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Contractual claims, Arbitration and the Insolvency Code – The interplay and fault lines

21 July 2021

by Puneeth Ganapathy Vaishali Goyal

The Insolvency & Bankruptcy Code, 2017 (‘Code’) was, inter alia, enacted for the resolution or liquidation of companies defaulting on their debts. These debts may include claims subject to an arbitration or sums determined in the form of an award. In the present article, we identify some potential scenarios where parties to an arbitration agreement must be conscious of the interplay between arbitration and the Code.

1. Initiating Insolvency Proceedings for contractual defaults

Under the Code, a Financial Creditor (lender, holder of debt-securities, etc.) or Operational Creditor (supplier, employees, tax authorities) can initiate insolvency proceedings against a corporate debtor, upon proving the existence of a ‘debt’ and a ‘default’ of that debt. The Adjudicating Authority, National Company Law Tribunal (‘NCLT’) is required to determine these questions in a time-bound and objective manner without lengthy proceedings similar to a trial.[1]

In practice however, default under complicated transactions or situations may not be capable of objective determination, without a proper trial of factual issues. For instance, the Supreme Court in Indus Biotech Private Ltd. v. Kotak India Venture[2], found that non-payment of sums on the redemption of optionally redeemable preference shares did not constitute a default under the Code. The Supreme Court held that in the facts of that case, the parties were negotiating on the formula to be applied for calculation of the value of the preference shares. In view of the failure to arrive at an agreement as to the value, the court held that the circumstances were too premature to constitute a ‘default’ by the company failing to pay redemption monies.

In this decision, the Supreme Court held that the existence of an arbitration clause was not relevant for the determination of ‘default’ under the Code and the NCLT was independently required to determine this. However, the decision of the Supreme Court was made while also passing directions under the Arbitration Act, to constitute an arbitral tribunal to determine the disputes between the parties.

While the court appeared to, and explicitly did hold that there was no ‘default’ under the Code, irrespective of the existence of an arbitration agreement, it was clearly influenced by the factum of failure of an agreement as to the amount payable on redemption, and that the parties had a dispute resolution mechanism in the form of an arbitration agreement in the relevant contracts, which was capable of deciding this issue.

Accordingly, where terms of an agreement providing for repayment of debt do not specify the amount due at the outset, and provide for procedures for determining this value, a creditor may find it difficult to initiate insolvency proceedings based on the alleged debt.

 2. Initiating insolvency proceedings based on an Arbitral Award

i. Does an Award constitute a Financial Debt or Operational Debt?

The Code differentiates between the treatment of Financial Debt and Operational Debt. Primarily, Operational Creditors do not get a right to participate in decisions on approval of the resolution plans for the debtor and are given low priority in payments. On this account, Operational Creditors, usually end up recovering paltry sums from the resolution or liquidation of the debtor, as even the Financial Creditors themselves take significant haircuts on their claims.[3]

While an arbitral award will constitute debt, sums due under an arbitral award will not usually constitute a ‘Financial Debt’ under the Code. The National Company Law Appellate Tribunal (‘NCLAT’) has held that a Financial Debt assumes initial disbursement of money and the required repayment thereof along with the time-value of that money.[4] On this basis, the NCLAT has held that sums awarded in an arbitral award cannot be said to be sums that were initially disbursed by the Award-holder/creditor to the Award-debtor and which are to be repaid by the latter.[5] These are sums determined by an arbitral tribunal, and hence cannot constitute Financial Debt, and would then be considered Operational Debt.

The decision of the NCLAT in Sushil Ansal is currently in appeal before the Supreme Court. While the decision of the NCLAT does correctly consider the nature of most arbitral awards, it can be argued that the rationale of this decision may not cover awards arising from a conventional lending transaction (i.e. where there was actual prior disbursement of sums to the award-debtor by the award-holder) and the award is merely certifying the liability of the award debtor to repay the sums initially borrowed by it.

ii. Availability of proceedings challenging an arbitral award and its impact on proceedings under the Code

As explained above, sums payable under arbitral awards are usually treated as Operational Debts. Under the Code, Operational Debts can only be used to initiate insolvency proceedings if the debts are undisputed. The Supreme Court in K. Kishan v. Vijay Nirman Company Ltd[6] has thus held that awards against which proceedings are available for setting aside the award would not be ‘final’ and the debts would be considered disputed until those proceedings are disposed-off by the relevant court.

