Last week an important judgement of the Supreme Court of India made headlines in corporate circles, particularly in the context of financial recoveries. We have analyzed the judgement in brief.

Some key basic facts: Kotak India Venture (Offshore) Fund (“Kotak“) had in accordance with the terms of the share subscription agreement and the shareholders’ agreements (collectively referred to as “Agreements“) subscribed to the optionally convertible redeemable preference shares (“OCRPS“) issued by Indus Biotech Private Limited (“Indus“). Indus had proposed to make a Qualified Initial Public Offering (“QIPO“), and Kotak elected to convert its OCRPS into equity shares prior to the QIPO. The parties negotiated the conversion formula and had differences leading to disputes. Kotak eventually invoked its rights to seek redemption of the OCRPS in accordance with the terms of the Agreements.

Indus failed to redeem the OCRPS, Kotak approached the National Company Law Tribunal (“NCLT“) seeking the initiation of the corporate solvency resolution process under Section 7 of the Insolvency and Bankruptcy Code, 2016 (“IBC“). Correspondingly, Indus filed an interim application under Section 8 of the Arbitration and Conciliation Act, 1996 (“Arbitration Act“) before the NCLT and requested to refer the dispute to arbitration in accordance with the dispute resolution mechanism as agreed and envisaged under the Agreements. The NCLT vide its order dated June 09, 2021 (“Order“), allowed the application filed under the Arbitration Act. As a consequence, the petition filed by the Kotak under IBC was dismissed. Kotak thus appealed before the Supreme Court, against the Order.

Issue: The primary issue that the Supreme Court delved into was, inter alia, determination of “default” under section 7 of the IBC and also arbitrability of insolvency proceedings initiated with the NCLT under section 8 of the Arbitration Act.

Supreme Court Decision: The Supreme Court upheld the decision of the NCLT and held that an application for initiation of the corporate solvency resolution process under the IBC is inadmissible until the parties attain a resolution through the arbitration process as envisaged under the Agreements.

Placing reliance in the decision held in Innovative Industries Limited v. ICICI Bank and Another ((2018) 1 SCC 407), the Supreme Court observed that in order to trigger an application under Section 7 of the IBC, prima facie 4 (four) factors should exist: (i) there should be a debt; (ii) default should have occurred; (iii) debt should be due to financial creditor; and (iv) such default which has occurred should be by a corporate debtor.

The Supreme Court emphasized that a mere existence of a debt, is not a determining factor for the establishment of a default. The Supreme Court elaborated on how a duty is cast on the adjudicating authority to ascertain the existence of a default on a case to case basis and by relying on evidentiary records. Further, the Supreme Court adjudged that while the adjudicating authority has the right to determine the occurrence or the non-occurrence of a default, the proceedings only on the date of admission of the application and not the date of filing an application, becomes a proceeding in rem and cannot be subject to arbitration from that point onwards.

In the present case, the main bone of contention was the applicable formula for the conversion of the OCRPS.  Kotak’s claim was that it would be entitled to 30% (thirty percent) of the total paid up share capital. On the other hand, Indus was of the opinion that Kotak was eligible to only 10% (ten percent) of the total paid up share capital. The parties had thus to resolve the difference in opinion and achieve the conversion of the OCRPS held various meetings and had taken concrete steps towards resolving the dispute, which was yet to see finality. The Supreme Court held that a mere claim cannot be ground for establishment of default and admission of a petition. The Supreme Court said that if that were to become the norm, companies which are running its administration effectively would become prey to the corporate insolvency resolution process. The Supreme Court thus conclusively held that in situations where petitions under the IBC are yet to be admitted and, in such proceedings, if an application is made under Section 8 of the Arbitration Act, the adjudicating authority is duty bound to first decide to its satisfaction whether default has occurred or not, even if the application under the Arbitration Act is kept along for consideration. Accordingly, the consequence of the consideration made therein on the IBC application would befall on the application under the Arbitration Act. In the case at hand, the Supreme Court relying on the correspondences provided to it, adjudged that the moot point was and is the conversion of the OCRPS and the allotment of equity shares against the OCRPS, in view of the QIPO which was still a matter of discussion between the parties and hence it was premature to determine if default had actually occurred at the given point of time. The Court also relied upon the occurrence of the board meetings with the presence of the nominee director of Kotak where the discussions were held and decisions were made on the matters pertaining to the issuance of equity shares. The Supreme Court thus upheld the conclusion arrived by the NCLT citing that default could not be established and hence deemed it necessary that the petition under the IBC be dismissed and the petition under the Arbitration Act be allowed, atleast for the time being.

Some Thoughts: Well, in our view, the securities issued to Kotak were OCRPS, which as nomenclature clearly suggests, permits optionality on conversion (into equity shares) and optionality on redemption (by payment of the redemption amount by the issuer company). Arguably, if Kotak does not eventually agree to a conversion pricing, then Indus is bound to redeem them and pay redemption amounts to Kotak, which Kotak did demand at the very first place. The mere participation in board meetings of Indus and discussion on the conversion pricing etc. should not take away other fundamental rights of the OCRPS holder viz. right to seek redemption. Kotak did exercise such right and Indus failed to make payment thereof. There may be issues from Companies Act perspective on the redemption of OCRPS, which too requires consideration. Nonetheless, no contentions seem to be made by Indus that Kotak did not have the right to redeem; and no contentions seem to be made by Indus that Indus has any legal embargo to make such payments. Claims from Kotak to make redemption payments and failure by Indus to do so, arguably, leads to default. Although, determination of whether such a claim is debt due or not should have been done by adjudicating authority. And such an adjudication need not go through arbitration if the OCRPS holder is exercising its legally valid and binding rights to redemption.

Further, the present view that default cannot be ascertained until the conclusion of the ongoing discussions may be a shift from an existing position on determination of defaults under the IBC.

We will keep examining this issue as it will certainly keep unfolding itself in time to come. Watch this space for more…

Authors:
Hardeep Sachdeva, Senior Partner
Rachel Noronha, Associate