[Sikha Bansal is a Senior Associate at Vinod Kothari & Company and can be reached at [email protected]]
The ruling of the Supreme Court in Pioneer Urban Land and Infrastructure vs. Union of India comes as a breather for home-buyers, as it upholds the constitutional validity of the amendments made last year to section 5(8) of the Insolvency and Bankruptcy Code, 2016 (IBC). Section 5(8) defines ‘financial debt’ as a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes “any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of borrowing” [clause (f)]. An explanation was inserted by virtue of the Insolvency and Bankruptcy (Second Amendment) Act, 2018 wherein “any amount raised from an allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing”.
In this post, while analyzing the arguments put in favour of and against the said amendments, the author seeks to identify potential areas where answers still remain unaddressed or where the questions have become more complicated.
Arguments against treatment of home-buyers as financial creditors
The prominent arguments made against the amendment are that the deeming fiction has been stretched to absurd limits and one cannot do away with the essentials of being a financial creditor. The case of home-buyers do not involve “debt”, there is no “borrowing”, there is no “disbursal” and no “sum raised”. Section 5(8) is concerned only with transactions in which finance is involved. Instead of deeming that home buyers be regarded as financial creditors, they ought to be regarded as operational creditors. Classifying home-buyers as financial creditors would then blur this distinction between financial and operational contracts.
Besides, there is a specific law in the form of the Real Estate (Regulation and Development) Act, 2016 (RERA) dealing with the issues surrounding home-buyers. Also, given that the National Company Law Tribunal (NCLT) may have to delve into the “intent” and “bona fides” of the applicant allottee, the benches may have to bear the onslaught of real estate cases. As such, the explanation seeks to put a square peg in a round hole.
Arguments in favour of inclusion of home-buyers as financial creditors
On the other hand, there were arguments put in favour of the amendment. In substance, the allottees finance the project in which they will ultimately be given apartments. Section 5(8)(f), even read without the explanation, would, on its plain language, include real estate development agreements.
“Payment” includes “recompense” and “borrow” means “to obtain or receive money on loan for temporary use intending to give either money or something equivalent back to the lender” – here, “something equivalent” would be the apartment. In order to show that a “commercial” angle is involved, profit element is important.
“Time value of money” is present qua both allottee and builder – (i) allottee would pay less for a completed apartment where entire consideration is to be paid up front, while in case of under-construction projects, the payment would be in instalments (thereby involving more money); and (ii) The builder is actually receiving money in the form of “advance” which would be used to finance the building of the flats/apartments.
Moving to RERA, once a right under section 18 thereof, which provides for return of amount and compensation, is established, the same is enough to qualify the allottee as financial creditor. Also, under RERA, promoter is obliged to put 70% of moneys received from allottees in a separate account which can only be used for the project. These show that the transaction is a financing transaction. Where allottees finance a project by 100%, the IBC could not work until they are recognized as financial creditors.
Observations of the Supreme Court
The Supreme Court considered the report of the Insolvency Law Committee which deliberated that if forward sale or purchase transactions are structured as a tool or means for raising finance, there is no doubt that the amount raised from allottees may be classified as financial debt under section 5(8)(f). The Insolvency Law Committee in turn referred to the ruling in Nikhil Mehta and Sons (HUF) v. AMR Infrastructure Ltd, NCLAT, New Delhi, Company Appeal (AT) (Insolvency) No. 07/2017. Therefore, it was clarified that such amounts raised from an allottee fall within section 5(8)(f).
The provisions of RERA are in addition to and not in derogation of the provisions of the IBC and these laws provide parallel remedies to allottees. However, the IBC is not meant to be a debt recovery mechanism; hence, given the “bonafides of the allottee”, it is only such allottee who has completely lost faith in the management of the developer who will move the NCLT. Once the allottee establishes a prima facie case of ‘default’, the burden shifts on the developer, in order for dismissal of the application, to prove that – (i) the allottee himself is a defaulter, or (ii) the process under IBC has been invoked fraudulently, with malicious intent or for any purpose other than insolvency resolution, or (iii) the allottee is a speculative investor and merely wants to jump ship and uses IBC as a coercive measure to get back monies already paid by it.
Further, real estate developers must be distinguished from operational debtors, because – (i) in operational debts, a person supplying the goods or services is a creditor, which is exactly the opposite in real estate projects; (ii) an operational creditor has no interest in or stake in the corporate debtor, while an allottee is vitally concerned with the financial health of the corporate debtor; and (iii) in an operational debt, there is no consideration for the time value of money, but in real estate projects, money is raised from the allottees against time value of money (as explained earlier).
Comparing home-buyers with fixed deposit-holders and debenture-holders, the Court remarked that these can be assimilated – in all these cases, financial contracts need not involve large sums of money, and these are not directly involved in assessing the viability of the corporate debtor.
Some lingering questions
Though the Supreme Court, in unequivocal terms has upheld the constitutional validity as well the rationale behind the amendments calling for treatment of allottees of real estate projects as ‘financial creditors’, there are some continuing questions or concerns which remain either unnoticed or not addressed in details, as discussed below –
The deeming fiction
Notably, the explanation to section 5(8)(f) creates a deeming fiction, without going into the facts, circumstances or nature of the agreements between the allottee and the developer, that all amounts raised from the allottees shall be “deemed” to be having commercial effect of borrowing. If the explanation is merely clarificatory, then creating a deeming fiction, per se, becomes counter-intuitive. Therefore, there might be cases where the effect might not be that of a “commercial” “borrowing”, but it may still be regarded as falling within the purview of a financial transaction.
