[The Viewpoint] The Supreme Court ruling in Vidarbha: A dilution of Innoventive?

The Supreme Court judgment in Vidharba is likely to lead to situations where applications filed by OCs are given preference over applications filed by FCs for initiation of CIRP of a CD.
Pooja S Mahajan, Mahima Singh, Mehak Nayak
Pooja S Mahajan, Mahima Singh, Mehak Nayak

The Insolvency and Bankruptcy Code, 2016 (IBC) enables financial creditors (FCs) and operational creditors (OCs) of a corporate debtor (CD) to initiate the corporate insolvency resolution process (CIRP), under Section 7 and Section 9 of the IBC, respectively. The Supreme Court delved deep into these provisions for the first time in the landmark case of M/s Innoventive Industries Ltd v. ICICI Bank & Anr, followed by another landmark case of Mobilox Innovations Private Limited v. Kirusa Software Private Limited.

Broadly, the Court laid down the following tests to be applied by the National Company Law Tribunal (NCLT), for admission of Section 7 and Section 9 applications:

Pertinently, in Innoventive, the Court held that if debt and default are established and the Section 7 application is defect-free, it must be admitted by the NCLT.

However, the apex court has, in its recent judgment in Vidarbha Industries Power Ltd v. Axis Bank Ltd, held that the NCLT has the discretion not to admit a CIRP application filed by an FC. In contrast, an application filed by an OC is mandatorily required to be admitted if it meets the requirements of the IBC and is complete in all respects.

Brief facts of the Vidharba case

Vidarbha Industries Power Limited (VIOL) is a company engaged in the business of production of electricity for which tariff is regulated by the Maharashtra Electricity Regulatory Commission (MERC) and the Appellate Tribunal for Electricity (APTEL). Axis Bank filed a Section 7 application against VIPL before the NCLT, Mumbai seeking to initiate the CIRP for default to the tune of ₹553 crore. VIPL was expecting a substantial amount of funds pursuant to a favourable order of APTEL, which was challenged by MERC before the Supreme Court. As per VIPL, the implementation of APTEL’s directions would enable it to clear its outstanding liabilities.

VIPL filed an application seeking a stay on the Section 7 proceedings before the NCLT as long as MERC’s appeal against the APTEL order was pending in the Supreme Court. The NCLT dismissed the stay application, which was challenged by VIPL before the National Company Law Appellate Tribunal (NCLAT). The Appellate Tribunal dismissed the appeal, upholding the NCLT’s reasoning that once debt and default is established, the CIRP of a CD must necessarily be proceeded with. VIPL came in appeal before the Supreme Court.

The Supreme Court ruling

Section 7(5)(a) is directory, as opposed to Section 9(5)(a), which is mandatory

The Court examined the question as to whether Section 7(5)(a) of the IBC is a mandatory or discretionary provision. It observed that, ordinarily, the word ‘may’ is directory and the expression ‘may admit’ confers discretion to admit. On the other hand, the use of the word ‘shall’ postulates a mandatory requirement. As per the Court, there is no ambiguity in Section 7(5)(a) of the IBC and there was no cogent reason in this case to depart from the rule of literal construction.

It was observed that the legislature has, in its wisdom, chosen to use the expression ‘may’ in Section 7 5)(a) of the IBC, which is contrary to the use of the word ‘shall’ in an otherwise almost identical provision of Section 9(5)(i) of the IBC. It was, thus, apparent that the legislature intended Section 9(5((i) of the IBC to be mandatory and Section 7(5)(a) of the IBC to be discretionary.

Expedience Test

The Court held that, in the case of an application by an FC, the NCLT might examine the “expedience of initiation of CIRP”, taking into account all relevant facts and circumstances, including the overall financial health and viability of the CD, and may, using its discretion, not admit the application of an FC. In contrast, a CIRP application filed by an OC under Section 9(2) of the IBC is mandatorily required to be admitted if the application is complete in all respects and in compliance of the requisites of the IBC.

In this regard, the Court reasoned that legislature has consciously differentiated between FCs and OCs, given the innate differences between them, and observed that the impact of the non-payment of admitted dues could be far more serious on an OC than on an FC. It also remarked that the IBC does not countenance dishonesty or deliberate failure to repay the dues of an OC.

Significantly, the Court further observed that there is no doubt that a CD who is in the red should be resolved expeditiously, following the timelines in the IBC and without any extraneous matter in the way, but that “the viability and overall financial health of the Corporate Debtor are not extraneous matters."

Specifically on the facts of Vidarbha, the Bench observed that while disputes of the CD with the electricity regulator or the recipient of electricity may not be of much relevance, an award of the APTEL in favour of the CD could not be completely disregarded by the NCLT/NCLAT when it is claimed that, in terms of the award, an amount far exceeding the claim of the FC, is realisable by the CD.

It held that the existence of a financial debt and default in payment of such debt only gave the FC the right to apply for initiation of CIRP. The NCLT is required to “apply its mind to relevant factors” including the feasibility of initiation of CIRP, in this case, against an electricity generating company operated under statutory control, the impact of MERC’s appeal pending before the apex court, the order of APTEL and overall financial health and viability of the CD under its existing management.

