On January 25, 2019, the Supreme Court upheld the constitutionality of the Insolvency and Bankruptcy Code, 2016 (Code henceforth), in its entirety. The scheme of the Code, as a whole, was challenged on the ground that it violated Article 14 of the Constitution. The main argument was that the Code unfairly discriminated between operational and financial creditors. While the court’s judgment brings respite to the financial sector, we argue that the judgment is partly inconsistent with the legislative intent underlying the Code, and may end up diluting the Code’s effectiveness.
First, the judgment repeatedly emphasises that the objective of the law is reorganisation of the debtor, and that liquidation is a “last resort”. For instance, relying on the preamble of the Code and its own judgment in the case of ArcelorMittal, the Court observed that the “primary focus of the legislation 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”.
A plain reading of the preamble suggests that the preamble and the law are agnostic to the outcome of any given case. The Code does not prioritise resolution over liquidation. On the contrary, the law provides for automatic liquidation if no resolution is agreed upon, at the first instance, by the committee of creditors. The report of the Bankruptcy Law Reforms Committee (BLRC), which serves as the foundation for the rationale and design of the Code, is similarly outcome agnostic.
The repeated insistence on liquidation as a “last resort” reinforces the notion that liquidation is a bad outcome. This is inconsistent with the fundamental economic theory that capitalism requires easy exit, and that unsustainable firms must be allowed to die so that resources can be reallocated to more productive activity in the economy. A philosophy that liquidation must be avoided regresses the Indian legal framework to the days when sick firms were sought to be mandatorily rehabilitated.
A conscious endeavour to avoid liquidation at all costs, has practical implications. It encourages the judiciary to defer an outcome until a resolution is achieved. Active judicial intervention to revive a firm which is commercially resolved to be liquidated will adversely affect the timeliness of an insolvency process. Symptoms of this are evident. Most of the 12 large cases that were referred by the Reserve Bank of India in 2017 for resolution have been under the insolvency resolution process for more than 500 days. Even the smaller ones are taking an average time of more than 350 days to reach an outcome.
Second, for an Article 14 challenge to survive, it must be shown that the law unintelligibly discriminates between equals, and that such discrimination has no relation to the objectives sought to be achieved by the law. The main ground of challenge to the Code was that there was no intelligible difference between operational and financial creditors. This is a relevant distinction as operational creditors do not have a vote on the choice between reorganisation and liquidation of the debtor.
The court identified four main differences between operational and financial creditors. First, while financial creditors are secured, operational creditors are unsecured. This is largely true of the Indian debt market, as it currently stands. However, conceptually and in developed debt markets, financial creditors can be equally unsecured. For example, bond holders are often unsecured. In fact, the avowed purpose of the Code is to encourage lending to entrepreneurs who may not have assets to secure the borrowing. If the Code has its desired effects, we should see an increase in unsecured lending to firms. Over time, therefore, this distinction will be redundant.
Second, the court upheld the distinction on the basis that financial creditors are likely to be fewer by volume and value, compared to operational creditors. This is also not true, especially in the case of small and medium enterprises, whose largest creditor may be a supplier or vendor. Similarly, operational creditors may, as a group, be the largest creditors in value of a firm.
Finally, the court reasoned that financial creditors are more sophisticated, relative to operational creditors, and are involved in assessing the viability of the firm from the very beginning. The court then sought to draw a nexus between this distinction and the object sought to be achieved by the Code, as under:
“…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…”
It is unclear why financial creditors are perceived to be more likely to “preserve the corporate debtor as a going concern, while ensuring maximum recovery for all creditors”. Intuitively, employees and vendors are more adversely affected by the firm’s liquidation as they lose a source of employment and an operational revenue source. For this reason, such operational creditors are more incentivised to keep the firm as a going concern, relative to financial creditors for whom the debtor’s liquidation is a one-time write-off in their lending portfolio.
The reasoning of the court on the distinction between operational and financial creditors is weak and the judgment warranted a closer and more substantive nexus between the classification scheme of operational and financial creditors and the objective of the Code.
Third, the court took cognisance of the argument that the functioning of the NCLT with the administrative support of the Ministry of Corporate Affairs, and not the Ministry of Law and Justice (MLJ), would be inconsistent with its own earlier judgments. This is underpinned by the rationale that statutory tribunals, which perform quasi-judicial functions, must be independent of the executive wing in charge of implementing the law. This rationale is directly applicable to revenue tribunals as in such tribunals the litigant is contesting the claims of the revenue department. Arguably, it is less of a concern for tribunals that merely adjudicate disputes between private parties.
The reality is that several statutory tribunals continue to function with the administrative support of their respective nodal ministries. For example, the TDSAT continues to function with the administrative support of the Department of Telecommunications, and the labour courts with that of the Ministry of Labour and Employment. If the MLJ is now to administratively support these tribunals, capacity-building at the MLJ will be imperative.
To conclude, while the judgment offers greater stability to India’s legal insolvency regime, it is an unsettling precedent both in terms of ideological outlook and implementation of the law.
The writers are researchers at the Finance Research Group, IGIDR
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