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Puneet Shah, Principal Associate, IC Legal

Why vendors lack credible standing in M&A and bankruptcy situations

01 June, 2017

In recent months, a few incidents have come to light where vendors or trade creditors to a company sought criminal action and government intervention when the firm failed to pay their dues.

The issue appears to be gaining ground considering that many distressed companies and startups are becoming potential targets for mergers and acquisitions.

Vendors and trade creditors—or operational creditors—supply goods and services to a company. And they can pose stiff opposition to such M&A deals if their concerns are not addressed.

But can an unsecured operational trade creditor take legal recourse to obstruct a merger or acquisition proposal or initiate an insolvency process?

We have examined here key legal remedies that are available to unsecured operational trade creditors to businesses that may have defaulted on trade dues and which may be potential targets for mergers and acquisitions due to falling valuation and difficulty in sustaining operations.

Creditors have been empowered under the Companies Act of 2013 to approve any scheme of merger or amalgamation if they meet the specified value thresholds, which is three-fourths of aggregate creditors of the target company. The Act does not differentiate between approval from secured and unsecured creditors or financial and operational creditors; it simply uses the term ‘creditors’, which would encompass secured as well as unsecured trade creditors.

If a creditor’s outstanding debt is at least 5% of the total outstanding debt of the amalgamating company, it can object to the merger scheme before the National Company Law Tribunal (NCLT). Here again, the Act does not make any distinction between secured and unsecured creditors or financial and operational creditors. Thus, even operational trade creditors can object to the scheme of merger if they individually or collectively meet the above specified value thresholds.

Having said that, there are no credible legal precedents in the recent past where unsecured trade creditors have successfully blocked any merger proposal. This is particularly true when the merger scheme takes care of their concerns and provides for transfer of all the assets and liabilities of the amalgamating company (including trade dues to the operational creditors) to the merged company on an ‘as is where is basis’, making the merged entity liable to pay such dues in ordinary course.

Notably, the Act also mandates filing of a declaration of solvency by the companies involved in the merger process. So, what if the companies that are not commercially solvent and have outstanding dues to operational and trade creditors propose to merge themselves?

A cue can be taken from the newly enacted Bankruptcy and Insolvency Code of 2016. The operational trade creditors, under the code, have been empowered to initiate the corporate insolvency process against a merging corporate debtor if there is a payment default of a minimum amount of Rs 1 lakh.

However, the rights offered to operational creditors under the code become futile if the corporate debtor disputes the debt by merely filing an arbitration reference (if the trade contracts provide so) without really intending to resolve the dispute.

Existence of disputed debt makes the operational creditor ineligible to pursue an insolvency resolution process as the NCLT lacks the authority to examine whether the dispute regarding the debt raised by the corporate debtor is a genuine trade dispute.

This can be resolved by vesting the NCLT with the power to determine on merits whether the dispute is genuine and to adjudicate that such determination is a question of law or fact.

Further, the NCLT should be able to club and hear both the insolvency application and the merger application together to avoid any “forum shopping” by the concerned parties.

There is one other area where operational trade creditors lack credible clout and which may be an impediment for successful recovery of their trade dues. In the committee of creditors, which approves the insolvency scheme of a corporate debtor under the code, there is no representation provided to the operational creditors. This can be remedied by providing suitable representation to the operational creditors in the committee based on certain specified value thresholds so that their interest can be protected as a separate class.

Besides, the unsecured operational trade creditors may also consider filing a civil suit or summary suit under the Code of Civil Procedure to recover their trade dues. This right is available to them irrespective of any formal contract with the company debtor, subject to them able to prove a default in payment of trade dues. It is needless to mention that this process is tedious and time-consuming and is usually adopted only as a last resort.

Also, if an operational trade creditor can prove with substance that there has been criminal breach of trust or dishonest or fraudulent removal or concealment of property to prevent distribution among creditors, it can initiate criminal action (instead of a long-drawn civil suit) seeking arrest of key managerial personnel of the debtor, as we have seen in the recent past.

Thus, barring civil remedies, which lead to a long-drawn court battle, there are no other credible remedies available to the operational creditors – be it in approving of the merger scheme or the insolvency scheme – which ensures faster recovery of their trade dues.

Also, there are no legal provisions in the Companies Act or the bankruptcy code which obligate the board or key managerial personnel of a corporate debtor to settle all outstanding dues to the unsecured operational trade creditors before undertaking any merger or restructuring exercise.

If the government really wishes to make it easy to do business (which includes ease of shutting down by merger, restructuring or consolidation), it needs to set up a mechanism to ensure that genuine claims of operational trade creditors are adequately protected. This would help India rise the ladder in the ease of doing business rapidly.

The authors are Mumbai-based principal associates with law firm IC Legal. Views are personal.

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Why vendors lack credible standing in M&A and bankruptcy situations

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