Supreme Court Upholds Constitutionality of the Insolvency and Bankruptcy Code, 2016

On January 25, 2019, in the matter of Swiss Ribbons Pvt. Ltd. & Anr. v. Union of India, the Supreme Court (‘SC’) delivered a landmark verdict upholding the constitutionality of various provisions of the Insolvency and Bankruptcy Code, 2016 (‘Code’). While declaring the Code to be a beneficial legislation with a primary focus on revival and continuation of the corporate debtor, and not being a mere recovery legislation for the creditors, the SC has, inter-alia, dealt with the following issues:

1.  Classification of Operational and Financial Creditors is not Unconstitutional

One of the key challenges to the Code was on account of differential treatment between operational and financial creditors, and such differentiation being violative of the principle of equality enshrined under Article 14 of the Constitution of India. Keeping in mind that the primary objective of the Code is resolution and not liquidation, the classification was alleged to be arbitrary and unreasonable. The SC upheld the classification / differential treatment between “financial creditors” and “operational creditors” and held that such distinction is neither unreasonable nor discriminatory and hence, is not violative of Article 14.

Following are some of the various differences in the nature of the two classes of creditors outlined and examined by the SC:

(i)   Role of financial and operational creditors

Financial creditors, unlike operational creditors, are involved in assessing the viability of the corporate debtor from the very beginning and are also involved in the restructuring / reorganization of the borrower in the event there is financial stress. Further, the difference also lies in the nature of agreements with the two kinds of creditors (in terms of secured / unsecured, long term / short term, dispute resolution process and so on). Therefore, there is an intelligible differentia between the two which has a direct relation to the object of the Code, i.e. maximum recovery while preserving the corporate debtor as a going concern.

(ii)  No Voting Rights

When dealing with the issue of operational creditors not having voting rights in the Committee of Creditors (‘CoC’), the SC referred to the Report of the Bankruptcy Law Reforms Committee and the Report of the Insolvency Law Committee and observed that financial creditors, i.e., banks and financial institutions, are best equipped to assess the viability and feasibility of the business of the corporate debtor; whereas operational creditors are only involved in the recovery of amounts and are typically unable to assess the viability and feasibility of the business.

(iii)  Notice and Hearing

On the issue of notice and hearing, the SC referred to various provisions of the Code and its judgement in Innoventive Industries Ltd. v. ICICI Bank[1]. The SC observed that a corporate debtor is served with a copy of the application with the adjudicating authority and has the opportunity to file a reply and be heard. The Code prescribes penalties for furnishing false information and for fraudulent or malicious initiation of proceedings. Further, a financial creditor has to prove ‘default’ as opposed to an operational creditor who has to merely ‘claim’ a right to payment of liability or obligation in respect to the debt which may be due.

Upon bearing this aspect in mind, the difference between triggering an insolvency resolution process by financial creditors under Section 7 and by operational creditors under Sections 8 and 9 of the Code becomes clearer.

(iv)  Safeguards for Operational Creditors

The SC further noted that while looking into the viability and feasibility of resolution plans that are approved by the CoC, tribunals always examine whether or not the operational creditors were given roughly the same treatment as the financial creditors and whether plans have been modified such that the rights of the operational creditors are safeguarded. Further, the operational creditors are required to be paid liquidation value at the minimum. The amended Regulation 38 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 further strengthens the rights of operational creditors by providing priority in payment over financial creditors.

2.    Constitutional Validity of Settlement Post Admission [Section 12A]

On settlement of proceedings under the Code post initiation of corporate insolvency resolution process under Section 12A, the SC observed that the proceedings under the Code are a collective proceeding and therefore, the body which is to oversee the resolution process should be consulted before any corporate debtor is permitted to settle its debt. As a result, the SC deferred to legislative intent on the requirement of 90% voting share of the CoC for approval or withdrawal of application. It was further clarified that between the initiation of the insolvency resolution process and the constitution of the CoC, applications for withdrawal or settlement are to be made to the NCLT under Rule 11 of the National Company Law Tribunal Rules, 2016. It further clarified that if the CoC arbitrarily rejects a just settlement and/or withdrawal claim, the National Company Law Tribunal (‘NCLT’), and thereafter, the National Company Law Appellate Tribunal (‘NCLAT’) can set aside such decision under Section 60 of the Code.

