Navigating the Maze: Addressing Breach of Settlement Agreements in Corporate Insolvency under the IBC

The Insolvency and Bankruptcy Code (IBC) of 2016² in India revolutionised the landscape of corporate insolvency resolution. For creditors seeking to initiate the resolution process against a corporate debtor, establishing their claim as either “financial debt” or “operational debt” becomes crucial. The IBC clearly differentiates between financial and operational debts. As per the definition clause under Section 5(8) financial debt would mean any debt with interest, if any, disbursed against the time value of money and also includes any transaction which has a commercial effect of borrowing.³ So, it is purely a financial contract which may be a loan of a debt security. Whereas an operational debt as per Section 5(21) would mean dues on account of the provision of goods and services to the debtor,⁴ which also includes employment, and which were taken for the debtor’s day-to-day operations. These definitions hold immense significance as only creditors with debts falling under either category can initiate insolvency proceedings and no others. One question that often arises is whether a settlement deed executed between the creditor and the debtor can serve as the foundation for such claims. This article delves into the complex and sometimes murky legal terrain surrounding settlement deeds and their relationship with financial and operational debt under the IBC.

Settlement deeds: Bridging the gap or creating confusion

Settlement deeds serve as a mechanism to resolve pre-existing disputes between parties. Settlements can be opted by the debtors and creditors both before and after the initiation of the corporate insolvency resolution process (CIRP) under IBC and there is no bar upon entering into a settlement. They often involve concessions and adjustments to the originally agreed upon terms. They can also involve the restructuring of the debt, where further time is provided to the debtor to fulfil the debt obligations. RBI also developed a few out-of-court restructuring schemes and mechanisms through its guidelines and circulars before the enactment of the Code which often led to the evergreening of bad loans and hence, they were withdrawn.

In the very first week of this year, a news article highlighted that more than 7000 applications for initiation of CIRP are pending in the National Company Law Tribunals (NCLTs).⁵ Situations like these give impetus to the creditors to enter into out-of-court workouts and settlements with their debtors and provide them some extra time or even reduce their debt liabilities. But what happens if the debtor even after entering into the settlement deed with the creditors is still unable to fulfil his obligations under the agreement? Does the settlement deed merely modify the initial obligation where the rights of the creditor to initiate a CIRP are not waived, or does it supersede the underlying transaction, becoming the source of the debt itself? A growing concern in recent years is the implications of a breach of these settlement terms, particularly on a creditor’s right to agitate, reinitiate or revive the CIRP.

Divergent views and conflicting judgments

The issue of whether a default in payment of an instalment under a settlement agreement that was entered between the creditor and the debtor will be considered as the financial debt or the operational debt to which it was related, has a long line of inconsistent rulings of the NCLT and the National Company Law Appellate Tribunal (NCLAT). The author is of the view that the settlements between the creditors and the debtors are promoted, both, before and after the initiation of CIRP under the IBC, and the settlement agreements entered into between the parties should not close the doors of the adjudicating authority for the creditor in case the debtor continues to default. The rights of the creditor should not be hampered if it provides some rebate to the debtor to fulfil his liabilities.

The issue came before the NCLAT in Esther Malini Victor v. Oriental Bank of Commerce⁶. The contention of the appellant in this case was that there is no “default” committed as per the IBC, as the terms of the debt stood altered and revised by the master restructuring agreement entered between the lenders and the debtor. This contention of the appellant was rejected and the NCLAT confirmed the order of the NCLT where it admitted the application filed under Section 7 IBC⁷ and initiated a CIRP against the debtor mentioning that the existence of “debt” and “default” is established. Similarly, in Ludhiana Scrips (P) Ltd. v. K.C. Land and Finance Ltd.⁸, where the adjudicating authority had dismissed an application file by the financial creditor under Section 7 IBC, mentioning that the element of interest was not proved in the transaction, the NCLAT referred to the settlement agreements between the parties, two in this case, and concluded that transaction between the parties involved payment of interest and the requirement of time, value of money stands satisfied in the case. It held that the appellant is a financial creditor who is owed a financial debt, the default of which has occurred and hence, ordered CIRP initiation against the corporate debtor.

The NCLAT in Ahluwalia Contracts (India) Ltd. v. Logix Infratech (P). Ltd.⁹, where the operational creditor was awarded the contract to carry on construction and structural work and a memorandum of understanding (MoU)/settlement agreement was entered into between the corporate debtor (CD) and the operational creditor (OC) for the manner of payment and the mode of payment. The NCLAT held that the adjudicating authority (AA) had erroneously rejected the Section 9 application without considering the nature of the transaction involved.¹⁰ Even in Arenja Enterprises (P) Ltd. v. Edward Keventer (Successors) (P) Ltd.¹¹, the NCLAT inter alia implied that reliance can be placed upon the subsequent settlement agreement or a consent decree for the initiation of CIRP by the financial creditor, if money was advanced by the creditor for the time value of money and there was a default committed by the corporate debtor.

