Liability of directors for ‘wrongful trading’ under the Insolvency & Bankruptcy Code

Introduction

The Insolvency and Bankruptcy Code, 2016 (“IBC”) was notified by the government in November, 2016. The IBC was a major financial sector reform and has been instrumental in resolving a large proportion of non-performing assets, given a fillip to the secondary loan market and led to successful turnaround of several ailing companies. Another benefit has been the improvement in the standards of corporate governance due to imposition of post facto liabilities on erstwhile directors of the company. In this note we examine the issues surrounding directors’ liability particularly for ‘wrongful trading’ under the IBC.

To provide a brief overview, under IBC, creditors or the company itself, may file an insolvency application before the National Company Law Tribunals (“NCLT”). Once the application is admitted, a restructuring period – the Corporate Insolvency Resolution Process (“CIRP”) commences which is intended to lead to a going concern resolution within a maximum of 330 days. The NCLT passes an order for liquidation of the company in the event the company is not resolved within this timeline. On admission of an application for insolvency, the powers of the board of directors are suspended, and an insolvency professional assumes control over the affairs of the business. Under the IBC, the insolvency professional has a positive obligation to examine certain specified transactions under IBC, including transactions that give rise to the liability of directors under IBC.

Directors’ liability under IBC may be classified into two broad categories: disgorgement-based liability and punitive liability. The punitive liability to a large extent codifies the regime against directors for certain actions, including defrauding creditors, asset stripping and falsification of books of accounts of the company. These actions require an element of mens rea (or intent) to be proved so as to be applicable and liability may be more easily determined by a certain set of objective facts. However, it is the interpretation of the disgorgement-based liability which relates to the ‘wrongful trading’ which remains ambiguous under Indian law.

A. Wrongful trading under Section 66(2) of IBC

The general duties of directors of solvent companies are contained in Section 166 of the Companies Act, 2013, which provides that directors must act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment. Though the ambit of stakeholders to whom directors owe a fiduciary duty under Section 166 of the Companies Act, 2013 is cast broadly, it is widely understood that the primary duty of directors is towards shareholders. The new provision of ‘wrongful trading’ under the IBC modifies this position such that the duty of directors shifts away from shareholders and towards creditors of the company once it enters the twilight zone of insolvency.  As per the report of the Bankruptcy Law Reform Committee (which was instrumental in drafting the IBC), the objective behind introducing the provision of wrongful trading under IBC was to accord protection to creditors who may suffer from information asymmetry while dealing with a distressed company.

Wrongful trading has been defined under Section 66(2) of IBC. Under this provision, on an application made by an insolvency professional a director is liable to make contributions to the assets of the company and the NCLT may disgorge such amounts from the director’s personal assets if:

(a) the director knew or ought to have known that there was no reasonable prospect of avoiding the commencement of a CIRP against the company; and

(b) the director did not exercise due diligence in minimizing the potential loss to the creditors of the company.

Note, that a director is said to have exercised sufficient due diligence if such diligence was reasonably expected of a person carrying out the same functions as the director.

The wrongful trading provision has been borrowed from the UK Insolvency Act, 1986 (“1986 UK Act”). Criminal liability for directors for defrauding creditors existed in the UK even prior to the 1986 UK Act. However, the 1986 UK Act introduced a new standard to accord compensation-based remedy to those creditors who suffered a loss due to the mismanagement of the company in the zone of insolvency — even if such mismanagement by the directors of the company fell short of the level of criminality. The wrongful trading provision enabled contribution orders against a culpable director to be made without proof of actual dishonesty and without a criminal standard of proof. For instance, a company would be trading wrongfully if it incurred liabilities with no reasonable prospect of meeting them or when a company continued trading even when the value of its equity was heavily eroded.

B. Scope for liability for directors

The bankruptcy courts have wide discretion in imposing personal liability on directors found to be guilty of wrongful trading. It is worth mentioning that Section 66(2) of IBC does not distinguish between executive, independent or shadow directors and applies uniformly to all types of directors of a company. Therefore, this provision would be of greater concern to non-executive or nominee directors who typically play a more passive role in the affairs and operations of the company.

The most vexed issue under Section 66(2) of the IBC is the threshold at which courts will determine the ‘zone of insolvency’ to have commenced, thereby triggering the shift in directors’ duties. The wrongful trading section of the 1986 UK Act applies only when the directors should have known that there was no reasonable prospect of avoiding an insolvent liquidation of the company, whereas Section 66(2) of IBC applies when there was no reasonable prospect of avoiding the commencement of a CIRP against the company. It is worth noting that under IBC, a CIRP may be commenced on a mere payment default of INR 10 million (approximately USD 132,000) – which is a comparatively low threshold especially for large companies.

