A Significant Legal Conundrum in Section 7 under the Insolvency and Bankruptcy Code, 2016

Introduction

The Insolvency and Bankruptcy Code (the IBC) enacted in 2016¹, signifies a substantial reform in India’s legal framework for insolvency resolution. Before its introduction, the country faced a fragmented system composed of multiple laws and adjudicating bodies that frequently resulted in prolonged and inefficient insolvency proceedings. The IBC was created to consolidate these disparate laws into a single, comprehensive framework, streamlining the process for both corporate entities and individuals encountering insolvency. The primary objectives of the IBC are to facilitate the timely resolution of insolvency cases, maximise asset value, and encourage entrepreneurship while balancing the interests of all stakeholders involved.² By shifting the focus from a debtor-centric model to a creditor-driven approach, the IBC enhances creditors’ rights, enabling them to initiate insolvency proceedings against defaulting debtors.³ This legislative overhaul aims not only to improve recovery rates for creditors but also to cultivate a more favourable environment for business operations in India. The IBC is a key aspect of India’s economic reforms, tackling essential challenges in the insolvency landscape and promoting financial discipline across various sectors.

The IBC has made a bifurcation of creditors into financial creditors and operational creditors. The Supreme Court in Swiss Ribbons (P) Ltd. v. Union of India⁴, held that the classification of creditors made by the IBC does not violate Article 14⁵ and it satisfies the test of reasonability. The IBC grants the National Company Law Tribunal (the NCLT) which is the “adjudicating authority”, a sole and exclusive jurisdiction to deal with the insolvency resolution process for corporate debtors as outlined in Section 60⁶ read with Section 63⁷.

The legislature, while drafting the IBC, has created a significant conundrum in Section 7⁸. Two Division Benches of the Supreme Court, while interpreting this section, have pronounced diametrically opposite judgments. These contrary judgments further complicate the matter and contribute to a disputed interpretation of the law. The following hypothetical case aims to highlight a hidden issue that will be discussed in detail in this article.

(Note — “We have drafted this article considering that default has been proved by the financial creditor after fulfilment of other conditions as outlined in Section 7 of the IBC.”)

A hypothetical case to highlight a hidden issue

The corporate debtor X is a national telecommunications company. In 2018, X entered into a significant investment agreement worth $250 million with Monument Mining Limited (MMY Ltd.). On 26-12-2023, the company was set to receive a refund of $122 million from the Department of Telecommunications (DOT) under the Ministry of Communications and Information Technology, following the orders of the Telecom Disputes Settlement and Appellate Tribunal (TDSAT). An appeal was filed in the Supreme Court challenging the refund order issued by TDSAT, and the Court upheld this order, further directing that the refund amount be paid by 4-8-2024.

In 2017, the financial creditor DMB Bank provided X with a loan of $91 million at an interest rate of 5% per annum. X defaulted on the repayment of this loan by the due date in 2023. As a result, DSB Bank applied under Section 7 of the IBC to initiate the corporate insolvency resolution process (CIRP) before the NCLT on 19-7-2023. However, the NCLT rejected the application, citing its discretion to accept or reject applications under Section 7.

Dissatisfied with the decision, DSB Bank filed an appeal with the National Company Law Appellate Tribunal (the Nclat) which is the “appellate authority” on 22-8-2023. The Nclat upheld the order of the NCLT. Following this, DSB Bank appealed to the Supreme Court, challenging the Nclat‘s decision.

The key issue before the Supreme Court is whether the NCLT can reject or postpone an application for the initiation of CIRP proceedings when there is a default in the payment of dues by considering some other relevant factors that are beyond the default.

Legal scrutiny of Section 7

When any corporate debtor commits a default of one crore or more, a financial creditor, an operational creditor or the corporate debtor itself may initiate a CIRP for such corporate debtor.⁹ The ultimate purpose of initiating CIRP is to bring out the corporate debtor from the stage of insolvency through the process of revival and rehabilitation of the business through a resolution plan. While the term insolvency has not been explicitly defined under the IBC. Insolvency means a state of economic distress where individuals or corporate persons are unable to repay their outstanding debts or liability when such debts become due and payable in the ordinary course of business. As per Section 7¹⁰, a financial creditor either by itself or jointly with other financial creditors or any other person on behalf of the financial creditor, as may be notified by the Central Government, may apply for initiating the corporate insolvency resolution process against a corporate debtor before the adjudicating authority when a default has occurred.

