Are charitable (Section 8) companies covered under the IBC? Should they be covered therein?

Introduction

Financial distress and insolvency in the context of non-profit organisations (NPOs) have been widely discussed in other jurisdictions, however, Indian NPOs are yet to meet a similar fate, despite India containing in itself a huge NPO sector.[1] In India, NPOs majorly comprise of companies with charitable objects (Section 8 companies), societies, trade unions, trusts, cooperative societies, etc. This article talks of insolvency resolution only in the context of Section 8 companies.

Section 8 of the Companies Act, 2013[2] (CA’13) provides a framework for companies having charitable objectives like, promotion of commerce, art, science, sports, education, research, social welfare, religion, charity, protection of the environment, etc. Such companies cannot distribute dividends in members and are required to use the profits to promote their objectives. They are required to use terms like Foundation, Confederation, Association, etc. in their names instead of “‘Private”, “Private Limited”, etc.

The Insolvency and Bankruptcy Code, 2016 (IBC)[3] defines a “corporate person” under Section 3(7)[4], which, inter alia, includes a “company” under Section 2(20) of CA’13. Hence, a literal interpretation of the provisions does not bar IBC’s application to Section 8 companies. Further, Section 8 companies are not covered under the exclusionary clause of Section 3(7) of the IBC. Further, Section 2(a) makes the IBC applicable to “any company incorporated under the Companies Act” and does not create a differentia based on the objectives of different companies. Thus, clearly, Section 8 companies are covered under the IBC as a corporate person.

The pertinent question that arises is whether the application of IBC to such companies is appropriate? In other words, should the charitable motive of Section 8 companies affect the applicability of the IBC?

Application of the Insolvency and Bankruptcy Code, 2016 to Section 8 companies

The IBC envisages two potential outcomes – revival or liquidation. It intends to revive distressed businesses, even at the cost of some haircuts to creditors’ claims. During Corporate Insolvency Resolution Procedure (CIRP), the Committee of Creditors considers and votes on resolution plans (plans) submitted by various resolution applicants willing to take over the company by fully or partially paying off its debts. The primary goal of the process is to maximise the value of the company so that good plans are attracted to rejuvenate it. For revival of the company through the CIRP, there must exist the potential for profitability as a going concern for such company to attract good plans and avoid liquidation. One of the reasons for high liquidation to resolution ratio under IBC is that the companies under CIRP lack profitable viability.

By virtue of the nature of Section 8 companies, there is minimal scope of monetary returns for the members, neither is there a distribution of dividend in the long run. Hence, if a Section 8 company undergoes CIRP, most of them are unlikely to attract good plans. Alternatively, a restructuring of the company under which it is converted into a for-profit company is possible under a plan. However, this would dilute the public interest that the charitable company served.

Thus, absent a resolution plan, the company would get liquidated. Liquidation is undesirable for it destroys the company’s organisational capital, in addition to diminishing its assets’ values. For charitable companies, liquidation also jeopardises the larger public interest by destroying their intangible assets. For example, charitable companies dedicated to promoting arts are often sole custodians of certain intangible assets that enrich the society by providing cultural, civic, and social benefits for people at large, however they have no liquidation value.[5]

Proposed solution: A middle ground?

The above discussion does not intend to suggest that charitable companies should be completely exempted from the IBC. After all, these companies, like any other companies, require sources of funding, employees and strategic plans for their operations. For example, the extent of donations or credit a company obtains depends upon the credibility/influence it has in society, which in turn depends on the nature of projects undertaken and their success. Meaning that, while the core purpose of these companies is charitable with non-profit motive, their operations are similar to a for-profit company in terms of daily management. So, their creditors should not be devoid of the rights/benefits otherwise available under the IBC. Further, IBC is an economic legislation aimed at augmenting the economic viability of distressed companies and preserving their organisational capital (BLRC Report)[6]. So, if a Section 8 company is under distress, IBC should aid in its rescue.

Given that, one needs to reach some middle ground. Owing to the different nature and object of these companies, the CA’13 provides slightly different amalgamation and winding-up provisions for these companies than their for-profit counterparts. As per Section 8(10)[7], a Section 8 company can only be amalgamated with another Section 8 company having similar objects. Further, on winding up, the residual assets of the company are to be transferred to another Section 8 company having similar objects, or the proceeds go to the insolvency and bankruptcy fund formed under Section 224 of IBC[8]. The idea is to preserve the company’s objectives as far as practicable. The authors argue that similar concessional arrangement for them under the IBC is feasible and desirable.

