The Viewpoint – IBC Judgment: The Defaulter’s Paradise is Lost

By Nandini Gore and Khushboo Bari

“The Defaulters’ paradise is lost. In its place, the economy’s rightful position has been regained.”

                                   ~ Justice RF Nariman

By means of this article, we make an attempt to understand the landmark judgment rendered by the Hon’ble Supreme Court of India in the matter of Swiss Ribbons Pvt. Ltd. & Anr. v. UOI & Ors (lead matter) wherein the constitutional validity of the Insolvency and Bankruptcy Code, 2016 (the Code) has been upheld. The judgment dated 25.01.2019 has been rendered by a bench comprising Justice RF Nariman and Justice Navin Sinha and has been authored by Justice R.F. Nariman.

Mukul Rohatgi, Senior Advocate appearing on behalf of one of the petitioners had assailed the constitutional validity of the code. KK Venugopal, learned Attorney General of India along with Tushar Mehta, learned Solicitor General of India appeared on behalf of the Union of India. Rakesh Dwivedi, Senior Advocate appeared on behalf of the Reserve Bank of India had refuted the submissions made on behalf of the Petitioners.

The issues that were argued by the parties were respect to the preamble and approach of the Code, about NCLT and NCLAT, classification into financial creditors and operational creditors, notice, hearing, set off or counterclaim qua financial debts, operational creditors and committee of creditors, Section 12A vis-à-vis Article 14, information utilities, power of Resolution Professional, constitutional validity of Section 29A, addressing hardship arising from and monitoring the working of the Code, Section 53 vis-à-vis Article 14, constitutional validity of the Code and working of the Code. 

Upon considering the submissions forwarded, the Supreme Court thought it fit to first give a brief background of the Insolvency Law in India. The problems with the erstwhile bankruptcy law were highlighted. Lack of clarity of jurisdiction and the need for a single forum for adjudication was emphasized as opposed to multiple judicial fora (BIFR under SICA & Liquidation under Companies Act, 1956). It further classified the erstwhile regime as fragmented and prone to contrary judicial outcomes. The average time to resolve bankruptcy in India according to a 2014 World Bank report was stated to be 4 years, which was comparatively very high. Quoting the Eradi Committee Report relating to insolvency and winding up of companies dated 31.07.2000, the utility of the Sick Industrial Companies (Special Provisions) Act, 1985 was questioned.

The Supreme Court further emphasized the need for the courts of law to be cautious while interfering with legislation passed especially in social and economic fields. Legislation ideally should not be interfered with unless it is patently arbitrary and perverse. A need for consolidation of the insolvency process amalgamating various statutes governing the field such as Sick Industrial Companies (Special Provisions) Act, 1985, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and the Companies Act, 2013 was outlined.

Stress was placed on a time-bound outcome which directly links with the value of assets. A single scheme would result in benefitting all stakeholders in a holistic and natural way. Credit markets would also be developed and the ultimate goal of overall economic growth and development would be met. Liquidation is provided for, as a last resort and the Code is a beneficial piece of legislation. It aims at supporting the corporate debtor in a positive way to recover and not merely a tool for recovery from the creditors.

Circuit Bench of NCLAT was directed to be set up within a period of 6 months. In terms of the Madras Bar Association Case, it was directed that the administrative support for tribunals needs to shift to the Ministry of Law and Justice and not the Ministry of Corporate Affairs. The classification between a financial creditor and operational creditor was found to be neither discriminatory nor arbitrary nor violative of Article 14 of the Constitution of India. It was further observed that financial creditors i.e. banks and financial institutions (secured creditors) would be smaller in number than operational creditors (unsecured) of a corporate debtor. It was held that there existed clear intelligible differentia qua financial creditors and operational creditors.

An important move was also sought to be made with the bringing of the Code. The policy saw a shift from “inability to pay debts” to the determination of default. The triggering of the Code by financial creditors and by operational creditors is differentiated as financial creditors have to prove default while an operational creditor merely claims a right to payment. The Court has explained this by stating that a claim gives rise to a debt only when it becomes due and a default occurs only when a debt becomes due and payable and not paid by the debtor.

On the aspect of operational creditors having no vote in the committee of creditors, it was observed that financial creditors are in the business of money lending and therefore banks and financial institutions are best equipped to assess viability and feasibility of the business of the corporate debtor. Even at the time of granting loans, these institutions undertake a detailed market study and thus they are in a good position to evaluate the contents of a resolution plan. With respect to operational creditors, it was observed they are only involved in the recovery of amounts for goods and services and are typically unable to assess the viability and feasibility of business. Furthermore, the same treatment is given to operational creditors and financial creditors.

