Madras High Court: Clean State Theory Only Protects Third-Party Successful Resolution Applicant And Not Suspended Board Of Corporate Debtor From Future Claims

The High Court remarked:

“It should not be forgotten that CST is a judicial coinage to protect the third party-successful resolution-applicant from the uncertainties of future claims, and not invented to protect the fraud and suppression of the suspended board of the corporate debtor.”

Background Facts:

National Sewing Thread Co. Ltd. (Petitioner), a public limited company registered under the MSME Act, 2006, was under the Corporate Insolvency Resolution Process under Section 7 of Insolvency and Bankruptcy Code, 2016 ('IBC') due to its failure to service the loan obtained from the Indian Overseas Bank.

From June 2019, the petitioner also failed to pay the electricity charges due to Tamil Nadu Generation and Distribution Corporation Limited ('TANGEDCO'). On 19.01.2022, TANGEDCO issued a Demand Notice claiming Rs. 32 Lakhs as unpaid electricity charges.

The petitioner contended that since the CoC under its commercial wisdom passed the Resolution Plan which also received the NCLT approval, all the outstanding claims or liabilities, not covered by the Plan are extinguished.

The petitioner filed the writ of certiorari and mandamus to quash the Demand Notice issued by TANGEDCO and to further direct it to provide the electricity connection.

Observations by the High Court:

The Madras High Court dismissed the writ petition and held that the Clean State Theory only protects the third party – SRA and not the suspended board of the Corporate Debtor from uncertainties of future claims.

The Court emphasized that irrespective of whether the corporate debtor is an MSME, the suspended Board must fully disclose all creditors during the resolution process. It also observed that the theory shall be inapplicable to undisclosed creditors since the application shall unfairly penalize such creditors due to negligence of IRP or RP or deliberate non-disclosure by the suspended director.

For the application of the Clean State Theory to the SRAs, the High Court classified the SRAs into two categories – where the original promoters or substantially similar set of directors continue to manage the Corporate Debtor and where a third party – SRA takes over the Corporate Debtor post the resolution process.

It noted that where the original promoters or a substantially similar set of directors continue to manage the corporate debtor post-resolution, the Clean State Theory shall not be applicable to extinguish the rights of undisclosed creditors, as the suspended Board must disclose all creditors during the resolution process. Therefore, those who are responsible for disclosing information cannot benefit from withholding it and shall, therefore, be liable for future claims.

Whereas, where a third-party resolution applicant takes over the corporate debtor post-resolution, the Clean State Theory shall be applicable to extinguish the rights of undisclosed creditors against the SRA or its successors-in-interest, but not against the promoters or suspended board of directors of the corporate debtor.

The Court relied upon the Supreme Court's decision in the Committee of Creditors of Essar Steel India Limited, through authorised signatory vs Satish Kumar Gupta and Others which established the Clean State Theory holding that the SRA cannot unexpectedly be faced with “undecided” claims post the approval of the Resolution Plan. A SRA must be exactly aware of all the claims to be extinguished to be able to successfully take over and run the business.

The High Court also delineated the following measures that shall be applicable where the rights of undisclosed creditors are preserved against the former promoters or board of directors.

First, each promoter or director on the suspended board shall be personally, jointly, and severally liable to the undisclosed creditors, both financial and operational. to face both civil and criminal liability. These officials shall not be protected under Section 32-A of the IBC, as the said provision aims to extinguish criminal liability only when the resolution plan changes the management or control of the corporate debtor, and only protects third-party resolution applicants unrelated to the previous management.

Second, the members of the suspended board cannot evade their liabilities behind the veil of corporate personality. Therefore, when a corporate debtor is in crisis, close to liquidation, the legal distinction between the company and its shareholders dissolves to ensure justice for undisclosed creditors. The Court pointed out that the corporate veil is not an impenetrable barrier preventing the Court from lifting it when fraudulent or unfair actions attempt to hide behind it, especially when such actions harm innocent third parties.

In conclusion, the Madras High Court emphasized that the said theory has been designed to protect third-party SRAs from future claims uncertainties but not to shield the fraudulent actions or non-disclosures by the suspended board of the corporate debtor.

Case Title: National Sewing Thread Co. Ltd. vs Superintending Engineer, TANGEDCO and Anr.

Case No.: W.P. No.29845 of 2022 and WMP.No.29233 of 2022

Counsel for Petitioner: Mr. E. Omprakash, Senior Counsel assisted by Mr.Imayavaramban for M/s.Ramalingam & Associates

Counsel for Respondents: Ms.Keerthana R.Shenoi for Mr.V.Venkata Seshaiya, Standing Counsel for TANGEDCO

Date of Judgment: 07^th June, 2024

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