1. Introduction

a) Recently, in the case of Indus Biotech Private Limited v. Kotak India Venture Fund-I ,  the NCLT Mumbai had to deal with a situation where even while there was a claim of a Financial Debt under the Insolvency and Bankruptcy Code, 2016 (“Code”), such debt was a disputed one. The NCLT observed that the very things which were important determinants in ascertaining whether or not a ‘default’ of a financial debt had actually occurred were itself disputed by the Corporate Debtor and accordingly NCLT came to a conclusion that there was no ‘default’ as per provisions of the Code. The Order was given on 9th June, 2020.

b) The NCLT further observed that there was an arbitration clause in the agreement, the arbitration was invoked and the disputes that formed the subject matter of the Petition were arbitrable. In the said background, the NCLT refused to admit an application under section 7 of the IBC. This Order of NCLT has created a stir in the legal fraternity. This Update provides a brief but an interesting analysis of the said Order.

2. Legal Background

a) Under the Code, two types of creditors have a right to file an insolvency petition, i.e. an operational creditor and a financial creditor. The difference between a financial creditor and an operational creditor is that a financial creditor’s claim from the Corporate Debtor is based on a debt which is disbursed against the consideration for time value of money. Whereas, an operational creditor’s claim is in respect of the provisions of goods or services delivered / rendered.

b) In case of an Operational Creditor, it is well settled that, – if there is a pre-existing dispute with respect an operational debt (i.e. the dispute must have arisen before a demand notice calling upon to pay the debt is raised), then the Operational Creditor cannot file an insolvency petition. In contrast, a ‘Financial Debt’ by its very essence, cannot be disputed as such. The Financial Creditor must only prove that there has been a ‘default’ of such Financial Debt.

c) It is also well settled that where there exists an (undisputed) Operational Debt or a Financial Debt, and if the Operational Creditor or the Financial Creditor files an insolvency petition and if the Corporate Debtor fails to pay the debt, NCLT has the jurisdiction to declare the Debtor as insolvent regardless of any other dispute resolution mechanism the Parties would have agreed upon such as Arbitration. In other words, the jurisdiction of the NCLT cannot be ousted.

  1. Facts of the Case (in brief) – a) In 2007-08, the Kotak Private Equity Group (including the Financial Creditor) subscribed to a share capital of Rs. 27,00,00,000/- in equity shares and Optionally Convertible Redeemable Preference Shares (OCRPS) of Indus Biotech Private Limited (the Corporate Debtor). A Share Subscription and Shareholders Agreement (SSSHA) was entered into between the Parties.

b) The financial creditor opted for and chose to convert the OCPRS into equity shares in order to make a Qualified Initial Public Offering (QIPO) as per the applicable SEBI (Issue of Capital & Disclosure Requirements) Regulations, 2018.

c) During the QIPO process, a dispute arose between the two parties with regard to the calculation and conversion formula to be followed while converting the OCRPS into equity shares.

d) Some months after this dispute emerged and was ongoing, the Financial Creditor contended that they were entitled to trigger provisions relating to early redemption of OCRPS equivalent to Rs. 367,08,56,503/- and sent a notice to the Corporate Debtor regarding the same.

e) When the Corporate Debtor failed to redeem the OCPRS, the financial creditor filed a Company Petition under Section 7 of the IBC seeking the initiation of insolvency proceedings against the Corporate Debtor.

f) The corporate debtor invoked the arbitration agreement under the SSSHA seeking to refer the disputes between the parties to arbitration under Section 8 of the Arbitration and Conciliation Act, 1996.

 4. Contentions of Parties (in brief)

Contentions of Financial Creditor

a) The fact of there being pre-existing disputes between the parties is irrelevant under a Section 7 petition, though it would assume significance in a petition under Section 9 of the IBC filed by an operational creditor.

b) A section 7 petition under the Code does not pertain to recovery of debts. If there is a financial debt and a default has occurred in respect thereof, the NCLT must admit the Petition for the initiation of insolvency proceedings.

c) The Agreement provided that if the QIPO did not take place by the QIPO date, then the investment will be redeemable at the IRR of 30%. If not redeemed, then it will be treated as a ‘debt.’

d) A Section 7 petition belongs to that class of litigation which is incapable of being referred to arbitration since it is a matter in rem. The reliefs sought by the financial creditor, i.e. initiation of insolvency proceedings are not arbitrable disputes since they arise out of a matter in rem.

e) The existence of an arbitration clause has no bearing effect on a Section 7 petition under the Code.

Contentions of Corporate Debtor 

f) The underlying Company Petition was in the nature of a ‘dressed-up’ Petition, in as much as the real dispute between the parties was with regard to matters pertaining to the agreement reached between the parties and interpretation of its various clauses, which could be resolved by arbitration.

g) The Corporate Debtor was a highly profitable debt-free Company and did not need resolution.

h) Section 8 of the Arbitration and Conciliation Act, 1996 that seeks to refer the disputes between parties to arbitration is mandatory in nature. The SSSHA contained an arbitration clause which was wide enough to cover the disputes between the parties, as the disputes entailed valuation of the OCRPS, fixing of QIPO date and the right of the financial creditor to redeem such OCRPS when it had participated in the process of conversion of its OCRPS into equity shares, which are commercial in nature. The Court must hence sway towards enforcing arbitration agreements, since that is the bargain struck by the parties.

i) Where an arbitration clause exists, the court has a mandatory duty to refer the disputes arising between the contracting parties to an arbitrator. It was held that the language of section 8 of the Arbitration & Conciliation Act, 1996, is peremptory and the court is under an obligation to refer parties to arbitration.

