Pre-Admission Adjudication and the Clean Slate Theory: Balancing Competing Purposes

Aditya Sushant Jain*

Introduction

The enactment of the Insolvency and Bankruptcy Code [“IBC”], in 2016 marked a landmark shift in the Indian Bankruptcy regime, making the process of insolvency and restructuring more efficient and strictly time-bound, so as to ensure that there is no wastage of resources by litigatory delays. The 2016 code envisioned a “debtor in possession” model instead of the hugely inefficient Sick Industrial Companies (Special Provisions) Act, 1985 (Now repealed) “creditor in control” model, thus striving to improve the struggling credit culture of the Indian Economy. However, the IBC had two competing purposes; ensuring that the process is strictly time bound so that resources are put to alternative uses as quickly as possible, while at the same time, balancing the interests of all stakeholders. More often than not, the latter suffered in pursuance of the former. History is witness to the fact that whenever such large-scale reforms take place in any economy, often, macro-economic issues override individual interests, natural justice, and fairness. Such has been the fate of IBC.

For example, in pursuance of a time-bound insolvency process, resolution professionals who are neither trained in adjudication nor are members of the judiciary are vested with immense adjudicatory powers at the pre-admission stage, so much so that they can simply write off crores of claims by not mentioning them in the resolution plan. Such “disputed claims” are then completely extinguished without any appellant mechanisms left due to the “clean slate theory” as will be explained later. Thus, at the expense of “balancing the interests of all the stakeholders”, the purpose of ensuring a time bound process is upheld. These competing purposes have further perplexed courts and they have given contradictory judgements, which has further clouded the act in judicial uncertainty. The antidote to this conundrum, as this article shall argue is to take the adjudicatory powers away from the resolution professional and give it back to the Adjudicating Authority [“AA”], especially in light of the recent proposed amendment by the Insolvency law committee that fixes the time limit for the pre-admission process to be 30 days. This defeats any apprehension that the transference of such adjudicatory powers will cause delays and will hurt the time-bound process.

The Pre-Admission Stage

From the above discussion, it is crystal clear that a time-bound process for insolvency resolution was not only ideal but necessary for a healthy insolvency regime. The same was enshrined in the statutory language of the 2016 Code. The Code provided a timeline of 6 months, which may be extended to a further 90 days for the completion of CIRP process. The maximum possible timeline, including all exclusions of days was postulated to be 330 days, following which the assets of the company will necessarily have to be liquidated. The clock starts after the application for insolvency has been admitted by the National Company Law Tribunal [“NCLT”]. The code allows the creditor to file for insolvency by moving an application in the AA i.e. NCLT for default of as little amount as one lakh. Now the pre-admission process commences, for which the time limit stipulated by the Government is 30 days, wherein the AA determines whether to either admit the application or reject the application under Section 7 (in the case of financial creditors) or Section 9 (in case of operational creditors). The question of whether sections 7 and 9 are mandatory or discretionary has been a matter of contention for long, further exacerbated by the contrary judgements given by the court.

Discretionary powers of the AA at the pre-admission stage

In cases such as that of Innoventive Industries v. ICICI Bank, the court held that the limited jurisdiction of the AA was to determine solely whether a default has occurred, and if it answered in the affirmative, it was mandatory for the court to admit the application. The same was affirmed by the Supreme Court in E.S. Krishnamurthy & Ors. v. M/s Bharath Hi Tech Builders Pvt. Ltd where the apex court held it wrong on part of the AA to direct the parties to settle instead of admitting the application for insolvency since the default was proven. Similar judgements in Allahabad Bank v. Poonam Resort Ltd and Allahabad Bank v. Link House Industries Ltd. largely curtailed AA’s powers during the pre-admission process. On the other hand, in a recent Supreme Court Judgement titled Vidarbha Industries Power Limited v. Axis Bank Limited, the court ruled contrary to earlier judgements and relied on the word ‘may’ provided in sections 7 and 9 of the IBC, to rule that the power conferred to the AA during the pre-admission process was discretionary in nature and not mandatory, and the mere existence of a default does not make it mandatory for the AA to admit the application for insolvency. The same conclusion was arrived at in an earlier case of Dharani Sugar and Chemicals Ltd. V. Union Of India, wherein the court held that admission to CIRP under the code requires application of judicial mind.

