A critical element for any corporate insolvency law is the point of trigger. The law must clearly provide the grounds on which an insolvency application against a corporate debtor should be admitted. If there is any confusion at this stage, precious time could be wasted in litigation. That would cause value destruction of the distressed business. All stakeholders collectively would suffer. On the other hand, if the law is clear and litigation can be minimised, the distressed business could be resolved faster. Its value could be preserved. And all stakeholders collectively would benefit. Evidently, objective legal criteria for admission are critical for an effective corporate insolvency law.

The balance-sheet test is one method for determining insolvency at the point of trigger. This test, however, is vulnerable to the quality of accounting standards. That’s why the Bankruptcy Law Reforms Committee did not favour this test in the Indian context. Instead, it recommended that a filing creditor must only provide a record of the liability (debt), and evidence of default on payments by the corporate debtor. This twin-test was expected to provide a clear and objective trigger for insolvency resolution. The hope was this would minimise litigation at admission stage, enabling quicker resolution of distressed businesses.

The Supreme Court’s latest ruling is likely to radically alter these expectations. Even if the NCLT is satisfied that a financial debt exists and that the corporate debtor has defaulted, it may not admit the case for resolution if the corporate debtor resists admission on any other grounds. Corporate debtors are likely to use this precedent to the fullest to resist admission into IBC. The likely outcome would be more litigation and delay at the admission stage, enhancing the risks of value destruction in the underlying distressed business. Unless the NCLT consciously constrains the use of its own discretion at the admission stage, the IBC may well end up like the SICA.

The SICA had established the Board for Industrial and Financial Reconstruction (BIFR) as a specialist tribunal to ensure speedy resolution of distressed industrial companies. Belying all expectations of the law “on the books”, the law “in action” soon acquired a notorious reputation for delays. The BIFR became a haven where companies could seek shelter from their creditors for years, with managers siphoning off assets in the interim.

To better understand why the SICA came to operate in this way, Van Zwieten compiled and analysed a dataset of 1,066 judgments. The study revealed a series of judicial innovations with the stated intention to facilitate rescue of distressed companies. An unintended consequence of this pro-revivalist judicial approach was to add significant delays in disposal of cases. It also resulted in improving the position of some stakeholders at the expense of others — particularly institutional creditors such as banks. The study concluded that the influence of courts appeared central to understanding how and why the SICA failed.

In all fairness, the Supreme Court has been extremely pragmatic in its interpretation and application of the IBC. Even in the recent ruling, the court has rightly cautioned that the NCLT should not exercise its discretionary power in an arbitrary or capricious manner. Yet, this decision may have opened a Pandora’s box. Policymakers would be well-advised to take note before history starts repeating itself.

This article was originally published in The India Express on 22 July 2022 Written by: Pratik Datta, Senior Research Fellow.

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