Supreme Court Upholds Constitutionality of the Insolvency and Bankruptcy Code

“The defaulter’s paradise is lost. In its place, the economy’s rightful position has been regained”[1]

It is not at all surprising that those affected by debt recovery and insolvency legislation, being primarily debtors, would mount constitutional challenges to those legislation. Earlier examples include challenges to the Sick Industrial Companies (Special Provisions) Act, 1985 (D Ravikumar v Union of India) and its repeal (ATV Projects (India) Limited v Union of India), the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (Delhi High Court Bar Association v Union of India) and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Mardia Chemicals Limited v Union of India).

Consistent with the above trend, the Insolvency and Bankruptcy Code, 2016 (the “Code”) also faced a constitutional challenge. In a significant ruling, the Supreme Court of India yesterday in Swiss Ribbons Pvt Ltd v Union of India rejected the challenge and upheld the constitutional validity of the Code. The purpose of this post is to outline the various grounds on which the petitioners challenged the constitutional validity of the Code, and the Supreme Court’s ruling on those.

Background

The Supreme Court began by noting the pre-existing state of insolvency law in India and the factors that led to the enactment of the Code. The multiplicity of legislation and fora led to calls for a unified and comprehensive legislation. The Court then clarified its aversion to interfere in matters of policy that underpin economic legislation, referring to this idea as “judicial hands-off qua economic legislation”. In doing so, it addressed in a rather lengthy manner the development of the jurisprudence in the United States on this aspect, before dealing with the Indian legal position. The Court clarified that the constitutionality of the Code must be viewed in the light of such a judicial approach. Finally, The Supreme Court carefully analysed the objectives of the Code as outlined in the Preamble, as interpreted in its previous decision in Innoventive Industries Ltd v ICICI Bank Ltd. It re-emphasised that the primary focus of the legislation is to achieve corporate resolution of the debtor and to avoid liquidation, and that too in a time-bound manner, to protect the interests of various stakeholders.

Administrative Challenges

In the above background, the Court began by considering various challenges mounted on administrative matters. The first was that the selection committee for appointment of members of the National Company Law Tribunal (“NCLT”) and the National Company Law Appellate Tribunal (“NCLAT”) was dominated by bureaucrats rather than judicial members. The Court noted that this was addressed by amendments to section 412 of the Companies Act, 2013 that were made in 2017, by which parity was achieved. In any event, the original composition of the selection committee was such that it consisted of two judicial members and two bureaucrats.

On the question of accessibility, the Court noted that the availability of the bench of the NCLAT only at New Delhi was inadequate and that, based on an assurance of the Attorney General, it directed the Union of India to establish circuit benches of the NCLAT within a period of six months.

On a related matter, the Court found that the functioning of the NCLT and the NCLAT under the Ministry of Corporate Affairs instead of the Ministry of Law was contrary to the jurisprudence laid down in Union of India v R Gandhi, President Madras Bar Association, and directed the Union of India to follow that judgment both in letter and spirit.

Classification between Financial Creditor and Operational Creditor

The most strident criticism against the Code has been its dichotomy between financial creditors and operational creditors, and that fact that only the financial creditors have a seat at the table when deciding the fate of an insolvent debtor. In the present case, the petitioners challenged the validity of this legislative design on the ground that it amounted to discrimination under Article 14 of the Constitution, and focused on the fact that such a distinction has not been made anywhere else in the world. In dealing with this contention, the Court set out the jurisprudence regarding classification for purposes of Article 14 and then analysed the provisions of the Code dealing with the dichotomy between financial creditors and operational creditors. It then went only to discuss the rationale for the distinction catalogued in the report of the Bankruptcy Law Reform Committee (“BLRC”).

In rejecting this challenge to constitutionality, the Supreme Court observed that financial creditors are mostly secured creditors, while operational creditors are mostly unsecured. This is a distinction well understood in company law, not just in India but elsewhere as well. Moreover, financial creditors tend to be few in number, while operational creditors could be many. Moreover, financial debts are usually simple to prove based on documentation, while operational debts tend to be riddled with disputes regarding supply of goods or services. The Court then went on to note:

  1. Most importantly, financial creditors are, from the very beginning, involved with assessing the viability of the corporate debtor. They can, and therefore do, engage in restructuring of the loan as well as reorganization of the corporate debtor‘s business when there is financial stress, which are things operational creditors do not and cannot do. Thus, preserving the corporate debtor as a going concern, while ensuring maximum recovery for all creditors being the objective of the Code, financial creditors are clearly different from operational creditors and therefore, there is obviously an intelligible differentia between the two which has a direct relation to the objects sought to be achieved by the Code.

The fact that financial creditors can prove their debts based on information provided by the information utilities cannot be subject to misuse in view of harsh penalties prescribed in the Code for wrongful claims by financial creditors.

As for disenfranchisement of the operational creditors in the decision-making process, the Court again relied on the elaborate rationale set out in the BLRC’s report. Since financial creditors are in the financial business, they are best placed to assess the viability of the corporate debtor and the steps to be taken for its resolution. On the other hand, the involvement of the operational creditors is short-lived, and they are only interested in recovery. Moreover, the NCLT has an obligation to ensure that the operational creditors receive at least liquidation value, which effectively protects their interests despite their not having a say in the decision-making process. For these reasons, the Supreme Court found no discrimination against operational creditors under Article 14 of the Constitution.

