India: Acknowledgement Of Debt By Inclusion In Balance Sheet

Background

Determining the existence of an undisputed debt is one of the most crucial tests a tribunal must undertake under the Insolvency and Bankruptcy Code, 2016 ("IBC").

In March 2020, a five-member bench of the National Company Law Appellate Tribunal ("NCLAT") rendered a decision in the case of V. Padmakumar vs. Stressed Assets Stabilization Fund (SASF) & Another.¹ ("Padmakumar") wherein four out of five members held, inter alia, that entries reflected in the balance sheet of a company do not amount to acknowledgement of debt under the Limitation Act, 1963 ("Limitation Act"). On this question of law, the fifth member dissented with the opinion of the majority by relying on a catena of judicial precedents.

In September 2020, a three-member bench of the NCLAT had the occasion to consider the applicability of Padmakumar in the case of Bishal Jaiswal vs. Asset Reconstruction Company (India) Limited. & Another ("Referral Order"). The bench made a reference to a larger bench to reconsider the majority opinion in Padmakumar². The referral was turned down by a five-member bench of the NCLAT³ ("Rejection Order"). Subsequently, the Rejection Order was challenged before the Supreme Court ("SC"). Before we understand the decision of the SC on this issue, it is worthwhile to analyze the ratio in Padmakumar and the reasons why Padmakumar came to be referred.

Referral Order: Why Was Padmakumar Referred by the Three-Member Bench of NCLAT?

To hold that the entries in the balance sheet of a corporate debtor do not come to the rescue of a financial creditor, the majority decision in Padmakumar relied on two judgments of the NCLAT – (i) G. Eswara Rao vs. Stressed Assets Stabilization Fund & Another.⁴ ("Eswara Rao"), which was decided by a division bench, and (ii) V Hotels Limited vs. Asset Reconstruction Company (India) Limited⁵ ("V Hotels") decided by a three-member bench.

Eswara Rao, inter alia, held that 'as the filing of balance sheet / annual return being mandatory under section 92(4), failing of which attracts penal action under section 92(5) & (6), the balance sheet / annual return of the 'corporate debtor' cannot be treated to be an acknowledgement under section 18 of the Limitation Act.' It further went on to state that if entries in a balance sheet are accepted as acknowledgement of debt, such a debt would continue to be acknowledged endlessly because a company is required to file its balance sheet under the Companies Act, 2013 year after year. The bench held that such a position would be contrary to Article 137 of the Limitation Act which allows for a limitation period of only three years. V Hotel lays down that 'books of accounts cannot be treated as an acknowledgment of liability in respect of debt payable to the financial creditor signed by the corporate debtor or its authorised signatory.'

It is interesting to note that the majority decision in Padmakumar failed to take into account the judgments of the Supreme Court and the High Court which have consistently held that entries in books of accounts of an entity, including its balance sheet, qualify as acknowledgement of debt under section 18 of the Limitation Act.

The dissenting member in Padmakumar has specifically referred to the judicial precedents on this issue. He also relied on an earlier decision⁶ of the NCLAT dealing with similar facts. He opined that, 'audited balance sheets can be referred to and relied on to see if contents therein amount to acknowledgement.'

Without taking into consideration the apparent error in equating annual returns under section 92 of the Companies Act, 2013 with the term 'balance sheet', the crux of the ratio in Padmakumar appears to be that because a balance sheet is mandatory to be filed, any disclosure made therein is only out of statutory compulsion. Therefore, such an entry could not be called a voluntary acknowledgement of debt. This position taken by the majority is incorrect.

A liability is disclosed in the balance sheet when a company has a present obligation,thesettlement of which will result in outflow of resources embodying economic benefits.⁷ If there is no obligation to settle a liability, the question of disclosure in the balance sheet does not arise.

It has been held by the Calcutta High Court ⁸ that, 'there was a compulsion upon the managing agents to prepare the documents but there was no compulsion upon them to make any particular admission. They faithfully discharged their duty and in doing so they made honest admissions of the company's liabilities. Those admissions though made in discharge of their duty are nevertheless conscious and voluntary admissions.'

