IBC AND INVESTOR PROTECTION IN INDIA: IMPLICATIONS OF THE INDUS BIOTECH RULING

Introduction

The National Company Law Tribunal (NCLT), recently decided there existed an arbitrable dispute in the case of Indus Biotech Private Limited (‘Indus’/Corporate Debtor) v. Kotak India (Offshore) Fund & Ors. (‘Kotak’/Financial Creditor). Kotak held Optionally Convertible Redeemable Preference Shares (‘OCRPS’). The NCLT did not classify the failure of Indus to repay the redemption amount as a default under Section 7 of the Insolvency and Bankruptcy Code, 2016 (IBC/Code) and nullified Kotak’s right to redemption of the OCRPS.

Although the contentions were brought forward to the Supreme Court by the way of appeal, the findings of NCLT were approved. The issues arising out of these two judgements will be discussed further, first let us get a brief factual background:

In 2007-2008, Kotak subscribed to equity shares and OCRPS issued by Indus. Indus wanted to do a Qualified Initial Public Offering (QIPO) (QIPO). In order to comply with regulation 5(2) of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations 2018, Kotak decided to convert its OCRPS into Indus equity shares prior to the QIPO. A disagreement occurred during negotiations between the two parties over the computation and conversion methodology to be used for converting the OCRPS into equity shares. Kotak invoked the terms of the Share Subscription and Shareholders Agreement (“Agreement”) to seek redemption of the OCRPS at the redemption value while the dispute was still ongoing.

Notably, the Agreement outlined the procedure for redeeming the OCRPS, including the ‘redemption value,’ the time period within which the ‘redemption value’ must be paid to Kotak when it becomes due, and the circumstances under which Kotak may require Indus to redeem the OCRPS (such as, for instance, upon the occurrence of an exit event like a QIPO or upon the expiry of December 31, 2018, being the original tenure of the OCRPS). The agreement further stated that the ‘redemption value’ would be considered a debt owing by Indus to Kotak from the due date until it was fully repaid. When Indus failed to redeem the OCRPS within the agreed-upon time frame, Kotak regarded the failure as a breach of the Code and filed a petition with the NCLT under Section 7 of the IBC to initiate Indus’ bankruptcy proceedings. Indus, on the other hand, filed an interim application with the NCLT under Section 8 of the Arbitration & Conciliation Act, 1996, requesting that the tribunal submit the problems to arbitration, constituted in the Agreement’s dispute resolution mechanism.

Reasoning of NCLT and Supreme Court:

The NCLT, as well as the Supreme Court sided with the corporate debtor’s contentions and held the Section 7 application to be inadmissible until the dispute between the parties is settled through arbitration. The primary reasons for their complementary decisions are explored below:

a. Existence of Default

The main problem was determining the proper formula to use when converting Kotak’s OCRPS into Indus due to the QIPO being examined. The agreement stipulated the process for conversion, as well as a conversion range of 10 to 30 percent, based on the OCRPS valuation. Kotak asserted that upon conversion, they were entitled to equity shares equal to 30 percent of the paid-up capital, but Indus contended that they were only entitled to 10 percent. Both parties held several discussions and correspondences, but after failing to reach an amicable resolution, Kotak proceeded to redeem the OCRPS in accordance with the terms of the Agreement, which required Indus to redeem the shares within 15 days of the redemption date. Indus refused to comply with Kotak’s redemption notice and did not return the redemption value to Kotak.

Further, placing reliance on section 7(5) of the IBC and past Supreme Court judgments, the NCLT held that for an application under Section 7 to be admitted, the adjudicating authority must be satisfied of the existence of default, although the SC upheld this position and observed that an objective assessment by the adjudicating authority is necessary to yield satisfaction as to the existence of default for an admission of an application.

The NCLT, held that the determination of existence of default centred around three things – (1) the valuation of Kotak’s OCRPS; (2) the right of Kotak to redeem such OCRPS when it had participated in the process to convert its OCRPS into equity shares of Indus; and finally, (3) the unilateral fixation of the QIPO date. It was found that these three problems needed to be resolved conclusively in order to establish whether Indus had committed a default by failing to pay the redemption value to Indus. As a result, the presence of default could not be proved definitively without a settlement of the parties’ disagreement. The NCLT’s conclusions were upheld by the Supreme Court, which based its decision on the parties’ desire to convert the OCPRS into equity shares, as is evidenced by meetings and correspondence.

