Status of subsidiary company vis-à-vis Holding Company under the Insolvency Law – By Chidambaram Ramesh

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Status of subsidiary company vis-à-vis Holding Company under the Insolvency Law

-By Chidambaram Ramesh
[The author of ‘The Law of Employee’ Provident Funds – A Caselaw Perspective’]

                In modern times, business enterprises often prefer, for a variety of reasons, to perform their activities in the form of two or more independent subsidiaries rather than as a single company. The concept of limited liability on the legal entity theory treats the company as a legal persona constituting an entity in itself separate and distinct from its members. Likewise, if registered under the Companies Act, the subsidiary companies are also treated as separate legal entities. Incorporation under the Companies Legislation thereby places a proverbial ‘veil’ between the incorporated company and those who have incorporated or legally created it. This article analyses the intriguing relationship between the holding company and its subsidiaries under the Indian insolvency legal framework.

The subsidiary company is a ‘Related Party’

A subsidiary company of the Corporate Debtor as well as a holding company to which the Corporate Debtor is the subsidiary – both come within the meaning of ‘related party’ to each other in terms of sub-clause (i) of clause 24 of Section 5 of the Insolvency & Bankruptcy Code, 2016. In other words, the Code makes a commutative relationship between the holding company and its subsidiary.

Assets of the Corporate Debtor include those held in its subsidiary also

When the interim resolution professional takes control and custody of the assets over which the corporate debtor has ownership rights, he has to take into consideration the shares held in any subsidiary of the corporate debtor also, as per the mandate of section 18(f) of the I & B Code. Simultaneously, the explanation to section 18 of the Code specifically excludes the ‘assets of the subsidiary company’ (both Indian and foreign) from the meaning of ‘assets of the Corporate Debtor.’ In the same vein, section 36 of the Code defines the ‘liquidation estate’ to include any asset over which the Corporate debtor has ownership rights, including the hares held in any subsidiary of the Corporate Debtor.  But again, clause (4) of Section 36 of the I & B Code excludes the subsidiary’s assets (Indian or foreign) from the meaning of ‘liquidation estate.’ Thus, the insolvency law demarcates the assets and liabilities of the holding company and its subsidiary in the process of CRIP.

No right of representation in the CoC

Section 21 of the I & B Code mandates the interim resolution professional to constitute a creditors committee after collating all claims received against the corporate debtor and determining its financial position. The committee of creditors shall comprise all financial creditors of the corporate debtor. The proviso to clause (2) of Section 21 clarifies that a related party (the holding company or its subsidiary, as the case may be) to whom a corporate debtor owes a financial debt shall not have any right of representation, participation or voting in a meeting of the committee of creditors. However, if the subsidiary company happens to be a creditor, it is not debarred from submitting a resolution plan.[1]

No change in the management of the subsidiary during CIRP

Under Section 28 of the I & B Code, a resolution professional cannot take certain actions without the committee of creditors’ prior approval. Section 28(1)(j) of the Code stipulates that the resolution professional cannot change the management of the corporate debtor or its subsidiary without the committee of creditors’ prior approval. Therefore, changes, if any, in the management of the subsidiary company’s management also comes within the effective control of the Committee of Creditors of the Corporate Debtor (holding company).

No transaction with the subsidiary

Section 28 (1)(f) of the I & B Code also proscribes any related party transactions (which includes transactions with the subsidiary company also) during the corporate insolvency resolution process without the prior approval of the committee of creditors.

The look-back period for avoidable transactions

Section 46 of the I & B Code allows the resolution professional or the liquidator to apply to avoid an undervalue transaction made by the Corporate debtor if such transaction was made with any person within one year preceding the date of commencement of insolvency. In case such transaction was made with a subsidiary company (related party), the time limit is two years preceding the insolvency commencement date. In addition to this, Explanation I to sub-clause (1) of Section 46 clarifies that where a person, who has acquired an interest in the property from another person other than the corporate debtor, or who has received a benefit from the preference or such another person to whom the corporate debtor gave the preference, is a related party (that is,  the holding or subsidiary company as the case may be), it shall be presumed that the interest was acquired or the benefit was received otherwise than in good faith unless the contrary is shown.

The status of the subsidiary in the waterfall mechanism

            In J.R.Agro Industries Private Limited v Swadisht Oils Private Limited (2018) ibclaw.in 21 NCLT, the NCLT, Allahabad disallowed the related party’s priority claim over other operational creditors. The Tribunal observed, “if the claim of [the] related party is given priority over operational creditors, it would not be just to [the] operational creditor.” In that case, the related party and the corporate debtor had common directorship and common promotors. Considering these aspects, the NCLT directed that the related party’s claim should rank subordinate to operational creditors’ claim. It should be treated at part with the equity shareholders under s.53(1) (h) of the Code, and be considered inferior in rank to the unsecured financial creditors as well as ‘other debts and dues.’

No moratorium on the insolvency of the subsidiary company during pendency of CIRP of Holding Company

Alok Infrastructure Limited is the subsidiary company of Alok Industries Limited – the holding company. The subsidiary company had availed loan from Axis Bank Limited. It failed to repay it, and the creditor bank applied Section 7 of the I & B Code for initiation of CIRP against the subsidiary company. The subsidiary company challenged the admission of the application on the ground that the Holding Company viz., M/s Alok Industries Limited is already in the process of Corporate Insolvency and hence the initiation of the CIRP against the subsidiary company at that point of time would result in the violation of the moratorium imposed in the case of the holding company. In other words, the issue for consideration before the NCLT was whether the NCLT has the power to initiate CIRP against the subsidiary company during the pendency of the CIRP against the holding company after the imposition of moratorium under section 14 of the I & B Code. The NCLT, Mumbai Bench held that the initiation of the CIRP against a subsidiary of a Corporate Debtor under the CIRP would not be hit by Section 14(1)(a) moratorium by any stretch of imagination. Further, the present proceeding is completely different, and as far as the Corporate Debtor is concerned, there is a debt, and there is a default.

