[Tanisha Gautam is a 4th year B.A., LL.B. (Hons.) student at the Institute of Law, Nirma University, Ahmedabad]
The Insolvency and Bankruptcy Code, 2016 (IBC) established the boundaries between ‘financial debt’ and ‘operational debt’, which has been further clarified and expounded upon by the judiciary over time. The landmark judgment by the Supreme Court in Global Credit Capital Limited v. Sach Marketing Pvt. Ltd. revolves around the categorization of Sach Marketing’s claim against Mount Shivalik Industries Limited (corporate debtor) as either a financial or operational debt under the IBC. The proper classification of a security deposit amount as a financial or operational debt formed the crux of the matter. By virtue of this precedent, the Supreme Court has shed light on the intricate distinctions between these two types of debts, providing the much-needed clarity and guidance.
Brief Facts of the Matter
The dispute arose from two agreements dated April 1, 2014, and April 1, 2015 (the Agreements), between the corporate debtor and Sach Marketing. Under these Agreements, the corporate debtor appointed Sach Marketing as a ‘sales promoter’ to promote its beer, with the condition that the latter must deposit a minimum-security amount (Rs. 53,15,000/- in the first Agreement and Rs. 32,85,850/- in the second Agreement) with the corporate debtor, on which interest at 21% per annum would be paid. Initially, Sach Marketing filed a claim as an operational creditor, which was subsequently withdrawn; it later filed a claim as a financial creditor. The interim resolution professional (IRP) partially acknowledged the claim as operational and financial debt. However, the claim was denied on the grounds that Sach Marketing could not be deemed a financial creditor.
Aggrieved by this decision, Sach Marketing challenged it before the National Company Law Tribunal (NCLT), but the challenge was dismissed. Meanwhile, the NCLT approved a resolution plan submitted by Kals Distilleries Pvt. Ltd. for the corporate debtor’s insolvency resolution process. Sach Marketing appealed to the National Company Law Appellate Tribunal (NCLAT). On such appeal, the NCLAT concluded that Sach Marketing should be designated as a financial creditor rather than an operational creditor based on the nature of the claims arising out of the Agreements.
Analyzing the Supreme Court’s Ruling
The Supreme Court in the present case laid down clear tests determining the type of debt. It established that to construe whether a debt is operational or financial, it is necessary to ascertain the ‘real nature of the transaction covered in writing’.
Observations on Operational Debt
The Supreme Court elucidated a crucial principle regarding the determination of whether a debt arising from a written agreement for rendering services qualifies as an operational debt or a financial debt under the IBC. The Court emphasized that the written document cannot be taken at face value; instead, it is imperative to ascertain the real nature of the transaction through a meticulous examination of the agreement’s provisions.
In the present case, the court scrutinized the Agreements between the corporate debtor and Sach Marketing, who was appointed as a sales promoter. Despite the purported service agreements, several factors indicated that the substantial security deposit amount paid by Sach Marketing did not bear a correlation with the services to be rendered. Notably, the meagre monthly payment of Rs. 4,000/- and the absence of any commission linked to sales performance raised doubts about the genuine nature of the Agreements.
Furthermore, the Supreme Court observed that while the Agreements permitted termination with a 30-day notice period, they conspicuously lacked any provision for the forfeiture of the security deposit. This absence of a forfeiture clause, coupled with the corporate debtor’s obligation to refund the security deposit with 21% interest after the specified period, led the Court to conclude that the security deposit payment had no nexus with the performance of other contractual obligations by Sach Marketing.
Consequently, the Supreme Court concurred with the NCLAT’s determination that the security deposit amounts represented debts covered by section 3(11) of the IBC. Sach Marketing’s entitlement to seek a refund of the security deposit with interest constituted a ‘claim’ within the purview of section 3(6) of IBC, as it represented a right to payment. Importantly, the Supreme Court clarified that for a debt to qualify as an operational debt under section 5(21) of the IBC, the claim must be concerning the provision of goods or services. In the context of a service contract, there must be a direct correlation between the agreed service and the claim. Upon examining the facts of the case and applying the relevant law, the Court determined that only the amount of Rs. 4,000/- paid by the corporate debtor to Sach Marketing for promoting the beer would be classified as an operational debt and, consequently, the substantial security deposit amount, being unrelated to the purported services, could not be classified as an operational debt.