Inequity and judicial uncertainty

Henceforth, there is a certain level of judicial uncertainty when it comes to the discretionary powers of AA during the pre-admission process. This question is so perplexing to the courts, primarily because it lies at the centre of two varying purposes of the IBC, whether to ensure a quick, time-bound process to maximise the value of assets, or to balance the interests of all stakeholders. This judicial uncertainty at the pre-admission process further exacerbates inequity once the resolution plan is approved, especially when the same is read in consonance with the judicially developed “clean slate theory”. The problems of fairness and inequity posed by the clean slate theory have a simple solution of removing this judicial uncertainty surrounding the pre-admission process, as shall be argued further.

Clean Slate Theory

Let’s, for a moment, assume the application has passed the pre-admission process and the courts have admitted the application for insolvency. The committee of creditors has been formed and a resolution professional has been appointed to formulate a resolution plan which shall then be approved by 66 % of creditors. (note that operational creditors are not conferred any voting powers). Assume for a moment that certain claims of a minority of creditors or operational creditors are in dispute. The existence of default isn’t the matter of contention here but rather the correct amount is. Once the majority, i.e., 66% of financial creditors approve the resolution plan, all the claims that were in dispute stand extinguished. Such is the clean slate theory. If the resolution professional fails to take into account their claims, or simply writes the claim as ‘nil’ in the plan, the claim altogether stands eviscerated i.e., the creditor shall get nothing. The same happened in a recent case of Fourth Dimension Solution v. Ricoh India Ltd. wherein the petitioner, being an operational creditor had his claim of about Rs. 511 crores extinguished since the same was the subject matter of arbitration proceedings and the Resolution Professional, being also an adjudicatory authority, simply wrote the claim as ‘nil’ in the resolution plan on account of being disputed. National Company Law Appellate Tribunal [“NCLAT”] cited the landmark judgement of Essar Steel India Ltd and asserted, “it is clear that when the resolution plan is approved by the Adjudicating Authority, the claims of the appellant which are not part of resolution plan shall stand extinguished and the proceedings thereto shall stand terminated. Therefore, the appellant cannot pursue such claims, when the resolution plan was pending for approval before the adjudicating authority.” This pretty much sums up the clean slate theory, which although upholds the ‘time-bound process’ as a purpose of the IBC but utterly fails on the “balancing the interests of all stakeholders” part.

The judicial uncertainty surrounding the clean slate theory

The clean slate theory has been upheld, time and again in multiple judgements such as in Santosh Wasantrao Walokar v. Vijay Kumar Iyer, where claims of certain creditors were rejected by the Resolution Professional and such rejection was challenged. The court, while relying on Essar Steels refused to entertain any petitions and ruled that since the Resolution Plan already has been approved, all such claims stand extinguished. On the other hand, whenever the NCLT has gone against the ‘clean slate theory’, the same judgements have been overruled by the apex court. Prasad Gempex v. Star Agro Marine Exports Pvt. Ltd. is one such example where the tribunal held that while the resolution plan could not be modified to accommodate a previously rejected claim, it would be open to the creditor to pursue the claim in other fora even after the approval of the resolution plan. The same order was quashed by the Supreme Court, arguing that a successful resolution applicant cannot be faced with ‘undecided’ claims after the approval of the resolution plan and thus no claims can exist apart from those decided by the resolution professional or the adjudicating authority. This judgement effectively left all the creditors with disputed claims without any forum for appeal.

However, in a rather shocking turn of events, when the Fourth Dimension case was appealed to the Supreme Court, the apex court surprisingly allowed the appeal and allowed the appellants to recover their amount by arbitration proceedings even after the Resolution Plan was approved. Henceforth, consequent to this order, the clean slate theory is hereby, also put under the dark clouds of judicial uncertainty. 

Faults in the clean slate theory

The clean slate theory, while efficiently succeeds in quickly putting idle resources to alternative uses by encumbering litigatory delays and thus making the macro-economic systems stronger, fails to pass the test of natural justice. Firstly, it stands directly against the principles of Audi alterum partem by refusing to provide a forum to hear the creditors with undecided claims. Secondly, it stands against the doctrine of Ubi Jus Ibi Remedium since in most of these cases, the existence of default is acknowledged by both parties, it is only the amount that is under dispute. Therefore, since there is at least some default, some compensation must also be provided. Thirdly, under Section 26 of IBC, the proceedings for avoidance transactions and wrongful trading are permitted to continue even after the approval of the resolution plan by the AA. This unfair treatment of certain transactions to be continued whereas others to be extinguished further exacerbates the iniquity. And finally, the clean slate theory unduly confers immense adjudicatory powers on the resolution professional who is neither trained in judicial adjudication nor has any experience deciding cases.