Accordingly, debts under awards cannot be used to initiate insolvency proceedings when setting aside proceedings are pending or available. The Court in K. Kishan clarified that insolvency may be initiated on the basis of an award, when either the proceedings for setting-aside have been rejected or the limitation period to file such proceedings has expired.[7]

Under the Arbitration Act, the limitation period for setting aside an arbitral award is three months. During this period, or after filing of a setting aside application and prior to its rejection, the award cannot be treated as final and will be treated as incapable of initiating insolvency proceedings. It is also relevant in this context to consider that on account of the pandemic and prevailing conditions in India, the limitation for filing setting aside proceedings against arbitral awards has been extended from March 2020 until further orders of the Supreme Court.[8] Arbitral Awards passed shortly before and during this period may thus be incapable of initiating insolvency proceedings.

iii. Interplay between initiation of insolvency proceedings and enforcement proceedings in respect of an award.

Under the Code, ‘debt resolution’ is to be treated as distinct from ‘debt recovery’, although existence of debt is the basis of both categories of actions. Section 65 of the Code accordingly provides:

‘If, any person initiates the insolvency resolution process or liquidation proceedings …for any purpose other than for the resolution of insolvency, or liquidation, as the case may be, the Adjudicating Authority may impose upon such person a penalty which shall not be less than one lakh rupees, but may extend to one crore rupees’

The natural consequence of this section is that where it can be established that an insolvency resolution has been initiated with a view towards debt-recovery, coercion, etc, and not genuine debt-resolution, such an application must be dismissed.

Whether an application to initiate insolvency would constitute genuine debt-resolution or a purpose other than resolution (i.e. debt-recovery) would appear to be purely based on the factual matrix of a given case, and the extent to which the true motivations of the parties can be ascertained. However, some decisions involving decrees and arbitral awards indicate that the NCLT can dismiss the insolvency application under Section 65, as being for a ‘purpose other than resolution’, on the basis of enforcement proceedings in respect of the award.

When a debt is due and unpaid under an Arbitral Award, which has not been set-aside and has become final, the award-holder will usually have two options (i) initiate insolvency proceedings against the award-debtor and (ii) initiate enforcement proceedings for the award, under the Arbitration Act. This is a choice of the Award-holder. Therefore, where the Award holder chooses to initiate insolvency proceedings instead of enforcement proceedings, this decision may not be assailable.[9]

The choice of an award-holder not to pursue enforcement of the award, and file insolvency proceedings may be genuinely based on the apprehension that the debtor is unable to discharge its debts. In such an event, there is nothing in the Code that prevents the award-holder from resorting to insolvency, rather than enforcement proceedings.

In some cases however, courts may that award-holders intend to coerce the Award-debtor to settle and pay the awarded sums by filing insolvency proceedings, rather than trying to enforce their awards. This is since the Award-debtors, usually being operational creditors, have very limited potential of recovery of their claims under the Code, and their real strength lies in the fact that they can force the company into resolution proceedings.

Following this approach, in several decisions, based on the facts of a given case, the NCLAT has inferred that the filing of insolvency proceedings on the basis of an award amounted merely to a coercive effort at debt-recovery instead of approaching the relevant enforcement court, thus barred by Section 65.[10]

On the other hand, where the Award-holder has already resorted to enforcement proceedings in respect of a decree or award, the recent consistent trend of decisions by the NCLAT shows that any parallel invocation of insolvency will be regarded as being for a ‘purpose other than resolution’, and thus barred by Section 65.[11]

3. Treatment of pending claims or dues under an Award against a company declared insolvent

The above issues dealt with the initiation of insolvency proceedings on the basis of arbitration claims or an arbitral award. A different scenario arises where NCLT announces commencement of insolvency proceedings against the corporate debtor (against whom a claim is pending, or an award exists), on an insolvency application initiated by a third-party.

Section 14 of the Code bars the continuation or institution of any proceedings, including an arbitration or enforcement of an award,[12] against a company, against whom insolvency proceedings have already been commenced.

The creditor (based on pending claims or sums due under an award) has to then file his claims before the Resolution Professional placed in control of the Corporate Debtor by the NCLT. The Resolution Professional only has the power to ‘verify’ the existence of the claim on the basis of documents[13] and cannot ‘adjudicate’ any dispute as to the claim.[14] Where the Resolution Professional rejects the claim, its character (financial or operational debt) or its quantum, the creditor may appeal this decision before the NCLT.[15] Accordingly, disputes in relation to contractual claims or arbitral award, which would otherwise be decided by an arbitral tribunal or supervising court in setting aside proceedings, are brought within the fold of the NCLT.

