CRACKING THE CODE – PART II – Initiating an Insolvency Proceeding

The Code offers a comprehensive and uniform insolvency legislation which deals with partnerships, firms and companies. The aim is to construct a separate framework for bankruptcy resolution. A Financial Creditor or an Operational Creditor can initiate a CIRP against a Corporate Debtor at the National Company Law Tribunal (“NCLT”).

Further to our Part I, in this Part, we deal with the process of initiating a resolution process and the manner in which the NCLT has dealt with issues and questions arising out of the applications made to it.

Financial and Operational Creditor

The Code has brought changes in definition of the Creditor for the first time in India, it describes two types of Creditors. Financial Creditor and the Operational Creditor.

Financial Creditor is defined in section 5(7) of the Code. According to the Code, a Financial Creditor means a person (“person” includes— (a) an individual; (b) a Hindu Undivided Family; (c) a company; (d) a trust; (e) a partnership; (f) a limited liability partnership; and (g) any other entity established under a statute) to whom a Financial Debt is owed and includes a person to whom such debt is legally assigned or transferred to.

Whereas, Section 5(8) defines “Financial Debt” as:

  1. Money borrowed in payment of interest of interest,
  2. Amount raised by acceptance,
  3. Any amount raised by note purchase, debentures, loan, stock or any similar instrument
  4. Amount raised by lease or hire purchase contract which is considered as a capital lease under Indian accounting standards.
  5. Receivables which are been sold or discounted on non-recourse basis.
  6. Amount which is raised by means of forward (future) sale or purchase agreement which have a commercial effect of borrowing.
  7. Any transaction which aim at protection against any fluctuation or benefit against fluctuation in the value price.
  8. Any counter – indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other letter issued by a bank or Financial institution.
  9. Liability which arises because of guarantee and indemnity.

Hence any Person who receives any amount as mentioned above is a Financial Debtor.

Operational Creditor has been defined in Section 5(20) of the Code as any person to whom an operational debt has been legally assigned or transferred.

Operational Debt means a claim in respect of goods, employment and services that includes, debt in respect for repayment of loans arising under any law for the time being in force and includes dues payable to the Central Government, State Government or any local body.

The case of Col. Vinod Awasthy vs. AMR Infrastructures Limited dealt with the meaning of an Operational Creditor. In this case, the petitioner signed a MOU with the infrastructure company for purchasing a flat. The MOU stated, that a sum will be provided by the company each month as an ‘assured return’ until the petitioner gets possession of the property. The company failed to pay the assured sum and to provide possession of the property. The petitioner filled an application under the Code, and claimed the due as an Operational Creditor under Section 9 of the Code. The NCLT dealt with the definition of the two debts, according to the NCLT “Operational Debt” as defined in Section 5(21) of the Code means a claim arising in respect of provision of goods or services including employment or a debt in respect of the repayment of dues arising under any law to the Central or State Government or any local authority whereas “Financial debt, “is defined as debt disbursed against the time value of money (such as bank loans, debentures etc.). Based on this reasoning the payments owned by AMR, therefore could not be considered as an Operational Debt and the petitioner cannot be called as Operational Creditor hence, the payments owed by AMR could, therefore, not be considered as ‘Operational Debt’ and the petitioner could not be considered an Operational Creditor.

Threshold

According to Section 4(1) of the Code, the minimum amount of the default by the corporate debtor is one lakh rupees: Provided that the Central Government may, by notification, specify the minimum amount of default of higher value which shall not be more than one crore rupees, in case of individual and partnership firms the amount minimum amount is one lakh rupees.

Default

Occurrence of a Default is a trigger for initiation of the CIRP. Thus, the concept of Default plays a major role in the Code.

‘Default’ under the Code means non-payment of debt when whole or any part or instalment of the amount of debt has become due and payable and is not repaid by the debtor or the corporate debtor. Thus, it can be inferred that first, a claim arises out of a contract, non-payment of this claim in the manner specified in the contract, leads to occurrence of a default.