Transfer of adjudicatory powers to the Resolution Professional

This problem is further exacerbated when the adjudicated authority is absolved of all its adjudicatory powers at the pre-admission process, and the same is vested with the resolution professional who is neither trained in adjudication nor has any judicial experience. Since the jurisdiction of the NCLT and NCLAT is being transferred to the resolution professional, the judgement in Rojer Matthews v. South India Bank Ltd applies squarely. The question in front of the court, in this case, was whether it was constitutional for the executive to transfer the jurisdiction of the High Court to a tribunal manned by “technical members” with neither any adjudicatory nor judicial experience. The court, through its incisive judgement, ruled that technical members not belonging to the judiciary nor having any experience to adjudicate cases cannot be expected to decide cases. In an earlier related case with the same issue at hand, Madras Bar Association v. UOI 2014, the court stated, “Only judges/members who stature and qualifications are commensurate to that of the court from which the powers have been transferred should man the tribunals the tribunals”. In a slew of cases following Rojer Matthews and the trilogy of the Madras Bar Association cases, the court, while constantly striking down the tribunal rules notified by the government, highlighted the necessity of judicial experience, or adjudicatory experience especially when any non-judicial member is entrusted with adjudicatory functions. The same logic must also be applied to Resolution Professional under the IBC, and they must not be blindly entrusted with adjudicatory functions, due to their acute lack of experience in adjudication. Ridding the NCLT (AA) of its discretionary and adjudicatory powers at the pre-admission process goes against the statutory language of the code since the word ‘may’ stipulated under sections 7 and 9 itself confers adjudicatory powers to the AA. Furthermore, Rule 11 of NCLT also confers ‘inherent powers’ to NCLT in order to meet the ends of justice. Taking away these powers from NCLT and simply transferring them to the Resolution Professional who has no adjudicatory experience is patently unconstitutional as was argued in Rojer Mathews and the Madras Bar Association cases. Transferring powers from NCLT to Resolution Professionals also leads to a failure of natural justice, given the fact that once the RP decides to not include certain claims which may be disputed at the time, and the same plan is approved by 66% of financial creditors, the dissenting creditors will be left with no forum to appeal RP’s decision as all their claims shall stand extinguished the second the resolution plan is approved due to the ‘clean slate theory’.

Conclusion – Way forward

Clearly, the two purposes of IBC namely; a time-bound process and balancing interests of all stakeholders often stand in competition with each other and judicial judgements have largely been conflicted on which of the two to favour consequently leading to judicial uncertainty and the favouring of one on the expense of the other. The judicial uncertainty surrounding the clean slate theory and the failure of natural justice can be corrected, simply by the apex court by recognising the discretion of the adjudicating authority to decide on the validity of the disputed claims, during the pre-admission process itself. It is also pertinent to note that a period for the disputed claims to be decided before the pre-admission process has also been recommended to be 30 days by the government hence taking away the discretionary powers of the NCLT purely on grounds of delay cannot be argued once the same is implemented. Giving immense adjudicatory powers to the resolution professional purely based on the mandate of 66% of financial creditors goes against the ‘balancing the interests of all stakeholders’ purpose of the IBC since there may occur what’s called the phenomenon of the “tragedy of commons” that leads to a competition between all creditors to recover their debts. It is incorrect to assume that the incentives of each creditor shall align. For instance, prior to 2016, there was a huge NPA problem in the country, and subsequently the RBI resorted to sorting out the problem of NPA using collective action of lenders and consequently employed a consortium lending arrangement. This did not produce any fruitful results as some lenders in the consortium had classified the loan as “Non-Performing” whereas others categorised it as “healthy”. This ultimately led to the infamous February 12 circular which discontinued all schemes and asked the banks to resort to operating insolvency. This circular was then ultimately struck down by the apex court. Hence, through past experiences, it has been made clear that solely forming a committee of creditors and hoping that it would balance the interests of all stakeholders is incorrect, as more often than not, stakeholders have competing interests. This is further exemplified due to the fact that; operational creditors have no voting rights in the Committee of Creditors. To balance these interests is the job of the Adjudicating Authority and not of the Resolution professional. The apex court should make the availability of discretionary powers awarded to the adjudicatory authority under sections 7 and 9 abundantly clear. Given the importance IBC holds in the economy, it is imperative that the judicial uncertainty surrounding the statute is cleared so the process of insolvency and restructuring in India not only becomes quick and time-bound but also more equitable, fair and in line with the principles of natural justice.

*The author is a student at Jindal Global Law School.