Admissibility of a Loan in IBC in Case of Violation of 186 of Companies Act 2013 - MMJC

Introduction

The provisions of section 186 of the Companies Act, 2013 (Act) states that a Company can not give loan to any person or body corporate exceeding 60% of its paid-up share capital, free reserves, and securities premium account, or 100% of its free reserves and securities premium account, whichever is more unless a special resolution has been passed at a general meeting. The challenge arises when a company, being a Financial Creditor (FC) or a Corporate Debtor (CD) under the Insolvency and Bankruptcy Code, 2016 (IBC), breaches this limit without the mandated special resolution.

Questions for Consideration

1. Whether the violation of section 186 of the Act prohibits a FC from invoking IBC against a CD (u/7 of IBC) despite having an established debt and default.
2. Alternatively, can the CD rely on non-compliance with section 186 of the Act as a shield against insolvency.

This article refers orders where the Tribunals have adopted two approaches while determining the admissibility of section 7 of IBC application despite existence of debt and establishment of default.

Analysis of the Law

1. Debt not in accordance with provisions of applicable law is not legally enforceable debt: In the matter of UKG Steels Private Limited v. Exotic Buildcon Private Limited, UKG Steels Private Limited (FC) extended an inter-corporate loan to the Exotic Buildcon Private Limited the CD that exceeded 60% of the aggregate of its paid-up share capital and free reserves, as per its balance sheet. The FC neither made the disclosure of such inter corporate loan in its balance sheet nor it was able to submit a special resolution passed at the Extra- Ordinary General Meeting (EOGM) u/s 186 (3) of the Act. The loan agreement was also silent about the resolution passed by shareholders. FC filed a section 7 application under IBC against the CD .

HON’ABLE NCLT dismissed the application u/s 7 of IBC and stated that loan given by FC were ultra vires and loan advanced was not a legally enforceable debt. HON’ABLE NCLT further held that loan given contrary to the limit prescribed under Section 186 of Companies Act, 2013 is an ultra vires act and is not a legally enforceable debt. CD enjoying the benefits of a FC’s transgression, lacks standing to contest the breach and its ramifications.

Similarly in the matter of Jambudwip Exports and Imports Limited v. UP Bone Mills Private Limited. Jambudwip Exports and Imports Limited (FC/lender) initially provided funds as an advance for goods, subsequently the said advance was converted into an intercorporate loan by executing a Memorandum of Understanding (MOU). This amount exceeded the limit prescribed under section 186(2) of the Act, and  the FC failed to obtain prior approval through a special resolution at a general meeting. Consequently, the HON’ABLE NCLT New Delhi dismissed the FC’s petition, deeming the debt as unenforceable.    

In a more recent matter ofProplarity Infratech Private Limited v. Sky High Technobuid Private Limited. The principal bench of HON’ABLE NCLT, Delhi (now pending appeal) adopted the similar view. It was alleged by Sky High Technobuild Private Limited the CD (borrower) that Proplarity Infratech Private Limited the FC (lender company) had extended the purported loan in excess of the limits set by section 186 without obtaining the necessary shareholder approval. HON’ABLE NCLT ruled that in view of non-compliance with section 186 of the Act, granting of such a loan was an ultra vires act, and therefore not a legally enforceable debt.

• Debt not in accordance with provisions of applicable law is not legally enforceable debt:

HON’ABLE NCLT Mumbai took a contrary view in the matter of Pegasus Assets Reconstruction Private Limited v. Whiz Enterprises Private Limited. The Whiz Enterprises Private Limited [‘CD’] argued that its corporate guarantee should be deemed void in view of the provisions of section 186 of the Act as it exceeded the limits set out in the section 186 of the Act. The HON’ABLE NCLT emphasised that the CD was well aware of the fact that it was entering into a deed of corporate guarantee for the loan disbursed to the principal borrower (proprietary firm of the director of the CD). Further any belated attempt to interpose such objections to evade payment obligations or insolvency was unacceptable.

Similarly in the matter of India Bulls Commercial Credit Limited Vs Koshika Bioscience Private Limited at HON’ABLE NCLT Mumbai wherein the India Bulls Commercial Credit Limited [‘FC’], gave loan to Pro Fin Capital Financial Services (Principal Borrower). The CD/respondent/guarantor-Koshika Bioscience Private Limited, gave a corporate guarantee to the FC in favour of Principal Borrower against the loan amount. As per the deed of guarantee submitted by the FC before HON’ABLE NCLT, the CD irrevocably and unconditionally agreed that the CD would pay the guaranteed amount stipulated in the guarantee deed without any delay to the FC as if the CD was a borrower. On failure of the principal borrower to repay the loan facility on time, an event of default occurred under the loan agreement. The CD argued that the guarantee issued was in violation of section 186 of the Act. The FC relied on the board resolution wherein it was stated that approval of members would be accorded in the general meeting. According to the Doctrine of Indoor Management it was presumed that the company must have complied with the relevant provisional requirements of the law. The HON’ABLE NCLT held that the FC relied on the board resolution and argued that there is no violation of section 186 of the Companies Act, 2013. Even if it was so, it may, at best be the procedural violation by the Company which does not invalidate the guarantee issued by the CD.

