VHVK E Newsletter June 2021
Jun 2021
Volume V Issue 3
VHVK Law Bulletin
We are pleased to present this third issue of VHVK Law Bulletin for 2021, featuring the following:
- Criminal prosecution for cheque dishonour can continue against directors despite moratorium granted to company under the Insolvency & Bankruptcy Code (Supreme Court)
- Commercial summary suits not subject to timeframes applicable to ordinary civil suits (Bombay High Court)
- ESG (Environmental, Social and Governance) disclosure duties expanded for Top 1000 listed companies (SEBI)
- Business goodwill no longer a depreciable asset for income tax (Finance Bill, 2021)
- Acknowledgment of debt in balance sheet extends limitation period to bring legal proceedings (Supreme Court)
- Formal error in demand notice does not invalidate enforcement proceedings under the SARFAESI Act, 2002 (Supreme Court)
IBC moratorium does not cover prosecution of directors for cheque dishonour
When a corporate debtor is granted moratorium for debt obligations under the Insolvency & Bankruptcy Code (IBC, section 14), the moratorium would only cover criminal prosecution of the corporate debtor for the offence of cheque dishonour under the Negotiable Instruments Act, 1881 (NI Act). In Mohanraj v Shah Bros,1 the Supreme Court held that natural persons (directors and other persons in control) would not be protected by the moratorium. Criminal cases can continue against the individuals.
In an effort to improve integrity in financial transactions and accountability, the NI Act places drawers of cheques under criminal liability if cheques are dishonoured when presented to banks for payment. The IBC aims to facilitate restructuring by financially stressed companies and enables them to obtain interim protection from creditors through moratorium. For a limited period, moratoriums stay creditors’ rights to recover debt and enforce security rights against debtors’ assets. This can facilitate companies in working towards insolvency resolution without disruption and get back to financial health.
Use of post-dated cheques is common in business transactions, to assure payments to suppliers and to lenders. When banks dishonour cheques issued by companies undergoing debt restructuring under IBC and have been granted moratorium, a question is whether the moratorium would protect both companies and their directors/ persons in control from criminal prosecution under the NI Act. Supreme Court’s ruling in Mohanraj v Shah Bros resolves the issue by holding that prosecution can continue against directors/ persons in control of corporate debtors.
Mohanraj v Shah Bros’ decision creates a conundrum for directors. When a corporate debtor’s financial stress is evident (from the IBC proceeding), it would be harsh to actively prosecute directors for failure to honour cheques issued by the company. Another question is about the fate of the prosecution if the corporate debtor successfully finalizes insolvency resolution. It is unclear if the prosecution of directors can still continue in such situations. Considering the complexities involved, there is a case for statutory amendment to clarify the consequences.
Time limits under Civil Procedure Code do not apply to commercial summary suits
In Diligent Media Corp Ltd v Sandy Ltd,2 the Bombay High Court held that Commercial Summary suits filed under the Commercial Courts Act, 2015 would not be governed by the time limits applicable to regular civil suits under the Civil Procedure Code, 1908 (CPC). Specifically, the court ruled that the 120-day limit for defendants in regular lawsuits to file written statement (reply to the claim filed by plaintiffs) need not apply to Commercial Summary suits. The ruling treats Commercial Summary suits on a different footing from regular lawsuits.
A longstanding complaint is about delay in courts. To deal with the complaint, the Civil Procedure Code was amended to stipulate timelines for completing the different stages involved in the adjudication process. One such is the 120-day limit for defendants to file written statements. This applies uniformly and courts cannot condone delay beyond the statutory time period. The strict procedural rule seeks to address the known problem of defendants playing for time and delaying proceedings. The Commercial Courts Act, 2015 was enacted as a part of the overall strategy to improve economic efficiency and facilitate speedy resolution of business disputes.
In Digital Media v Sandy, the Bombay High Court held that Order 37 of the Civil Procedure Code, which governs summary suits can also apply to Commercial Summary suits. On this basis and considering the defendant had made efforts, albeit unsuccessful, to resist the suit through an application for dismissal, the High Court granted additional time to the defendant to file written statement. It is apparent a crucial consideration for the court was the fact the defendant had taken other legal steps to defend the suit, even though it had not filed the written statement within the permitted time. The court, however, imposed costs of ₹ 1,00,000 on the defendant for failure to file written statement in a timely manner.
ESG disclosure expanded for Top 1000 listed companies
ESG (Environmental, Social and Governance) disclosures have emerged as an important trend, worldwide, in the corporate governance landscape. Recently, Securities & Exchange Board of India (SEBI) expanded the ESG reporting duties of the Top 1000 listed companies, ranked by market capitalisation.3 Effective 2022-23, companies must file Business Responsibility and Sustainability Reports (BRSR) that would replace the current Business Responsibility Reports (BRR).
