Voluntary Liquidation and the risk of creditor fraud

Voluntary liquidation, a self-imposed windup and dissolution of a corporate entity under the Insolvency and Bankruptcy Code (IBC), is covered in Chapter V, consisting of one single section, that is, Section 59, captioned ‘Voluntary liquidation of corporate persons’.

This allows a corporate person (referred to as the "company" for convenience) to voluntarily liquidate itself as long as it has no debt or will be able to pay all of its debts from the revenues of its liquidated assets and as long as it is not being liquidated to defraud its creditors. 

Section 59(6) of the IBC states that the provisions of Sections 35 to 53 of Chapter III and Chapter VII shall be largely applicable. Further, the IBBI (Voluntary Liquidation Process) Regulations, 2017 govern the process of winding up the company’s affairs and distributing its assets to its creditors and shareholders.

Notably, the decision to liquidate must be approved by a special resolution. If the company owes any debt to any person, creditors representing two-thirds of the value of the debt also need to approve such a resolution.

The liquidation proceeding commences on the date of the passing of the resolution, and the company appoints a registered insolvency professional (IP) as the liquidator, whose role is principally akin to the role of a liquidator in compulsory liquidation, to manage the process, verify and collate claims, and to oversee the realisation and distribution of assets.

To this extent, voluntary liquidation serves legitimate purposes and provides an easier exit option compared to earlier methods that were often cumbersome and lengthy. Additionally, the requirement of payment of debts by the company in full within a specified period aims to balance the interests of all stakeholders and promote a streamlined process.

However, there are serious concerns about its potential misuse for fraudulent intentions, particularly to defraud creditors. Even though it is incumbent upon the company to satisfy the solvency test by fully paying its creditors, what if the company fails to recognise its creditor’s claim based on false contentious issues, fabricated legal defences or contested facts? Whether the IBC provides complete justice to such a creditor remains a concern.

Section 33(5) of the IBC, covering ‘moratorium’, is not applicable by virtue of Section 59(6), while the rights of the creditors to bring legal proceedings, including recovery suits, against the company are generally suspended in view of the whole scheme of the IBC, particularly Section 63. Thus, creditors resort to remedies available under the Code. In doing so, the claim is brought before the liquidator. However, since the liquidator’s role is primarily to review and verify claims, claims involving disputed facts, contentious issues, or those not backed by sufficient proof are likely to be rejected.

As per Section 42 of the Code, such rejection of claims can be appealed before the NCLT. However, the NCLT’s role and procedures are distinct from those of a civil court. The NCLT operates within a specialised legal framework, and adjudication processes do not involve evidentiary hearings, cross-examination, discovery by interrogatories, etc. Thus, it heavily relies on documents, financial records, and submissions made by the parties involved. The NCLT ruling is further contestable, but the adjudication's limited scope remains unchanged. This limitation can highly prejudice the creditors’ claims and their right to receive just and fair treatment. This potential and probable misuse defeats the fundamental aspect of voluntary liquidation, which is that the company must pay its debts.

The liquidator is also expected to investigate the company’s affairs, including fraudulent transactions and preferential payments. However, voluntary liquidation generally lacks the transparency and scrutiny that are typically associated with formal insolvency. The liquidator is required to suspend the process of liquidation if he believes that it is being carried out to deceive or defraud creditors or if he believes the company will be unable to fully repay its debts from the proceeds of its liquidated assets. However, the company-appointed liquidator is likely to be beholden to the interests of his appointee and so partisanship cannot be ruled out.

The likelihood of fraud or unjust treatment of creditors increases further because throughout voluntary liquidation proceedings, up to the time a liquidator submits a dissolution application, the NCLT has no regulatory or supervisory role.

Considering the necessity of voluntary liquidation while at the same time protecting the rights of creditors, it is essential to be vigilant by introducing proper checks and balances and having regulatory measures providing for stringent oversight.

Also, the claim verification process in cases of voluntary liquidation and involuntary liquidation must be distinct, considering the objectives of each type of liquidation. In voluntary liquidation, the verification process must be completely transparent, and the liquidator needs to cooperate and be held accountable to ensure a fair and equitable outcome for creditors.

About the Author: Tanu Priya Gupta is an Advocate-on-Record, Supreme Court of India and a Partner at Sarvagya Legal.