The Curious Case of Reverse CIRP: A Headway in Insolvency Law?

[By Soumya Modi and Kunal Dave]

The authors are students of National Law School of India University, Bangalore and National Law Institute University, Bhopal.

 

INTRODUCTION

Due to the claims of homebuyers, the Insolvency and Bankruptcy Code, of 2016 (hereinafter, the Code or IBC) has seen several developments since its inception.  A recent judicial experiment in this respect is the National Company Law Appellate Tribunal-devised “Reverse Corporate Insolvency Resolution Process (reverse CIRP)” which has no genesis under the Code. This concept was formulated to protect the interests of the allottees of the real estate projects whose interests (getting possession of the unit) conflicted with the interest of other financial creditors who were concerned with the repayment of their money. Furthermore, even though real estate allottees are now financial creditors, the tribunal thought that they do not have the commercial expertise to understand the viability of a resolution plan.[i] Considering this unique position of homebuyers, the National Company Law Appellate Tribunal (NCLAT) brought in this innovation.

However, judicial innovations may not always lead to desirable outcomes. The danger looms over the phenomenon of reverse CIRP, given the porousness with respect to the funds of the project. In terms of Section 4(2)(l)(D) of the Real Estate (Regulations and Development) Act (hereinafter, RERA), 70% of the amount realized for the real estate project has to be kept in a separate account only for meeting project costs. However, India has bore witnessed to several flagrant violations of this requirement. The ongoing Supertech controversy got triggered when Supertech Limited did not maintain 70% funds in this account. Additionally, Maharashtra has also witnessed a large number of instances of divergence of funds from such accounts.

The tribunals have not consistently implemented this condition in most reverse CIRP cases. The likely outcome would be the enhancement of the risks of some stakeholders (promoters) benefiting at the expense of others. The thrust here is that an objective legal criterion for keeping a check on the funds is critical for an effective reverse CIRP process. Therefore, a shift from the ex-post determination in reverse CIRP cases to formulating an ex-ante regime can help in overcoming the self-serving tendencies that the promoter may have as well as bring a sense of predictability to the process.

This blog will provide an overview of the reverse CIRP process, and reveal its shortcomings. Further, it will take into consideration the implications of this shortcoming from the Meld Model which is a synthesis of exclusive legal positivism (ELP).[ii] In furtherance of this model, this blog will adopt an ELP lens to the situation of reverse CIRP and will analyze the consequence of departing from it through law and economics to make a case for an ex-ante regime.

AN OVERVIEW OF REVERSE CIRP

In light of the specific concerns of homebuyers, the NCLAT formulated the doctrine of Reverse CIRP while deciding an appeal in Flat Buyers Association Winter Hills v. Umang Realtech Pvt. Ltd. The idea essentially provides that in the case of real estate companies, the promoter will disburse funds as a lender and not as a promoter to ensure the completion of the project. The NCLAT has also in later judgments ruled that the reverse CIRP should be carried out in a project-wise manner.[iii]

The project-specificity of the process reverberates in the recently proposed Amendments to IBC. Since the IBC as it stands currently provides for insolvency resolution of a company as a whole, the default in one project would trigger the Corporate Insolvency Resolution Process (CIRP) against the entire company. In order to address these difficulties, the Ministry of Corporate Affairs has proposed certain Amendments that provide for a ‘project-wise Resolution’.

SHORTCOMINGS IN THE CURRENT REGIME

While the proposed Amendment comes in as a relief to the real estate developers as well as the allottees, the specific contours of the process still remain largely undefined, especially in terms of a monitoring mechanism. In Flat Buyers, the tribunal directed the Resolution Professional to ensure the completion of the project with the funds provided by the lender and the amount generated from allottees. However, no reference was made by the tribunal of the 70% requirement. Similarly, the Supreme Court in Anand Murti vs Soni Infratech Pvt. Ltd. and Amit Katyal vs Meera Ahuja upheld the concept of reverse CIRP but did not mandate this requirement under RERA.[iv] Further, in the case of Whispering Tower v. Abhay Narayan, the Tribunal allowed project-wise reverse CIRP, but no mention was made of this requirement. However, in Suspended Director of M/s. Supertech Ltd. v. Union Bank of India (Hereinafter, Supertech), the tribunal directed the RP to ensure that all receivables are maintained in a separate account.[v] Although the Tribunal’s vigilant stance in Supertech is appreciable the same can be attributed to the peculiarities of the facts in the case as the Uttar Pradesh-RERA had reported prior mismanagement of this separate fund.

Therefore, there is no consistency in the approach of the courts for putting a monitoring mechanism in place for the utilization of funds by the promoters.

THE MELD MODEL

   (i) THE ELP ANALYSIS

Exclusive Legal Positivists posit that a legal question can only be settled by referencing legally binding sources. When analyzing reverse CIRP as formulated in Flat Buyers, from the perspective of ELP, it is clear that the NCLAT’s reasoning is not grounded in any source of law. In fact, by making it a promoter-driven process the tribunal has supplanted its logic over that of the legislature. This is because the NCLAT created new terms that would conflict with Section 29A of the Code, which disqualifies the promoter of the debtor company from becoming a resolution applicant. As mentioned in the case of Chitra Sharma v. UOI, this section prevents the backdoor entry of promoters who may attempt to regain control of the entity.[vi] NCLAT in Flat Buyers introduced the terms ‘intended Lender’ and an ‘outsider financial creditor’ who essentially are promoters who ‘intend’ to be a lender while staying outside the CIRP process. The assumption here is that the allotters would be able to get their homes faster without third-party involvement vis-a-vis them involved. This falls foul of the Code which advocates for severance with the suspended management, once CIRP has been initiated.[vii] The NCLAT seems to have loosened this key mandate of the Code.

