Extension of Liability in Group Insolvency Proceedings

[By Ananya HS]

The author is a third year student of the National Law School of India University, Bangalore.

Background

A significant proportion of Indian businesses are fundamentally structured as group enterprises operating as a single economic unit. These enterprises commonly engage in related party transactions in the nature of cross-collateralization, inter-corporate loans, and so on. These enterprises largely adhere to the concept of separate legal personality of group entities, but precedent suggests that the close linkage between different units of an enterprise in the areas of operation, business and management go on to raise unique challenges especially, when individual group entities become insolvent. Additionally, there are concerns of directors of the parent company in an enterprise exercising control over the subsidiaries, leading to further complications in the ascertainment of liability if a single entity approach is adopted. In certain enterprise groups, the parent company may also be deemed to be the director of the subsidiary.[i] The Insolvency and Bankruptcy Board of India (“IBBI”), in 2019, constituted a Working Group (“WG”) to prepare a report (“WG Report”),[ii] seeking recommendations for the introduction of a group insolvency framework. This step was taken in light of the various recent cases[iii] involving collective defaults and collapse of entire groups. The importance of considering unrecognised factors such as the position of a subsidiary in the group or the degree of integration between the companies, among other things, during insolvency resolution has also been acknowledged in this stead. The WG Report consists of a number of recommendations for amending the Insolvency and Bankruptcy Code, 2016 (“IBC”) in order to equip it to deal with the insolvency of conglomerates and groups. Among various suggestions, the WG categorically recommended that the IBC need not be amended to extend liability to parent companies or its directors in case of group insolvency proceedings.

This piece argues that the recommendation of the Working Group against the extension of liability to directors of the parent company in case of group insolvency proceedings must not be a blanket one, and stresses the importance of lifting the corporate veil in this regard in certain situations involving group insolvencies.

Observations of the Working Group – Problems and Inconsistencies

The WG, in its report, has discussed the aspect of extension of liability at length, and several stakeholders seem to have indicated to the WG that there may be multiple cases where a need to hold the parent company and its directors liable may arise. This could be in the case of fraud, fund diversion, mismanagement of debtor, wrongful trading, or upon finding that the directors of the parent company were a shadow or de facto directors of the subsidiary company. The WG stated that the underlying purpose behind extending liability in such a manner is to pre-emptively deter perverse behaviour, and came to the conclusion that currently, the IBC is sufficiently equipped to deal with such behaviour by companies. This questionable conclusion was arrived at by examining the definition of “officer” of a company under the IBC, borrowed from Section 2(60) of the Companies Act, 2013, which encompasses a wide definition of who an officer in default is, and includes within its purview, shadow and de facto directors. The applicability of this definition to Chapter VII of Part II of the IBC, to hold such officers liable for the specified activities was deemed to be a sufficient ex-ante deterrent, leading to the abovementioned conclusion of the WG.[iv] The WG Report also fails to acknowledge another problem that exists in determining the liability of an individual appointed as a director in more than one of the subsidiary companies. If one director is slated to oversee the management of one or more subsidiaries, and of the group as a whole, conflicts of interest are bound to arise eventually, and such conflict may relate to incidence of control and ownership as well.[v]

The WG has failed to supply substantial justification as to why it has provided a recommendation contrary to the opinions of stakeholders as well as established law in other jurisdictions. The UNCITRAL Guide on Insolvency Law (“Guide”) contains a list of circumstances where liability may, in fact, extend to directors of the holding company. The Guide also states that a mere incidence of control or domination of one member by another member will not serve as a ground for extension, and the WG Report uses it in order to support its recommendation. However, it is to be noted that the same is perfectly aligned with the argument of extending liability only in cases where there is a direct correlation between the working of the parent company and the insolvency of its subsidiary. The Guide provides for some indicative factors on which extension of liability can be based, including grievous negligence in the management of the subsidiary, breach of duty of care or diligence in management by the parent company, abuse of managerial power, or any direct causal link between the manner of management of the subsidiary and its subsequent insolvency.[vi] These grounds are beyond the purview of the provisions of the IBC, and cannot be classified as extraordinary circumstances, which would be dealt with by courts as and when they arise.

Lifting the Corporate Veil – The Single Economic Unit Argument

One of the key issues faced by group insolvency is the dichotomy that exists between effectuating the economic reality of an integrated business functioning through the establishment of subsidiaries, thus referring to the corporate group as a unit, or adhering strictly to the corporate form and treating each subsidiary as a separate legal entity. In situations like this, concerning subsidiary companies working within a single corporate group, an argument of a single economic unit can be made for the lifting of the corporate veil. This argument is based on the fact that subsidiary companies generally constitute a single unit for economic purposes, regardless of their separate legal personalities within the group, and must, therefore, be seen as a single legal unit.[vii]  Since all the companies aim to achieve a single economic goal, liabilities ought to be attached to the whole group. The argument has been criticised as being based more on economics than on the law, but courts can also arrive at this conclusion by looking beyond the legal fiction of a separate legal entity in order to examine the internal workings, and come to the same conclusion. The recent downfall of the IL&FS group comprising of a large number of group entities as well as the collective default by the Videocon group has brought the need to lift the corporate veil in such situations to light.

Conclusion

The WG Report is a step in the right direction for insolvency law in India, since there have been a large number of instances where the recovery process has been limited, or has even failed, as a result of the proceedings being dealt with in isolation, since each entity in a group usually forms part of an inextricable linkage of supply chains of operations. The non-extension of liability in these cases, as demonstrated above, is a recommendation that ought to be reconsidered by the drafters of the amendment to include these norms in the IBC. Lifting the corporate veil in this manner will make the insolvency process more effective.

End Notes

[i] Vardaan Ahluwalia and Varsha Yogish, Staggered Lifting of the Corporate Veil: A Case for Group Insolvency Norms, India Corporate law – A CAM Blog (Oct. 21, 2019) https://corporate.cyrilamarchandblogs.com/2019/10/group-insolvency-norms/.

[ii] K R Srivats, Group Insolvency Resolution: UK Sinha-led panel recommends phased implementation of framework, The Hindu Business Line (Oct. 14, 2019), https://www.thehindubusinessline.com/economy/group-insolvency-resolution-uk-sinha-led-panel-recommends-phased-implementation-of-framework/article29682632.ece

[iii] Some examples include the insolvency resolution processes initiated for Videocon, Lanco, Era infrastructure, Educomp, Amtek, Jaypee Adel and Aircel.

[iv] Insolvency and Bankruptcy Board of India, Report of the Working Group on Insolvency, (2019).

[v] UNCITRAL Legislative Guide on Insolvency Law, Part three: Treatment of Enterprise Groups in Insolvency, (Jul. 2012), https://www.uncitral.org/pdf/english/texts/insolven/Leg-Guide-Insol-Part3-ebook-E.pdf.

[vi] Risham Garg, Issues in Insolvency of Enterprise Groups, Journal of National Law University Delhi 50, (2019), https://journals.sagepub.com/doi/full/10.1177/2277401719870006.

[vii] Piyush Gupta, Single Economic Entity And Corporate Separatedness Doctrine: A Juxtaposition, Mondaq (Mar. 7, 2010), https://www.mondaq.com/india/Anti-trustCompetition-Law/788042/Single-Economic-Entity-And-Corporate-Separatedness-Doctrine-A-Juxtaposition.

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