IBC: Can Financial Creditor be referred to Arbitration in an Application filed u/s 7 of the IBC?

Introduction:

Earlier this month, the National Company Law Tribunal ("NCLT"), Mumbai Bench, in an unprecedented decision, in Indus Biotech Private Limited v. Kotak India Venture Fund-I referred parties to arbitration in a petition filed by Kotak India Venture Fund-I ("Kotak") under section 7 of the Insolvency and Bankruptcy Code, 2016 ("IBC"). The NCLT, Mumbai Bench has refused to admit the application filed by Kotak against Indus Biotech Private Limited ("Indus") under section 7 of the IBC on the grounds that the disputes were arbitrable and arbitration agreement existed between the parties. As per scheme of the IBC, a corporate debtor, in a petition filed under section 9 of the IBC, having a defence of pre-existing dispute in its pocket can stall the initiation of insolvency proceedings against it till the resolution of a dispute. However, the defence of pre-existing dispute is not available to a corporate debtor in a petition filed by a financial creditor under section 7 of the IBC. The above position was reinforced by National Company Law Appellate Tribunal ("NCLAT") in Vinayaka Exports v. Mrs. Divya M. Jain, it observed that existence of dispute as to amount of debt owed to a financial creditor has no relevance in a petition filed under section 7 of the IBC. Thus, it appears that the NCLT, Mumbai Bench has clearly departed from well settled principles by referring parties to arbitration in a petition filed by a financial creditor under section 7 of the IBC.

Background:

On August 20, 2007, Kotak entered into Share Subscription and Shareholders Agreement ("SSSA") with Indus for subscribing to the share capital of Indus. Under SSSA, Kotak subscribed to Optionally Convertible Redeemable Preference Shares ("OCRPS") issued by Indus. In the meantime, Kotak intended to make Qualified Initial Public Offering ("QIPO"), and for that purpose it choose to convert OCRPS into equity shares. During the QIPO process, certain disputes arose between the parties regarding calculation and conversion formula to be adopted in carrying out valuation of OCRPS. While the dispute persisted, Kotak sought to trigger early redemption clause provided under SSSA, and claimed Rs. 367,07,50,000. When Indus failed to redeem the OCRPS, Kotak filed an application before NCLT for initiation of Corporate Insolvency Resolution Process ("CIRP") under section 7 of the IBC. While the application of Kotak for initiation of CIRP against Indus was pending for admission before NCLT, Indus invoked arbitration clause under SSSA for referring the disputes to arbitration. Thereafter, Indus filed an Interim Application under section 8 of the Arbitration and Conciliation Act, 1996 ("Arbitration Act") before NCLT seeking to dismiss the application filed by Kotak under section 7 of the IBC and refer the parties to arbitration. The issue that fell for consideration before the NCLT was whether provisions of the Arbitration Act will prevail over the provisions of the IBC?

The NCLT held that since disputes exist between Indus and Kotak, it is not satisfied that a default has occurred, and consequently, the section 7 application cannot be admitted until such disputes are resolved. Further, since disputes involved between the parties are arbitrable and have a bearing on judicial determination of existence of default under section 7(4) of the IBC, invocation of arbitration is justified in reaching to the conclusion as to whether there exists a default. Lastly, another reason given by NCLT to dismiss the application under section 7 of the IBC and refer parties to arbitration was that Indus is a solvent, debt free and profitable company, and that admitting the application would prematurely push an otherwise economically viable company into insolvency. Therefore, no meaningful purpose will be served by initiating CIRP against Indus at this stage.

Analysis of the NCLT's order:

Although, the decision of the NCLT to dismiss the application filed by Kotak, for initiation of CIRP against Indus under section 7 of the IBC, was justified, the reasoning adopted by the NCLT in doing so was flawed. The NCLT dismissed the application on the grounds that since there is a dispute between the parties, it is not satisfied that a default has occurred. Had NCLT first inquired that whether there exists a financial debt; and whether Kotak is a financial creditor, there would not have been any need for determining the existence of default.

As per section 7 of the IBC, an application for initiation of CIRP against a corporate debtor can be filed by a financial creditor. According to section 5(7) of the IBC, financial creditor is a person to whom financial debt is owed. According to section 5(8) of the IBC, there are two essential elements for any transaction to be termed as 'financial debt' i.e. 1) It should be a debt along with interest, which is disbursed against the consideration for the time value of money; and 2) It may include any of the events enumerated in sub clauses (a) to (i). On conjoint reading of section 5(7) and 5(8) of the IBC, it can be said that a person is not entitled to initiate CIRP under section 7 of the IBC unless financial debt is owed to him.

Whether failure to redeem OCRPS would fall within the ambit of financial debt?

