Dissecting the landmark SC verdict, upholding IBC’s constitutional validity – Part I

The decision of the Supreme Court (‘the Court’) in Swiss Ribbons Pvt. Ltd & Anr. v. UOI[1] [LSI-18-SC-2019(NDEL)], is a significant decision not only in the context of the Insolvency and Bankruptcy Code, 2016 (‘IBC/the Code’) but also in the larger context of how Courts are interpreting and are to interpret economic legislation.

The constitutionality of various provisions of the IBC were challenged before the Court, and, all the provisions under challenge have been upheld. The overarching principle which permeates through the judgment is that executive action relating to economic activities should be viewed by the courts with greater latitude than laws touching civil rights. The Court has noted that legislation, particularly in economic matters is essentially empiric and it is based on experimentation or what one may call trial and error method and therefore it cannot provide for all possible situations or anticipate all possible abuses. The constitutionality of economic legislation should therefore, be judged by the generality of its provisions and not by its crudities or inequities or by the possibilities of abuse of any of its provisions. The judgment also stands out for its significant reliance on the Report of the Bankruptcy Law Reforms Committee (BLRC) to understand the need and basis for the provisions contained in the IBC.

The judgment starts off by noting that the primary focus of the IBC is to ensure revival and continuation of the corporate debtor by protecting the corporate debtor from its own management and from a corporate death by liquidation. The Code is thus a beneficial legislation which puts the corporate debtor back on its feet, not being a mere recovery legislation for creditors. The interests of the corporate debtor have, therefore, been bifurcated and separated from that of its promoters / those who are in management. Thus, the resolution process is not adversarial to the corporate debtor but, in fact, protective of its interests.

The key challenges which were raised by the writ petitioners and the manner in which the Court has dealt with them is analyzed below:

Challenge relating to appointment of members to the NCLT and the NCLAT:

A challenge was raised that the selection committee of members had more technical members as compared to judicial members and was in contravention to the law laid down by the Supreme Court in Madras Bar Association v. UOI (I)[2] and Madras Bar Association v. UOI (III)[3]. Since on facts it was shown by the Union of India (‘the Union’) that there were equal number of judicial and technical members on the selection committee and that the guidelines laid down by the Court in its earlier decisions had been followed, this contention was not accepted by the Court.

NCLAT Bench only at Delhi:

The challenge was made on the basis that as the NCLAT was substituting the jurisdiction of the High Courts, the constitution of NCLAT bench only at Delhi and not at every jurisdiction where there was a High Court was violative of the law laid down by the Court in Madras Bar Association v. UOI (II)[4]. The Court, accepting the submission of the Union that the earlier decision in Madras Bar Association (II) would be followed, has directed the Union of India to set up circuit benches of the NCLAT within a period of 6 months from the date of judgment.

Therefore, at a practice level, litigants can expect circuit benches of the NCLAT to start functioning in other jurisdictions also.

Tribunals functioning under the Ministry of Corporate Affairs (‘MCA’) and not under the Ministry of Law and Justice:

The challenge was raised on the basis that the administrative support for the NCLT and NCLATs was from the MCA and not the Ministry of Law and Justice - as mandated by the earlier decision of the Court in Madras Bar Association (II). The Court, while noting the submission of the Union that Article 77(3) of the Constitution provides that once rules of business are allocated among various Ministries, such allocation is mandatory in nature, and, that matters which arise under the IBC have been allocated to the MCA, has nevertheless noted that the government should in letter and spirit endeavor to follow the decision of the constitutional bench in Madras Bar Association (II).

Classification between ‘financial creditors’ and ‘operations creditors’ under the IBC:

The challenge made was that the classification between ‘financial creditors’ and ‘operational creditors’ under the IBC was arbitrary, discriminatory and violative of Article 14 of the Constitution of India.

