Financial Creditors To Face A New Hurdle While Initiating Insolvency

Financial creditors who relied on balance sheets as proof of debt to initiate insolvency proceedings may now face a new hurdle following a ruling by the National Company Law Appellate Tribunal.

Till now, creditors relied on the acknowledgement of debt in balance sheet entries while initiating insolvency proceedings, which helped them get over the three-year limitation period hurdle. Since debt would reflect in the balance sheet every year, the clock for limitation period would start afresh. Once the limitation period is over, no insolvency can be initiated.

But the tribunal has now held creditors cannot rely on balance sheet entries as proof of debt and continue to extend the limitation period.

Resolution of debt in a large number of cases where insolvency proceedings weren’t initiated due to ongoing settlement discussions will be hindered and will spell trouble for creditors reeling under legacy NPA issues, Indranil Deshmukh, partner at Cyril Amarchand Mangaldas & Co., said.

The NCLAT View

The NCLAT had in March allowed an appeal filed by the former director of Uthara Fashion Knitwear Ltd., which challenged the admission of insolvency proceedings initiated by the Stressed Assets Stabilization Fund. The appellate tribunal held that balance sheet entries cannot be considered as acknowledgement of debt for limitation.

While hearing another case in September, three members of the tribunal referred this ruling to a larger bench for reconsideration.

Last week, a five-member bench of the NCLAT, while hearing the reference, reiterated its earlier findings which were:

• The limitation period of three years will start from the date of default—the date of declaration of an account as a non-performing asset by a bank or financial institution.
• Creditors cannot rely on balance sheet entries showing debt as an acknowledgement for extending the limitation period.
• A company is required to file a balance sheet or annual report every year as per requirements under the Companies Act.
• As such, entries in the balance sheet cannot be considered to be a voluntary acknowledgement of debt. If it’s considered so, it would imply that no limitation period applies to the Insolvency and Bankruptcy Code, which is contrary to the law.

Ruling Against Commercial Understanding: Lawyers

Even as the NCLAT has declined to reconsider its decision, as many as five appeals challenging the March judgment are currently pending in the Supreme Court. Lawyers that BloombergQuint spoke with said the NCLAT’s decision goes against the prevailing commercial understanding and business practices.

So far, high courts have granted recognition to balance sheet entries as evidence of a debt in the context of commercial and banking laws while deciding certain cases, lawyers told BloombergQuint. But the NCLAT has refused to do so while observing that matters under the IBC are not recovery proceedings but aim at the resolution of a corporate debtor.

The distinction drawn by the NCLAT between recovery proceedings and an insolvency resolution process would create an anomalous position, Kumar Saurabh Singh, partner at Khaitan & Co., told BloombergQuint.

“It would mean that while a creditor will be empowered to initiate recovery proceedings on account of extension of limitation period on the basis of the borrower’s recording of debt in its balance sheet, it will be disentitled to initiate insolvency resolution process for the same default,” Singh said.

Even if a balance sheet is prepared out of legal obligation, it’s considered to be reflective of the correct financial position of a company’s assets and liabilities. If a company admits a creditor’s claim against it as a crystallized liability in its balance sheet, such a record should be considered as a voluntary acknowledgement of debt, Singh explained.

Deshmukh said a company’s balance sheet is prepared in accordance with various accounting, statutory and regulatory requirements, to ensure transparency and high corporate governance standards. It is well settled that a debt shown as outstanding in the balance sheet is considered as an acknowledgement of debt for limitation purposes, he said.

The NCLAT’s decision would require a re-examination and will need to settled by the Supreme Court, both the lawyers said.