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Substantive Consolidation: A Remedy in Equity or Law?

Authors: Aaryan Dhasmana* &  Hamza Khan**

Third-year* and Second-year** law students at National Academy of Legal Studies and Research (NALSAR), Hyderabad

 

I. Introduction


The prevalence of company groups is experiencing a notable uptrend globally, owing to the financial and operational advantages of companies forming such structures. This prevalence, as well as the subsequent insolvency of such groups, has led to jurisdictions like the EU and Canada devising special frameworks to consolidate and optimise the resolution process of group companies.


However, despite witnessing a similar boom in company groups, India still needs to incorporate necessary amendments in the Insolvency and Bankruptcy Code, 2016 (IBC) catering to group insolvency. This has forced the Indian judiciary to take a proactive stance to ensure the effective resolution of company groups by applying the equitable principle of ‘substantive consolidation’.


However, this judicially-constructed remedy needs to reflect the concerns of various stakeholders. Apprehensions regarding the failure to reflect all such concerns have been heightened owing to the recent case of Giriraj Enterprises v. Regen Powertech (Giriraj), where the NCLAT emphasised that the Indian version of substantive consolidation was a measure in furtherance of the IBC’s objectives, thus severing the remedy from its equitable roots.


This article aims to highlight the adverse consequences that this severance can have for important stakeholders under the IBC. Additionally, it proposes legislative changes required to remedy these issues.


II. The Need for Consolidation


Insolvency laws, across most jurisdictions, focus on resolving insolvency at the individual company level owing to the separate legal personality of corporate entities. However, similar to cases justifying the need to lift the “corporate veil” in corporate law jurisprudence, the insolvency of group companies also presents one of the several scenarios where maintaining the separate identity of companies under a group structure may do more harm than good.


Corporate entities in a group are interlinked through shared finances and operations. Group members often enter into joint transactions with third parties, with the parent companies serving as sureties for their subsidiaries. In such a situation, disentangling the assets and liabilities of particular companies often becomes value-destructive, involving a prolonged and costly legal inquiry.


Moreover, creditors and other parties often engage with companies by analysing the finances of the overall group rather than the particular entities, owing to the group functioning as a single economic entity. Disentanglement in such cases thus goes against the expectations and interests of these stakeholders. Hence, consolidation of the insolvency resolution of these companies becomes necessary to optimise the returns stakeholders can recover.


Further, consolidation can also produce tangible benefits for the company undergoing the corporate insolvency resolution process (CIRP) as it allows separate subsidiaries in a group to tap into the resources of their parent company, facilitating the operation of subsidiaries as going concerns during the CIRP. This also increases the possibility of the revival of subsidiary companies, considering that they would not have attracted any resolution applicants if presented separately from the companies they depend on for their operation.


III. The Exceptional Nature of Substantive Consolidation


Despite its absence in the IBC, the Indian insolvency courts have adopted the principle of substantive consolidation, a bankruptcy law analogue to veil-piercing developed in the US bankruptcy regime, to ensure that the objectives of the IBC are met.


Unlike procedural consolidation, where the court treats different companies as separate entities while coordinating their resolution process in tandem with each other, substantive consolidation involves pooling the assets and liabilities of an insolvent group together. This allows for forming a shared pool, which can go into a common CIRP.


This pooling goes against the well-established principle of separate legal personalities of two corporate entities. Thus, it is not surprising that the insolvency courts have emphasised its exceptional nature ever since its introduction in the Indian insolvency jurisprudence in SBI v. Videocon (Videocon). In this case, a test involving two prongs was prescribed. The first prong requires the establishment of commonality of operational control and resources, while the second requires determining the viability of the revival in the absence of consolidation. Both of these criteria must be satisfied by the party demanding substantive consolidation.


IV. The Giriraj case: severance of substantive consolidation from equity


The Giriraj case involved a plea for consolidating a subsidiary and a parent company undergoing CIRP. The subsidiary, in this case, Regen Infrastructure and Services Pvt. Ltd., was wholly owned by the parent, i.e., Regen Powertech Pvt. Ltd., and it was alleged that the subsidiary was formed solely for the operational convenience of the parent. The opposing party opposed the consolidation on the grounds that it would amount to an exercise of extraordinary equity jurisdiction, which the NCLAT did not possess.


