage of the moratorium period. Where it appears that the application for initiating CIRP has been filed conclusively or fraudulently and not for the purpose of the insolvency resolution process, then the Adjudicating Authority should not initiate the CIRP process. To clarify this position, specific provisions may be added to Section 65 of the code to vest Adjudicating Authority with the power to decide the intention of filing the application process and to reject applications filed with fraudulent or malicious intent for any purpose other than for insolvency resolution.

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