Equity investors should be mindful of the Insolvency Code!

The Insolvency and Bankruptcy Code (Code) is proving to be a game changer; going by recent cases emanating from the National Company Law Tribunals and appellate forums (NCLT). Early trends seem to suggest that the Code may have a profound impact on the way corporate India deals with its debt arrangements. However, the regime for operational creditors under the Code may have created unexpected challenges for all stake holders, especially institutional equity investors. Institutional equity investors are usually financial investors and do not involve themselves in day to day operations of investee companies. This defining feature of a financial investor may need to be revisited to a limited extent, to avoid pitfalls under the Code.

The Code recognizes 2 types of creditors who can approach the NCLT to initiate a resolution process against a corporate debtor; a financial creditor and an operational creditor. Financial creditors should not be difficult to manage, since investors usually contract for comprehensive financial reports that cover details regarding debt finance. But, the regime for an operational creditor could prove to be a stumbling block for equity investors. An operational creditor is essentially an unpaid supplier of goods or services to the debtor in question. The consequences on a debtor, for defaulting on debts (Rs. 100,000* or more) to a financial creditor or an operational creditor are the same. Upon admission of the claim by the NCLT, the board of directors loses control over the operations of the debtor company.

A supplier can drag a company into the resolution process if its dues remain unpaid on the due date. At what point does one consider a supplier’s debt as due and payable? This will be determined by the terms of contract or subsequent exchange of communication between the debtor and the operational supplier. Once an invoice raised by the operational supplier has been acknowledged and agreed to be paid, it would in all circumstances be deemed as due and payable. Thereafter, delay by the debtor in repaying the operational supplier would expose the company to risks under the Code. It is common knowledge that non-payment of invoices when payable, are a routine practice for most Indian businesses. Complicating an investor’s problem, is the propensity of Indian litigants to ‘take a chance’ in an Indian court, with the belief that an unsuccessful outcome can be appealed or settled at a later stage.

In such a backdrop, the Code is proving to be an efficient tool in the hands of unpaid operational creditors. A company that has the financial means, but chooses not to pay its operational creditors, could be in for a rude shock under the Code. The only protection available to such a corporate debtor is, where the debt of the concerned operational creditor was in dispute and such dispute existed prior to the date on which the debtor receives a formal claim notice from the operational creditor. In most cases, the NCLT has been rightly refusing to entertain ‘frivolous’ grounds to establish a pre-existing dispute. Under the Code, ‘taking a chance’ has proven to be a suicidal strategy, as some companies have painfully discovered.

Given the grave consequences on non-payment of legitimate dues of an operational creditor, it would be in the best interests of all stakeholders to put in place a mechanism to avoid surprises. While monitoring day to day cash flow operations of an investee company would be counterproductive, contractual covenants can be included to flag off details of unpaid vendors in the monthly financial reports. Further, any notice, under the Code, received by an investee company should be reported immediately to all members of the board/ investor nominee. It would also be prudent to ensure that systems are in place to ascertain the genuineness of an operational creditor’s claim. Since, the prescribed time for responding to such a notice is only 10 days. Lastly, where possible, financial systems should be put in place, to ensure that all due vendor payments are settled in a fixed cycle. In conclusion, while the Code has thrown up unexpected surprises, it should be viewed as a disciplining exercise for Indian businesses. All stakeholders must endeavour to adapt to the new normal.

Ajay Joseph (Partner, Veyrah Law) and Priyanka Zaveri (Associate, Veyrah Law)

This article was first published in DNA India. Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.