 5. Key aspects of the Judgment of the NCLT (Unquoted)

a) The Code required the NCLT to ascertain and record satisfaction as to the occurrence of default before admitting the application. Mere claim by the financial creditor that the default has occurred is not sufficient. The same is subject to the NCLT’s summary adjudication. Therefore, in a section 7 petition, there has to be a judicial determination by the NCLT as to whether there has been a ‘default’ within the meaning of section 3(12) of the IBC.

b) The disputes that form the subject matter of the underlying Company Petition, viz., valuation of shares, calculation and conversion formula and fixing of QIPO date are all arbitrable, since they involve valuation of the shares and fixing of the QIPO date. Therefore, an attempt must be made to reconcile the differences between the parties and their respective perceptions. On a perusal of the contentions and facts, the NCLT was not satisfied that a ‘default’ had occurred.

c) Disputes arising from rights in personame. rights restricted to the parties within the contract are generally amenable in arbitration and disputes relating to rights in rem i.e. rights which extend to parties outside a private contract are required to be adjudicated by courts and public tribunals, being unsuited for private arbitration. However, it was held that this was not a rigid or inflexible rule. Disputes relating to subordinate rights in personam arising from rights in rem have always been considered to be arbitrable and therefore the dispute in question would fall within the ambit of arbitrability.

d) It will be unnecessary to push a solvent, debt-free and profitable company into insolvency and no meaningful purpose will be served.

  1. Brief Analysis and Key Take Away

a) With due respect to NCLT, we think that the judgment given in this case suffers from some fallacies. Firstly, in this case, the NCLT had to deal with a situation where even while there was a claim of a Financial Debt, such debt was a disputed one. Under the Insolvency Code, it is well settled that, – the question as to whether or not there is a pre-existing dispute must be considered by the NCLT only when it is deciding on a claim of an Operational Debt.A ‘Financial Debt’ by its very essence, as such cannot be disputed as such. The Financial Creditor must only prove that there has been a default of such Financial Debt. In this case, the peculiarity which the NCLT noted was that the things which were important determinants in coming to a judicial conclusion as to whether or not a default had actually occurred were itself disputed and accordingly NCLT came to a conclusion that there was no ‘Default’ as per provisions of the Code. Here we think that the NCLT ought to have made atleast an attempt to make a prima facie determination as to whether the dispute raised by the Corporate Debtor vis-à-vis the right of the Financial Creditor to redeem such OCRPS was a valid dispute. If this dispute was complex and required an extensive probe, then the NCLT could have left it up to the arbitrators to decide. However, if the question as to whether the Creditor had the right to have the OCRPS redeemed was easily determinable on a plan reading of the SSSHA and if the NCLT could have determined upon such prima facie evaluation that the dispute raised by the Debtor was not a genuine one, then the NCLT had the jurisdiction to order insolvency.

In case of redemption of the OCRPS, there is no question of valuation of shares or conversion; redemption is nothing but simply returning of the capital; but here a question would have arisen here whether OCRPS would constitute a “financial debt” under the Code because under Companies Act, 2013, unlike debentures, preference shares are not of the nature of ‘debt’ per se but under the legal framework of FEMA, 1999, any optionally convertible instruments are considered to be debt instruments (i.e. External Commercial Borrowings).

b) Secondly, it would be relevant to refer to the decision of NCLT (Mumbai Bench) which was given on 14th January, 2019 in the case of Vijay Rochlani v. Shantai Exim in which it was held by the NCLT that, – In the present case, the cause of action had arisen when the Debtor company had refused to return the loan. However, in the Civil proceedings the cause of action is in operation when the litigating parties file a suit of divorce. Both the legal proceedings are independent having no nexus with each other, therefore, can be independently adjudicated by two different judicial forum.

By applying the aforesaid precedent to the facts of the present case, it can be well argued that, – NCLT is a special forum to adjudicate claims of insolvency and accordingly, if case is made out by the Creditor of a default of a ‘financial debt’, then irrespective of other disputes, NCLT has to order the debtor as insolvent.

c) Thirdly, while adjudicating whether there was a ‘default’ of the ‘financial debt’ in question, the Court also took into consideration the fact the Company was otherwise solvent and debt-free and pushing such Company into insolvency would yield undesirable results. Judging by the context in which the NCLT has made this observation, we don’t think that the intention of the NCLT to introduce a “solvency test” as one of the pre-requisites to consider before ordering insolvency; but, because the NCLT has specifically noted this aspect in its Order, debtors will start using this as a precedent to support similar cases where it is not very clear whether a particular operational / financial debt is genuinely disputed and NCLT will then be required to take a holistic view keeping in mind the financial position of the debtor. Otherwise, where the cases are not complex, the Code clearly articulates that, – once the NCLT is satisfied that there exists a financial or an operational debt (without any pre-existing dispute) and if there is a ‘default’ of such debt then NCLT has to declare the Company as ‘insolvent’.

d) Lastly, in this order, NCLT has given superiority to Arbitration Act over the Code. With due respect to the NCLT, we think that this is erroneous particularly when Section 238 of the Code states that, – “The provisions of this Code shall have effect, notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law”. This section is non obstante and has an overriding effect over all other statues.

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