According to section 5(8)(c) of the IBC, if the amount is raised by issuance of bonds, debentures, or any similar instrument, then such a transaction falls within the ambit of financial debt. There is a fundamental difference between the amount raised by issuing debentures and the amount raised by issuing OCRPS. The distinction was emphasized by the Calcutta High Court in Hindustan Gas and Industries Limited v. Commissioner of Income Tax, where it observed that in cases where money is raised by way of issuing redeemable convertible preference shares, such amount goes to the share capital of the company, and where money is raised by issuing debentures, such amount goes to loan capital of the company. Since the amount contributed by preference shareholders goes to the share capital, the company does not become debtor for such payment. In contrast, the amount raised by way of issuance of debentures goes to the loan capital of the company and consequently such debenture holders act as creditors of the company and are entitled to fixed rate of interest whether there are profits or not. In view of the above, it can be argued that there is no element of 'consideration for time value of money' when money is raised by issuing OCRPS as preference shareholders are not entitled to any fixed rate of interest but entitled to get dividends only out of profits. Therefore, it can be concluded that transaction of raising money by way of issuing OCRPS will not fall within the ambit of financial debt under section 5(8) of the IBC.

Whether Kotak can be termed as a financial creditor?

Moreover, the owner of a preference shareholder cannot be termed as a creditor of the company. The above view was fortified by Bombay High Court in Aditya Prakash Entertainment Pvt. Ltd. v. Magikwand Media Pvt. Ltd., wherein the court observed that the shareholders of redeemable preference shares of a company do not become creditors of the company if their shares are not redeemed at appropriate time. Further, Gujarat High Court in Anarkali Sarabhai v. CIT Gujarat, had observed that where the company defaults in redeeming the preference shares, holder of the redeemable preference shares cannot compel the company to redeem the shares by suing in debt for the return of its capital.

In the present case, Kotak has filed an application under section 7 of the IBC on the grounds that Indus has failed to redeem the OCRPS. From the foregoing, it is clear that neither Kotak can be classified as financial creditor of Indus nor failure of Indus to redeem OCRPS would fall within the ambit of financial debt. Therefore, had NCLT first determined whether there exists a financial debt or not, there would not have been any need to ascertain existence of default. Consequently, there would not have been any need to refer parties to arbitration in a petition filed under section 7 of the IBC.

IBC vis a vis Arbitration Act

In the present case, although, NCLT framed the question as to whether the provisions of Arbitration Act will prevail over the provisions of the IBC, it did not give a conclusive finding on the same, and kept the question open for debate in future cases. Despite, section 238 of the IBC provides for overriding effect of the IBC over any other law, the provisions of the IBC will not prevail over the provisions of the Arbitration Act in all the cases, and will vary from case to case.

It is a well settled principle that in case of conflict between a general law and a special law, a special law will prevail. Further, in case of conflict between two special acts, the latter act will prevail. However, this is not a sacrosanct rule. In Life Insurance Corporation of India v. D.J. Bahadur, Supreme Court observed that a statute may be classified as special statute vis a vis other statute for certain purposes, and that special statute may be classified as general statute vis a vis other special statute for certain other purposes. There is always an element of relativity present while determining whether a statute is a general statute or a special statute. Moreover, Supreme Court in Ashoka Marketing Limited and Another v. Punjab National Bank & Others, observed that in case of inconsistency between two special statutes, conflict has to be resolved by referring to purpose, policy and intention of the legislature manifested by language of the statute. Therefore, it can be concluded that a statute cannot be classified as special for all purposes, and the classification is only relative in nature, depending upon the subject matter of dispute which is sought to be resolved.

In the present case, the maxim Leges Posteriores Priores Contraries Abrogant- in case of conflict between two special acts, the latter one prevails, will not be applicable as providing absolute overriding effect to the IBC, being the latter law, will militate against the well settled principles of statutory interpretation. The aim of the IBC is to bring all the laws relating to insolvency under one umbrella and to conclude insolvency resolution of corporate persons in a time bound manner. Further, as per scheme of the IBC, NCLT is not required to undertake fact-finding exercise, and resolve disputes as to amount of debt owed. On the contrary, under the IBC, NCLT has only been given 'summary jurisdiction' to ascertain the existence of default. On the other hand, Arbitration Act provides for speedy resolution of disputes by way of private adjudication. Thus, if there is any dispute as to the amount of debt, determination of it does not fall within the ambit of the IBC. Therefore, in cases where there is a dispute as to existence of debt, IBC will categorised as a general statute vis a vis Arbitration Act, and will have no overriding effect over the Arbitration Act.

Conclusion:

As per scheme of the IBC, the Adjudicating Authority is required to dismiss the application filed by an operational creditor, if there is any pre-existing dispute between the parties. However, the IBC is silent on the approach to be adopted by the Adjudicating Authority when debt, in an application filed under section 7 of the IBC, is itself disputed. The Supreme Court has time and again clarified that the IBC is not a recovery mechanism and the NCLT should only entertain applications where the debt is undisputed, and can be determined by summary jurisdiction of the NCLT. In all other cases, where the debt is disputed, irrespective of whether it is a financial debt or operational debt, it should be left for appropriate forum to decide i.e. either civil court or by way of arbitration, provided there exists an arbitration clause.

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