Scrutinizing the Status of Settlement Agreements Under the IBC

[Neelabh Niket is a 4th Year B.A., LL.B. (Hons.) student at Hidayatullah National Law University in Raipur]

On 3 June 2022, the New Delhi Bench of the National Company Law Tribunal (NCLT) in Ahluwalia Contracts (India) Limited v. Logix Infratech Private Limited (Ahluwalia) rekindled the debate on the commencement of the Corporate Insolvency Resolution Process (CIRP) by creditors on the premise of a settlement agreement. While dealing with an operational debt in the instant case, the NCLT held that a default under the terms and conditions of a settlement agreement does not constitute an ‘operational debt’ for the purposes of the Insolvency & Bankruptcy Code, 2016 (IBC). The judgement, thus, joins a list of several other cases wherein both the financial and operational creditors have been denied the right to initiate CIRP based on a settlement agreement. More disconcertingly, it raises serious concerns around the future and validity of such agreements while enforcing claims under the IBC. This post intends primarily to assail these judgements while scrutinizing the validity of the settlement agreement concerning both financial and operational creditors.

Financial Creditors

Financial creditors have had to bear a heavy brunt due to the adverse orders passed by the adjudicating authorities rejecting their claims to initiate CIRP based on a settlement agreement. For instance, the National Company Appellate Tribunal (NCLAT) in Amrit Kumar Agrawal v. Tempo Appliances Pvt. Ltd held that merely breaching the terms of any agreement, including a settlement agreement by a party whereby some payment was due, would not fall within the scope of section 5(8) of IBC, so as to constitute a ‘financial debt’. Importantly, the NCLAT also held that, in such agreements, there is (a) no disbursement against the consideration for the time value of money, and; (b) the element of commercial borrowing is missing. In a similar vein, the NCLT Delhi in Nidhi Rekhan v. Samyak Projects Pvt Ltd held that a debt obligation arising out of a settlement agreement cannot be attributed as a financial debt.

The judgements culminated in a rather peculiar situation wherein debts which were perfectly ‘financial’ before the settlement agreement lost their inherent nature to become a standard debt, now unenforceable under the IBC. In a way, the creditor paid the cost of entering into a settlement agreement with the debtor, based on mutual trust and confidence. Therefore, a major question that arises then is whether such an arrangement between the parties operates to change the very nature of debt owed to the financial creditor, thereby rendering it outside the purview of the Code.

In all fairness, an affirmative answer to the above question would militate against the very soul and purpose of the Code. An erstwhile financial debt, albeit now found under the settlement agreement, nonetheless remains a loan disbursed against the consideration for the time value of money. The settlement agreement does not rewrite the terms and consideration under which the credit facility was originally availed by the debtor. Even after the execution of the settlement agreement, the status of both the creditor and the debtor remains intact. It is not out of place to cite Seethai Mills Ltd. v. N Perumalswamy wherein the Supreme Court held the following:

It may be that the original debt had merged in the decree and the person who was originally a creditor had become a decree-holder afterwards, but that does not in any way destroy his character as a creditor or the character of the money due to him from the company as a debt.” [emphasis supplied]

Additionally, it is to be kept in mind that obligations in the settlement agreement do not arise in thin air, but they owe their existence to prior financial liability that remained due. Thus, it is imperative not to interpret settlement agreements in isolation and one must take their foundation into account before determining their admissibility under the Code. A classic example of the same may be found in Kolla Koteswara Rao v Dr Sk Srihari Raju wherein the NCLT carefully located a financial debt under a sale agreement relating to a piece of land. The summarized facts are that the corporate debtor owed some amounts to the lender and had failed to repay it. A one-time settlement agreement (OTS) was entered into by the parties to settle the claims. The applicant (being the financial creditor) deposited a substantial amount with the lender under the OTS on behalf of the Corporate Debtor. The applicant and the corporate debtor entered into a sale agreement to clear the debt against the corporate debtor. However, the agreement was terminated at the instance of the corporate debtor and the financial creditor demanded repayment of the amount which it had paid on the behalf of the corporate debtor. Ideally, the consideration for such sale would have been the land itself but, due to the provisions of the settlement agreement read together with the interest component in the sale agreement, the amount advanced by the creditor was said to be classified as disbursement against consideration for the time value of money and hence considered a ‘financial debt’ by the NCLT.

Admittedly, not all obligations to repay a certain debt under the settlement agreement can be classified as financial debt. It is necessary that such debt shall arise out of a right of claim and must be defaulted when it becomes payable.  In Arenja Enterprises v Edward Keventer Successors Pvt,  the NCLAT implied that financial creditors could rely on a settlement agreement or a subsequent consent decree for initiating CIRP, provided that there was money advanced by the creditor which was utilized by the debtor for increasing the returns, and that there was a default on the account of the corporate debtor. In Mphasis Limited v. Strategic Outsourcing Services Pvt Ltd, a sum of Rs. 4 crores advanced by the creditor was not considered to be a financial debt, as the settlement agreement did not stipulate a higher return of the money advanced.

Thus, it is not necessary that only a loan agreement will alone classify a debt as financial debt. The Supreme Court held emphatically in Pioneer Urban Land and Infrastructure v. Union of India that sub-clause (f) section 5(8) of the Code is a ‘catch-all’ phrase which subsumes within its amounts raised under transactions which are not necessarily loan transactions, so long as they have the commercial effect of a borrowing.

Operational Creditors

Due to the intrinsic nature of an operational debt, the road for the operational creditors to enforce such a settlement agreement seems to be much easier and straightforward. The Code acknowledges that these creditors are not concerned with resuscitating and improving the financial health of the corporate debtor. Thus, the pre-requisites for classifying the debt either as disbursed against the consideration for the time value of money or commercial borrowing do not apply. On the contrary, the fact that the corporate debtor has admitted its liability under the settlement agreement is a testament to the fact there is no pre-existing dispute between the parties and that all the claims have been settled before a demand notice is sent to the corporate debtor as required under section 8(1) of the Code. It must, however, be noted that the right of payment acquired by the operational creditor and debt payable in the settlement agreement shall be in respect of the goods and services as provided by the operational creditor to the corporate debtor.

The recent judgement in Ahluwalia has also failed to make a note of a series of other judgements which have rightly allowed the operational creditors to commence CIRP against the corporate debtors relying on a settlement agreement.

Conclusion

In sum, the adjudicating authority shall focus on the background and the nature of the debt owed to the creditors for determining the admissibility of the settlement agreement or any other similar agreement for commencing insolvency proceedings. In essence, if any agreement stands on a commercial borrowing or a right of payment that arises in respect of goods and services due to that agreement, as a thumb rule, such agreements shall be allowed to form the basis for initiation of a CIRP. A categorical clarification by the Supreme Court on the matter would surely ease the matter and settle the debate once and all. 

Neelabh Niket

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