Settlement Process

Section 12A was inserted into the Code to provide that a resolution applicant can seek the withdrawal of an insolvency proceeding if it is approved by a 90 percent voting share of the committee of creditors. This constitutionality of this provision too was challenged in the case. The Court considered the background to the issue (as previously discussed on this Blog). The Court did not see any difficulty in the need for such a high threshold for approval of a withdrawal as a proceeding under the Code was a collective proceeding, being in rem. Moreover, the legislation policy was explained in the report of the Insolvency Law Committee (“ILC”) that recommended the provision. Hence, the Court found no issue regarding the validity of section 12A of the Code.

Institutions under the Code

The roles and functions of several institutions set up under the Code were called into question in this case, albeit unsuccessfully. For instance, the Court found no apprehension with information being provided by information utilities under the Code, as the utilities carry significant responsibilities as outlined in the Code. Moreover, the information regarding defaults as provided by an information utility is only prima facie evidence, which can be rebutted by the corporate debtor.

Similarly, the Court doused concerns raised regarding the role of the resolution professional, and curbed fears that the professional usurped adjudicatory powers. The Court recognised that the resolution professional only carries administrative powers under the Code (and not quasi-judicial powers). Ultimately, the resolution professional’s actions are carried out under the scrutiny of the NCLT.

Ineligible Bidders

Section 29A of the Code, which lists out persons not eligible to be resolution applicants, has attracted a great deal of controversy due to its expansiveness. In ArcelorMittal India Private Limited v. Satish Kumar Gupta, the Supreme Court offered a purposive interpretation of the legislative provision.

The first issue that came about in the present case is whether section 29A had retrospective application. The Supreme Court began by noting that 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 this passing” (para 64). Resolution applicants were found to have no vested rights to be considered in a resolution process and, hence, no such right was taken away by section 29A.

The Court was called upon to decide the scope of section 29A(c) and specifically whether it can relate only to situations involving malfeasance. It noted that the legislative purpose of section 29A is such that it “includes persons who are malfeasant, or persons who have fallen foul of the law in some way, and persons who are unable to pay their debts in the grace period allowed”. Sub-section (c) of section 29A also deals with the account of a person that has been declared a non-performing asset (“NPA”) by the Reserve Bank of India (“RBI”). After a review of the relevant RBI Master Circulars, the Court found that “accounts are declared NPAs only if defaults made by a corporate debtor are not resolved”. A grace period of one year is given to such person to pay off the debt and, during this period, “it is clear that such person can bid along with other resolution applicants to manage the corporate debtor”. The Court then went on to hold:

  1. … The legislative policy, therefore, is that a person who is unable to service its own debt beyond the grace period referred to above, is unfit to the eligible to become a resolution applicant. The policy cannot be found fault with. Neither can the period of one year be found fault with, as this is a policy matter decided by the RBI and which emerges from its Master Circular, as during this period, an NPA is classified as a substandard asset. The ineligibility attaches only after this one year period is over as the NPA now gets classified as a doubtful asset”.

Further, there was a constitutional challenges to the residual provision in section 29A(j), which makes the ineligibility criteria applicable to a “connected person” as well. In particular, it relates to the definition of a “related party”, which is defined in section 5(24) of the Code. The petitioners specifically raised the concern that the mere fact that a person happened to be a relative of an ineligible bidder cannot ascribe such ineligibility to such person as well, subject to satisfaction of other qualifications. Here, the Court narrowed down the scope of the provision by holding:

  1. We are of the view that persons who act jointly or in concert with others are connected with the business activity of the resolution applicant. Similarly, all the categories of persons mentioned in Section 5(24)A) show that such persons must be “connected” with the resolution applicant within the meaning of Section 29A(j). This being the case, the said categories of persons who are collectively mentioned under the caption “relative” obviously need to have a connection with the business activity of the resolution applicant. In the absence of showing that such person is “connected” with the business of the activity of the resolution applicant, such person cannot possibly be disqualified under Section 29A(j). …

[Emphasis supplied]

The Court also found adequate rationale for exclusion of small and medium industries from the eligibility criteria laid down in sections 29A(c) and 29A(h) as “other resolution applicants may not be forthcoming, which then will inevitably lead not to resolution, but to liquidation”.

Some Observations and Conclusion

In this case, the Supreme Court adopted a broader approach to uphold legislation that deals with economic matters. It did so in the context of a tumultuous background (prior to the enactment of the Code) and failure of prior legislation. The Court also placed emphasis on the fact that the operation of the Code has been continuously monitored with periodic amendments introduced within a short span of time. It also lays out the statistics in terms of effectiveness of the Code thus far in light of settlements and successful resolutions.

One aspect that is worth noting is that the Court extensively relied on the law reform process to elicit the rationale for various provisions of the Code. In that sense, the careful work carried out both by the BLRC as well as the ILC have enabled the Court to adopt a more robust view of the constitutionality of the various provisions of the Code.

Once again, the Supreme Court has complemented the rescue culture instilled by the Court by limiting challenges by debtors and paved the way for continued implementation of the corporate resolution process that has been underway for the last two years.

[1] Supreme Court of India in Swiss Ribbons Pvt Ltd v Union of India, Writ Petition (Civil) No. 99 of 2012, judgement dated 25 January 2019 (para 86).

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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