Classification of Advance Payment Claims as Operational Debt: Intention Test

[Kartik Adlakha is a final year B.B.A., LL.B. (Hons.) student at Jindal Global Law School]

Insolvency and Bankruptcy Code (‘the Code’) defines ‘operational debt’ as claims arising in respect of provision of goods or services. The term ‘claim’ under the Code refers to right to payment or right to remedy for breach of contract if such breach gives rise to a right to payment. Due to the scheme of the Code, goods or service contracts where the buyer has not paid the seller for the goods received are squarely covered under operational debt. However, things get murkier in situations where the buyer has paid an advance amount to the seller but has not received any goods or services in exchange. In such a case, an important question of whether a claim arising without exchange of any goods or services can be classified as an operational debt needs to be answered. In January 2021, NCLT’s Mumbai bench has answered this question in Sunteck Realty Limited v Goodwill Theatres Private. The post will discuss this judgment in detail, along with others to analyze this conundrum in detail.

The issue was previously discussed in this post on this Blog.  

Factual Background

Goodwill Theatres Private Limited approached Sunteck Realty Limited for the redevelopment of their property. Both of them planned to sign a development management agreement for the same. Therefore, the parties signed a term sheet to agree on the basic terms and conditions of the development management agreement.

The term sheet appointed Sunteck Realty as the project manager for performing services in relation to the project as an agent/contractor of Goodwill Theatres in exchange for payment of development management fees. The scope of services included arranging finances, short fall funding, and taking all decisions related to the project in consultation with Goodwill Theatres. Scope of services and payment of development management fees were well captured within the clauses of the term sheet.

Term sheet stated that Sunteck Realty had to pay an advance token amount of INR 2.51 crores upon the signing of the term sheet which was to be returned along with interest on termination of the term sheet. The term sheet also stated that the parties would execute the development management agreement on or before expiry of two months from signing of the term sheet and if the parties fail to sign the agreement within the specified time period, the term sheet will automatically terminate unless extended in writing.

Sunteck Realty paid Goodwill Theatres INR 2.51 crores as advance upon signing of the term sheet, but the parties could not agree upon critical terms and conditions and therefore failed to sign the agreement. Sunteck Realty issued a demand notice to recover the advance token amount of INR 2.51 crores given to Goodwill Theatres but they failed to repay Sunteck Realty. As a last resort, Sunteck Realty filed a section 9 petition under the Code as an operational creditor, claiming default in repayment of the advance token.

However, Goodwill Theatres claimed that Sunteck Realty was not an operational creditor because Sunteck Realty didn’t supply any good or services to them. 

Main Issue

The main issue before the bench was whether the advance token amount claimed could be considered an operational debt under IBC.

Devising and Applying the Intention Test

NCLT noted that the intention of parties while executing the term sheet was to clearly indicate that Sunteck Realty was being engaged to perform services in relation to the project as an agent or contractor of Goodwill Theatres in exchange for payment of development management fees. Scope of services and payment of fees was also well defined in the term sheet. The NCLT further pointed out that the mutual obligations detailed in the term sheet, clearly demonstrated that Sunteck Realty was engaged to provide services to Goodwill Theatres, therefore the advance token given is part of the service rendered by Sunteck Realty and thus, should be construed as an operational debt. 

Analysis

It flows from Sunteck Realty Limited v Goodwill Theatres Private Limited, that as per the NCLT’s Mumbai Bench, the advance amount given in situations where the underlying basis of the advance amount is a contract to transfer goods or services, in these situations the advance amount given will be treated as operational debt, because the intention of parties was to engage in exchange of goods or services.  

However, other benches of the NCLT have a different view regarding this issue. In 2018, the NCLT’s Kolkata Bench in SHRM Biotechnologies Private Limited v VAB Commercial Private Limited came across the same issue. Here, SHRM Biotechnologies (‘SHRM’) had hired VAB Commercial (‘VAB’) to arrange an investor for SHRM. A mandate letter was issued by SHRM, which stated that SHRM would pay INR 3 lakhs as advance to VAB, which would be refunded to SHRM in case VAB failed to arrange any deal with a prospective investor for SHRM.

