Back door for promoters to retain control closed
The Supreme Court, in deciding a case dealing with the promoters of Gujarat NRE Coke, a company going through the insolvency process, has closed a major loophole in the Insolvency and Bankruptcy Code (IBC). The court declared that Section 230 of the Companies Act, which allows anyone to propose a “scheme of compromise or arrangement” with the companies’ creditors, was subject to the spirit of the IBC, which prevents promoters from finding a “back-door entry” into their former company. The Insolvency and Bankruptcy Board of India (IBBI) had introduced a specific provision that had closed this loophole, saying that anyone disqualified by the IBC could not use Section 230 of the Companies Act instead to propose a resolution plan. This had been challenged in court by the promoters of Gujarat NRE Coke; the court has now said that Section 29A of the IBC, which prevents promoters from bidding for their own companies, could not be overridden by Section 230 of the Companies Act.
The IBC, which is the current government’s landmark financial reform, is still a work in progress. Multiple actions have had to be taken by the regulators and by policymakers to ensure it works efficiently and fairly. The court’s recent action should be seen in that larger context, of trying to ensure that a complex new insolvency structure retains the spirit with which it was designed. That spirit privileged both the efficient use of capital and also accountability. The efficient use of capital requires that companies that can no longer continue be shut down, but one that could, with some reorganisation or debt management, be retained as a going concern should be allowed time and space for that reorganisation. This requirement can at times conflict with the other principle, that of accountability. This requires that those who are responsible for a company going into bankruptcy should lose control of their company — a principle as old as the concept of equity itself. Of course, on some occasions, it might be the case that those who are best placed to use the capital efficiently are those who originally ran the company.
Yet the IBC correctly identifies that, in such a case, the principle of accountability should take precedence because otherwise perverse incentives are set up. Promoters would then look at bankruptcy merely as a mechanism to retain control of their companies while getting rid of their pesky creditors. This would incentivise misbehaviour. Thus, even if it is in the short-term interests of creditors to come to some arrangement on resolution with promoters, the IBC seeks to prevent such deals from occurring. The court has correctly recognised this as a foundational requirement for an effective bankruptcy system in India, and has acted to preserve it. It is to be hoped that few such additional loopholes are found. There are other actions the government must take to preserve the IBC’s integrity in the coming year, as the effects of the pandemic will begin to make themselves felt on the financial system. These must include addition of capacity. Overall, however, the relatively swift action from all stakeholders to ensure that the IBC works as intended is comforting.