[Aditya Chhangani is a practising advocate at the Rajasthan High Court]
The Bilateral Netting of Qualified Financial Contracts Act, 2020 (“Netting Act”) came into force with the goal of fostering stability and competitiveness in the Indian financial sector. In simple terms, netting means setting off any obligations or claims arising out of a Qualified Financial Contract (“QFC”). A single net payment obligation that is owed from one counterparty to the other can be ascertained by offsetting claims between two parties to a financial contract using the regulatory framework that the Act provides. The Netting Act effectively incentivizes banks and financial institutions to hedge their risks by entering into Credit Default Swap (CDS)-like arrangements, which are financial derivatives that function as a form of insurance against the default of a borrower. This would release greater capital for other functions such as granting new loans or carrying out investments, and thereby increase financial stability.
This article examines the Netting Act and its interplay with the Insolvency and Bankruptcy Code (“IBC”) in India. The Netting Act aims to foster financial stability by allowing netting of QFCs, thereby reducing overall exposure and mitigating credit and settlement risks. However, conflicts arise between the Netting Act, which permits netting proceedings during a moratorium, and the IBC’s provisions, which impose a moratorium to protect insolvent parties. The article delves into the non-obstante clauses in section 238 of the IBC and section 5(4) of the Netting Act, highlighting judicial interpretations and the need for a harmonized legal framework. It provides various suggestions including the adoption of international best practices to resolve conflicts and enhance legal clarity.
Impact of Netting under Qualified Financial Contracts
The Netting Act significantly impacts QFCs, particularly in the context of insolvency. By establishing a framework for close-out netting, which allows the termination of all outstanding contracts between two parties and the calculation of a single net amount owed, the law overrides the IBC and other statutes, ensuring that these netting agreements are enforceable even when one party becomes insolvent. This shift from the traditional pari passu principle gives the non-insolvent party super-priority, allowing them to settle claims independently of the general creditor pool. The law also enables financial institutions to calculate exposure on a net basis, reducing capital requirements and freeing up resources for lending and investment, thereby enhancing financial stability. Additionally, the Netting Act expedites the settlement of claims by allowing for the acceleration of obligations and determining a net settlement amount without needing the consent or notice of the insolvent party or the insolvency practitioner. It also limits the powers of insolvency practitioners, preventing them from nullifying netting agreements even in cases of preferential or undervalued transactions under the IBC. However, despite these advantages, the law has procedural ambiguities, particularly regarding the detailed process for close-out netting in insolvency situations, which may require further clarification or amendments for effective implementation.
Protections Laid Down for Insolvent Parties under the IBC
The term moratorium is not defined under the IBC, but the Merriam Webster dictionary defines it as “legally authorized period of delay in the performance of a legal obligation or the payment of a debt; a waiting period set by an authority; or a suspension of activity”. Section 14 of the IBC protects an insolvent party, after the commencement of the moratorium period. Section 14(1)(b) clearly prohibits, “transferring, encumbering, alienating or disposing of by the corporate debtor any of its assets or any legal right or beneficial interest”, once the moratorium period has been declared. The applicability of section 14(1) of the IBC nowhere explicitly excludes any financial contract entered into by the party. In the case of P. Mohanraj v. Shah Bros. Ispat (P) Ltd., it was held that clauses 14(1)(a) and (b) of the IBC form a shield to protect the corporate debtor against pecuniary attacks while under the moratorium period, further noting that “any crack in this shield is bound to have adverse consequences, given the object of Section 14, and cannot, by any process of interpretation, be allowed to occur.”
In the case of Gujarat Urja Vikas Nigam Ltd. v. Amit Gupta, the Supreme Court even went on to discuss the Insolvency Committee Report to highlight the importance of the moratorium period imposed under Section 14 of the IBC. Emphasis was laid on how ipso facto termination clauses affect the position of the corporate debtor, when allowed to be invoked at the commencement of insolvency, while highlighting the recommendations from the Report to add an explanation to section 14(1) of the IBC.
Analysing the Non-Obstante Clauses: Section 238 of the IBC vs. Section 5(4) of the Netting Act
Section 238 of the IBC stipulates that its provisions shall prevail over any conflicting laws currently in force or any instruments deriving effect from such laws. This section incorporates a ‘non-obstante clause,’ a critical principle of statutory interpretation. This clause effectively neutralizes any contrary provisions, ensuring the primacy of the enacting part of the section.