The Court noted that there could be no violation of Article 14 if (i) there existed intelligible differentia in classification between the two classes; and, (ii) there was no manifest arbitrariness. The Court after a detailed analysis of the provisions of the IBC, the report of the BLRC on the need for such distinction, the Insolvency Law Committee Report, 2018 and other material has concluded that there is a distinction between ‘financial creditors’ and ‘operational creditors’. Some of the key factors of distinction drawn by the Court between ‘financial creditors’ and ‘operational creditors’ are summated in the below table: 

The Court has also noted that financial creditors are, from the very beginning, involved with assessing the viability of the corporate debtor. They can, and therefore do, engage in restructuring of the loan as well as reorganization of the corporate debtor‘s business when there is financial stress, which are the things operational creditors do not and cannot do. Thus, preserving the corporate debtor as a going concern, while ensuring maximum recovery for all creditors being the objective of the Code, financial creditors are clearly different from operational creditors and therefore, there is obviously an intelligible differentia between the two which has a direct relation to the objects sought to be achieved by the Code.

The Court after an analysis of the provisions of the IBC has also noted that a financial creditor to maintain an application under the Code has to prove ― default, as opposed to an operational creditor who merely claims a right to payment of a liability or obligation in respect of a debt which may be due. The Court has noted when this aspect is borne in mind, the differentiation in the triggering of insolvency resolution process by financial creditors under Section 7 of the Code and by operational creditors under Sections 8 and 9 of the Code becomes clear.

No vote of operational creditors in the Committee of Creditors (‘CoC’)

The Court while upholding the provisions which give no voting right to operational creditors in the CoC, has noted that under the IBC:

(i)                 The CoC is entrusted with the primary responsibility of financial restructuring;

(ii)               Since the financial creditors are in the business of money lending, banks and financial institutions are best equipped to assess viability and feasibility of the business of the corporate debtor. Since banks and financial institutions undertake detailed studies before sanctioning a loan, and since financial creditors have trained employees to assess viability and feasibility, they are in a good position to evaluate the contents of a resolution plan. On the other hand, operational creditors, who provide goods and services, are involved only in recovering amounts that are paid for such goods and services, and are typically unable to assess viability and feasibility of businesses;

(iii)             A resolution plan cannot pass muster under section 30(2)(b) read with section 31 of the Code, unless a minimum payment is made to operational creditors, being not less than liquidation value. Also, during the resolution process, the ‘operational creditors’ have priority over the ‘financial creditors’; and

(iv)             Under amended section 38 of the Code, there is a mandatory requirement that the resolution plan should take into account the interests of the ‘operational creditors’.

Basis the above, the Court held that it did not find that ‘operational creditors’ are discriminated against or that Article 14 has been infracted either on the ground of equals being treated unequally or on the ground of manifest arbitrariness.

Constitutionality of section 12A of the IBC:

This provision was introduced w.r.e.f. 06.06.2018 and permits withdrawal of an application under section 7 or section 9 or section 10 of the Code - which application has been admitted by the adjudicating authority, on an application made by the applicant with the approval of 90% voting share of the CoC. The Court while upholding such provision as constitutionally valid noted that:

(i)                 At any stage where the CoC is not yet constituted, a party can approach the NCLT directly. The Tribunal may, in exercise of its inherent powers under Rule 11 of the NCLT Rules, 2016, allow or disallow an application for withdrawal or settlement. This will be decided after hearing all the concerned parties and considering all relevant factors on the facts of each case;

(ii)               Once the Code gets triggered by admission of a creditor\'s petition under section(s) 7 to 9, the proceeding that is before the Adjudicating Authority, being a collective proceeding, is a proceeding in rem. Being a proceeding in rem, it is necessary that the body which is to oversee the resolution process must be consulted before any individual corporate debtor is allowed to settle its claim; and

(iii)             The main thrust against the provision of section 12A is the fact that 90% of the CoC has to allow withdrawal. This high threshold has been explained in the ILC Report as all financial creditors have to put their heads together to allow such withdrawal as, ordinarily, an omnibus settlement involving all creditors ought, ideally, to be entered into. In any case, the figure of ninety per cent, in the absence of anything further to show that it is arbitrary, must pertain to the domain of legislative policy; and

(iv)             If the CoC arbitrarily rejects a just settlement and/or withdrawal claim, the NCLT, and thereafter, the NCLAT can always set aside such decision under section 60 of the Code.

The remaining aspects of the judgment, will be discussed in Part- II of this Article.