Corporate Insolvency: Boundaries of Operational Debt: Part 2

[Job Michael Mathew is a V year student at NALSAR University of Law, Hyderabad

Part 1 in the series is available here]

Following from the issues set out in Part 1, I now discuss the meaning of ‘goods/services’ as used in section 5(21). While the meaning of ‘goods’ is clear and settled on account of definition in Sale of Goods Act, the meaning of ‘service’ does not enjoy the same certainty. The term is defined in a number of statutes such as the Service Tax Act, Chapter V of Finance Act 1994 amongst others.  For example, in the Service Tax Act it is defined in extremely wide terms bringing within its ambit any activity done by one person for another person for consideration with a few exceptions such as sale of goods, transfer of immovable property, a transaction in money or actionable claims[1].

In Jindal Steel and Power Limited v DCM International Limited, it was held that the definition of service in Service Tax Act cannot be imported to the Code as the Code and the Act stand on completely different footing. This is because one is a fiscal statute for levying taxes on services for which the legislature has cast a wide net whereas the Code is in relation to insolvency which has serious and crippling consequences and therefore needs to be construed strictly. What then is the meaning of service as used in Code? In Parmod Yadav v Divine Infracon it was held that ‘goods/services’ as used in section 5(21) are those that relate to the direct input to the direct output supplied or produced by the corporate debtor. Such a reading is informed by the combined reading of regulation 32 of  Insolvency and Bankruptcy Board of India ( Insolvency Resolution Process for Corporate Persons) Regulations, 2016 and section 5(21) of Code.  Regulation 32 defines ‘essential goods and services’ for the purposes of section 14(2) dealing with the obligation on part of essential goods or services providers to continue with its provision during the time of moratorium.

The essential goods and services referred to in section 14(2) shall mean-

(1) electricity; (2) water; (3) telecommunication services; and (4) information technology services, to the extent these are not a direct input to the output produced or supplied by the corporate debtor. Illustration- Water supplied to a corporate debtor will be essential supplies for drinking and sanitation purposes, and not for generation of hydro-electricity.

The tribunal decided that since ‘essential goods and services’ are those that are not a direct input to the output produced or supplied by the corporate debtor, ‘goods and services’ are those that are a direct input to the output produced or supplied by the corporate debtor.  It is humbly submitted that such reasoning gives rise to a number of unintended consequences.

First of all such reasoning assumes that there are only two categories of goods and services, i.e., goods and services used as direct input for output and essential goods and services such as water and electricity which is required for the continued working of a business. It fails to account for a third category of goods or services that are not used as direct input nor required for the continued operation of the business. Let us take the example of a mining company that wants to set up an indoor sports facility in its corporate headquarters for its employees. They contract the work to X Limited and then refuse to make payments at the time of payment. The services that X Limited provided are neither direct input for output nor essential for the continued operations of the company. Does this mean X Limited will not have a claim under section 5(21)?  In M/s Value Line Interiors Private Limited v M/s Shipra Hotels Limited, it was held that an entity that provided interior fitting work to a corporate debtor is an operational creditor. The corporate debtor in this case was a hotel and considering the example used in regulation 32 it is difficult to say that interior fitting services are a direct input in the output of a hotel. In any case, the tribunal did not undertake such a discussion and held the same to be an operational debt after holding that providing interior fitting works amounts to service.

Secondly, regulation 32 identifies only four categories of goods and services. The Insolvency Law Committee recommended that a proviso be added to section 14(2) which states that for continuation of supply of essential goods or services other than as specified by the Insolvency and Bankruptcy Board of India (IBBI), the interim resolution professional (IRP) or the resolution professional (RP), as the case may be, shall make an application to the NCLT and the NCLT will make a decision in this respect based on the facts and circumstances of each case. This recommendation was however not accepted and therefore according to the Code essential goods and supplies are limited to just four categories. Does this mean that operational debts can only arise with respect to these four categories of goods or services? We know from decided cases that this is not so and yet this is a direct implication of the reasoning that gives meaning to goods or services in section 5(21) on the basis of regulation 32.

Thirdly, under the combined reading of section 5(21) and regulation 32, what happens to providers of essential goods and services? If operational debt extends only to goods and services and not essential goods and services then how will the claims of providers of essential goods be adjudicated under the code? Practically, this may not be a problem because the amounts due to such providers are deemed to be part of the insolvency resolution costs and payments due to them are separated from that of operational and financial creditors. However, the above is only true in a situation when the providers continued to provide such services after the imposition of moratorium. In a situation where they are not required to continue those services after the moratorium and they are owed some money, the amount due to them will not be made a component of insolvency resolution costs.  The priority accorded to essential suppliers can be said to be consideration for not terminating the supply even after default and playing a role in the rescue of the company.  When certain supplies are essential for the business, its termination or demand for better terms on the onset of the insolvency process can hamper the rescue process and section 14(2) aims to prevent the same. If those suppliers were not called upon contribute to the rescue of the company by continuing to supply at the same terms during the moratorium, there arises no need to give them priority over other creditors. Therefore, in a situation when such suppliers are owed money before the imposition of moratorium, how will their claims be addressed?

In light of these problems it is humbly submitted that the meaning of ‘goods and services’ in section 5(21) should not be derived from regulation 32.  While, the definition of service from a fiscal statute may not be appropriate for the Code, affording any exclusionary understanding to the term without explaining the policy rationale behind the same will lead to confusion and chaos.

Thus, in order to answer the question that was posed at the beginning of the post the most important part of the puzzle is whether undertaking to make electricity, maintenance and other payments amount to a service or not.  In Metal Power Analytical India Private Limited, in the same fact situation the tribunal held that such payments due are not operational debt as they do not fall within any of the four categories and there was no assignment of debt in favour of the applicant as well.  The argument advanced in this post, i.e., there is a claim on account of breach of contract and the claim relates to provision of goods or services was not tested in this case. 

In conclusion, it is my view that it wrong to hold that only entities that have supplied or provided goods or services can initiate insolvency proceedings.  As long as there is a claim and the claim relates to a provision of goods or services, it does not matter whether the person filling was the one who supplied goods or services.  Secondly, if a claim arises out of a breach of contract, it needs to be tested if the breach relates to provision of goods or services and not whether the contract itself relates to it. Thirdly, the meaning of the term ‘service’ as used in section 5(21) requires clarification either from the legislature or the judiciary.

[Concluded]

Job Michael Mathew

[1] Section 65B(44), Chapter V of Finance Act 1994.

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