CIRP Process for Creditors

The Code prescribes two different processes of initiation of CIRP for an Operational Creditor and the Financial Creditor.

Process by a Financial Creditor

The Code empowers a Financial Creditor to directly apply to the NCLT without even providing a demand notice to the defaulting debtor. The Financial Creditor(s) need to make an application as per Form 1 appended to the Insolvency and Bankruptcy (Application to Adjudicating Authority) Rules, 2016 and along with the application need to furnish documents and evidence which supports the claim against the debtor along with the name of the resolution professional and other information as specified in the Code. The NCLT within 14 days needs to ascertain the existence of a debt by evaluating the evidence provided to support the application as per Form 1. In case there are any deficiencies in the application, the NCLT shall provide an additional period of seven days to the Creditor to resolve the deficiencies.

While this provision may be a silver lining for Financial Creditors, it is very onerous for a defaulting debtor as the Financial Creditor, can directly make an application to the NCLT after the default has occurred. This point of law was addressed in the case of Innoventive Private Limited vs. ICICI, it was contended that the NCLT being a creation of the Companies Act, 2013 (“Act”) is bound by Section 420 of the Act which stipulates ‘reasonable opportunity of being heard’ to be given to the ‘parties’ before passing an order. Further, Section 424 of the Act, which grants liberty to the NCLT and the NCLAT to regulate its own procedure mandates that the principles of natural justice should be followed. Therefore, the aforesaid sections cast duty upon the NCLT and the NCLAT to issue a notice to and hear a party before passing any order affecting the rights of the party. The petitioner contended that, the foundation of law is based on the stones of natural justice, the petitioner urged that the basic principle of audi alteram partem is violated, as there is no chance given to the defaulter to even be notified before the initiation of the CIRP and thus affects the image of the company in the market and also impairs the ability of the debtor to conduct his business, the counsel argued on the essentiality of the principle of natural justice while following the ‘procedure established by law’, counter argument to this was that the audi alteram partem rule is not cast in a rigid mould and judicial decisions establish that it may suffer situational modifications. The core of it must, however, remain, namely, that the person affected must have a reasonable opportunity of being heard and the hearing must be a genuine hearing and not an empty public relations exercise. However, the Hon’ble High Court of Delhi did not accept this argument, and held that adherence to principles of natural justice would not mean that in every situation the adjudicating authority is required to afford reasonable opportunity of hearing to the Corporate Debtor before passing its order. The requirement of NCLT and NCLAT to adhere to the principles of natural justice and the fact that, the principles of natural justice are not ousted by the Code of 2016 can be found from Section 7(4) of the Code and Rule 4 of the Insolvency and Bankruptcy (Application to Adjudicating Authority) Rules, 2016. Rule 4 deals with an application made by a financial creditor under Section 7 of the Code of 2016. Sub-rule (3) of Rule 4 requires such Financial Creditor to despatch a copy of the application filed with the adjudicating authority, by registered post or speed post to the registered office of the Corporate Debtor.

Process by an Operational Creditor

Operational Creditor can initiate the CIRP as per Section 8 and Section 9 of the Code. An Operational Creditor is required to serve a demand notice on the defaulting debtor as per Form 3 or 4 appended to the Insolvency and Bankruptcy (Application to Adjudicating Authority) Rules, 2016, by attaching relevant documents. Thereafter, the debtor is required to bring to the notice of the Operational Creditor within 10 days, an ‘existing dispute’, evidence of payment already been made, or simply make the payment. After the expiry of 10 days, the Operational Creditor may initiate the CIRP by filing an application in the NCLT as per Form 5 appended to the Insolvency and Bankruptcy (Application to Adjudicating Authority) Rules, 2016.

(2) The application under sub-section shall be filed in such form and manner and accompanied with such fee as may be prescribed.

(3) The operational creditor shall, along with the application furnish:

(a) a copy of the invoice demanding payment or demand notice delivered by the operational creditor to the corporate debtor;

(b) an affidavit to the effect that there is no notice given by the corporate debtor relating to a dispute of the unpaid operational debt;

(c) a copy of the certificate from the financial institutions maintaining accounts of the operational creditor confirming that there is no payment of an unpaid operational debt by the corporate debtor; and

(d) such other information as may be specified.

