Author: Sumit Kulkarni *

Introduction

The increasing participation of Indian corporations in global trade has resulted in the rise of cross-border disputes between Indian and foreign entities being resolved through arbitrations conducted at neutral foreign venues. In a bid to promote the resolution of disputes through arbitration, the Indian courts (“Courts”) have largely adopted a policy of non-interference in the enforcement of foreign arbitral awards except on the limited grounds provided in the Arbitration and Conciliation Act, 1996 (“the Act”). However, despite the best efforts of the Courts to expedite the enforcement proceedings, the adjudication of the same often takes several months to complete.

Meanwhile, during the pendency of the enforcement proceedings, the entities against which a foreign award is sought to be enforced often find themselves grappling with the issue of whether to disclose the liability arising out of the foreign award in their statutory financial statements. Due to the strict financial disclosure regime, any contravention of the statutory disclosure provisions by a company may result in heavy fines or even imprisonment of its directors for up to one year.[1]

This post analyses the provisions, modes, and effects of disclosure of liability arising out of a sub-judice foreign award in a company’s statutory financial statements.

Foreign Award as a Claim in India

A domestic arbitral award can be directly enforced as a decree of the Court.[2] Similarly, a foreign decree from a reciprocating territory is also directly enforceable in India.[3] However, unlike a domestic award or a foreign decree, a foreign arbitral award in itself is not an executable decree. As a signatory, India’s regime of enforcement of foreign arbitral awards is governed by Chapter I,^[4] Part II of the Act adopted from the New York Convention on Recognition and Enforcement of Foreign Arbitral Awards, 1958. As held by the Supreme Court in the case of Government of India v. Vedanata Limited & Ors. (“Vedanta”), a foreign award is enforceable as a deemed decree only when it is recognized as such by an Indian court. In other words, the enforcement of a foreign arbitral award can be divided into two stages:

• Recognition Stage (Secs. 47 and 48): A party seeking to enforce a foreign award has to furnish evidence of the arbitration proceedings, viz. original foreign award, original or a duly certified copy of the arbitration agreement, and any such document substantiates the award in question to be a foreign arbitral award. Additionally, the foreign award must withstand the challenges to its enforceability against the grounds provided in section 48 that may be raised by the party against which the award is sought to be enforced.
• Enforcement Stage (Sec. 49): Only when the Court is satisfied that the foreign award passes the scrutiny of sections 47 and 48 does it become enforceable as a deemed decree of the Court.

Therefore, a foreign award that is not recognized or is still undergoing adjudication of recognition in the Court is not a fructified claim or a current liability.

Foreign Award as a Debt under Insolvency Law

As a deemed decree of the Court, a foreign award is a debt[5] for which the award-holder can initiate insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (“IBC”) against the award-debtor, i.e., the party against which the award is sought to be enforced.

However, two coordinate benches of the National Company Law Tribunal (“NCLT”) delivered contradictory judgments when the question arose whether an unrecognized foreign award is a debt enforceable under IBC. The Hyderabad Bench^[6] of the NCLT held that insolvency proceedings on the basis of a foreign award can only be initiated if the award has passed both the recognition and enforcement stages under the Act. On the other hand, the Mumbai Bench^[7] of the NCLT erroneously equated the foreign award with a foreign decree. It held that the recognition of a foreign arbitral award is not a mandatory prerequisite for the commencement of insolvency proceedings. It is submitted that the judgment of the Hyderabad NCLT is the correct position of law in this issue in contrast to the judgment of the Mumbai NCLT, the ratio of which is contrary to the Supreme Court’s dictum in Vedanta.

Furthermore, as held by the Madras High Court,[8] the categorization of a liability arising from a decree or an arbitral award into an operational debt[9] or financial debt[10] depends on the nature of the underlying claim, which stands crystallized through the arbitral or Court proceedings. Insolvency proceedings cannot be initiated against an operational creditor if there is a pre-existing dispute between the parties.[11] As per the Supreme Court’s ruling in the case of K. Kishan v. Vijay Nirman Co. (P) Ltd., if an award-debtor files an application for setting aside[12] of the arbitral award in the Court, it shall amount to a “pre-existing dispute,” which disentitles the award-holder from initiating insolvency proceedings against the award-debtor.