4. Claims filed by the insolvent company in arbitration proceedings

While arbitration proceedings cannot be filed or continued against an insolvent company, an insolvent company can file or continue claims against other parties. The insolvent company, represented by the Resolution Professional, is free to pursue claims (and counterclaims) against third parties. The objective of this appears to be that while the assets of the insolvent company cannot be allowed to deplete, the Resolution Professional has a duty to ‘maximize’ the value and assets of the insolvent company.[16]

Where an arbitration involving the insolvent company includes both, claims by the company, as well as counter-claims against the company, the claims may thus be pursued by the Resolution Professional before the arbitral tribunal, while the counter-claims will be barred by the Code (or vice versa). While this may not appear satisfactory from the point of consistency of decision-making, especially where the claims and counterclaims are closely connected,[17] the Code effectively prevents any proceedings which can objectively have an adverse result on the assets of the insolvent company.

The Supreme Court has accordingly clarified that allowing claims and counterclaims to continue in an arbitration involving an insolvent company would be an incorrect application of the provisions of the Code as the same could objectively result in an award against the debtor and lead to asset depletion.[18]

5. Doing business with insolvent companies after commencement of insolvency proceedings: Contractual claims arising therefrom

Under the Code, the Resolution Professional is supposed to continue the business of the company as a going concern during insolvency resolution proceedings. Accordingly, the business and contracts of the debtor continue and disputes can arise in relation to performance of contracts in this period.

To ensure that the company is successfully managed as a going concern, the Code ensures that the supply of goods and services essential to carry on business is not terminated or suspended during moratorium period.[19] Powers have also been conferred on the Resolution Professional to take effective measures, including raising interim finance, enter into contracts on behalf of the corporate debtor, and exercise rights on behalf of the corporate debtor in appropriate proceedings for the benefit of the corporate debtor.[20]

Since no proceedings other any other law can be pursued against insolvent companies, except as provided under the Code,[21] the NCLT is residually empowered to resolve such disputes.[22]

These residual powers of the NCLT Code have been affirmed, with certain limitations, by the Supreme Court in Gujarat Urja Vikas Nigam Limited vs. Amit Gupta and Ors.[23] In this decision the Supreme Court restrained the supplier from terminating an agreement with the insolvent company, since it was the only supplier and was crucial to the continuation of business of the debtor. Even though the termination was as per the terms of the contract, it was held that the termination would mean certain death of the debtor defeating the entire purpose of the insolvency resolution proceedings.

6. Strategic considerations for Creditors (Claimants and Award Holders)

As will be evident from the above, claimants and award holders against debtors face significant challenges in proceedings under the Code. These challenges could occur either when the creditors choose to themselves initiate insolvency proceedings against the debtor, or when they are forced to participate in insolvency proceedings initiated by third parties against the Corporate Debtor.

Award holders and claimants, usually seen as Operational Creditors, do not in most circumstances recover even a fraction of their dues, where the creditor has genuinely turned insolvent. Where the creditor is not genuinely insolvent, proceeding under the Code carries significant threat of corporate death of the creditor, and is thus aimed at coercing a settlement by the claimant/award holders. The latter kind of actions, as noted previously, could be dismissed either as coercive proceedings or cases of disputed debts.

One way to grapple with these issues could be for Creditors to pursue claims and arbitration proceedings against multiple parties in the same arbitration, where possible, to mitigate the risk of being forced to participate in insolvency proceedings. If one of the parties does turn insolvent, claims and awards can be pursued and enforced against other parties, while only the proceedings against the insolvent company will be barred.

Parties who are non-signatories to the contract, can be brought into the fold of arbitration proceedings. Recent trends in Indian arbitration law indicate a liberal approach towards inclusion of non-signatories as parties to an arbitration, based on theories of ‘group of companies’, ‘alter-ego’ or ‘network of agreements’. This could include subsidiaries, parents, promoters and key individuals involved in the negotiation, conclusion and operation of the contractual relationship with the debtor company.

Where multiple parties have joint and several liability to pay sums due under an award, the insolvency of one party may accordingly not hamper the chances of recovery against the other parties. This could either be safeguarded by drafting arbitration agreements to this express effect and involving multiple signatories, or by invoking arbitrations against non-signatories as noted above.

[The authors are Principal Associate and Associate respectively, in Commercial litigation practice at Lakshmikumaran & Sridharan Attorneys, New Delhi]

 

[1] Sections 7, 9, 10, 12 of the Insolvency & Bankruptcy Code, 2017; Embassy Property Development Private Limited v. State of Karnataka & Ors., Civil Appeal no. 9170 of 2019; Swiss Ribbons Pvt. Ltd. & Anr. v. Union of India & Ors., Writ Petition (Civil) No. 99/2018.