A bare reading of Section 7 clearly indicates that insolvency proceedings under the IBC can only be initiated by a financial creditor, either individually or jointly. The essential requirement for a creditor to be recognised as a financial creditor under this section is that financial debt is owed to them, as defined in Section 5(7) of the IBC¹¹. This financial debt may encompass any of the transactions specified in Sections 5(8)(a) to (i) of the IBC. In Atul Jain v. Tripathi Hospital (P) Ltd.¹², the Nclat observed, that the basic requirement of the existence of financial debt being owed by the corporate debtor to the financial creditor has to be first satisfied and cannot be overlooked.

In Atul Jain case¹³ the Nclat observed that the conditions for a Section 7 application to be admitted, the adjudicating authority is only required to be satisfied whether the corporate debtor has defaulted; whether the application filed by the financial creditor is complete and whether any disciplinary proceedings are pending against the insolvency resolution professional proposed by the financial creditor. It has been vehemently contended that no provision in the IBC necessitates proving that there is duly established financial debt. In Innoventive Industries Ltd. v. ICICI Bank¹⁴, the Supreme Court observed that when the adjudicating authority is satisfied that a default has occurred based on the documents presented before it, the application must be admitted unless it is incomplete. If the application is incomplete the adjudicating authority is required to give notice to the applicant allowing them to rectify the defect within 7 days of receipt of a notice from the adjudicating authority. According to sub-section (7), the adjudicating authority shall then communicate the order regarding the admission or rejection of the application to both the financial creditor and the corporate debtor within 7 days.

In the subsequent case of E.S. Krishnamurthy v. Bharath Hi-Tecch Builders (P) Ltd.¹⁵, the Supreme Court observed that based on the application received, the adjudicating authority is empowered only to verify whether a default has occurred or if a default has not occurred. Based upon its decision, the adjudicating authority must then either admit or reject an application, respectively. These are the only two courses of action that are open to the adjudicating authority in accordance with Section 7(5). The adjudicating authority cannot compel a party to the proceedings before it settles a dispute. The Court further clarified that when considering a petition under Section 7, the adjudicating authority’s role is simply to confirm whether a default has occurred or not. Section 7(5) allows the adjudicating authority with only two options: to issue an admission order under Section 7(5)(a) or to reject the petition under Section 7(5)(b). Therefore, unless the debt is not due or is otherwise prohibited by law, the adjudicating authority is obligated to admit a petition under Section 7.

The Supreme Court in Pratap Technocrats (P) Ltd. v. Monitoring Committee of Reliance Infratel Ltd.¹⁶, held that once there is an admitted or acknowledged default by the respondent, the adjudicating authority is statutorily bound to admit the petition. By refusing to entertain the petition based on the possibility of a settlement, the authority exceeded its jurisdiction. The appellate authority simply upheld the adjudicating authority’s decision. In doing so, both the adjudicating and appellate authority acted as courts of equity, which is not permitted under the IBC.

The Supreme Court and the Nclat have observed in the plethora of judgments that the word “may” mentioned in Sections 5(a) and (b) should not be interpreted in the liberal sense, so has to give discretion power to the NCLT while deciding the application. The Court emphasised that the word “may” has to be interpreted in a strict sense, so has to give only two options to the NCLT either to issue an admission order if a default has occurred or to reject the application if no default has occurred. There is no third option available to the NCLT for applications made under Section 7 of the IBC.

Two diametrically opposite judgments of the Supreme Court on legal conundrum

Vidarbha Industries Power Ltd. v. Axis Bank Ltd.¹⁷

In this case, the NCLT admitted Axis Bank’s application in May 2017, for initiating CIRP against Vidarbha Industries Power Limited (VIPL). VIPL subsequently appealed to the Nclat, which upheld the NCLT’s decision. The matter eventually reached the Supreme Court, where VIPL argued that Section 7(5)(a) of the IBC grants discretionary power to the NCLT and that it should consider the company’s financial health before admitting an insolvency application. Conversely, Axis Bank contended that once a default is established, the application must be admitted as per statutory requirements.

The Supreme Court held that the adjudicating authority would have to exercise its discretion to admit an application under Section 7 of the IBC and initiate CIRP on the satisfaction of the existence of a financial debt and default on the part of the corporate debtor in payment of the debt unless there are good reasons not to admit the petition. This Court in Indus Biotech (P) Ltd. v. Kotak India Venture (Offshore) Fund¹⁸ observed that there is a necessity for proper application of mind and due adjudication and consideration of contentions raised by the parties and materials adduced by them. The mere existence of debt is not enough.