After considering the arguments put forth by both sides, the NCLAT highlighted its goal-oriented approach by stating that consolidation was a possible means to maximise the value of assets and increase the possibility of revival. Further, the court held that this substantive consolidation would further the objectives of IBC as it would help enforce the commercial wisdom of the Committee of Creditors (CoC). This is because the CoCs of both the parent and the subsidiary, in this case, believed that a single entity should purchase both the companies together, owing to operational reasons.


Thus, according to the NCLAT, substantive consolidation could not be construed as a principle of 'equity' but a 'legal principle.' It was an act done to achieve the primary objectives of the IBC, i.e., ‘maximisation of value of assets’, 'value addition,' and implementation of the ‘commercial wisdom’ of the CoC.


V.  Significance of the equitable nature of the remedy


The equitable nature of substantive consolidation can be rooted back to its formulation by US bankruptcy courts, which have the power to rule based on equity principles. The equitable roots of substantive consolidation have been highlighted in the case of In Re Vecco Const. Industries and Food Fair Inc. 


The US bankruptcy courts, in all these cases, while upholding their power to consolidate proceedings as well as the assets and liabilities of the debtors, allowed the substantive consolidation based upon equitable principles. Similarly, in the case of Donut Queen Ltd., it was held that substantive consolidation necessarily hinges on a balancing of equities, with those favouring consolidation on one side and continued debtor separateness on the other.


In the Indian context, while the insolvency tribunals, i.e., NCLTs and NCLATs, may not possess an extraordinary equity jurisdiction, the equitable nature of the remedy of substantive consolidation has been expressed since its very introduction in the Indian insolvency jurisprudence. The second prong of the test laid down in Videocon essentially aims to balance the equity between consolidation and maintaining corporate separateness to ensure that entities are consolidated only when they cannot get any viable bids on their own. The case explicitly mentions that “equity and fairness ought to be a yardstick by lifting the corporate veil."


Requiring the balancing of equities allows a further layer of scrutiny, which cements the exceptional nature of the remedy of substantive consolidation. This balancing act allows an inquiry into not just the gains accrued owing to consolidation, i.e., value maximisation, but even the harm caused by the activity. It is essential to acknowledge that substantive consolidation carries potential disadvantages for specific stakeholders. While, as mentioned before, some creditors evaluate company finances by looking at the entire group, some other creditors and entities engage with companies by assessing them as distinct legal entities.


In the event of consolidation, these creditors might find themselves compelled to accept larger haircuts and suffer more significant losses as part of the collective resolution plan when the assets of multiple companies are combined into a shared pool. Consequently, while the benefits of consolidation are undeniable, they must be carefully weighed against other critical considerations.


Such concerns have been rightly flagged in the report of the IBBI Working Group on Group Insolvency. While backing the demand to incorporate a proper substantive consolidation framework, the report recommends limiting its application only to cases that the courts deem as “just and equitable”.


VI. Conclusion


Severance of substantive consolidation from its equitable roots can have far-reaching consequences, particularly with regard to the exceptional nature of the remedy. There is a potential for harm to creditors, particularly those who have given loans based on the principle of separate legal entities. Indian insolvency tribunals, however, are appropriately cautious while referring to the equitable nature of the principle, given that the IBC does not bestow them with equity jurisdiction.


Thus, the solution to this quandary requires an amendment to the IBC, properly highlighting the nature of substantive consolidation and the conditions for its applicability to ensure a principle-based approach to judicial discretion in such cases.


The requirement for balancing equities can also be indirectly introduced by providing for a vote within the CoCs of all the companies proposed to be consolidated. This will ensure that entities within a group undergo substantive consolidation only when the CoC deems the measure as net beneficial for the entity. This will not just cement the significance of balancing stakeholder interests but simultaneously reaffirm the importance of CoC’s commercial wisdom.

 


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