Supreme Court: The constitutional validity of provisions of IBC pertaining to the personal guarantors upheld

The Supreme Court, in its judgement dated November 9, 2023, in the matter of Dilip B. Jiwrajka v. Union of India and Others [Writ Petition (Civil) No. 1281 of 2021] (decided along with multiple other similar tagged-along writ petitions on similar legal issue), has upheld the constitutional validity of provisions of the Insolvency and Bankruptcy Code, 2016 (“IBC”) pertaining to insolvency resolution process of personal guarantors.

Facts

In the present case, the constitutional validity of Sections 95 (Application by creditor to initiate insolvency resolution process), 96 (Interim moratorium), 97 (Appointment of resolution professional), 98 (Replacement of resolution professional), 99 (Submission of report by resolution professional) and 100 (Admission or rejection of application) of IBC were challenged vide three hundred and eighty-four petitions under Article 32 (Remedies for enforcement of rights conferred by this Part) of the Constitution of India (“Constitution”). The Supreme Court did not reproduce the individual facts of each case as it was deciding the constitutionality of the said provisions of IBC.

Notably, by way of background, in the matter of Lalit Kumar Jain v. Union of India [(2021) 9 SCC 321], the Supreme Court has, inter alia, held that the liability of a guarantor is not discharged merely on the discharge of the Corporate Debtor.

For the purpose of reference herein, Mr. Dilip B. Jiwrajka shall be referred to as the “Petitioner” and Union of India shall be referred to as the “Respondent”.

Issue

Whether the provisions of Sections 95 to 100 of IBC are unconstitutional and violate the principles of natural justice.

Arguments

Contentions of the Petitioner:

It was submitted by the Petitioner that there must be determination of existence of debt by a judicial body before appointment of a resolution professional and an action initiated by the resolution professional.

Further, the Petitioner contended that an automatic interim moratorium should not commence upon filing of a petition under Section 95 of IBC.

Petitioner contended that the fundamental aspect as to whether the jurisdiction to entertain an application under Chapter III of Part III (Insolvency resolution and bankruptcy for individuals and partnership firms) of IBC exists, must be determined at the threshold by giving the debtor or personal guarantor an opportunity to be heard and that such jurisdictional question ought to be determined prior to appointment of resolution professional under Section 97(5) of IBC itself.

Further, Petitioner sought natural justice by a judicial body at the stage of Section 97(1) of IBC and it was contended that prior to the appointment of a resolution professional, without incorporating a requirement for a hearing before the adjudicating authority, Sections 95 to 100 of IBC would be arbitrary and violative of Article 14 (Equality before law) of the Constitution.

Contentions of the Respondent:

It was contended by the Respondent that adding an intermittent stage, as suggested by the Petitioner, for the adjudicating authority to decide a ‘jurisdictional question’ would result in the dislocation of the very scheme of IBC pertaining to observance of stringent timelines.

It was contended by the Respondent that the requirement of observing the principles of natural justice arises under Section 100 of IBC at the adjudicatory stage and not under Section 97 of IBC. Hence, the compliance pertaining to natural justice at a stage prior to Section 100 of IBC would result in dislocation of the entire scheme of IBC. Further, at the stage of an application under Sections 94 (Application by debtor to initiate insolvency resolution process) or 95 of IBC, no adjudication takes place. Additionally, no significant consequence on a debtor or personal guarantor takes place before the adjudication under Section 100 of IBC. Hence, there is no breach of natural justice under Chapter III of Part III of IBC.

Additionally, the Respondent submitted that the function of a resolution professional under Section 99 of IBC is not of adjudicatory nature as it does not bind the adjudicating authority. Rather the resolution professional’s purpose under Part III of IBC is merely to collate the facts and submit a report along with recommendations to the adjudicating authority.