This Court in Surendra Trading Co. v. Juggilal Kamlapat Jute Mills Co. Ltd.¹⁹, held that the power of adjudicating authority to pass an order under Section 10(4)²⁰ is not mandatory but directory in nature and this interpretation would equally apply while interpreting the provision of Sections 7(5) and 9²¹ of the IBC.

The Supreme Court further held that the legislature has consciously differentiated between financial creditors and operational creditors, as there is an innate difference between financial creditors, in the business of investment and financing, and operational creditors in the business of supply of goods and services. Financial credit is usually secured and of much longer duration. Such credits, which are often long-term credits, on which the operation of the corporate debtor depends, cannot be equated to operational debts which are usually unsecured, of a shorter duration and lesser amount. The financial strength and nature of business of a financial creditor cannot be compared with that of an operational creditor, engaged in the supply of goods and services. The impact of the non-payment of admitted dues could be far more serious on an operational creditor than on a financial creditor.

The Supreme Court ruled that Section 7(5)(a) of the IBC is directory rather than mandatory. This means that while the NCLT has the authority to admit applications based on established debt and default, it also has the discretion to reject such applications if doing so serves the interests of justice and aligns with the objectives of the IBC i.e. primarily the revival of financially distressed companies. The Court further emphasised that factors such as a corporate debtor’s financial viability and ongoing regulatory processes should be considered when deciding on insolvency applications. The Court further states that it is certainly not the object of the IBC to penalise solvent companies, temporarily defaulting in repayment of their financial debts, by initiation of CIRP. This Division Bench judgment is significant as it introduces a level of discretion for the NCLT in handling insolvency applications under Section 7 of the IBC.

This decision aims to balance the rights of creditors with the need for corporate revival, potentially preventing unnecessary liquidations of companies that may still have viable paths forward if given time and support. The ruling allows for a more nuanced understanding of corporate insolvency, recognising situations where companies may be temporarily unable to meet their financial obligations due to external factors beyond their control.

M. Suresh Kumar Reddy v. Canara Bank²²

In this case, the Supreme Court addressed critical issues surrounding the admission of insolvency petitions under Section 7 of the IBC. The case arose when Canara Bank, as a financial creditor, filed a petition against Kranthi Edifice Pvt. Ltd., the corporate debtor, due to defaults in repaying loans and bank guarantees. The NCLT admitted the application on 27-6-2022, after confirming the existence of a financial debt and default by the corporate debtor. M. Suresh Kumar Reddy, a suspended director of Kranthi Edifice, appealed against this admission to the Nclat, arguing that the NCLT had discretion in admitting such applications. However, his appeal was dismissed, prompting him to escalate the matter to the Supreme Court. The Supreme Court ruled that once the NCLT is satisfied that a financial debt exists and default has occurred, then there is hardly any discretion left with the NCLT to refuse the admission of an application made under Section 7.

The Supreme Court distinguished this case from its earlier judgment in Vidarbha Industries Power Ltd. case²³, which had allowed for some discretion in similar circumstances. The Court emphasised that the principles established in previous cases like Innoventive Industries Ltd. case²⁴ and E.S. Krishnamurthy case²⁵ still hold good precedence, asserting that if a debt is due and payable, failure to pay constitutes a default that necessitates admission of the petition under Section 7. The Court further clarified that the decision of Innoventive Industries Ltd. case²⁶ was in the setting of facts of the case before this Court. Such a decision cannot be read and understood as taking a view that is contrary to the view taken in Innoventive Industries Ltd. case²⁷ and E.S. Krishnamurthy case²⁸.

The judgment firmly established that an application under Section 7 should only be rejected if it can be proven that the debt is not due and payable. This ruling aims to provide clarity and consistency in insolvency proceedings, reducing any ambiguity surrounding the Tribunal’s discretion. This decision is a significant clarification regarding the mandatory nature of admitting insolvency petitions once a financial debt and a default are established. It highlights a return to a stricter interpretation of Section 7 of the IBC, ensuring that financial creditors can effectively seek resolution when corporate debtors fail to fulfil their obligations. At last, this judgment to a reasonable extent, has attempted to settle the tempest caused earlier by a Coordinate Bench of the Supreme Court in Vidarbha Industries Power Ltd. case²⁹.