There were other cases where a completely opposite view was taken with regard to the settlement agreements between the debtor and creditor. In Shapoorji Pallonji and Co. (P) Ltd. v. Shore Dwellings (P) Ltd.¹² and Sharada Murty Ananthapalli v. Mindlogicx Infratec Ltd.¹³, where the NCLT referred the settlement agreements between the parties to rule that the application filed for initiation of CIRP are for the purposes of recovery under the settlement agreements and were not for resolution of the corporate debtor.

In Trafigura India (P) Ltd. v. TDT Copper Ltd.¹⁴, where the parties entered into a settlement agreement for an extension of settlement of the amount due and payable by the CD, and the amount due was unequivocally acknowledged and admitted in the agreement, yet the NCLT rejected the application for initiation of CIRP and in appeal the NCLAT confirmed the order of the NCLT, holding that the default of instalment of the settlement agreement will not be construed as default of an operational debt.

It is important here to mention an old judgment of the Madras High Court in Seethai Mills Ltd. v. N. Perumalsamy¹⁵, where it held,

5. … A creditor, who has instituted a suit and obtained a decree against the company, will still be a creditor of the company to whom money is due by the company. 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.

Moreover, it is pertinent to note that the settlement agreements which are being talked about in the article do not arise out of thin air. They are always related to some prior financial obligations which are due which form the basis of the negotiations between the parties. Therefore, it becomes necessary that these agreements are not construed in isolation but as extensions of the liabilities which are their foundation, while they are being scrutinised for admission of application under the IBC.

Right to revive CIRP for non-compliance of a settlement agreement

Interestingly, in Bhavesh Gandhi v. Amluckie Investment Co. Ltd.¹⁶, where the admission order was requested to be withdrawn on the ground that the parties had compromised, the NCLAT cautioned the corporate debtor from defaulting or backing out of the settlement by saying,

6. We make it clear that only part payment has been made towards satisfaction of the full and final claim of the financial creditor in terms of the settlement agreement and the balance payment is agreed to be paid as per the schedule indicated hereinabove. In the event of default on the part of the corporate debtor in adhering to the terms of schedule, the financial creditor shall be at liberty to approach the adjudicating authority to reopen the corporate insolvency resolution process proceedings in accordance with law.

Hence, giving an opportunity to the financial creditor to reinitiate the CIRP even after settlement or compromise decree has been entered into between the parties, in case the default is again committed. Similar words of caution were also given to the corporate debtor in Kavita Anil Taneja v. ISMT Ltd.¹⁷

Similarly, in Himadri Foods Ltd. v. Credit Suisse Funds AG¹⁸, after the adjudicating authority disposed of the petition because a settlement has been arrived between the parties, the creditor filed for revival or restoration of the proceedings because of non-compliance with the terms of settlement. The NCLT allowed the restoration of the petition. In an appeal by the erstwhile directors, the NCLAT while discussing the merits of the case mentioned that the non-compliance of the terms of the settlement, which were recorded in the order of NCLT while disposing of the earlier petition, giving liberty to the financial creditor to come back, would result in revival of CIRP.

In a more recent judgment in Priyal Kantilal Patel v. IREP Credit Capital (P) Ltd.¹⁹, a fresh application under Section 7 IBC, which the financial creditor filed after there was a breach of consent terms in the settlement agreement by the corporate debtor. The corporate debtor in this case also contended that no application for initiation of CIRP is maintainable as a breach of the agreement would not constitute a “financial debt” under IBC. The NCLAT rejecting this contention observed that the right of the financial creditor would not be wiped out nor the nature and character of the financial debt would change by the mere fact of entering into an agreement. The breach of terms of the agreement in such a case would amount to a default of the financial debt which was originally given to the CD and any contrary interpretation would provide undue advantage to the CD and frustrate the objective of the Code.

Conclusion

The legal landscape regarding settlement deeds in the context of IBC remains contentious. Whether a settlement deed can unlock the door to initiating insolvency proceedings under the IBC remains a question demanding further research and clarity. By analysing the legal debate, understanding the underlying economic rationale, and considering the impact on stakeholders, this research aims to contribute to a more comprehensive understanding of this crucial aspect of Indian insolvency law. A few points that the creditors must take care of while settling with their debtors are—

(i) First of all, do not try to settle and if keen on settling then do not settle without filing an application to the adjudicating authority for initiation of CIRP because it has been seen in the cases mentioned above that the courts provide liberty to file for revival of CIRP is given by the courts to the creditors in case of non-compliance of the settlement terms and can even ask for this liberty from the courts.

(ii) Secondly, the terms of the agreement should clearly specify that the extra time if provided is just an extension given to settle the amount payable and due to the creditor and in no way prejudices the right to initiate CIRP in case the debtor continues to default on the payments and is non-compliant to the terms of the settlement.

The author submits that the settlement agreements cannot be construed to deprive the creditor of its claim for financial or operational debt and for that matter initiation or revival of the CIRP. The adjudicating authority must determine the underlying nature of the transaction it relates to. If the underlying debt is a financial debt or operational debt, then the non-compliance must be construed in a similar manner.