The mandate letter mentioned clearly that VAB would serve as an advisor to SHRM for the period mentioned in the same. Upon signing of the mandate letter SHRM paid the advance amount of INR 3 lakhs to VAB but VAB failed to arrange any deals with prospective investors for SHRM and neither refunded the advance paid upon completion of the time period mentioned in the mandate letter. Upon not receiving the repayment of advance despite the issue of a demand notice, SHRM proceeded to file a section 9 petition under the Code as an operational creditor.

However, the NCLT’s Kolkata Bench, refused to admit the application noting that there was no transfer of goods or services from VAB to SHRM. The bench pointed out that, as per the bench’s understanding, VAB was a service provider and a mandate letter was issued to engage VAB to provide advice to SHRM but concluded that in their opinion this debt did not arise from provision of goods or services, therefore it is not an operational debt.

The order was an unreasoned one, which jumped to hasty conclusions without any application of mind; because despite recognizing that the commercial nature of VAB in this transaction was of a service provider, the bench failed to classify the claim as an operational debt and also failed to recognize that the service of providing advice and arranging an investor was provided by VAB to SHRM though it did not result in an actual deal with an investor for SHRM. There not being a final deal does not mean that there was no transfer of services from VAB to SHRM. Moreover, the bench failed to give any cogent reasons as to why this claim could not be classified as an operational debt, the order lacked any reliable reasoning or analysis for the conclusion that the bench reached.

In 2020, the same issue arose before the Hyderabad Bench of the NCLT in Sri Lakshmikantha Spinners Ltd. v. Chinnam Poorna Chandra Rao, where Sri Lakshmikantha Spinners (‘Spinners Ltd.’) had paid the entire money in advance for various purchase orders of yarn to Ata Agro Commodities Limited (‘Ata Agro’)but received incomplete orders on various occasions. In the meanwhile, another financial creditor started insolvency proceedings again Ata Agro and Spinners Ltd. filed its claim for refund of the advance amount as a financial creditor before the interim resolution professional (‘IRP’); however the IRP refused to consider the claim and asked Spinners Ltd. to file again as operational creditor. Spinners Ltd. filed a petition under section 60(5) of the Code to appeal the IRP’s decision.

Spinners Ltd. relied on SHRM Biotechnologies Private Limited v VAB Commercial Private Limited (the case previously discussed) to show that they should not be considered as operational creditors because in SHRM, the bench held that claims arising from advance payment for goods or services were not a part of operational debt. However, Spinners Ltd. while relying on this case, failed to see that the bench in SHRM had also dismissed the application rather than admitting the same as financial debt.

The Hyderabad Bench, rightly ruled that this since this was a transaction involving procurement of goods and services, Spinners Ltd. could only be considered as an Operational Creditor and went on to ratify the decision of the IRP to consider Spinner Ltd.’s claim as operational debt. The Bench did not go into the question of whether advance payment claims should come under operational debt implying that the advance claims arising out of contracts regarding provision of goods or services still come under operational debt despite the fact that there was no actual exchange of goods or services.

Conclusion

The Code does not mention that there should be actual transfer of goods or services for a claim to be recognized as an operational debt. Section 5(21) of the Code only mentions that the claim should be “…in respect of provision of goods or services”, therefore it is unfair and irrational to deprive buyers of goods or services the benefit of the specialized debt recovery system put in place by the Code when sellers of goods have the same right to file under the IBC, when left unpaid for goods or services they have provided. Buyers should have the equal right to file under the IBC, when they have made advance payments but have not received goods or services in exchange.

To require actual exchange of goods and services to allow buyers to file under the IBC, means putting an additional artificial barrier for buyers to file under the Code, which was not intended by the legislature. The intention test applied by the NCLT’s Mumbai Bench in Sunteck Realty Limited v Goodwill Theatres Private provides a useful solution which combines both the legislative requirements for a claim arising from advance payments to be counted under operational debt by requiring that there be an underlying contractual intention to buy goods or services; and also puts buyers on an equal footing with sellers in terms of having a right to file under the IBC.

– Kartik Adlakha