This does not mean that the process by itself has no merit. Undoubtedly, this judicial experiment has brought much-needed respite to homebuyers. However, going against the letter of law without sufficiently analyzing the implications of this decision violates the ELP principles. One such implication could be siphoning off funds by the promoter if adequate safeguards are not put in place. While judges in Supertech ordered the transfer of 70% of the funds to a separate RERA account, no such condition was placed in other cases including Flat Buyers. Therefore, while this judicial intervention was a welcome step for the allottees, it is still being implemented without sufficient guidance. The critique of the ELP scholars is that in the absence of adherence to the letter of the law, the burden of courts of establishing the necessity and legitimacy of the said deviation should be quite high. This would boost the confidence of the stakeholders in judicial intervention while also ensuring a certain degree of predictability. However, in the present case, this burden is not being fulfilled here given the uncertainty regarding the checks and balances over the promoter, which could lead to siphoning off funds, which in turn would shake up the legitimacy of the reverse CIRP process itself. Therefore, inconsistency in the implementation militates against the principles of ELP and might also sidestep the policy goals of the code itself as seen in the case of S.29A.

  (ii) INTERPLAY OF LAW AND ECONOMICS: NEED FOR SETTLING THE DUST

Louis Kaplow has given us two dimensions of legal commands: rules (ex-ante) and standards (ex-post).[viii] Rules differentiate between legal and illegal in a clear manner. Standards, on the other hand, are general legal criteria that would require the judicial application of mind. Kaplow has argued that the choice between the two has to be made by keeping in the mind the costs that would be associated with both. Standards may have lower promulgation costs than rules, but their enforcement costs would be much higher than that of rules. This is because the contours of a standard can only be gradually specified by judicial decisions.[ix] This is precisely what is happening with reverse CIRP: there is a use of imprecise standards when it comes to the creation of a separate account as per RERA.

Because there is no ex-ante rule for promoters to follow, there is ample space for ambiguity which would lead to weak enforcement. Had there been an ex-ante rule regarding this, it would have become easier to monitor the promoter’s activities. The Amendment currently provides that whenever there is a default by a real estate promoter then a project-wise CIRP will have to be carried out. However, this is only giving us a standard without actually giving the actors specific rules to abide by. This means that in case of dispute, adjudicatory bodies will have to do an ex-post assessment to check for abuse of funds. An ex-ante rule regarding this can significantly reduce the costs of monitoring. Borrowing from the Meld Model, the situation as it exists right now will create a myriad of transaction costs. One, judges would have to determine whether the promoters had siphoned off funds without any guiding principles. Two, the promoters will have uncertainty about their expected conduct in order to escape liability.

However, that is not to say that ex-ante policies are without faults; in fact, Kaplow argues that they suffer from high economic costs. But the alternative of having a toothless monitoring mechanism in place may result in greater externalities and an extraordinarily high cost of failure of the reverse CIRP process. As Kaplow has argued, the final choice depends on the comparative cost-benefit analysis between having an ex-ante and ex-post regime Therefore, it is proposed that an ex-ante rule mandating a separate account for such projects be put in place.

CONCLUDING REMARKS

In all fairness, the NCLAT has been extremely pragmatic in its experimentation of reverse CIRP.

The court has rightly protected the rights of home buyers by giving primacy to their needs. Yet, without specific guidelines, this judicial innovation may well end up being too fixated on being the savior of the allottees without actually defining the contours of the process. On a macro level, the risk is that siphoning off funds may scuttle a key tenet of the Code as enshrined under S. 29A: keeping erstwhile promoters at bay. Policymakers thus would be well-advised to formulate a mandatory RERA account requirement for promoters spearheading the reverse CIRP. While the proposed Amendments do not go into the specifics of how this reverse CIRP is to be carried out. However, solely mandating a project-wise CIRP which the Amendment currently does, fails to address the core problem of promoters benefiting at the expense of other stakeholders. There is no clarity as to how this independence between projects will be ensured and the workability and legitimacy of reverse CIRP hinges upon how this problem is remedied.

 

[i] Flat Buyers Association Winter Hills – 77, Gurgaon vs Umang Realtech, Company Appeal (AT) (Insolvency) No. 926 of 2019 (Order dated 04.02.2020)

[ii] Rahul Singh, “The Meld Model: The Holy Grail of Indian Corporate Jurisprudence” (NLS BLR) <https://www.nlsblr.com/the-meld-model-the-holy-grail-of-indian-corporate-jurisprudence> accessed April 13, 2023

[iii] Whispering Tower Flat Owner Welfare Association Vs. Abhay Narayan Manudhane, RP of Corporate Debtor, Company Appeal (AT) (Insolvency) No. 896 of 2021(Order dated January 4, 2022).

[iv] Anand Murti vs Soni Infratech Pvt. Ltd., Civil Appeal Nos. 7534 Of 2021 (Order dated 27.04.2022); Amit Katyal vs Meera Ahuja, Civil Appeal No. 3778 of 2020,(Order dated 03.03.2022).

[v] Ram Kishor Arora Suspended Director of M/s. Supertech Ltd. v. Union Bank of India & Anr Company Appeal (AT) (Insolvency) No. 406 of 2022(Order dated June 10, 2022)

[vi] Chitra Sharma v. Union of India [Writ Petition (Civil) No. 744 of 2017]

[vii] Sanjeev Kumar, “Reverse CIRP: An Alien Concept to the IBC Regime” (Bar and Bench – Indian Legal news) <https://www.barandbench.com/columns/reverse-cirp-an-alien-concept-to-the-ibc-regime> accessed April 13, 2023,

[viii] Louis Kaplow, Rules versus Standards: An Economic Analysis, 42 Duke L.J. 557 (1992).

[ix] Ibid.

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