Classification of unpaid interest as Operational Debt: Clear, but not so clear!

The Insolvency and Bankruptcy Code, 2016 defines operational debt in Section 5(21) as being a ‘….claim in respect of the provision of goods or services….’.

Accordingly, any default pertaining to the non-payment of dues by the buyer to the seller would fall within the category of operational debt. The operational creditor, i.e. the seller, would be well within its rights to claim such debt by preferring an application under Section 9 of the Code if such debt exceeds rupees one crore.

This position, however, opens up a path of ambiguity when one thinks about the interest that such sellers would want to claim in addition to the contractual amount in view of the delayed payment.

The situation becomes particularly interesting in the context of enterprises covered under Micro, Small and Medium Enterprises Development Act, 2006 (MSME Act), which was enacted specifically to promote, develop and facilitate micro, small and medium enterprises in India.

Section 15 of the MSME Act expressly states that if the buyer fails of make timely payment to the seller, the buyer shall "be liable to pay compound interest with monthly rests to the supplier on that amount from the appointed date or, as the case maybe, from the date immediately following the date agreed upon, at three times of the bank rate notified by the Reserve Bank."

The express legal stipulation in the MSME Act on the payment of interest has further increased the confusion on the categorization of such interest as operational debt. Companies are repeatedly receiving notices from creditors threatening insolvency actions on the basis of unpaid interest amounts, despite having cleared payments in relation to the principal amount.

Court rulings excluding interest from the ambit of operational debt

The NCLT Chandigarh Bench, in its order delivered on April 18, 2017 in Wanbury Ltd. v. Panacea Biotech Ltd., on being called upon to answer the question as to whether the claim for interest falls within the term ‘debt’ under the Code, disallowed such claim. The NCLT analyzed the difference between the definition of ‘financial debt’ and ‘operational debt’ and held that while interest formed a part of the definition of ‘financial debt’, it was notably absent from the definition of ‘operational debt’ and accordingly the intention of the legislature was not to include interest within the ambit of operational debt.

Additionally, the NCLT held that the invoices filed by the appellant did not contain any specific clause for interest and therefore there was no justification for the payment of interest. On appeal to the NCLAT, the matter was amicably settled between the parties, and accordingly no ruling was passed on merits of the matter.

Subsequently, the NCLT New Delhi Bench, in its order delivered on August 31, 2017, in Teknow Consultants & Engineers Pvt. Ltd. v. Bharat Heavy Electricals Limited, on being faced with the question on interest in relation the MSME Act, disallowed the claim for interest of the appellant on the basis that there was a specific clause in the agreement between the parties which stipulated that no interest shall be payable on any money due to the appellant.

Additionally, the NCLT held that since the appellant was registered under the MSME Act, a claim regarding the interest could only be referred to the Micro and Small Enterprises Facilitation Council for adjudication.

The NCLT Mumbai Bench, in its order dated February 1, 2018, in Swastik Enterprises v. Gammon India Limited,dealt with a situation where a claim under the Code was made on unpaid interest while admittedly the principal amount had been paid. The NCLT held that for a claim of interest to be allowed, there needs to be cogent evidence and proper documentation and such rate of interest should have been agreed upon by the parties.

Additionally, it was held that mere filing of a calculation sheet by the appellant would not establish interest. Accordingly, the claim for interest was disallowed on the basis of inadequate documentation and there being no agreement for the payment of interest between the parties.

Thereafter, the NCLT Mumbai Bench, in Govind Sales v. Gammon India Limited, dealt with a situation where the applicant was seeking to recover its interest amount under Section 15 and 16 of the MSME Act from the alleged corporate debtor. It was an admitted position that the entire principal amount had been paid by Gammon India to Govind Sales. On the plea raised by Gammon India regarding the status of Govind Sales as an MSME, the NCLT held that the applicant had merely annexed an ‘Udyog Aadhar Memorandum-Online Verification’ form to evidence its status as an MSME.

Additionally, the ‘applied for’ and ‘added on’ date on the form was subsequent to the execution of the agreement between the parties. The NCLT held that the existence of Govind Sales as an MSME was disputable and that the tribunal had limited powers to adjudicate on such dispute. Accordingly, the application was dismissed.

Alternate approach being adopted in certain rulings

The aforementioned rulings tend to shift the balance in favour of the corporate debtor in relation to a claim being preferred solely for the purpose of recovering interest. In certain rulings, however, the NCLT has taken a different view of the issue.

The NCLT Mumbai Bench in its order dated April 10, 2017, in DF Deutsche Forfait AG and Ors. v. Uttam Galva Steel Ltd., while adjudicating on an application filed under Section 9 of the Code for default in principal amount along with interest and dealing with the contention that a demand for interest along with the principal amount would turn the debt into a financial debt, held that interest could be claimed along with operational debt in case there was delay in repayment.

This ruling was, however, appealed in the NCLAT and was struck down.

More specifically in relation to the MSME Act, the NCLT Hyderabad Bench, in ShriKrishna Rail Engineers Private Limited v. Madhucon Projects Limited, on an application filed by an operational creditor which was an MSME for default in payment along with interest, held that interest could be claimed even though no such provision was there in the agreement between the parties or that the operational creditor had not approached the council under MSME Act. It is pertinent to note that the operational creditor had proved its MSME status by filing a memo along with a gazette notification.