The NCLAT observed that the provision in Section 14(1)(a) of the I & B Code speaks about moratorium for prohibiting institution of suits or continuation of pending suits against the Corporate Debtor including the execution of any judgment, etc. But it does not speak about the initiation of CIRP against the subsidiary of the Corporate Debtor. The NCLAT further clarified that the Corporate Debtor could not take shelter under Section 60(5)(b) of the I & B Code which speaks about the jurisdiction of the NCLT in respect of claims by or against the Corporate Debtor including the subsidiary of the Corporate Debtor but that cannot lead to a conclusion that CIRP of a subsidiary of a Corporate Debtor against whom the CIRP is to be initiated, shall be dealt with by the same NCLT where the Corporate Debtor (holding company) is undergoing the CIRP, even though the registered office of the subsidiary falls under the jurisdiction of another NCLT.

            With the above observations, the Mumbai Bench of NCLT had admitted insolvency proceedings against Alok Infrastructure, the subsidiary of Alok Industries, while CIRP against Alok Industries was still underway. In an appeal filed against the said order, the NCLAT also upheld the admission order passed by the NCLT.

Lifting the Corporate Veil

            The affiliate companies, distinct in form, used to have frequent substantial commercial unity and this has been taken note of by various courts. The doctrine of lifting the veil can be applied where companies are in a relationship of holding and subsidiary – particularly in revenue matter when the question of controlling interest is on the issue and broadly speaking where fraud is intended to be prevented.

Though the subsidiary company is treated as a separate legal entity for Company law, the corporate veil’s lifting is permissible if the public interest requires to do so. In such an event, the question before the Court is one of company law, and the corporate personality is of secondary importance. The important test is whether the method adopted for evasion of legal obligations would subvert public interest.

 In Workmen of Associated Rubber Industry Ltd. v Associated Rubber Industry Ltd.,[2] a company purchased shares in another company. The dividends that accrued from there were used for payment of bonus to its workmen. The company transferred all those shares to its wholly-owned subsidiaries which had no other business of its own, and the balance sheet and profit and loss account could not reflect the surplus for payment of bonus. In such exceptional cases, the Supreme Court observed that it was entitled to lift the veil of corporate entity ‘to pay regard the economic realities behind the legal façade.’ “A new company is created wholly owned by the principal company, with no assets of its own except those transferred to it by the principal company, with no business or income of its own except receiving dividends from shares transferred to it by the principal company and serving no purpose whatsoever except to reduce the gross profits of the principal company. These facts speak for themselves. There cannot be direct evidence that the second company was formed as a device to the Principal company’s gross profits for whatever purpose. An obvious purpose that is served and which stares one in the face is to reduce the amount to be paid by way of bonus to workmen. It is such an obvious device that no further evidence, direct or circumstantial, is necessary.” 

In State of U.P v Renusagar Power and Co and others,[3] the Supreme Court observed, “It is high time to reiterate that in expanding horizon of jurisprudence, lifting of corporate veil is permissible. Its frontiers are unlimited.” The Court held that the corporate veil should be lifted where the associated companies are inextricably connected to reality, part of one concern. In New Horizons Ltd. v Union of India,[4] the Supreme Court considered the aspect of lifting the corporate veil. Citing DHN Food Distributors Ltd. v London Borough of Tower Hamlets, the Court of Appeal was dealing with the relationship between a holding company and its two subsidiaries. Lord Denning, M.R. observed, “this group is virtually the same as the partnership in which all the three companies are partners. They should not be treated separately so as to be defeated on a technical point.” In the same case, Goff, L.J. said, “this is a case in which one is entitled to look at the realities of the situation and to pierce the corporate veil.” In U.K.Mehra vs Union of India,[5] a Division Bench of the Delhi High Court observed that where a subsidiary is wholly owned by the principal company which has pervasive control over it and the former acts as the hand and voice of the latter, the subsidiary would be nothing but an instrumentality of the principal company, and wherever public interest demands, the Court must lift the corporate veil in the interest of justice.

The Doctrine of Substantial Consolidation

In Venugopal N. Dhoot v State Bank of India and others,[6] the NCLT, Principal Bench, New Delhi set a precedent by consolidating the Corporate Insolvency Resolution Process (CIRP) matters of a group of companies as one to be heard by the NCLT, Mumbai Bench. In State Bank of India v Videocon Industries Limited case, the NCLT, Mumbai Bench ordered for substantive consolidation of the assets and liabilities of as many as thirteen group entities. In another instance, in the case of Adel group, the NCLT initiated procedural coordination to ensure simultaneous proceedings with a common Resolution Professional for certain companies belonging to the same group.

            The provisions of the Indian insolvency law make a clear distinction between the assets and liabilities of the holding company and its subsidiary in the process of CIRP. Simultaneously, the courts of law have paved the way for lifting the veil in case of any camouflage transfer of funds between the holding company and its subsidiary to avoid the liabilities. 

           

Reference

[1] J.R. Agro Industries P. Ltd v. Swadisht Oils P. Ltd, (2018) ibclaw.in 21 NCLT

[2] AIR 1986 SC 1, 1985 (51) FLR 478, 1986 157 ITR 77 SC, (1986) ILLJ 142 SC, 1985 (2) SCALE 321, (1985) 4 SCC 114, 1986 (1) SLJ 218 SC, 1986 (1) UJ 235 SC

[3] (1988) 4 SCC 59

[4] (1995) 1 SCC 478

[5] (1994) 1 Comp LJ 263 (Del.HC)

[6] C.A.1022 (PB)/2018

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