Withdrawal of application admitted under sections 7, 9 or 10 of the code was held to be not violative of Article 14 of the Constitution of India. Such proceedings being in rem necessitate the consulting of the body overseeing the resolution process before settling of the claim by any corporate debtor. The limit of 90% of the committee of creditors having to approve the withdrawal is justified as ideally, all creditors need to be involved in the process. Furthermore, any arbitrary decision is subject to judicial challenge thus safeguarding against the concerns raised on behalf of the petitioners.

Regarding the assault on private information utilities, it has been observed that they are subject to stringent requirements such as expeditious authentication and verification. No adjudicatory powers have been given to resolution professionals. The resolution professionals are given administrative powers only as opposed to quasi-judicial powers as had been sought to be canvassed by the petitioners. Juxtaposing the powers of the liquidator and of the resolution professional, a clear distinction emerges as to the nature of their powers. A determination of the value of claims by the liquidator is quasi-judicial in nature and amenable to review by the Adjudicating Authority. Lastly, as compared to the liquidator the resolution professional is fettered by approvals required from the committee of creditors and their general oversight.

Another major concern raised by the petitioners was to the constitutional validity of Section 29A of the Code dealing with persons not eligible to be “resolution applicant”. Following the judgment in the matter of ArcelorMittal, it was held that since a resolution applicant applying under Section 29A(c) has no vested right, no fault can be assigned. The aspect of no vested right has been also expanded to counter the argument of the erstwhile promoter who may alone purchase the immovable and movable properties sold in liquidation piecemeal by public auction or by private contract. Ineligibility of persons under Section 29A of the Code includes malfeasant persons or persons otherwise in default of the law of the land or people unable to pay their debts in the mandated period thereby creating a barrier from purchasing the assets of the corporate debtor who is either a willful defaulter or otherwise.

In so far as the period of one year prescribed in terms of Section 29A is concerned, a reference to the RBI guidelines is mandatory. In terms of the said circular, accounts are declared NPA only if defaults made by the corporate debtor are not resolved within a period of one year and three months resulting in the asset being classified as a substandard asset. Thereafter, the person becomes ineligible to become a resolution professional.

The challenge to the concept of “Related Party” read with Section 29A(j) of the Code wherein an apprehension as to a person related to an ineligible person being further considered ineligible for being a resolution professional due to such relation was clarified by the Supreme Court. It was held that the relation/connection was one to the business activity of the resolution applicant and in absence of the same, no disqualification could possibly occur under the aforesaid section.

It was further clarified that “Related Party” would cover both natural as well as artificial persons. The argument of connected persons in terms Explanation I, clause (ii) of Section 29A(j) of the Code not being referred to a person in the management or control of the business of the corporate debtor in the future was negated by stating that such an interpretation would be arbitrary as in such a case the explanation would then apply to an indeterminate person. It was further stated that the Explanation I covers a person who is in management or control of the business of the corporate debtor during the implementation of the resolution plan, if the person is otherwise covered under the definition of “connected persons”.

With respect to the exemption of micro, small and medium enterprises from the ambit of Section 29A of the Code, it was observed that this was necessary as due to their structure other resolution applicants may not be available, leading to no resolution at all. This would lead to a scenario where liquidation becomes the default result, which goes against the very fabric of the Code.

A challenge to Section 53 of the Code was also made by canvassing a scenario wherein, in the event of liquidation operational creditors will receive no payments due to their ranking lower in the ladder to other creditors, which would also include other unsecured creditors who happen to be financial creditors. This challenge was also negated by the Supreme Court, in as much as it was explained that repayment of financial debts is essential to infuse capital in the economy which can be further put to use. This was said to have created intelligible differentia between financial debts and operational debts. It was further clarified that unsecured debts are of various kinds and if some legitimate interest is sought to be protected having relation to the object sought to be achieved by the statute in question then it would not fall foul of Article 14.

Having adjudicated all of the aforementioned challenges and after giving appropriate direction, the Supreme Court has approved of the Code in toto as a positive and necessary step towards not only a better mechanism to govern the field of insolvency law but also as an important step towards infusing capital in the economy. Concrete figures have been quoted to make a case for a quantifiable and proven positive result since the enactment of the Code. The Government’s active approach in tweaking the Code as and when required was also lauded by the Supreme Court.

Therefore, in conclusion, it can be said that “passing of the constitutional muster” was a positive endorsement by the highest court of the land. The ground realities are ever changing and there is a constant need for the statutes to remain relevant. The Government has shown promising results in this area and it is hoped that this would be an ongoing exercise in the times to come. The enactment of the Code was a much-needed first step and has laid a solid foundation for the evolution of insolvency law in our country.

About the authors: The authors are lawyers at Karanjawala & Co. Nandini Gore is Senior Partner, whereas Khushboo Bari is a Senior Associate at the law firm.  

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