Hence to conclude it can be stated that when a CD admitted the acquisition of a loan or issuance of a corporate guarantee, subsequently leading to a default, it is estopped from evading its responsibility or resisting insolvency proceedings under the IBC merely on the technical grounds of non-compliance with Section 186 of the Act. Further HON’ABLE NCLT held that non-compliance to provisions of section 186 of the Act is merely a procedural violation and does not prejudice the claim of applicant FC. It is well settled legal principle based on Latin maxim commodum ex injuria sua nemo habere debet, which means that ‘no party can take undue advantage of his own wrong’. After signing and issuing of the guarantee on behalf of the CD and after handing over a duly signed board resolution, the same director cannot wiggle out of it on any ground of anomaly or violation of provisions of the Companies Act, 2013 by the CD. Hence the corporate guarantee was valid and enforceable.

HON’ABLE NCLT Kolkata, in the matter EDCL Infrastructure Ltd. Vs. Urban Infraprojects Private Limited. –has adopted a similar view that Section 186(2) of the Companies Act, 2013 is a protection mechanism to the shareholders/ stakeholders of the Company so that the persons who are managing the company cannot and should not give loan in excess of limits prescribed which would be in excess of their capacity and could land the company in deep trouble in case of a default of the loan lent. It is not open for the CD to take shelter under such violations and refuse to repay money borrowed.

• Whether the violation of section 186 of the Act prohibits a FC from invoking IBC against a CD (u/7 of IBC) despite having an established debt and default –

Loan given contrary to the limit prescribed u/s 186 of the Act is an ultra vires act and is not a legally enforceable debt. CD enjoying the benefits of a FC’s transgression, lacks standing to contest the breach and its ramifications.

• Alternatively, can the CD rely on non-compliance with section 186 of the Act as a shield against insolvency –

Section 186 of the Act cannot serve as a tool for Corporate Debtors to evade responsibility or resist insolvency when faced with a Financial Debt. According to Section 5(8) of the IBC, for a debt to qualify as Financial Debt, two crucial conditions must be met: (i) there must be a debt, including any interest, disbursed for the time value of money; and (ii) money must be disbursed from creditor to debtor. The essence of Financial Debt remains unaffected by any (in)fraction of Section 186.

The principles while determining the admissibility of a section 7 (IBC) application.

The Doctrine of Election and Estoppel –Those who consciously enjoy the advantages arising from a contract are barred from subsequently contesting its validity or enforceability. This is to ensure fairness and equity. Consequently, when a CD admits the acquisition of a loan or issuance of a corporate guarantee, subsequently leading to a default, it is estopped from evading its responsibility or resisting insolvency proceedings under the IBC merely on the technical grounds of non-compliance with section 186 of the Companies Act, 2013.

Doctrine of Indoor Management

The doctrine of indoor management implies that an outsider whose actions are in good faith and has entered into a transaction with a company can have a presumption that there are no irregularities internally and all the procedural formalities have been complied with. In cases where a CD defaults on a financial debt arising out of a loan exceeding the limits of section 186, Tribunal may attempt to invoke the doctrine of indoor management, claiming entitlement to presume that the FC adhered to internal procedures while extending the loan. (India Bulls Commercial Credit Limited Vs Koshika Bioscience Private Limited, EDCL Infrastructure Ltd. Vs. Urban Infraprojects Private Limited)

Further in cases like Proplarity Infratech Private Limited v. Sky High Technobuid Private Limited, UKG Steels Private Limited v. Exotic Buildcon Private Limited and Jambudwip Exports and Imports Limited v. UP Bone Mills Private Limited it can be concluded that when the requirements of section 186 are not met the transaction itself is void ab initio and therefore , granting of such a loan becomes an ultra vires act, and not a legally enforceable debt.

CONCLUSION

After taking note of all the above orders and principles we observe that the HON’ABLE HON’ABLE NCLT have adopted different views on account of non-compliance of section 186 –

One view is of treating the financial transaction as ultra vires and not enforceable, and the other view of treating a violation or breach on the part of the company extending the loan, security or guarantee should not allow the borrower to prevent itself free from its repayment obligations.

Setting aside financial transactions on this ground will lead to a situation where a borrower, can avoid its repayment liability, after obtaining financial assistance, by taking a plea of an internal non-compliance of section186 of the Act on the part of the lender goes against the very objective of the section, to protect the interest of the shareholders of a company.

Further, where a bank or financial institution obtains a third-party security or guarantee from a group company of the borrower and where such security provider or guarantor has not complied with section 186 of the Act, then in such a situation, if the guarantee or security transaction itself would be treated as void or ultra vires and unenforceable, it would lead to a situation of a party taking advantage of its own wrong. A corporate guarantor or security provider cannot be rewarded for its own breach of section 186 of the Act, by terming such a transaction as void or ultra vires on account of its own internal non-compliance.