There is room to even invalidate entries in the balance sheet in so far as the balance sheet is not ratified by the shareholders or there are other documents, such as director's report, to indicate the contrary. In the case of In Re: Pandam Tea Company⁹, the Calcutta High Court held that 'it is true the balance sheet is a statutory document and perhaps is a separate document but the balance sheet not confirmed or passed by the shareholders cannot be accepted as correct. Therefore, in order to validate the balance sheet, it must be duly passed by the shareholders at the appropriate meeting and in order to do so it must be accompanied by a report, if any made by the Directors'.

The reason for not considering an unratified balance sheet has been explained by the Supreme Court¹⁰, '..where a statement is made without intending to admit the existence of jural relationship, such intention should be fastened on the person making the statement by an involved and far-fetched reasoning.'

While referring Padmakumar to a larger bench for reconsideration, the three-member bench had highlighted the incorrect reasoning adopted by the majority members in holding that entries in balance sheet are involuntary admission of debt. Although the majority decision in Padmakumar was rightly referred for reconsideration, a five-member bench turned down the reference.

Rejection Order: Why Was Padmakumar Upheld by the Five-Member Bench of NCLAT?

In December 2020, a five-member bench of the NCLAT rejected the Referral Order and held¹¹ ("Rejection Order") that (a) in disagreeing with the ratio in Padmakumar, the three-member bench did not follow judicial discipline, and (b) the decision in Padmakumar was passed after consideration of precedents with respect to acknowledgement of debt, therefore, reflecting debt in a balance sheet does not amount to acknowledgement of debt for the purpose of the IBC.

Judicial Discipline

The bench that passed the Rejection Order came down heavily on the Referral Order for the reason that the three-member bench ought not to have referred the decision of a five-member bench (Padmakumar) for reconsideration and must have observed judicial discipline. Law of precedents mandates that the decision of a larger bench is binding on a smaller bench. In Union of India v. Raghubir Singh¹², the SC held that 'There is no constitutional or statutory prescription in the matter, and the point is governed entirely by the practice in India of the Courts sanctified by repeated affirmation over a century of time.' The practice in question has certain exceptions too.

In the case of Central Board of Dawoodi Bohra Community and Others v. State of Maharashtra and Others¹³, the SC, inter alia, held as follows: "A Bench of lesser quorum cannot doubt the correctness of the view of the law taken by a Bench of larger quorum. In case of doubt all that the Bench of lesser quorum can do is to invite the attention of the Chief Justice and request for the matter being placed for hearing before a Bench of larger quorum than the Bench whose decision has come up for consideration. It will be open only for a Bench of coequal strength to express an opinion doubting the correctness of the view taken by the earlier Bench of coequal strength, whereupon the matter may be placed for hearing before a Bench consisting of a quorum larger than the one which pronounced the decision laying down the law the correctness of which is doubted." The said position is in line with the earlier decisions of the SC in Pradip Chandra Parija and Others v. Pramod Chandra Patnaik and Others¹⁴and Chandra Prakash and Others v. State of Uttar Pradesh¹⁵.

From the above, it is evident there is an exception which permits a bench with lesser quorum to respectfully disagree with a larger bench and refer the matter to a bench of strength equal to the said larger bench for consideration. Thereafter, if the latter larger bench believes that the decision of former larger bench deserves reconsideration, it may refer the matter to an even larger to decide on the disagreement among benches. The Referral Order was passed by three-member bench, disagreeing with the order of a five-member bench. In line with the above exception to the law of precedents, it put up the matter for reconsideration of bench of co-equal strength, i.e., consisting of five members.

In light of the above, the Referral Order was well within its bounds and did not deserve the flak it reserved in the Rejection Order.

Acknowledgement of Debt

While reiterating the ratio laid down in Padmakumar and the judicial precedents discussed therein, the Rejection Order stated that entries of debts in the balance sheets of a corporate debtor cannot be considered to be acknowledgement of debt. In doing so, the Rejection Order relies on the decision of the SC in Babulal Vardharji Gurjar v. Veer Gurjar Aluminium Industries Private Limited and Others¹⁶("Babulal"). The Rejection Order further observes that disclosure of debt in balance sheets, being mandatory in nature under the Companies Act, 2013, cannot be considered to be valid acknowledgement.