Similarly, under the Act, with the exception of the ground of patent illegality, the grounds for setting aside[13] a domestic arbitral award are pari materia to the grounds of refusal to recognize a foreign award.[14] So, the nature of legal proceedings being similar in both cases, it can be concluded that if adjudication of the objections filed by an award-debtor against the enforcement petition of a foreign arbitral award is pending in the Court, it will also fall under the category of “pre-existing dispute.” As such, an unrecognized foreign award in an operational debt cannot be enforced through IBC until it passes the recognition stage.

Disclosure of Liabilities Arising Out of Legal Proceedings

A duly incorporated company has to make mandatory financial disclosures in its balance sheets as per the format prescribed under Schedule III of the Companies Act, 2013.[15] Currently, depending upon the net worth of a company, the accounting standards applicable to the reporting of financial statements can either be Indian GAAP (“AS”)[16] or Indian Accounting Standard (“Ind AS”)[17]. Under both Accounting Standards, a liability arising out of an ongoing legal proceeding is classified as a “contingent liability”[18], which must be disclosed except when the probability of outflow of resources embodying economic benefits is remote.

Effect of Acknowledgement of a Liability in the Balance Sheet

By recognizing a liability as contingent, an enterprise recognizes an obligation for which an outflow of resources embodying economic benefits is “probable.” Thus, a liability that is contingent will fructify to become an obligation only on the happening or non-happening of a certain event. So, the declaration of a contingent liability, by itself, may not act as an acknowledgment of that liability.

In the case of Asset Reconstruction Co. (India) Ltd. v. Bishal Jaiswal the Supreme Court observed that an entry of a liability made in the balance sheet is an acknowledgment of that liability for the purposes of section 18(1) of the Limitation Act, 1963. However, the Court observed that the statutory compulsion to prepare a balance sheet under section 129 of the Companies Act, 2013 does not extend to making unequivocal admissions of liability. The Court held that if a liability in the balance sheet is entered along with caveats in the Auditor’s Report or Notes[19] stating that the liability is not acknowledged and contingent upon the happening or non-happening of an event, then it is not an unequivocal admission of that liability. Resultantly, such an entry of liability will not amount to an acknowledgment of that liability.

Disclosure of Contingent Liability

Depending upon the circumstances, a company can choose to either omit or disclose a contingent liability arising out of an ongoing dispute. In deciding on the exact form of the disclosure, a company must consult its lawyers and Chartered Accountants to determine the probability of success in the ongoing dispute.

Firstly, if a company cannot gauge the probability of the happening or non-happening of the event on which liability is contingent, then it should disclose such a contingent liability in the balance sheet. However, to avoid an own goal of acknowledgment of that liability, it is necessary that the contingent liability entered in the balance sheet carries with it, a caveat in the Notes or Auditor’s Report clearly indicating that the said entry is not an acknowledgment of liability but a merely a statutory entry of the contingent liability which is not yet fructified. Similarly, a company against which a claim is being adjudicated in a legal proceeding shall have to disclose the claim amount as the contingent liability, along with the caveat that the liability is not acknowledged but contingent on the outcome of the legal proceedings.

Secondly, in the opinion of a company, if the disclosure of a contingent liability may cause prejudice to its position in an ongoing dispute, then it may choose not to disclose the details of such a liability. In such cases, the company shall have to disclose only the existence and the nature of the dispute, along with the reason for non-disclosure of the said liability.[20] However, this exemption must be exercised only when disclosure would cause a genuine and irreparable prejudice to the company. An undue expansive exercise of the exemption may attract penal provisions of the Companies Act, 2013.

Thirdly, if the probability of the outflow of resources embodying economic benefits is very remote, then the company may choose not to disclose the contingent liability at all. Accordingly, in an ongoing dispute, if the subject matter of the suit is based on entirely frivolous claims which are unlikely to succeed, then the company may choose to omit the disclosure of liability arising out of such a dispute. However, owing to the strict penal nature of Section 129 of the Companies Act, 2013, it is recommended that the option of omission of disclosure of contingent liabilities should be exercised only in extremely rare cases.

