Supreme Court Decision in Vidarbha: Return to the Pre-IBC Era

[Abhismita Goswami is a Trainee Associate at Mindspright Legal, Mumbai]

An application for initiating a corporate insolvency resolution process (“CIRP”) under the Insolvency and Bankruptcy Code, 2016 (“IBC”/ “Code”) can be filed with the National Company Law Tribunal (“NCLT”) by the financial creditors (“FCs”) and operational creditors (“OCs”) of a corporate debtor (“CD”), under section 7 and section 9 of the IBC, respectively.

Section 7 stipulates that once the NCLT has received an application, it must ascertain the existence of default within 14 days. Unless the application is incomplete, it is bound to admit the application if the NCLT is satisfied that a default exists and that there are no disciplinary proceedings against the proposed interim resolution professional. The Supreme Court strengthened the law in this regard in the landmark case of Innoventive Industries Ltd. v. ICICI Bank wherein the Court held that if debt and default are established, and the application is complete, it must be admitted by the NCLT.

The Code provides for the conduct of CIRP in a time-bound manner for faster resolution, and to ensure the same, the Legislature kept “default” as the parameter for admission of an application for initiation of CIRP under section 7. The simple test of “default” made sure that neither a CD nor the NCLT uses any other irrelevant or extraneous factors which can delay the admission of an application.

However, the Apex Court, in its recent finding in the case of Vidarbha Industries Power Limited v. Axis Bank Limited, has deviated from this long-settled position and held that section 7(5)(a) of the IBC confers discretionary power on the NCLT not to admit a CIRP application filed by a FC even if it satisfied that a debt exists and the CD is in default. It further observed that, in contrast, the NCLT has to mandatorily admit an application filed by an OC under Section 9 if it meets the requirements of the Code.

This post seeks to analyse the Supreme Court ruling and how it would impact the IBC regime, especially when there is already an inordinate delay in admitting companies into CIRP.

The Supreme Court ruling in the Vidarbha case

For the first time, the Supreme Court was called upon to examine the interpretation of the word “may” used in section 7(5)(a) of the IBC. The Court delved into the question as to whether the power conferred upon the NCLT under the said Section is mandatory or discretionary. Taking note of the fact that the Legislature used the word “may” in Section 7(5)(a), whereas used “shall” in section 9(5)(a), the Court observed that the usage of two different words in almost identical provisions convey that the Legislature intended section 7(5)(a) to be discretionary and section 9(5)(a) to be mandatory in nature.

The Court, while observing that the NCLT must apply its mind to the relevant factors before exercising discretion to decide whether an application should be admitted, held that the viability and overall financial health of the CD is not an extraneous matter but rather a relevant factor to be considered by the NCLT. Taking note of the ethos of the IBC to be resolution and not recovery, the Court concluded its decision on the premise that the Code does not penalise solvent companies which have temporarily defaulted on payment of its financial dues.

The Court noted that the existence of financial debt and default in payment of such debt only gives the FC the right to apply for initiation of CIRP and not a right to have the application admitted based on such default. Concluding that the NCLT has discretionary power under Section 7(5)(a) to admit an application of an FC, the Court added a note of caution, observing that such discretion should not be exercised arbitrarily and the same has to be informed by reasons.

Implications in the insolvency law regime

The Innoventive case had cleared the ambiguity regarding the criteria to be followed by NCLTs while admitting an application of an FC. Before Innoventive, the CDs used to come up with the defence that the default was not intentional or the same occurred due to exceptional circumstances or that the companies were otherwise solvent. This turmoil was put to rest by the Apex Court in Innoventive.

The law under section 7 so far has been that if the two ‘D’s, i.e., debt and default, are established, the NCLT would have to admit the CD into insolvency. However, by way of the Vidarbha decision, the Supreme Court has added another ‘D’ (discretion) in the mix. The NCLTs have the discretion to apply their mind and reject an FC’s application for initiation of CIRP even when the other two Ds have been established.

This decision has unsettled a basic feature of the legislation, taking it back to the pre-IBC regime. The order has rejected “default” as the fundamental criterion and has reverted to the pre-IBC parameter of “inability to pay”. This practically negates the conscious legislative decision of keeping “default” as the criteria to initiate CIRP and thereby frustrates the Code in itself. Needless to say, the Apex Court has not considered the precedents set by itself.

After considering the recommendations of the Bankruptcy Law Reforms Committee, the Legislature had taken a mindful decision to shift the parameter of initiating insolvency against a company from “inability to pay debt” to “existence of a debt” and “non-payment”. The word “inability” was obliterated so as to welcome a new era of faster, better and more efficient resolution. However, this judgement defeats the very purpose of this paradigm shift.

Justice Nariman in Swiss Ribbons v. Union of India elaborately considered this shift in the legislative policy and observed that it was for the reason that section 433(e) of the Companies Act, 1956 was repealed by the Code and a change in approach was brought in. There were four policy reasons for this shift, one of them being that the cause of default is not relevant in a situation of financial stress.

The decision of the Supreme Court in Vidharbha Industries has taken the insolvency regime to the pre-Innoventive era, where the CD had the opportunity to argue that the FC’s application should not be admitted since the company defaulted for extraneous factors or that it is commercially solvent or that it holds an award in its own favour, expecting significant receivables in the future which would enable it to clear its dues. The NCLTs are not equipped to make decisions on the financial viability of a CD, and while time and again the Apex Court has affirmed the commercial wisdom of the FCs, this judgement has taken away the power to make credit decisions from them.

This judgement has further triggered the question as to whether an application filed by an FC is essentially different from one filed by an OC for initiation of CIRP. Considering an example where an FC has filed an application for a claim of Rs. 200 crores and a separate application has been filed by an OC for a claim of Rs. 300 crores while the CD holds an award expecting a significant receivable of Rs. 700 crores and now applying Vidarbha, it can be concluded that for the same set of facts, an application by the OC would be mandatorily admitted while the NCLT can exercise discretion to reject the application of the FC even when default has been established. The Apex Court has clearly failed to consider this situation which would inevitably lead to inequitable outcomes in the future and create unwarranted confusion. This would give rise to multiple litigation questioning the discriminatory treatment of applications filed by FCs.

The IBC, which provided for a new regime for resolution of corporate insolvency in a time-bound manner, ensuring maximisation of the value of the assets of the CD, would likely lose much of its effectiveness after this judgement. One of the key factors which helped in attaining the objects of the Code was the swift admission of a CD into CIRP. However, as a result of the present decision, an examination of the financial health of the CD and its ability to pay its financial dues, coupled with the discretion of the NCLT to hold admission in abeyance indefinitely, would undoubtedly lead to even longer delays in admission, and the assets of the CD would see further value erosion on account of delay. The ruling has disturbed the long-settled jurisprudence, which was designed to ensure the objectives of IBC are achieved. This order has serious implications for debt recovery and resolution in the economy.

– Abhismita Goswami

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