It was submitted by the Respondent that the object of corporate insolvency resolution process (“CIRP”) under Part II (Insolvency resolution and liquidation for corporate persons) of IBC and in Chapter III of Part III of IBC is completely distinct as Part II of IBC deals with the resolution of corporate insolvency and Part III of IBC deals with the resolution and bankruptcy of individuals and partnership firms. Therefore, Chapter III of Part III of IBC has contemplated appointment of a resolution professional straightaway preceding the adjudicatory function by an adjudicatory body.

Respondent also submitted that a distinction exists between a moratorium under Section 14 (Moratorium) of IBC and an interim-moratorium under Section 96 of IBC as it is for the benefit of guarantor or debtor and does not impose embargo on alienation of assets, legal rights or beneficial interest of the debtor.

Respondent submitted that the constitutional validity of a statute which the Parliament is competent to enact cannot be challenged on the basis an alleged ground of misuse of a provision in a particular case.

Observations of the Supreme Court

The Supreme Court while rendering its judgement divided the judgement into parts which are as follows:

Part I: Comparative Analysis of Parts II and III of IBC:

It was observed by the Supreme Court that the object of CIRP under Part II and in Chapter III of Part III of IBC is completely distinct in nature as Part II of IBC deals with insolvency resolution and liquidation for corporate entities. On the other hand, Part III of IBC deals with insolvency resolution and bankruptcy for individuals and partnership firms. Further, it was observed by the Supreme Court that there exists considerable difference in the provisions of Parts II and III of IBC relating to the role and functions of a resolution professional, even though both use the expression ‘resolution professional’. Section 5(27) (Definitions) of IBC provides that a resolution professional, for the purposes of Part II, means an insolvency professional appointed to conduct the CIRP or the pre-packaged insolvency resolution process, as the case may be, and to include an interim resolution professional.

The role of Adjudicating Authority:

The Supreme Court was of the view that the resolution professional does not possess an adjudicatory function in terms of the provisions of Section 99 of IBC and there has been no provision made in Part III of IBC empowering the resolution professional to take over the assets or the business which is being carried on by the individual or the partnership. The role of resolution professional under Section 99 of IBC is that of a facilitator. The role of the resolution professional is purely recommendatory in nature and cannot bind the creditor, the debtor or the adjudicating authority.

The Supreme Court also noted that Section 14(1)(b) of IBC empowers the adjudicating authority to declare a moratorium restraining the transfer, encumbrance, alienation or disposal by the corporate debtor of any of its assets or any legal right or beneficial interest therein. Further, the moratorium under Section 14 of IBC operates on the order passed by an adjudicating authority whereas the purpose of the moratorium under Section 96 of IBC is protective in nature.

The Supreme Court in respect to the role of the adjudicating authority, held that after the submission of a recommendatory report by the resolution professional, the adjudicating authority’s adjudicatory functions begins. Hence, the Supreme Court provided its observation pertaining to the role of the resolution professional, the imposition of the moratorium as well as the stage at which the function of the adjudicating authority comes into play, under Parts II and III of IBC.

Part II: Applicability of the principles of natural justice:

The Supreme Court analysed the ambit of Section 99(4) of IBC which is prefaced by the words “for the purposes of examining an application”. It implies that when the resolution professional is empowered to seek information or explanation in connection with the application, such information or explanation must be relevant to and bearing a connection with the nature of the application itself. Such power to seek any information or any explanation is concerned with the nature of the application submitted under Sections 94 or 95 of IBC.

The right for filing such representation is sufficient compliance of the principles of natural justice which postulates the concept of audi alterum partem, that is, an opportunity of being heard to a person who is liable to be affected by an investigation, enquiry, proceeding or action. Therefore, the Supreme Court observed that the assertion by the Petitioner in relation to the violation of natural justice principle holds no merit.

