The Dilemma of Jurisdiction under Arbitration and Insolvency: Another Trolley Problem? – Part II

[Kartikey Sanjeev Bhalotia and Arshit Kapoor are 2nd year students at National Law University Odisha]

In lieu of the conclusion in the previous post, the authors opine that in a case where there exists an arbitrable dispute between the parties, the admission of an application under section 7 of the IBC can undermine the sanctity of a contract and the underlying trust required for every business transaction. This is because it would be against public policy for a party to a contract to be permitted to settle claims not by proceeding under the arbitration clause which was created under free will and sound mind, but instead through the relatively easy route under section 7 of the IBC.

This view is supplanted by Supreme Court’s ruling in Embassy Property Development Pvt. Ltd. v. State of Karnataka wherein the court held that the scope of section 238 of the IBC cannot be extended to override the public policy of India. Moreover, such law would be detrimental to India’s long-standing aim of establishing itself as an arbitration-friendly jurisdiction.

In the scenario where an arbitrable dispute does not have a bearing on the determination of ‘debt’ and ‘default’, a legal interpretation favouring the IBC to the Arbitration Act becomes problematic when the respondent under a section 7 application has not made the requisite payment on account of the pending arbitrable dispute between the parties. An admission of a section 7 application in such a scenario would essentially lead to the creation of legal duress on the respondent, for it would have to face insolvency despite being solvent and financially capable of repayment. In such context, the applicant would be bestowed with superior bargaining power and the respondent would have to settle for an unjustified consideration. This is completely contradictory to the aims and objectives of the IBC.

Different requirements for applications under section 7 and section 9

It is important to understand the reason behind creating a difference in standards for admission of an application under section 7 and section 9 of the IBC. Volume 1 of the report of the Bankruptcy Law Reforms Committee (‘BLRC Report’), while laying down the rationale behind the different requirements in dealing with applications filed under section 7 and section 9, observed:

“While both types of creditors can trigger the IRP under the Code, the evidence presented to trigger varies. Since financial creditors have electronic records of the liabilities filed in the Information Utilities of Section 4.3, incontrovertible event of default on any financial credit contract can be readily verifiable by accessing this system. The evidence submitted of default by the debtor to the operational creditor may be in either electronic or physical form, since all operational creditors may or may not have electronic filings of the debtors’ liability. Till such time that the Information Utilities are ubiquitous, financial creditors may establish default in a manner similar to operational creditors.” [at page 77]

The above observation clearly points towards one of the primary reasons behind the different tests for admission of applications under the said provisions. In laying down the above reasoning, the BLRC assumes that electronic documentations and records of default filed in the information utilities can objectively determine every financial debt and its consequent default. However, the above assumption fails in cases where the very existence of the objectively documented debt or default depends upon the subjective interpretation of the contract between the parties.

Moreover, clause 8 of the Insolvency and Bankruptcy Bill and the Supreme Court in Swiss Ribbons Pvt. Ltd. v. UOI have reasoned that the existence of genuine disputes is more likely in cases of operational debts than in cases of financial debts [at paragraph 27]. This is based on the assumption that operational debts may involve subjective analysis with respect to the quality of goods or services, or the existence of the debt itself; whereas financial debts are objectively and electronically documented thereby negating the possibility of genuine disputes as to the existence of debts and defaults between the parties. This cannot be held to be true in all circumstances. An example of this exception is well documented in the facts of Indus Biotech where even in a case of financial debt there was a dispute as to the existence of default between the parties.

Possibility of Subjective Analysis in Financial Debts

The above analysis of the legislative and judicial reasoning for the exclusion of the test of pre-existing dispute from section 7 of the IBC shows that the assumption made throughout the authorities mentioned above does not hold in all circumstances. This is because financial debtors primarily transact with banking and financial institutions, which is not the case in present IBC jurisprudence. The expanding definition of financial creditors has created great room for financial relations that are governed by contracts that call for subjective analysis in determining various rights and obligations of the parties.

In the case of an operational debt, there exist possibilities of subjective analysis of the terms of the contract between the parties. Similar possibilities may arise in the case of a financial debt, which were not contemplated by the legislative authorities while assuming the absolute objectivity of such debts. For example, a dispute may arise between a corporate guarantor and a corporate debtor with respect to the manner of payment of the amount of subrogation, where the contract of corporate guarantee includes an arbitration clause. There may also arise a dispute between the parties to a capital lease agreement regarding the condition of assets received by the corporate debtor.

In both of the above examples, the dispute between the parties may not have any bearing on the existence of the default in the objective sense. However, such default is highly likely to be on account of the existence of a dispute between the parties. In the first example, the corporate debtor may have defaulted due to the uncertainties of the manner of payment. In the second example, the corporate debtor/lessee may not have paid the instalments as the condition in which the assets are received by him may not be in terms with the contract. The resolution of these disputes would boil down to the subjective interpretation of the contract.

Concluding Remarks

The above analysis shows that a policy decision that has the effect of giving room for genuine arbitrable disputes (that do not have a bearing on the existence of debt and default) under section 7 of the IBC, would not be contrary to the legislative intent behind the exclusion of the test of pre-existing dispute from the provision. The authors find that there is an immediate need for the legislature and other appropriate authorities to come up with a middle ground that is in the interest of justice and public policy.

[Concluded]

– Kartikey Sanjeev Bhalotia & Arshit Kapoor

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