Observing that it is not the object of the IBC “to penalize solvent companies, temporarily defaulting in repayment of its financial debts, by initiation of CIRP”, the Court held that Section 7(5)(a) of the IBC confers discretionary power on the NCLT to admit an application of an FC under Section 7 of the IBC. However, it added a note of caution for the NCLTs, observing that such discretionary power cannot be exercised arbitrarily or capriciously. The NCLT would have to consider the grounds made out by the CD against admission, on their own merits.

With the above observations, the Court set aside the orders of the NCLAT and the NCLT and further directed the NCLT to reconsider VIPL’s application for stay on further proceedings.

Our thoughts

The IBC is widely regarded as path-breaking legislation which ushered in a new regime for resolution of corporate insolvency in a time-bound manner, to ensure value maximisation in the best interests of all stakeholders. A key step towards attainment of these objectives is swift admission of defaulting companies into CIRP, so that further value erosion on account of delay is prevented.

Before Innoventive, there was ambiguity on the parameters to be borne in mind by NCLTs while adjudicating an application under Section 7 of the IBC. CDs would often come up with various defences, including the plea that the default was unintentional or occasioned due to circumstances beyond their control, or that they were otherwise commercially solvent. This ambiguity was put to rest by the twin objective tests of ‘debt’ and ‘default’ laid down by the Supreme Court in Innoventive, which largely helped settle and streamline the process of adjudication of Section 7 applications. In Innoventive, the Court categorically held that,

The moment the adjudicating authority is satisfied that a default has occurred, the application must be admitted unless it is incomplete...”.

This principle has since been applied by NCLTs and NCLAT while considering Section 7 applications. However, the Court's decision in Vidarbha marks a significant departure from this principle.

As per Vidarbha, before admitting a Section 7 application, NCLTs have a discretion to consider circumstances beyond debt and default and examine whether it is expedient to initiate CIRP. While the Court has added a note of caution that such discretionary power cannot be exercised arbitrarily or capriciously, the parameters for exercise of such discretion are not clear, leading to an element of subjectivity in the adjudication process.

It also gives rise to the question whether, apart from debt and default, the NCLTs are now required to apply the ‘balance sheet insolvency’ and/ or ‘commercial insolvency’ test in order to determine whether a Section 7 application is to be admitted or not. Notably, except for a handful of cases where the CD is clearly insolvent and unable to pay its debts, such as where its operations are shut with no possibility of payment, in almost every case, the CD will have the opportunity to argue that the Section 7 application should not be admitted since it is unable to pay the FC due to extraneous factors. The question of what constitutes extraneous/non-extraneous factors would have to be discerned as per the varied facts of each case. For instance, a CD may argue that its assets are in excess of its liabilities or that it is expecting significant receivables in the future or that it has assets to be monetized or that it is otherwise commercially solvent.

The judgment also leads to the question whether there should be any real distinction between FCs and OCs who want to file an application for CIRP against a CD. It appears that henceforth, provided there is no pre-existing dispute, the route to initiate CIRP will effectively become easier for OCs, when compared to that for FCs, even if the FCs’ debt is significantly larger. This can be tested by contemplating the following hypothetical situation for a CD:

  • X owes an amount of ₹10 crore to an OC towards supply of certain goods to X. There is a default and no pre-existing dispute. The OC files a Section 9 application for initiation of CIRP of X. The application is complete in all respects. X does not have the funds to pay the amount in full, but is expecting a receivable of ₹500 crore under an order which is under challenge before the Supreme Court.

  • X owes an amount of ₹100 crore to an FC towards certain loan facilities extended by the FC to X. After default, the FC files a Section 7 application for initiation of CIRP of X. The application is complete in all respects. X does not have the funds to pay the amount in full, but is expecting a receivable of ₹500 crores under an order which is under challenge before the Supreme Court.

Now, applying Vidarbha, the NCLT will mandatorily have to admit the Section 9 application filed by the OC of X, even though X has a contingent receivable which far exceeds the operational debt. However, the NCLT will have the discretion not to admit the Section 7 application filed by the FC on the ground that it is not expedient to initiate the CIRP of X in view of the expected receivable of ₹500 crore. This is likely to lead to inequitable and incongruous outcomes. It is also likely to lead to situations where applications filed by OCs are given preference over applications filed by FCs for initiation of CIRP of a CD.

While it is true that the IBC is not a recovery mechanism, the fear of admission into CIRP has led to significant financial discipline amongst the CDs and multiple out-of-court settlements, with substantial recoveries for both FCs and OCs. The driving force behind this has been clear and unambiguous tests for admission of CD into CIRP as laid down by the Court in Innoventive and Mobilox.

The decision of the Court in Vidharba appears to have diluted the tests for admission laid down in Innoventive. The introduction of the expedience test for admission of Section 7 applications is likely to lead to protracted litigation over what constitutes expedience, further delaying adjudication of such applications before NCLTs, which are already grappling with a huge backlog on account of various factors, including shortage of members. It is also likely to deter FCs from filing Section 7 applications in the future, fearing delay and attendant costs.

Pooja S Mahajan is Managing Partner, Mahima Singh is Managing Associate and Mehak Nayak is an intern at Chandhiok & Mahajan.

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