Similarly, section 5(4) of the Netting Act contains a non-obstante clause that asserts the supremacy of netting proceedings over the moratorium imposed under section 14 of the IBC. This creates a legal conundrum regarding which legislation prevails when there is a conflict between the Netting Act and the IBC. The core issue is whether netting proceedings can continue despite the imposition of a moratorium, or if section 238 of the IBC, with its overriding effect, takes precedence.
The strategic inclusion of non-obstante language in section 238 of the IBC aims to ensure the IBC’s provisions remain authoritative, even when in conflict with other laws. This is reinforced by judicial interpretations. In the landmark case of Innoventive Industries Ltd. v. ICICI Bank and Anr., the Supreme Court held that the non-obstante clause in Section 238 of the IBC is framed in the broadest terms possible, ensuring that any right of the Corporate Debtor under any other law cannot impede the operation of the IBC. A similar judicial approach was observed in Duncan Industries v. A.J. Agrochem, where the Supreme Court addressed a conflict between the IBC and the Tea Act, 1953. The Court ruled that section 238 of the IBC would supersede the Tea Act, affirming that insolvency proceedings under the IBC could proceed without the Central Government’s consent, even in the absence of such consent, thereby denying the Corporate Debtor’s appeal.
These landmark judgments underscore that Section 238 of the IBC prevails over any conflicting provisions in other statutes. However, no judgments have specifically addressed the conflict between the IBC and the Netting Act yet. Consequently, it remains an open question whether the IBC’s provisions will ultimately prevail in such disputes. While section 238 of the IBC is designed to ensure its provisions override conflicting laws, the ambiguity regarding its interaction with the Netting Act, particularly in the context of close-out netting during insolvency, necessitates further judicial clarification. This underscores the need for a harmonized legal framework that aligns with international standards to resolve such conflicts effectively.
Way Forward
While there is a clear stance behind the intent of the applicability of the moratorium period, that is to ensure the Corporate Debtor continues to operate as a going concern, the lacuna still exists in varied circumstances, where the provisions of the Netting Act clearly disregard the applicability of moratorium period. In the international context, closeout netting implies that the legal effects indicated by the parties (the close-out netting agreement) would be accepted and enforced under applicable insolvency legislation, as opposed to the Indian context where Netting as a term has not been defined under the IBC, even though some jurisdictions recognize netting in their insolvency framework, the amount to which they do, as well as the breadth and legal ramifications of close-out netting rules, vary significantly.
While the notification from the Ministry of Corporate Affairs explicitly excludes certain types of agreements from the purview of Section 14 (1) of the IBC, the ambiguity regarding close-out netting still persists. The Netting Act being a relatively recent enactment, will certainly attract a string of amendments to provide more clarity regarding situations that comes into conflict with other laws.
To date, no judicial ruling has addressed the conflict between the Act and the IBC. However, the author contends that there is a pressing need for a harmonized legal framework concerning netting, one that aligns with the international standards. The United Nations Commission on International Trade Law (UNCITRAL) Legislative Guide on Insolvency Law highlights the enforceability of close-out netting as a critical consideration in the development of insolvency legislation and recommends that close-out netting be permitted within the applicable insolvency procedures.
The interaction between the Netting Act and the IBC underscores a significant and complex legal conundrum that necessitates immediate attention. The provisions of section 238 of the IBC, designed to ensure the Code’s supremacy over conflicting laws, stand in potential conflict with section 5(4) of the Netting Act, which prioritizes netting proceedings even during a moratorium period. This inherent conflict calls for a more harmonized legal framework that aligns with international standards.
Several additional considerations and suggestions could further enhance the robustness of the legal framework surrounding netting and insolvency in India. There should be an effort to integrate the principles of netting within the broader insolvency framework. This could involve amending the IBC to explicitly recognize and define netting, ensuring that its provisions are seamlessly aligned with those of the Netting Act. By inculcating netting principles directly into insolvency law, regulators can create a more cohesive and predictable legal environment. Additionally, regulatory bodies should collaborate to develop comprehensive guidelines that address the interplay between netting and insolvency. These guidelines could clarify procedural aspects and establish clear protocols for handling conflicting scenarios, thus providing market participants with a more transparent operational framework.
From an international perspective, India can benefit from adopting best practices observed in jurisdictions with mature financial markets. For instance, the European Union’s Financial Collateral Arrangements Directive provides valuable insights into how close-out netting and insolvency can coexist effectively. Adopting similar measures can help bridge the gap between domestic and international standards, enhancing India’s competitiveness in the global financial arena.
– Aditya Chhangani