Anusha Nair

The Insolvency and Bankruptcy Code, 2016 (or the IBC, in short) has undoubtedly been one of the most important legislations in the field of corporate law in the recent times. The Act provides for the reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner. Though the Act is not notified for partnership firms and individuals, it has been hugely successful in corporate insolvency proceedings in the last two years. Its enactment has led to speedy resolution in more than 80 matters and almost 1300 cases have been admitted by the NCLTs so far.

On 25th January, 2019, the Supreme Court upheld the constitutionality of the IBC in the case of Swiss Ribbons Pvt. Ltd. & Anr. v. Union of India & Ors, in its entirety. The petitioners had filed a writ petition in the Supreme Court challenging the constitutional validity of various provisions under the Code including Section 7, 8 and 9 that deals with initiation of corporate insolvency resolution proceedings (CIRP) by the creditors of the concerned corporate debtor. This was an important judgment as it enunciated, inter alia, the intelligible differentia between Financial creditors and Operational creditors under the Code. The petitioners had contested the differential treatment that Financial and Operational creditors received under certain provisions and argued that such a classification violates Article 14 of the Constitution. The contentions put forth by the petitioners in a three pronged attack on the Code are as follows:

  • Firstly, there is no real difference between financial and operational creditors as the debtor has an obligation to pay outstanding dues to both the types of creditors. This obligation exists either for the repayment of loans advanced or paying the price of the goods purchased or the services rendered. Hence the distinction lacks the backing of a sound logical differentia.
  • Secondly, the fact that operational creditors are required to give a notice to the debtor before initiating any proceeding under the Act is also hotly contested. Financial creditors, on the other hand, are not required to give any such notice and they have the right to trigger resolution proceedings by the mere existence of a default on the part of the debtor. This is regarded as discriminatory and manifestly arbitrary by the petitioners.
  • The third main concern relates to the exclusion of operational creditors from the Committee of creditors. They are eligible to be a part of the committee only if their debts amount to 10% of the aggregate of the debt owed. This is termed as “hostile discrimination” against the operational creditors under the Code.

The objective sought to be achieved by the Code has an integral role in this discussion. The Code aims to enable the creditors to obtain maximum recovery of their dues while maintaining the corporate debtor as a going concern. Only if all plans for an effective resolution fail, liquidation proceedings will be triggered. Hence the main motive of the Act is financial restructuring of the corporate debtor in a way that all creditors recover the maximum value of the debts owed to them. Keeping this in mind, the Hon’ble Court based its decision with respect to the distinctive treatment of the creditors on three prime issues:

1. Nature of transaction

In order to distinguish both the types of creditors, the Court, firstly, perused the definitions of financial and operational debts and observed that, “the definition of financial creditor and financial debt makes it clear that a financial debt is a debt together with interest, if any, which is disbursed against the consideration for time value of money… On the other hand, an operational debt would include a claim in respect of the provision of goods or services, including employment, or a debt in respect of payment of dues arising under any law and payable to the Government or any local authority.

Financial creditors are usually the banks and other financial institutions which lend loans to the corporate debtors. Such loans are usually secured and involve huge amounts of money. Operational creditors are the suppliers of goods and services that are required in the normal course of business of the corporate debtor including trade debts and wage or salary claims. The defaults in such transactions involve smaller amounts of money and are unsecured. The fact that financial creditors are usually lesser in number as compared to operational creditors follows as a natural inference.

Due to the varying nature of these transactions, it is obvious that agreements with a financial creditor differ greatly from that of the contractual relations with an operational creditor. The evidence produced and the method of its procurement by the creditors to establish existence of defaults also differs between the two. Records of financial debts can be easily accessed and verified through the Information Utility (IU) services. Operational debts, on the other hand, may or may not have electronic records which make them difficult to verify.

Nevertheless, the single most important aspect of difference between the two creditors is that financial creditors are always concerned with assessing the economic viability of the corporate debtor. They are involved in the assessment of the financial feasibility of the corporate debtor’s activities even before granting of the loan in the first place. Operational creditors, on the contrary, are merely concerned with the repayment of their individual trade obligations. They have no role to play in the financial restructuring of the debtor’s loans or reorganization of its business. The Court hence drew the following inference, “Thus, preserving the corporate debtor as a going concern, while ensuring maximum recovery for all creditors being the objective of the Code, financial creditors are clearly different from operational creditors and therefore, there is obviously an intelligible differentia between the two which has a direct relation to the objects sought to be achieved by the Code.

