The Supreme Court of India, in its decision in Mobilox Innovations Private Limited v. Kirusa Software Private Limited (Mobilox), has brought about much needed clarity to the Insolvency and Bankruptcy, 2016 (IBC) by expounding on the scope of Section 5 (6) of the IBC. To set the context, Section 8 (1) of the IBC provides for the first step in the initiation of insolvency proceedings, by serving of a demand notice on the corporate debtor. However, Section 8 (2) (a), read with Section 9(5), makes it clear that a disputed debt cannot be the basis for initiation of the insolvency process. Such ‘disputes’ are to be brought to the notice of the creditor in a reply to the demand notice. In the absence of case law, the meaning of the term ‘dispute’, as enshrined in Section 5 (6) of the IBC, had been the subject of much controversy. For instance, the Mumbai Bench of the National Company Law Tribunal (NCLT) narrowly interpreted the term ‘dispute’ by limiting it to pending suits and arbitral proceedings. In contrast, the Delhi NCLT construed the expression to include disputes raised by the corporate debtor for the first time, in his reply.
In turn, the NCLAT restrictively interpreted the term to include only pending proceedings. This would essentially result in a ‘first mover’s advantage’, wherein the debtor would be left without a defence if the creditor were to serve a notice upon him under Section 8, before the debtor is able to initiate any formal legal proceedings against the creditor, with respect to any dispute. Needless to say, this construction would be patently unfair; especially where disagreements with respect to the debt arise only a few days before the notice is served, giving the debtor little time to contest the debt.
On appeal, the Supreme Court noted the differences between the IBC and the draft bill prepared by the Bankruptcy Law Reform Committee, and undertook an expansive interpretation by including within the scope of Section 5(6) such disputes that are raised post the serving of notice. Given the decision, the debtor would now have reasonable time to prove the existence of a dispute. Before examining more closely the reasoning of the Supreme Court in this matter, it is necessary to briefly discuss the principles and intent underlying the IBC, which were relied upon by the Court to arrive at its conclusion.
A notable change brought about by the IBC was the unification of an otherwise fragmented insolvency framework, and the consequent elimination of parallel proceedings, given that all creditors would be a part of a single insolvency process under the IBC. This is in stark contrast to the previous regime, wherein each creditor would proceed individually under the Companies Act, SICA, SARFAESI and other relevant legislations.
Such a consolidation sought to implement the principle of collective distribution. Further, it envisaged the introduction of expediency into the insolvency resolution process. Accordingly, the insolvency resolution process envisaged by the IBC is premised on the principle that each creditor of the same class should receive a share that is proportionate to the debt owed to him, also known as the Pari Passu principle.
These two objectives of the IBC, and the underlying principles, constituted the core reasoning of the Court in Mobilox. The Supreme Court undertook an extensive review of the legislative history of the IBC (including the United Nations Legislative Guide on Insolvency, the Bankruptcy Law Reform Committee Report and the draft bill of the IBC) in an attempt to ascertain the legislative intent behind it. On the basis of this, the judgement cautions against the use of the IBC as a tool for coercion and debt recovery by individual creditors. It also reaffirms the objective of the IBC to ensure speedy resolution of insolvency, so as to prevent ‘recalcitrant management’ from taking advantage of undue delays.
Viewed in this framework, the two orders of the Supreme Court, namely ‘Pride Dairy’ and ‘Lokhandwala Construction’ derogate from these objectives, and hence, require reconsideration.
The facts of the two cases are similar. In both cases, the NCLT initiated insolvency proceedings against a corporate debtor, based on the application of a creditor. Subsequently, both parties reached a settlement for repayment of the debt in question. Pursuant to this, the debtor approached the NCLAT to dismiss the proceedings pending before the NCLT, as the dispute between the parties had, in its opinion, been resolved. However, the NCLAT refused to interfere with the order of the NCLT on the ground that the IBC does not permit withdrawal of an application once it has been admitted, even with the consent of both parties. Nonetheless, the Supreme Court used its powers under Article 142 of the Constitution (which is a discretionary power to do ‘complete justice’) to quash the insolvency proceedings, despite agreeing with the NCLAT on all points of law. Based on these facts and the ruling in Mobilox, a few issues with these orders are highlighted below.
A company facing the prospect of insolvency proceedings will typically have only limited resources that are insufficient to repay debts in full, which is the foundational premise of the pari pasu principle. The orders in Pride Dairy and Lokhandwala Construction allow the debtor to quell insolvency proceedings by entering into a settlement with the applicant creditor. The insolvency process now becomes a bargaining chip in the hands of creditors, allowing them to use it as leverage to recover the full amount owed to them by debtors, with the promise of withdrawal of proceedings once the sum has been paid. In this manner, these orders have the effect of conferring an extraordinary benefit on the applicant creditor, which the creditor would not have otherwise been able to derive from the collective distribution of the limited pool of resources available under insolvency proceedings. For instance, through this process, an unsecured creditor, can, through the timely filing of an insolvency application, get his debt satisfied even before the secured creditor.
Further, such a result only defers the initiation of proceedings against a debtor, who may practically be insolvent otherwise. Viewed in this manner, it enables the debtor to delay the process and continue his business unfazed, by satisfying the claims of a single creditor. It thus becomes evident that the two orders go against both principles highlighted by the Apex Court in Mobilox.
Practically, the effect of such an order is that it creates the risk of giving rise to certain complications prospectively. The IBC, under Sections 43 & 44, sets aside transactions that would put a creditor in a position more favourable than he would have been under insolvency proceedings. Added to that, the ambit of these provisions is not restricted to transactions entered into during the insolvency process, but extends to a period of two years preceding the commencement of insolvency proceedings. For this reason, in the abovementioned cases, if the debtor’s claim was settled in a manner prohibited by Sections 43 & 44 (as already elaborated), such a settlement could be subject to challenges.
Therefore, if another creditor were to initiate insolvency proceedings against the corporate debtors in Pride Dairy and Lokhandwala Construction, within two years of the settlement having been entered into, the settlement with the first creditor would theoretically fall within the purview of Section 43 of the IBC. Interestingly, the proviso to sub-section (3) of this section explicitly provides that transfers pursuant to court orders are not excluded from the ambit of this provision. In other words, even if the settlement is sanctioned, or permitted by a court order, as in the cases of Pride Dairy and Lokhandwala Construction, it could yet be reversed under the IBC.
However, Article 142 of the Constitution confers a unique power upon the Supreme Court, and orders passed pursuant to it are not in the nature of ordinary court orders. In this context, it would be interesting to see whether and how the NCLT applies Section 43 to settlements entered into pursuant to a Supreme Court order under Article 142.
Moreover, it is contestable whether such orders could be made under Article 142, which is an equitable provision that enables the Court to prevent miscarriage of justice on the facts of a particular case. In Lokhandwala Construction, the Supreme Court reasoned that the exercise of its powers under Article 142 would be appropriate since ‘all the parties’ were before it. However, insolvency proceedings are a collective process, to which every creditor is a party, and only two parties were before the Court in the above case, i.e., the debtor and the applicant. Of relevance in this context is the judgement of the Supreme Court in Jitendernath v. Jubilee Hills Coop. House Bld. Soc., wherein it was held that the Supreme Court cannot pass an order which causes injustice to parties that are not before the Court.
Given the implications of these orders and the clarification of the legislative intent of the IBC in Mobilox, it is imperative that the Court refrains from passing such orders in the future.
Rahul Sibal and Deep Shah are both Editors of the Nalsar Journal of Corporate Affairs and Crime and co-founders of the Nalsar Centre for Corporate and Tax Laws.