Observations on Financial Debt
The Supreme Court laid down a comprehensive test to determine whether a debt qualifies as a financial debt under section 5(8) of the IBC. This test involves a two-fold analysis:
- Satisfaction of the Initial Requirement
The Supreme Court emphasized that cases covered by categories (a) to (f) under section 5(8) of the IBC must firstly satisfy the initial requirement laid down in the earlier part of the provision. This prerequisite mandates the existence of a ‘debt along with interest’, wherein the interest must be considered against the ‘time value of money’. The Supreme Court in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and Phoenix ARC Private Limited v. Spade Financial Services Limited upheld that the existence of disbursement against consideration for time value of money is an essential requirement even for transactions covered under clauses (a) to (i) of section 5(8) of IBC defining financial debt. In the present case, the Court found that this initial requirement was met, since there existed a debt with an interest rate of 21% per annum, indicating consideration for the time value of money.
- Fulfillment of the Conditions under Clause (f) of Section 5(8), IBC
Having satisfied the initial requirement, the Supreme Court proceeded to examine the applicability of clause (f) of Section 5(8) of the IBC, which covers transactions not falling within the purview of clauses (a) to (e). However, clause (f) imposes two specific conditions: firstly, the amount must be raised under a transaction not covered by clauses (a) to (e) and, secondly, the transaction must have the ‘commercial effect of borrowing’.
The Supreme Court observed that in this case there were written arrangements for the transfer of funds to the corporate debtor. These arrangements fulfilled the definition of ‘transaction’ under section 3(33) of the IBC, which includes an agreement or arrangement in writing for the transfer of assets, funds, goods, etc., from or to the corporate debtor, consequently meeting the first condition of clause (f). Subsequently, to determine whether the second condition was satisfied, the Supreme Court relied on the three crucial observations.
- The Supreme Court asserted that as per the terms of the Agreements between the corporate debtor and Sach Marketing, the latter had to provide a security deposit to the former. Significantly, none of the two Agreements contained provisions regarding the forfeiture of the security deposit, implying that the corporate debtor was obligated to refund the security deposit.
- Further, the NCLAT held that since the security deposit payment bore no connection with the fulfillment of any other contractual obligations under the Agreements, the security deposit amounts constituted debts covered by the definition under section 3(11) of the IBC. This determination stemmed from the fact that Sach Marketing’s entitlement to demand a refund of the security deposit along with interest qualified as a ‘claim’ within the purview of section 3(6) of the IBC.
- Notably, the corporate debtor’s financial statements for the relevant fiscal years reflected the interest paid to Sach Marketing on the security deposit amount under the headings ‘long-term loans and advances’ and ‘other long-term liabilities’. This accounting treatment was a crucial factor that led the Supreme Court to conclude that the amount raised under the Agreements had the commercial effect of borrowing. This mirrors the reasoning in Pioneer Urban Land and Infrastructure Ltd. v. Union of India where amounts raised upfront from parties with the commercial intent of temporary use of funds and returning an equivalent asset later, while accounting for interest component, were held to have the commercial effect of borrowing under section 5(8)(f) of the IBC. Therefore, the expansive interpretation of commercial effect of borrowing laid down in Pioneer Urban Land has been effectively applied in the present case to categorize the disputed amounts as ‘financial debt’ by looking at the commercial substance and accounting treatment rather than just the form of the Agreements.
In light of these observations, the Supreme Court affirmed that the second condition of clause (f) of section 5(8) was satisfied, thereby establishing the debt as a financial debt under the IBC.
Conclusion
The landmark ruling of the Supreme Court in Global Credit Capital has profound implications for the Indian insolvency resolution framework. By providing a comprehensive two-pronged test to determine whether a debt qualifies as a financial debt, considering the existence of interest against the time value of money and the commercial effect of borrowing, the Court has brought crucial illumination to this critical aspect of the IBC.
This judgment holds significant implications for various stakeholders involved in the insolvency resolution process. Proper categorization of creditors as financial or operational creditors is crucial for their participation, voting rights, and distribution of proceeds during the resolution process. Furthermore, the clear tests laid down by the Supreme Court will help avoid disputes and litigation regarding the nature of debts, streamlining the insolvency resolution process.
The ruling also provides valuable guidance to corporate debtors, creditors, resolution professionals, and adjudicating authorities, enabling them to navigate the complexities of debt classification more effectively. As a landmark ruling from the highest court, this judgment will promote uniformity in the interpretation and application of the provisions of the IBC related to financial and operational debts. Ultimately, this decision reinforces the underlying principles of the IBC, promoting a more efficient and equitable insolvency resolution process in India.
– Tanisha Gautam