2. Notice under Section 8

Under Section 8 of the Code, the operational creditors cannot directly file an application to trigger the insolvency proceedings unlike the financial creditors under Section 7. Section 8 mandates the sending of a notice of default of payment to the corporate debtor. The debtor then gets an opportunity to file a reply and dispute such claim of payment. Once such a dispute arises, the Adjudicating Authority rejects the application. Whereas under Section 7, a financial creditor may directly file an application without the need of a notice.

This is because a financial debt or a loan agreement already contains a pre-determined schedule for repayment of the debt amount and the debtor is well aware of his obligations under the agreement. Additionally, any default can be swiftly proved by producing records from the information utilities. In case of an operational debt, the non-delivery of goods or deficiency in services can be a matter of adjudication either by virtue of arbitration clauses that usually form a part of the contract or under the appropriate adjudicating authority. Since the number of operational creditors is higher, false claims may lead to triggering of the Code for purposes that it was not meant to serve.

The notice in fact grants a better chance to the operational creditors for resolving the dispute in an out-of-court settlement and recovering money without going through unnecessary and lengthy court proceedings. The judgment sums up the observations made in this regard in the following words, “Whereas a claim gives rise to a debt only when it becomes due, a default occurs only when a debt becomes due and payable and is not paid by the debtor. It is for this reason that a financial creditor has to prove default as opposed to an operational creditor who merely claims a right to payment of a liability or obligation in respect of a debt which may be due. When this aspect is borne in mind, the differentiation in the triggering of insolvency resolution process by financial creditors under Section 7 and by operational creditors under Sections 8 and 9 of the Code becomes clear.

3. Committee of Creditors

The Committee of Creditors (CoC) is the body of all financial creditors of the corporate debtor that is constituted by the Interim Resolution Professional under Section 21. Operational creditors are expressly excluded from the CoC. They are not even allowed to be a part of the meetings of the CoC unless their aggregate debt amount is at least 10% of the entire quantum of debt according to Section 24(4). In any case, they possess no voting rights.

The Court enunciated the reason as follows, “Under the Code, the committee of creditors is entrusted with the primary responsibility of financial restructuring. They are required to assess the viability of a corporate debtor by taking into account all available information as well as to evaluate all alternative investment opportunities that are available. The committee of creditors is required to evaluate the resolution plan on the basis of feasibility and viability.” Since financial creditors are better equipped with determining the viability of the corporate debtor and financial restructuring, they are given the primary say in the CoC. They are at a better position to determine the soundness of a resolution plan than the operational creditors who have no such expertise and neither do they have any motive to do so. They are simply concerned with the payments for the goods sold or services rendered to the corporate debtor.

NCLAT has often delved into the resolution plans being brought before it to examine whether operational creditors are treated in an equitable manner. Section 30(2)(b) read with Section 31 ensures that an operational creditor receives not less than liquidation value under the proposed resolution plan. Regulation 38 of the regulations framed under the Insolvency and Bankruptcy Code was even amended in October 2018 to state that, “The amount due to the operational creditors under a resolution plan shall be given priority in payment over financial creditors.” This clearly shows the reasonable treatment that is given to the operational creditors by the Code as well as the Adjudicating Authorities. In no way does the Code undermine the rights of the operational creditors.

Conclusion

The foregoing discussion based on the judgment thus throws ample light on the fact that financial creditors and operational creditors are different from each other and hence cannot be treated as equals. No question of violation of Article 14 arises as neither equals are treated unequally nor are they subjected to manifest arbitrary treatment by the Code. The Court thus concluded that distinctive treatment of the creditors hence does not amount to discrimination.

Author Bio

Qualification: Student- Others
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Location: Mumbai, Maharashtra, IN
Member Since: 20 Jan 2019 | Total Posts: 1
Interested in Commercial Law, taxation and the financial aspects of the governance of the country. View Full Profile

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