(4) An operational creditor initiating a corporate insolvency resolution process, may propose a resolution professional to act as an interim resolution professional.

(5) The NCLT shall, within 14 days of the receipt of the application:

(i) admit the application and communicate such decision to the operational creditor and the corporate debtor if;

(a) the application made is complete;

(b) there is no repayment of the unpaid operational debt;

(c) the invoice or notice for payment to the corporate debtor has been delivered by the operational creditor;

(d) no notice of dispute has been received by the operational creditor or there is no record of dispute in the information utility; and

(e) there is no disciplinary proceeding pending against any resolution professional proposed under sub-section (4), if any.

The corporate insolvency resolution process commences from the date of admission of the application.

What is a Dispute?

There is a dilemma regarding the ‘dispute in existence’, as it is one of the most common defence that a corporate debtor may take to avoid the CIRP initiated by an Operational Creditor. Dispute is defined in section 5(6) of the Code as:

(a) the existence of the amount of debt;

(b) the quality of goods or service; or

(c) the breach of a representation or warranty.

Further, Section 8(2)(a) of the Code uses the expression –

(a) existence of a dispute, if any, and record of the pendency of the suit or arbitration proceedings filed before the receipt of such notice or invoice in relation to such dispute;

Where section 5(6) of the Code includes any arbitration proceedings as a “dispute”, section 8(2)(a) seems to exclude the same from the definition of dispute. The reason for the same is that, if as per section 5(6) arbitration proceedings are already covered in the definition of dispute, the same need not be explicitly mentioned after using the term “dispute”.

There have been conflicting interpretation as to what constitutes an “existing dispute” by the Mumbai Bench of the NCLT and the Delhi bench.

Essar Projects India Limited vs. MCL Global Steel Private Limited

The NCLT while interpreting the definition of the dispute under the Code, held that dispute in existence means and includes raising a dispute in a court of law or arbitral tribunal before the receipt of the Demand notice issued under Section 8 of the Code. The NCLT held that the dispute raised by a debtor for the first time in its reply to the demand notice cannot be interpreted as the dispute. With the above observations, the NCLT admitted the application.

Though the literal interpretation is deemed to be sufficient to reject the application of the Operational Creditors, as corporate debtors can raise any frivolous dispute, even after the receipt of the Demand Notice under the Code.

However, a directly conflicting decision was provided in the case of One Coat Plaster vs. Ambience Private Limited the NCLT, considering the dispute held that the dispute which was brought up for the first time by the corporate debtor after the receipt of the Demand Notice under Section 7 of the Code can satisfy the definition of a ‘dispute’.

The reasoning of the same bench of the Tribunal is further amplified in the case of Annapurna Infrastructure Private Limited & Ors. vs. Soril Infra Resources Limited, it was held that “the definition of the word ‘dispute’ is not exhaustive but is, in fact illustrative. In other words, a corporate debtor is not left with the only option of showing the existence of dispute by way of a pending suit, arbitration or to show the breach of representation or warranty the corporate debtor would be well within his right to show that goods and services were not supplied at all or the supply was far from satisfactory in case of demand raised by an Operational Creditor. Hence a Corporate Debtor would be well within his rights to reject the demand on any sustainable grounds. It would therefore, depend on the facts and circumstances of each case.”

The Court held that for the corporate debtor, it should ensure that if it is dissatisfied with the quality of goods or services, while payments to such vendors are being withheld, the corporate debtor needs to justify the reason for doing so.

The Code is a comprehensive attempt to try to restructure or revive a company in a time bound manner. The Code is a move towards establishing effective regulatory framework to deal with the insolvency and bankruptcy process. This Code will provide a deterrent effect on the companies and safeguard the rights of the Creditors.  

There are more in this series of IBC Revealed,  which we will publish shortly.

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