Concluding Remarks

The financial disclosure of a company reflects its financial health, profitability, cash flow, etc., which in turn determines its share value and ability to repay the debts. A pending legal proceeding, including enforcement of a foreign award against a company, if successful, may adversely impact a company’s financial health, which might have a negative effect on its ability to attract investment for its operations and expansion.

So, while choosing to disclose its contingent liabilities, it is imperative that a company maintains a fair balance with respect to its chosen mode of disclosure. On one hand, lies its fiduciary duty to be transparent about its current and probable liabilities towards its shareholders and creditors. On the other hand, an excessive disclosure of contingent liabilities may deter the investors due to the looming burden of the additional liabilities that may accrue. Therefore, a company must weigh the probability of success in an ongoing legal dispute before crystallizing its stance with regard to disclosure of its contingent liabilities.

For example, a dispute arising between a U.S. entity and an Indian Company (the “company”) for breach of a contract is governed by New York State law. The said dispute is adjudicated through an arbitration seated in New York, which culminates in an arbitral award directing the company to pay punitive damages to the U.S. entity. The punitive damages, if paid, would bring a significant financial strain on the Indian company. Additionally, the arbitral award is a well-reasoned and perfectly valid award under the law of the State of New York. In such a case, the company may choose to jump the gun and disclose the liability arising out of the arbitral award in its financial statements, which might hamper its ability to draw investors and raise capital through debt. On the other hand, if the company seeks legal advice on the subject matter, it will realize that there is a high possibility that the Indian courts might disallow the enforcement of the foreign award on the grounds that the award of punitive damages is contrary to the public policy^[21] of India.[22] Therefore, as the probability of enforcement of the foreign award is remote, the company has a choice whether to disclose the said contingent liability in its financial statement and curtail the adverse effects of an unnecessary disclosure.

Thus, we can presume that careful consideration of the modes of disclosure of information in relation to a contingent liability arising out of an unrecognized foreign award allows a company to find an equilibrium between its statutory obligations and commercial interests.

*Sumit Kulkarni is an India-qualified lawyer and Civil Engineer. His area of practice involves construction disputes, complex commercial disputes, insolvency, and public law. He advises and represents parties in ad hoc and institutional arbitration proceedings as well as litigations before Indian Courts and Tribunals.

[1] Companies Act, 2013, § 129(7).

[2] Arbitration and Conciliation Act, 1996, § 34.

[3] Civil Procedure Code, 1908, § 44A.

[4] Arbitration and Conciliation Act, 1996, § 44 to § 52.

[5] Insolvency and Bankruptcy Code, 2016 § 3(11).

[6] Adityaa Energy Resources Pte Ltd. v. Cauvery Power Generation Chennai (P) Ltd., CP-1014/2018.

[7] Agrocorp International (P) Ltd. v. National Steel and Agro Industries Ltd., CP (IB) No. 798/MB/C-IV/2019.

[8] Cholamandalam Investment and Finance Company Ltd. v. Navrang Roadlines Private Limited O.S.A. (CAD) No. 115 of 2022.

[9] Insolvency and Bankruptcy Code, 2016 § 5(21).

[10] Insolvency and Bankruptcy Code, 2016 § 5(8).

[11] Insolvency and Bankruptcy Code, 2016, § 9.

[12] Arbitration and Conciliation Act, 1996, § 34.

[13] Ibid.

[14] Arbitration and Conciliation Act, 1996, § 48.

[15] Companies Act, 2013, § 129 read with § 134.

[16] Companies (Accounting Standard) Rules, 2006.

[17] Companies (Indian Accounting Standards) Rules, 2015.

[18] Ind AS 37 Para 10; AS 29 Para 15.

[19] Companies Act, 2013, § 134(7).

[20] Ind AS 37 Para 92; AS 29 Para 72.

[21] Arbitration and Conciliation Act, 1996, § 48(2).

[22] Punj Llyod Ltd. v. IOT Infrastructure and Energy Services Ltd., 2018 SCC OnLine Bom 19741;  Home Care Retail Marts Pvt. Ltd. v. Haresh N. Sanghavi 2019 SCC OnLine Bom 392.