Position of the NCLAT on this legal conundrum

Sunder Nagar Coop. Housing Societies Union Ltd. v. SBI³⁰

In this case, Sunder Nagar Cooperative Housing Societies Union Ltd. (the corporate debtor) had acknowledged a debt owed to the State Bank of India (SBI). The NCLT initially admitted the petition filed by SBI under Section 7 of the IBC, which allows financial creditors to initiate insolvency proceedings against a corporate debtor upon demonstrating a default.

In its ruling, the Nclat distinguished this case from Vidarbha Industries Power Ltd. case³¹ by emphasising that there was a clear admission or acknowledgement of debt by the corporate debtor. The NCLAT noted that since there was no dispute regarding the existence of debt or default, it was bound by precedent to dismiss any appeals against the NCLT’s admission order under Section 7.

The Nclat referenced M. Suresh Kumar Reddy case³² to reinforce its position, asserting that once a creditor proves debt and default, the initiation of CIRP becomes mandatory for the NCLT. This ruling of NCLAT to a certain extent clarified the discretionary or mandatory power of NCLT, while dealing when dealing with a financial creditor’s application under Section 7.

Notification of MCA for inviting comments for the proposal

On 18-1-2023, the Ministry of Corporate Affairs (MCA), Government of India, invited comments from the public on the proposed amendment to the IBC (Proposal). The Proposal noted that the judgment of Vidarbha Industries Power Ltd. case³³ has interpreted the term “may” in Section 7(5)(a) of the IBC to indicate that the NCLT has the discretion to admit or reject the application despite the existence of a default. Further, the Proposal clarified that the NCLT is not required to delve into factors relating to the solvency and financial health of the corporate debtor.

The Supreme Court in Vidarbha Industries Power Ltd. case³⁴, has interpreted the use of “may” in Section 7(5) to indicate that the adjudicating authority has the discretion to admit or reject despite the existence of a default. Consequently, it is observed that the adjudicating authority delves into detailed factors relating to the solvency and financial health of the corporate debtor, which is not required as per the original intent of the law. This has resulted in confusion in the market regarding the scope of the adjudicating authority’s discretion at the admission stage. To alleviate any doubts in this regard, it is proposed that Section 7 may be amended to clarify that while considering an application for initiation of the CIRP by the financial creditors, the adjudicating authority is only required to be satisfied with the occurrence of a default and fulfilment of procedural requirements for this specific purpose (and nothing more). Where a default is established, the adjudicatory authority must admit the application and initiate the CIRP.

Opinion

We are of the opinion that the term “may” in Section 7 of the IBC should be interpreted as granting the NCLT discretionary power in accepting or rejecting an application for initiation CIRP. This interpretation aligns with the purpose of the IBC, which is primarily designed to address cases involving financially distressed companies, rather than those experiencing temporary defaults due to short-term financial difficulties. In such scenarios, where funds owed to a corporate debtor are pending and awaiting a Supreme Court judgment, the NCLT’s discretion becomes essential. This discretion allows for a thorough evaluation of the factual circumstances and the debtor’s financial health, ensuring that only truly distressed companies undergo the insolvency process. A rigid, non-discretionary approach could result in the initiation of proceedings against companies that, although in default for a brief period, remain solvent and capable of addressing their financial obligations. Thus, the discretionary power vested in the NCLT ensures that each case is examined on its own merits, facilitating a fair and comprehensive decision-making process in line with the overarching goals of the IBC.

Conclusion

The recent two conflicting judgments from the same Bench of the Supreme Court regarding the interpretation of Section 7 of the IBC have created confusion about whether the NCLT has a discretionary or mandatory role in admitting applications once a financial creditor proves debt and default. The NCLAT, in Sunder Nagpal Coop. Housing Societies Union Ltd. case³⁵, attempted to clarify that when a corporate debtor acknowledges or admits to debt and default, the initiation of the CIRP becomes mandatory. However, the Nclat did not address the situation in which there is no acknowledgement of debt or default by the corporate debtor. In such cases, it is unclear whether the NCLT will exercise its discretionary power. This issue remains unresolved and requires further clarification from the Supreme Court. The Court’s decision is crucial to establish a clear stance on the NCLT’s powers in such cases, while also ensuring that the judgment aligns with the Preamble and objectives of the IBC, which aim to promote efficient insolvency resolution and the smooth functioning of businesses. Given the significance of this legal question, it should be referred to a larger Bench of the Supreme Court for a thorough and final determination, which would help eliminate confusion and provide consistency in future insolvency proceedings.