[2] Indus Biotech Private Ltd. v. Kotak India Venture, Arbitration Petition (Civil) No. 48/2019.

[3] https://economictimes.indiatimes.com/news/company/corporate-trends/videocon-insolvency-creditors-to-take-96-haircut-on-dues-nclt-requests-increase-in-pay-out/articleshow/83561586.cms?from=mdr; https://www.thehindubusinessline.com/money-and-banking/authums-2887-cr-resolution-plan-for-reliance-home-finance-set-to-be-winning-bid/article34822538.ece

[4] Sushil Ansal v. Ashok Tripathi and Ors., Company Appeal (AT) (Insolvency) No. 452 of 2020

[5] Sushil Ansal v. Ashok Tripathi and Ors., Company Appeal (AT) (Insolvency) No. 452 of 2020 at Para 20,

“The answer to the question whether a decree-holder would fall within the definition of ‘Financial Creditor’ has to be an emphatic ‘No’ as the amount claimed under the decree is an adjudicated amount and not a debt disbursed against the consideration for the time value of money and does not fall within the ambit of any of the clauses enumerated under Section 5(8) of the ‘I&B Code’.”

[6] K. Kishan v. Vijay Nirman Company Pvt. Ltd., Civil Appeal No. 21824/2017.

[7] K. Kishan v. Vijay Nirman Company Pvt. Ltd., Civil Appeal No. 21824/2017 at Para 19.

[8]Order dated 27.04.2021 passed by the Supreme Court In Re Cognizance for Extension of Limitation, Miscellaneous Application No. 665/2021 in SMW(C) No. 3/2020.

[9] M/s Ugro Capital Limited v. Bangalore Dehydration and Drying Equipment Co. Pvt. Ltd., Company Appeal (AT) (Insolvency) No. 984/2019.

[10] Sushil Ansal v. Ashok Tripathi and Ors., Company Appeal (AT) (Insolvency) No. 452 of 2020; Sh G Eswara Rao v. Stressed Assets Stabilisation Fund and Anr., Company Appeal (AT) (Insolvency) No. 1097 of 2019; HDFC Bank Ltd. v. Bhagwan Das Auto Finance Ltd., Company Appeal (AT) (Insolvency) No. 1329 of 2019.

[11] C. Shivakumar Reddy v. Dena Bank and Anr., Company Appeal (AT) (Insolvency) No. 407 of 2019; International Asset Reconstruction Co. Pvt. Ltd. v. Jayant Vitamins Ltd., Company Appeal (AT) (Insolvency) No. 1472 of 2019.

[12] Alchemist Asset Reconstruction Company Ltd. v. Hotel Gaudavan Pvt. Ltd. and Ors., Civil Appeal No. 16929/ 2017

[13] Regulation 13 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016

[14] Swiss Ribbons Pvt. Ltd. and Ors. v. Union of India (UOI) and Ors., Writ Petition (Civil) No. 99 of 2018

[15] Mr Rajnish Jain v. (Manoj Kumar Singh – I.R.P.) & Ors., Company Appeal (AT) (Insolvency) No. 519 of 2020; Dr. Ramakant Suryanath Pande v. CS Prakash K. Pandya, CP No.870/IBC/NCLT/MB/MAH/2017 The Karad Urban Co-operative Bank Ltd. v. Khandoba Prasanna Sakhar Karkhana Ltd, MA 1509/2019 in CP No.1368/I&BC/MB/MAH/2017; Office of the Asst. State Tax Commissioner State Tax Department, Government of Maharashtra v. Shri Parthiv Parikh & Ors., Company Appeal (AT) (Ins) No.583 of 2020

[16] Committee of Creditors of Essar Steel India Limited Through Authorised Signatory v. Satish Kumar Gupta & Ors., Civil Appeal No. 8766-67 Of 2019.

[17] Power Grid Corporation of India Ltd. v. Jyoti Structures Ltd., O.M.P.(COMM.) 397/2016 (Delhi High Court).

[18] P. Mohanraj and Ors. v. Shah Brothers Ispat Pvt. Ltd., Civil Appeal No.10355/2018

[19] Section 14(2) of Insolvency & Bankruptcy Code, 2017.

[20] Sections 20 and 25 of Insolvency & Bankruptcy Code, 2017.

[21] Section 63 of Insolvency & Bankruptcy Code, 2017.

[22] Section 60(5) of Insolvency & Bankruptcy Code, 2017

[23] Gujarat Urja Vikas Nigam Limited v. Amit Gupta and Ors., Civil Appeal No. 9241 of 2019

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