Firstly, the aspect of Babulal relied on by the distinguishable from the facts of the case the Referral Order was borne out of. In the former, the financial creditors never took the stand of acknowledgement of debt in balance sheets before the NCLT. It was brought to the notice of the NCLAT only at the stage of appeal. For this reason alone, the SC held that section 18 would not be applicable in Babulal. It appears that that Rejection Order extrapolated the said aspect of Babulal to mean that section 18 is not applicable to the IBC. In this regard, the Referral Order had expressly and adequately distinguished itself from Babulal.

Secondly, the observation that 'preparation and filing of balance sheets is a mandatory requirement under the Companies Act, 2013 and must not fasten a liability on a corporate debtor' does not hold water for the reasons discussed above.

The concerns raised in the Referral Order with respect to acknowledgement of debt due of inclusion of the said debt in balance sheets of a corporate debtor were valid. Whether a case aims to recover money or wind up a corporate entity, the essence of 'debt' remains the same. Therefore, it is necessary that there is consensus among adjudicating authorities regarding debts reflecting balance sheets and their impact on the limitation period.

SC Judgment: Why Was Padmakumar Overruled?

Aggrieved by the Rejection Order, the financial creditor therein preferred appeal before the SC. On April 15, 2021¹⁷, the SC rendered its judgment, thereby putting an end to the inconsistencies in the stand taken by the NCLAT on this issue ("SC Judgment"). Below are the key elements of the SC Judgment.

Section 18 of the Limitation Act vis-à-vis section 238A of the IBC:

Section 238A of the IBC states that the provisions of the Limitation Act shall, as far as may be, apply to petitions or appeals under the IBC. The legislative intent behind section 238A can be found in the Report of the Insolvency Law Committee¹⁸. The said report contemplates that, "Given that the intent was not to package the Code as a fresh opportunity for creditors and claimants who did not exercise their remedy under existing laws within the prescribed limitation period, the Committee thought it fit to insert a specific section applying the Limitation Act to the Code. The relevant entry under the Limitation Act may be on case-to-case basis.'

Because the legislative intent is to apply the provisions of the Limitation Act on a case-to-case basis, the question before the SC was whether the expression 'as far as may be' in section 238A extends to section 18 of the Limitation Act as well. Section 18 lays down the effect of acknowledgement in writing – when, before the expiry of the prescribed limitation period, an acknowledgement of liability is made in writing and signed by the party (either by himself or through his agent) on whom the liability is fastened, a fresh period of limitation is computed from the time when the acknowledgement is so signed.

The SC, in Babulal, has categorically stated that if the situation so warrants, section 18 could be applied to an insolvency petition and there is nothing under the IBC that prevents the tribunals from doing so. It further opined that, "Section 18 of the Limitation Act would come into play every time when the principal borrower and / or the corporate guarantor (corporate debtor), as the case may be, acknowledge their liability to pay the debt. Such acknowledgement, however, must be before the expiration of the prescribed period of limitation including the fresh period of limitation due to acknowledgement of the debt, from time to time, for institution of the proceedings Under Section 7 of the Code."

By relying on the Babulal Case, the SC upheld the applicability of section 18 of the Limitation Act to insolvency petitions under IBC.

Liabilities shown in balance sheets amount to acknowledgement of debt

While reiterating its stand on this question of law, the SC addressed the following three issues:

Because preparing and filing a balance sheet is a mandatory requirement under the law, whether debts shown therein could be construed as voluntary acknowledgements?

The SC extensively relied on Bengal Silk Mills Co. v. Ismail Golam Hossain Ariff¹⁹ and a plethora of its own judgments and those from the High Courts. Bengal Silk (supra) held that, "There was compulsion upon the managing agents to prepare the documents but there was no compulsion upon them to make any particular admission. They faithfully discharged their duty and in doing so they made honest admissions of the company's liabilities. Those admissions, though made in discharge of their duty, are nevertheless conscious and voluntary admissions."