Considering that the right of the OCPRS holder to redeem the share is distinct from that of conversion of the said shares to equity shares, it is possible that any dispute pertaining to the modalities of conversion might have been the subject matter of a separate trial and adjudication altogether. The dispute at hand (conversion and the conversion formula) were completely extraneous to the determination of whether (a) Kotak had correctly sought redemption of the OCRPS (b) any amount was due and payable as redemption value by Indus (c) such redemption value could be classified as financial debt and(d) there was a default in making payment of the redemption value by Indus. If all of these considerations are taken into account, it is determined that there is no debt due or no default on the debt due, this is within the scope of S/ 7 of the IBC. The SC and the NCLT, on the other hand, have held that Kotak was not allowed to begin a redemption of the OCPRS since it had already begun the process of converting the OCPRS into equity shares, which was the subject of a separate dispute between the parties. When determining whether a debt or default was alleged prematurely by the petitioner, the courts have used a broad approach.

b. Solvency of the Corporate Debtor

Both SC and NCLT held that another aspect to be considered was the solvency of the Corporate Debtor. The NCLT in its findings stated that Indus is a solvent, debt-free and profitable company and such an allegation would unnecessarily put it into the CIRP. This runs contrary to what was held in Swiss Ribbons vs. Union of India[i] that emphasis should be on the solvency of the company and the presumption that solvent companies can’t commit default. This was also reiterated in the recent NCLAT judgment of Monostrone Leasing Pvt. Ltd. Vs. P M Cold Storage Pvt. Ltd.[ii] The NCLT was ruled to simply have to make a factual assessment of the presence of default and not to take into account any other considerations or circumstances relating to the creditor-debtor relationship. Furthermore, the debtor can only challenge the application if he or she can show that the claim amount was not payable under law or contract, therefore showing that the default did not occur at all.

The IBC has introduced templatised forms to be filled out with the required information for the commencement of bankruptcy proceedings against borrowers, and the issue of the borrower’s ‘ability to pay’ is largely irrelevant and insignificant. The creditor just has to factually prove through documentary evidence the existence of default i.e. (a) whether an amount is due and (b) whether the same has been paid.

As in this case, if we start debating and assigning importance to other criteria like the borrower’s solvency (which are totally beyond the scope and aim of IBC), we may end up with incongruent NCLT rulings on the same issue of law and requiring further clarification from the SC.

Conclusion

The key findings of both the rulings revolve around the procedural provisions of the agreement. It was held that having initiated the process of conversion of the OCRPS which resulted in a dispute, Kotak was wrong to initiate another and altogether a separate right to redemption of the said OCRPS during the pendency of the dispute. The procedural provisions, especially the exit rights, should be watertight. It is crucial that procedural provisions of such investment documents align with the commercial aspects and enable investors to choose a parallel line of rights available in the document. For this, it is important to have clear timelines for the completion of actions required. This becomes even more important in the case of investors’ exit rights; sufficient flexibility should be built into drafts ensuring free and favourable exit to investors.

The agreement also provided for a range of conversion (10-30%), depending on the valuation of OCRPS. In order to pre-empt such disputes, the parties may consider allowing valuation mismatches within a small range (say, 2% range of variation) and then settling upon the mean of two numbers or having an alternate mechanism which might involve hiring a neutral accountant or valuation expert to review the valuation methodology and deliver a final valuation to the parties.

Both the judgments do not elaborate on the manner in which the wordings of the Agreement were interpreted. It can only be hoped that these rulings by the NCLT and the Supreme Court don’t set precedents in relation to interpretation of the provisions relating to the exit rights of the investors and price protections under investment documents. These are sacrosanct to the investment thesis and any dilution of these rights may impact India’s standing as a destination for foreign and domestic capital.

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[i] Swiss Ribbons vs. Union of India, 2019 SCC OnLine SC 73.

[ii] Monostrone Leasing Pvt. Ltd. Vs. P M Cold Storage Pvt. Ltd., 2020 SCC OnLine NCLAT 581.