Since 2012 Top 100 companies ranked by market capitalisation have been required to make disclosures on ESG issues. The rule was widened in 2019 to cover the Top 1000 listed companies. The latest SEBI move (May 2021) strengthens the ESG principle by expanding disclosures. Based on the National Guidelines on Responsible Business Conduct (NGBRC) framed by the Ministry of Corporate Affairs (MCA), the new SEBI regime stipulates more extensive ESG reporting by companies.
ESG is increasingly a metric applied by institutional investors in making investment choices. However, a potential concern is about the length of disclosures.4 The SEBI template is 35 pages long. When companies fill in details, the length will likely increase significantly. The volume of work involved in the exercise and related costs can generate some resistance from industry.
Goodwill, no longer a depreciable asset for income tax
From financial year 2021-22, depreciation cannot be claimed on the value of goodwill carried in balance sheets. Finance Bill, 2021 (section 7) will amend the Income Tax Act, 1961 (section 32) to make “goodwill of a business or profession” ineligible for depreciation. This can have an impact on M&A (mergers and acquisitions).
“Goodwill” is generally the label used to indicate the market value of an enterprise, not reflected in its physical assets (plant, machinery, buildings, inventory, et al) or intellectual property (patents, copyrights and the like). The concept reflects the notion or principle that the value of an enterprise, as a whole, is more than just the sum total of its individual assets. Widely used in mergers and acquisitions, the goodwill label is generally adopted to cover the difference between the sale consideration payable in a M&A transaction and the total value of target enterprises’ assets shown in balance sheets.
In CIT v Smifs Securities Ltd (2012),5 the Supreme Court held that depreciation can be claimed on goodwill. This would allow companies to write off, or amortize, the value of goodwill over time. It can be a tax incentive for companies to pursue inorganic business growth through M&A. The proposed amendment to the Income Tax Act removes the tax benefit from goodwill. This can have two significant implications.
- Barring depreciation can encourage companies to exclude the conventional “goodwill” concept in business valuation and allocate the entire consideration paid in M&A transactions among the physical assets and intellectual properties of acquired entities.
- Alternatively, companies might resort to writing off their goodwill in chunks and claim this as a business loss or a business expense (Income Tax Act, section 37). In this case, there will likely be controversy on the admissibility of the claim because goodwill is no longer a depreciable asset.
Acknowledging debt in balance sheet extends limitation period to bring legal action
In Asset Reconstruction Company (India) Limited v. Bishal Jaiswal,6 the Supreme Court affirmed that debtors recording a loan balance in financial statements amounts to acknowledgment of debt under the Limitation Act, 1963 (section 18). As such, it triggers a fresh period of limitation for creditors to bring legal proceedings for recovery.
The Limitation Act, 1963 prescribes time limits for initiating legal action. It reflects the public interest goal that proceedings to enforce legal rights must be brought in a timely manner and the threat of litigation ought not to continue indefinitely. For debts, the Limitation Act includes a beneficial rule for persons to whom money is owed. When borrowers acknowledge a debt before it becomes time-barred, the clock would start afresh from the date of acknowledgment. This extends the limitation period for creditors to bring legal action for recovery. For a long time now, recording debt in balance sheets has long been treated as acknowledgment of debt under the Limitation Act (e.g. Bengal Silk Mills v Ismail Golam Hossain Ariff (1962)).7
Affirming the position, the Supreme Court held balance sheet entries represent acknowledgment of debt. They entitle creditors to initiate recovery action. Grounded in common sense, the principle strengthens creditors. It would check borrowers from raising the technical defence of limitation, contradicting the acknowledgment of the debt in financial statements.
Formal error in statutory notice not fatal to SARFAESI proceedings
Mistake in stating the lender’s name in the demand notice issued under the SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest) Act, 2002 does not vitiate proceedings launched pursuant to the notice. Affirming this position in L&T Housing Finance Ltd v Trishul Developer,8 the Supreme Court reversed the decision of the Karnataka High Court in Trishul Developers v L&T Housing Finance.9
SARFAESI Act empowers lenders to seize mortgaged assets when borrowers are in default. To initiate seizure, lenders must first issue a demand notice under SARFAESI Act (section 13) to the debtor in default. In L&T Housing Finance v Trishul, the notice was issued in the name of an affiliate company with a similar name (L&T Finance Home Loans Ltd). This named entity was not the secured creditor that could enforce security rights under the SARFAESI Act.
In defending the seizure proceedings, the borrower succeeded in the Karnataka High Court with the plea that the demand notice was defective as it had the wrong name of the lender and this invalidated the proceedings launched pursuant to the notice. In appeal, the Supreme Court reversed the Karnataka High Court’s ruling. On facts, the Supreme Court held erroneous use of affiliate’s name was trivial and an inconsequential issue. Supreme Court’s ruling reflects the “group enterprise” theory that recognizes different entities under common control as a single unit for commercial purposes.
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VHVK Law Partners
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Bangalore 560 042 INDIA
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Ph: +91 80 2951 2353
VHVK Law Bulletin is issued for information purposes only and does not constitute legal advice. For more information on any of the material covered here and/or their implications for your situation, please obtain competent legal advice.