Does the debt related information in a balance sheet meet the requirements of section 18 of the Limitation Act?

The required characteristics of an 'acknowledgement in writing' are discussed in Khan Bahadur Shapoor Fredoom Mazda v. Durga Prasad Chamaria and Other²⁰, some of which are extracted hereunder:

The statement must relate to a present subsisting liability though the exact nature or the specific character of the said liability may not be indicated in words.

Words used in acknowledgement must, however, indicate the existence of jural relationship between the parties such as that of debtor and creditor, and it must appear that the statement is made with the intention to admit such jural relationship.

The admission in question need not be express but must be made in circumstances and in words from which the court can reasonably infer that the person making the admission intended to a subsisting liability as at the date of the statement.

In light of Khan Bahadur (supra), the SC noted that section 18 does not require that the acknowledgement must be addressed to the debtor, nor does it need to expressly promise future payment of the debt. It suffices if the document acknowledges a subsisting jural relationship between the creditor and the debtor. Therefore, balance sheets can be relied on to evidence acknowledgement of debt. For this purpose, the notes to accounts, auditor's report etc., must be read with the balance sheet.

Under what circumstances is a balance sheet liable to be rejected for the purposes of section 18 of the Limitation Act?

If a balance sheet is not ratified by the shareholders of a company during its annual general meeting, or the notes to accounts, auditor's report, or director's report indicate contrary positions on the debt, in such circumstances, there is no acknowledgement of debt under section 18 of the Limitation Act. While upholding this position, the SC relied on Pandam Tea Co. Ltd.²¹

Conclusion

The SC has once again upheld its long-standing position that reflection of debt in balance sheets amount to acknowledgement of debt under section 18 of the Limitation Act. Further, it is now clarified that section 18 is applicable to cases filed under the IBC as well. Consequently, the majority decision in Padmakumar stands overruled. With this, inconsistencies in the stands taken by the NCLAT regarding debts shown in balance sheets have been put to rest.

The views and opinions expressed in this article belong solely to the author and do not reflect the position of Tatva Legal, Hyderabad.

Footnotes

1. NCLAT judgment dated 12.03.2020 in Company Appeal (AT) (Insolvency) No. 57 of 2020

2. NCLAT judgment dated 25.09.2020 in Company Appeal (AT) (Insolvency) No. 385 of 2020

3. NCLAT judgment dated 22.12.2020 in Company Appeal (AT) (Insolvency) No. 385 of 2020

4. NLCAT judgment dated 07.02.2020 in Company Appeal (AT) (Insolvency) No. 1097 of 2019

5. NCLAT judgment dated 11.12.2019 in Company Appeal (AT) (Insolvency) No. 525 of 2019

6. NCLAT judgment in Guatam Sinha vs. UV Asset Reconstruction Company Limited & Ors. being Company Appeal (AT) (Insolvency) No. 1382 of 2019 dated 25.02.2020

7. Indian Accounting Standard notified by the Ministry of Corporate Affairs vide GSR 111 (E) dated 16.02.2015

8. Bengal Silk Mills Co. vs. Ismail Golam Hossain Ariff 1961 SCC Online Cal 128

9. 1973 SCC Online Cal 93

10. Lakshmirattan Cotton Mills Company Limited vs. The Aluminium Corporation of India Limited (1971) 1 SCC 67

11. Bishal Jaiswal v. Asset Reconstruction Company (India) Limited and Others [2021] 224 CompCas 166

12. 1989 (2) SCC 754

13. (2005) 2 SCC 673

14. (2002) 1 SCC 1

15. (2003) SCC (LS) 827

16. AIR 2020 SC 4668

17. SC Judgment dated 15.04.2021 in Civil Appeal Nos. 323, 3228 and 3765 of 2020, 3 and 1569 of 2021.

18. Report of the Insolvency Law Committee dated 26.03.2018 issued under the Ministry of Corporate Affairs

19. AIR 1962 Cal 115

20. AIR 1961 SC 1263

21. AIR 1974 Cal 170

Originally published 31 August, 2021

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