There may be sound logic for diluting the high trigger point of an insolvent liquidation (i.e., the UK standard) to a lower level of a payment default (i.e., the IBC standard) so as to incentivise directors to take corrective action at the first onset of any financial distress rather than waiting till a time where saving the company as a going concern is no longer commercially viable. At the same time, advancing the threshold at which directors need to take corrective action increases the prospect of personal liability. Given this onerous standard, the question is what steps directors can take to mitigate potential losses to creditors. Section 66(2) creates a safe harbor for directors’ actions taken to mitigate losses with sufficient due diligence. The bankruptcy court is entrusted with the task of deciding if the mitigating actions taken by the directors meet the standard expected of a hypothetical person carrying out the same functions as are carried out by such director. Therefore, a directors’ liability will depend on the subjective assessment of the NCLT as to whether their actions meet the “due diligence” standard. As a result, directors may not know a priori if their actions will meet the scrutiny of the judiciary.

UK case law considers several actions on the part of the directors as being reasonable and prudent so as to meet the due diligence test under the safe harbor. The takeaway seems to be that on one end of the spectrum, voluntarily filing for an administration procedure under the 1986 UK Act is certainly a safe and legally tenable course of action. Drawing an analogy, in the absence of judicial precedents or any further guidance from IBC, the safest option for directors facing an imminent payment default by a company also seems to be to voluntarily file for CIRP.

However, a voluntary CIRP filing raises two issues. The first issue is a procedural one. By way of an amendment to Section 10 of IBC, in effect from June 6, 2018, voluntary filing for CIRP of a company must to be supported by a special resolution passed by the shareholders. In companies where the directors also happen to be the majority shareholders, obtaining a special resolution may not be difficult. However, where this is not the case, the directors must satisfy the shareholders that a voluntary bankruptcy filing is beneficial to the shareholders as well. In practice, this may be difficult to achieve since during the CIRP of a company, there is no legal requirement to make any payments to equity shareholders unless they are in the money. Moreover, during the liquidation of a company, equity shareholders are at the bottom of the liquidation waterfall mechanism in the order of priority. Therefore, a situation may arise where a director, in satisfaction of her fiduciary duties towards the creditors of a company in the zone of insolvency, is convinced of the benefits of voluntarily filing for insolvency under Section 10 of IBC but fails to convince the equity shareholders of the company.

The second issue is more commercial in nature. Even if the directors can overcome the threshold requirement of the special resolution by shareholders of the company, Section 66(2) will nonetheless put directors in the position of making a difficult choice between filing for CIRP against the company at the first signs of distress and thereby avoiding personal liability; and making a genuine and good faith attempt to remedy the default and continue trading. Directors fearing wrongful trading liability may act in a risk-averse manner and may be tempted to file for a CIRP hastily instead of endeavouring to weather the temporary financial difficulty and preserve long-term value. This raises a possibility of premature CIRPs against fundamentally sound businesses, causing disruption to consumers, suppliers and employees. Further, if any action by the directors with a view towards protecting creditors’ interests turns out to be precipitous or without adequate basis, shareholders could hold the directors liable under Section 166 of the Companies Act, 2013.

C.  Means of mitigating liability of directors

Directors need to maintain a fine balance in preserving value in a sound business while avoiding personal liability for wrongful trading. It is not an easy choice, especially for companies that are clearly solvent but could potentially be dragged into a CIRP owing to temporary liquidity issues. In the absence of any clarity on how the concept of wrongful trading will play out in Indian bankruptcy courts, boards must proactively devise strategies to reduce the scope for liability. Some of the steps that directors may consider are:

(a) negotiate all debt contracts and material supply contracts such that any payment default entitles the counterparty to initiate an insolvency resolution process only after affording the company an adequately long notice period to consider all viable options, to help directors buy time to consider their options carefully;

(b) put in place processes in consultation with the company’s auditors to ensure availability of adequate and timely financial information about the company;

(c) regularly discuss and review the cash flows of the company and closely monitor all actual and contingent claims against the company;

(d) review the director and officer insurance policies to ensure that they cover any liability arising as a result of wrongful trading;

(e) engage independent and reputed merchant bankers to formally opine on the business prospects and solvency of a company in the near future at the earliest onset of distress; and

(f) obtain a legal opinion from a reputed law firm to ensure that the mitigating steps taken at the onset of a potential CIRP meet the test of “due diligence” under Section 66(2) of IBC.

Conclusion

IBC has radically altered the insolvency law landscape in India and has drastically reduced the scope for misfeasance by directors and promoters. However, mandating directors to take creditor-focused action at the early stages of a financial difficulty could create pitfalls for professional managers and directors who may not have any fraudulent or criminal intent. Additionally, the added requirement of shareholders’ special resolution prior to voluntarily filing for insolvency could create barriers to those directors that genuinely believe such voluntary filing is the best way forward for the company. Till such time as the dust settles on the law around wrongful trading, directors will be well advised to take all possible steps to eliminate personal liability without compromising their fiduciary duties towards shareholders of the company.

Authors:

Bahram Vakil, Founding Partner
Suharsh Sinha, Partner
Ashrita Gulati, Associate

Published In:International Insolvency & Restructuring Report
Date: July 13, 2020