Further, the NCLT Kolkata Bench, in its order dated December 19, 2018, in Gulf Oil Lubricants India Limited v. Eastern Coalfields Limited, while dealing with an application for interest as operational debt with the entire principal amount being already paid, held that the amount towards interest would also constitute debt recoverable from the corporate debtor.

It is pertinent to note that the NCLT noted that the invoices under which the goods were sold clearly indicated that the overdue amounts were carrying interest beyond the credit period. Accordingly, since each invoice contained the signature of the corporate debtor, the payment of interest was accepted by the corporate debtor. It was further noted that the claim for interest in the demand letter issued by the operational creditor was not disputed in the reply by the corporate debtor. Further, there was an indemnity bond executed between the parties which did not contain any condition but only mentioned full indemnity in case of any default.

Resolving the Conundrum – Efforts by the NCLAT

The aforementioned decisions of the NCLT created an ambiguous situation wherein applications in relation to interest on operational debt in certain situations were rejected, in view of inadequate documentation and absence of any specific contractual stipulation for such interest. Parallelly, certain applications claiming interest as operational debt were allowed.

The NCLAT, thereafter, in a series of judgments, has sought to set the record straight on the categorization of interest as operational debt.

In its order in SS Polymers v. Kanodia Technoplast Limited, the NCLAT, while dealing with an appeal in relation to an application preferred under Section 9 of the Code for the interest amount of over 2 lakhs, when the principle amount had been paid, held that such an application, only for recovering the interest, went against the principles of the Code and evidenced malicious intent which was barred by Section 65 of the Code. Accordingly, the appeal was dismissed.

Subsequent, in SBF Pharma v. Gujarat Liqui Pharmacaps Pvt. Ltd, the NCLAT noted that the appellant was pursuing the application under Section 9 of the Code only for the recovery of interest, which evidenced malicious intent of part of the appellant and such conduct was barred by Section 65 of the Code. Accordingly, no relief was granted to the appellant.

The NCLAT’s order in M/s Steel India v. Theme Developers Pvt. Ltd. also becomes important in this context. The NCLAT, on hearing an appeal preferred in relation to an application under Section 9 of the Code for recovery of interest amounting to INR 22,64,054, rejected the appeal on multiple grounds.

While the NCLAT quoted the aforementioned cases of SS Polymers and SBF Pharma, it shied away from rejecting the claim merely on the basis that outstanding interest would ipso facto not fall within the ambit of operational debt. It was noted that while outstanding interest would be an actionable claim, such interest had to be properly agreed between the parties.

Additionally, the NCLAT noted on the analysis of an earlier demand notice and correspondence thereto that there was an existing dispute in relation to the payment of interest on the date when the demand notice for the initiation of CIRP was issued by the appellant, and accordingly an application under Section 9 for the recovery of interest could not be entertained.

Subsequently, the NCLAT in Neeraj Jain v. Cloudwalker Streaming and Flipkart India Private Limited dealt with an application under Section 9 of the Code wherein the operational creditor made claims in relation to the value of goods along with seeking damages on account of custom charges, interest amount, and loss on account of non-taking of items delivered.

The NCLAT rejected the claim in relation to the value of goods because the operational creditor had not produced any record, purchase order, invoice or any document to substantiate its claim. Similarly, while rejecting the claims in relation to other losses, the NCLAT stipulated that such claims had not been ‘crystallized’.

Additionally, particularly in relation to the interest amount, the NCLAT held that while the operational creditor had claimed INR 7.75 crore as interest amount, Clause 13 of the supply agreement between the operational creditor and the alleged corporate bebtor limited the liability of Flipkart to INR 5,000 and accordingly, such high interest could not be demanded.

Conclusion

While cases such as Teknow Consultants, Swastic Enterprises, Goving Sales, Steel India and Flipkart delve more into specific stipulations in the contract and other documentary evidence produced by the parties, the rulings in Wanbury, SS Polymers and SBF Pharma have not shied away from categorically excluding interest from the ambit of operational debt.

The rulings of NCLT in Uttam Galva, ShriKrishna Rail Engineers and Gulf Oil Lubricants which have taken the view that unpaid interest would fall within the ambit of operational debt go against the rulings of the NCLAT which hold to the contrary. Accordingly, it would be fair to say that such rulings of NCLT are per incuriam in view of the position of law established by the NCLAT.

Such contrary rulings, however, have resulted in increasing the confusion around the issue with operational creditors still preferring to make applications under Section 9 of the Code for unpaid interest. Additionally, the rulings in Teknow Consultants, Swastic Enterprises, Goving Sales, Steel India and Flipkart end up raising the question as to whether interest would be payable if a contract has the relevant provisions in relation to interest or a party can produce adequate documents to evidence the payment of interest was pre-agreed amongst parties.

Accordingly, a pronouncement from the Supreme Court on this issue would bring about the much-needed clarity required on this aspect of law.

Tabrez Malawat (l) is a Partner and Gibran Naushad (r) is a Senior Associate at The Guild – Advocates and Associate Counsel.