A charitable company focuses on social welfare rather than economic benefits to its members. On the other hand, the IBC aims to maximise the value of the company under distress. Thus, there is an apparent mismatch between the objectives of Section 8 companies and the IBC. Similar consideration made an National Company Law Tribunal (NCLT) Judge, in Harsh Pinge v. Hindustan Antibiotics Limited[9] say that certain public sector undertakings, like the Hindustan Antibiotics Limited, are corporate entities but as their larger objective is social welfare and not making huge money, hence this should absolve them from the clutches of the IBC in event of default.

Insights from the United States and the United Kingdom

The US Bankruptcy Code exempts charitable companies from involuntary bankruptcy proceedings, initiated by the creditors. However, some scholars criticise this provision as it insulates the fraudulent charitable fiduciaries in companies from creditor-demanded bankruptcy.[10] However, for those companies that face insolvency due to genuine business failures, the UK model offers some insights. The UK Insolvency Act, 1986, that is a creditor-in-control model provides for an American style debtor in possession provision as well viz. the Company Voluntary Arrangement (CVA). Under CVA, the directors of a company may propose to its creditors an arrangement for satisfaction of its debts under which there would be debt haircut, delay in payment provision, or both. The directors then nominate an insolvency practitioner who then, in 28 days submits his report to the court opining if the arrangement has reasonable prospects of approval and implementation. For small-scale companies, the directors can also obtain a moratorium when CVA is proposed, to avoid individual recovery proceedings. On the court’s order, the CVA is discussed and voted by the creditors and if approved, goes for final court approval. After approval, the insolvency practitioner supervises the implementation after which the control goes back to the directors. This provision is in addition to the administration/winding-up provisions.[11]

In the Indian context, the apprehensions over the complete exemption under the US model hold merits. A blanket exemption from the IBC may open floodgates for unfair dealings or fraudulent conduct. In that case, the creditors should always have an option to approach the NCLT and follow the regular CIRP. An arrangement on lines of the UK CVA model should also be provided for Section 8 companies. This model is well suited for these companies that can avoid the rigours of the CIRP and also satisfy their debts and preserve their enterprises. On failure, the creditors can resort to the CIRP. Nevertheless, a rational creditor would prefer CVA over CIRP, for the former would be speedier and more certain. Adopting a procedure like CVA for such companies would allow early resolution and will be in the larger public interest. Implicit in such model is minimum governmental intervention in the process. It is important because these companies already face the problem of excessive governmental regulations in incorporation, functioning, receiving foreign contributions [regulated through the Foreign Contribution (Regulation) Act, 2010[12]], etc.[13], extending the same to restructuring (as is the current process of amalgamation)[14] would not be in the best interests of the company and the public. Making it a court-monitored, creditor-debtor-insolvency professional driven process would do far better, in terms of both its economic and social outcomes.

Conclusion

While Section 8 companies are not exempted and should not be exempted from the clutches of IBC, the inherent nature and objectives of these companies demands reconsideration on the role of IBC to rescue them from distress. The authors propose an option of the UK-style CVA model to be provided for these companies for rescue. Nevertheless, in determining whether to extend the benefit of CVA to a particular company or to directly subject it to the CIRP, the actual functioning of that company, possibility of misconduct, mala fide practices, etc. should be duly considered. But absence these cases, where a Section 8 company faces distress due to genuine business failure, a CVA-style arrangement should be preferred, and CIRP may act as the final resort.


*3rd year student (6th Semester), BA LLB (Hons.), National Law University, Delhi. Author can be reached at kumari.saloni18@nludelhi.ac.in

[1]As per MCA data, total number of charitable companies incorporated under Section 25 of the Companies Act, 1956 stood close to 5000 right before the implementation of the Companies Act, 2013. Further, a 2014 Report concludes that India has one NGO on 600 people of its population.

[2] Companies Act, 2013, Section 8. .

[3] Insolvency and Bankruptcy Code, 2016.

[4] Ibid, Section 3(7)

[5]Reid K. Weisbord, Charitable Insolvency and Corporate Governance in Bankruptcy Reorganisation, (2013) 10 Berkeley Bus LJ 305, 315.

[6]Report of the Bankruptcy Law Reforms Committee, Vol. I: Rationale and Design (November 2015). 

[7]Companies Act, 2013, Section 8(10).

[8]IBC, Section 224.

[9] C.P. No. (IB) 2482/2018, order dated 16-7-2019 (NCLT Mumbai Bench).

[10] Supra Note 5, 347.

[11]UK Insolvency Act, 1986 c. 45, Part I Company Voluntary Arrangements.

[12]Foreign Contribution (Regulation) Act, 2010.

[13]Pushpa Sundar, Why India’s Non-Profit Sector Needs Comprehensive Legal Reform (The Wire, 10-5-2017).

[14]As is provided under the Companies Act wherein amalgamation can happen if the Central Government is of that opinion [Section 8(10)].

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