3.    Persons not Eligible to be Resolution Applicant [Section 29A and Section 35(1)(f)]

Section 29A of the Code declares certain persons as not eligible to be resolution applicants and the liquidator is also barred from selling property or actionable claims of the corporate debtor to such persons[2]. The constitutionality of the provision was challenged on the ground that Section 29A(c) is not restricted to malfeasance and is retrospective and, therefore, arbitrary.

The SC clarified that categories of persons who are held ineligible from submitting a resolution plan under the section is not restricted to people who are malfeasant (such as an undischarged insolvent). Following the observations made by the SC in Arcelor Mittal India Private Limited v. Satish Kumar Gupta[3], the SC held that a promoter or any resolution applicant has no vested right to apply for being considered as a resolution applicant.

It is settled law that a statute is not retrospective merely because it affects existing rights; nor is it retrospective merely because a part of the requisites for its action is drawn from a time antecedent to its passing. On the issue of time period of one year provided in Section 29A(c), the SC observed that the primary basis for Section 29A lies in the fact that a person who is unable to service its own debts for such a long period of time is unfit to be a resolution applicant. It referred to circulars issued by the Reserve Bank of India which grant a long grace period to persons unable to pay debts, before an asset is classified as a non-performing asset.

Related Party and Relatives

While dealing with the concept of ‘related parties’ and ‘relatives’ under the Code, the SC has, however, read down this Section to provide that in relation to ‘connected persons’ it should only be persons who are connected with the business activity of the resolution applicant who are disqualified under Section 29A, rather than the original scope, which covered all ‘connected persons’.

4.    Distribution of Assets in Liquidation [Section 53]

The challenge to Section 53 on the ground that operational creditors are subordinate to all other creditors, including other unsecured financial creditors, in the liquidation process was rejected. The SC observed that the reason for differentiating between secured financial debts and unsecured operational debts is the relative importance of the two types of debts when it comes to the object sought to be achieved by the Code. Repayment of financial debt infuses capital in the economy.

With reference to workmen dues, which are also unsecured, it was observed that they have traditionally been placed above most other debts. Unsecured debts are of various kinds, and as long as there is some legitimate interest sought to be protected, having relation to the object sought to be achieved by the statute in question, Article 14 does not get infringed.

5.    Other Key Observations

  • The exemption granted to micro, small and medium enterprises under section 29A is valid. The rationale for excluding such industries from the eligibility criteria laid down in Section 29A(c) and 29A(h) is because in the case of MSME industries, other resolution applicants may not be forthcoming, which may inevitably lead to liquidation and not resolution.
  • The resolution professional is a facilitator of resolution plans whose administrative functions are overseen by the CoC and the NCLT. Therefore, it only has administrative and no quasi-judicial powers. On the other hand, when the liquidator ‘determines’ the value of claims admitted under Section 40, such determination is a ‘decision’, which is quasi-judicial in nature.
  • Circuit benches of the NCLAT are to be established by the Union of India within 6 months from the date of the order.
  • The NCLT and NCLAT must function under the Ministry of Law and Justice and not the Ministry of Corporate Affairs and the executive should follow the earlier judgements of the Court in this regard.
  • The constitutional challenge to the Code based on information utilities being private bodies and use of their records as conclusive evidence of default was rejected by the Court. It was noted that such evidence is only prima facie evidence of default, which is rebuttable by the corporate debtor and further referred to the requirements of authentication and verification by the corporate debtors.

[1] (2018) 1 SCC 407
[2] Section 35(1)(f) of the Code.
[3] Civil Appeal Nos. 9401-9405/2018, decided on October 4, 2018.

Date: January 29, 2019