For instance, where the real estate developer relies on the funding provided by the banks or financial institutions or its equity, and uses the amounts paid by allottees to meet the cost of such debt and equity and not as “financing” tool. Basically, the developer is adjusting the amounts paid by allottees against the financial debt raised from banks or financial institutions or against the costs incurred by the developer from its own funds. The amount may not be contributing to ‘financing of construction of the asset’, but rather be an apportionment towards cost of debt and equity. In such a scenario, it is difficult to accept the transaction as financing arrangement.
As also noted in Nikhil Mehta and Sons, all forward sale or purchase transactions may not be financial transactions – similarly, all real estate transactions between an allottee and a developer cannot be coloured with the same brush. Although the Insolvency Law Committee noted the observations made by NCLAT, it went on to classify the amounts raised under real estate contracts, effectively as “means of raising finance”.
Boundaries and essence of “time value of money”
The basic differentiation between financial and operational creditors was carved out by Bankruptcy Law Reform Committee (BLRC) that financial creditors are related to the debtor through a pure financial contract (such as loan or debt security), operational credit arises out of transaction on operations.
Hence, for financial transactions, IBC stipulates that there must be “time value” of money involved, that is, the one who disburses debt, should get consideration for time value of money. This, per se, does not negate the presence of time value of money in operational transactions. For instance, where goods are purchased on cash versus when goods are purchased on credit, there might be price differences (lower in cash, higher in credit). Also, “advances” need not always be in the form of ‘financing facility’ – the supplier may require ‘advance’ as a deterrent from the customer backing out from the transaction once the supplier has initiated work relying on the orders placed by the customer. Needless to say, advance payments also serve as working capital for businesses; but again, the intent of the person tendering advance is not to earn something on it, but to have goods or services (which are not consideration for time value of money). If ‘time value of money’ is taken as the sole factor for determining the nature of debt, then probably, all business transactions would qualify as financial transactions – which could not have been the scheme of things BLRC envisaged.
In the author’s view, what distinguishes a financial transaction from an operational transaction is the predominant intention of earning consideration for time value of money. That is, in case of a financial contract, the prominent intention of the borrower is to have “money”, and that of the financier is to have “money on money”; while in case of operational transactions, the dominant intention of the parties is to “exchange” money for something equivalent as a part of operations, wherein time value of money may be incidental (credit transactions), or may be in the form of penal levies (say, interest for delay in delivery of goods by the supplier or interest for delayed payments by customer). In real estate transactions, it cannot be said that the primary intention of allottees is to earn consideration for time value of money – their objective is to have an apartment. Merely because “time value of money” is involved incidentally, it should not change the fundamental nature/premise of the transaction.
Default under IBC and default under RERA and consequential remedies
Undoubtedly, IBC and RERA operate in different spheres; as such, the meaning and purview of “default” under both the laws are different with consequential provisions for remedy. Discussing RERA first, say a developer fails to complete project in time, then according to its section 18, an allottee who wishes to withdraw from the project can demand return of the amount tendered by the allottee along with interest and including compensation. This remedy is without prejudice to any other remedy available. In case the allottee is not intending to withdraw from the project, he is to be paid interest for the period of delay.
Now, if the scenarios are observed in the context of IBC, an allottee who wishes to withdraw from the project cannot be said to be interested in resolving the insolvency of the developer – he would be merely interested in getting his money back for which IBC is surely not the right place. Insofar, an allottee who does not intend to withdraw but wants possession, he has a claim (in the form of right to remedy for breach of contract), and there might also be a case of default (on the basis of argument that payment is payment in money or something equivalent – here, apartment); however, whether the nature of claim (and consequentially, debt) is financial or operational will depend on a number of factors (as discussed above).
The conundrum of ‘operational debt’
Operational debt is a claim in respect of provision of goods or services [section 5(21) of the IBC]. The definition is silent on whether the claim is only the claim of a person arising out of provision of goods or services by that person or it includes the claim of a person who paid an advance to obtain goods or services from the corporate debtor. Where operational debt includes advances received from customers, there seems to be no reason for differentiating real estate developers from operational debtors.
(Dis)parity with fixed deposit-holders and debenture-holders
The nature of transactions involving investments in fixed deposit and debentures is purely financial, and needs no elaboration. The intention of both these types of investors is to earn consideration for time value of money. No clarity or deeming fiction is required to include these transactions in the category of financial transactions. As such, whether the fixed deposits or debentures involve large sums of money or not, and whether the fixed deposit-holders or debenture-holders have the “ability to assess viability” of the corporate debtor or not, these are financial creditors fundamentally. As such, there is no comparability of the allottees with fixed deposit-holders and debenture-holders.
Objectives of IBC & NCLT
The IBC is primarily focused on solving the non-performing asset (NPA) problem in the country and it seeks to address the problem by addressing the root cause – which is ‘insolvency’ gauged by ‘default’. Placing allottees in the same pedestal as financial creditors will lead to overburdening the NCLTs across the country. The NCLTs have not been constituted to address real estate concerns but to address the broader problem of NPAs. Hence, the objectives of the IBC may suffer dilution on account of treatment of real estate transactions as financial transactions.
Understandably, the amendments as well as the ruling have a benevolent side towards addressing the plight of thousands of home-buyers who would have been rendered remedy-less by real estate developers, consumer fora, or even RERA. The Supreme Court seems to have put the hammer down; however given the complexity of transactions and the points above, the scenario may still be foggy.
– Sikha Bansal