Part III: Challenge to the constitutional validity of the provisions of IBC:

While interpreting Part II of IBC, the Supreme Court has drawn inference of the requirement for granting an opportunity to a debtor before initiating the insolvency resolution process against them. It was observed by the Supreme Court that Section 100 of IBC does not explicitly mention a hearing for a debtor. However, the requirement of a hearing for a debtor must be read into Section 100 of IBC. To support this observation, the Supreme Court held that in legal interpretation, when a statute is silent on a specific aspect, such as hearing, for which there is no explicit prohibition, the Supreme Court may imply or read in such a requirement. Therefore, the lack of explicit mention of a hearing in a provision does not automatically make it unconstitutional because such a requirement can be read into the statute.

The resolution professional in exercise of his duty under Section 99 of IBC may not embark on a roving enquiry into the affairs of the debtor or personal guarantor. The information sought by the resolution professional from the creditor, debtor, or third parties must be relevant to the examination of the application of insolvency resolution process. The Supreme Court observed that the proportionality test devised for privacy under Article 21 (Protection of life and personal liberty) of the Constitution is met by the virtue of vesting such powers in the resolution professional along with his duty to keep such information confidential. Additionally, the nature of the role of resolution professional, the powers of resolution professional, as well as its nexus with the legislation’s legitimate aim also leads to the conclusion that the provisions of Sections 95 to 100 of IBC are compliant with Article 14 of the Constitution. Therefore, an adjudicatory decision-making process of the nature which has been suggested by the Petitioner would not be implicated under Section 97(5) of IBC, since to accept the submission of the Petitioner would render the provisions of Sections 99 and 100 of IBC otiose.

Decision of the Supreme Court

The Supreme Court held that at the stages envisaged under Sections 95 to 99 of IBC, there is no involvement of judicial adjudication. The resolution professional appointed under Section 97 of IBC serves a facilitative role of collating all the facts relevant to the examination of the application for the commencement of the insolvency resolution process which has been preferred under Sections 94 or 95 of IBC. Additionally, the report to be submitted to the adjudicatory authority is recommendatory in nature on whether to accept or reject the application.

The Supreme Court held that there is no violation of natural justice under Sections 95 to 100 of IBC as the debtor is not deprived of an opportunity to participate in the process of the examination of the application by the resolution professional. The Supreme Court also held that until the adjudicating authority decides under Section 100 of IBC whether to accept or reject the application, no judicial determination takes place and the adjudicatory authority must observe the principles of natural justice while exercising its jurisdiction under Section 100 of IBC for the purpose of determining whether to accept or reject the application. The Supreme Court held that the purpose of interim-moratorium under Section 96 of IBC is to protect the debtor from further legal proceedings.

It was held by the Supreme Court that the provisions of Sections 95 to 100 of IBC are not unconstitutional as they do not violate Articles 14 and 21 of the Constitution.

VA View:

In the present case, the Supreme Court highlights the underlying spirit of IBC which is concerned with observance of stringent time lines under IBC as time bound resolution of insolvency constitutes the heart and soul of the provisions of IBC. The Supreme Court in this case has analyzed the scheme of IBC in-depth in light of the constitutional validity of the provisions of IBC and with the backdrop of the principle of natural justice.

The Supreme Court has rightly highlighted the role and functions of an adjudicating authority and the purpose of the interim-moratorium under Section 96 of IBC. This judgement ultimately settles and puts an end to the questions being raised pertaining to the similar set of issues and challenging the constitutional validity of certain provisions of IBC.

Further, on account of the present batch of writ petitions being sub-judice before the Supreme Court and status quo order of the Supreme Court in some of these writ petitions, the Adjudicating Authority was not in a position to proceed further and admit the personal guarantors in insolvency. However, pursuant to pronouncement of this judgment, the cases and mechanism of personal insolvency as envisaged under IBC will be proceeded expeditiously and the personal guarantors will no longer take shelter of pendency of constitutional challenge before the Supreme Court to evade the process of law.

For any query, please write to Mr. Bomi Daruwala at [email protected]

Supreme Court: Rents receivable can be assigned by a debtor to a creditor as actionable claim

The Supreme Court, vide its judgment dated October 19, 2023, in the matter of Infrastructure Leasing and Financial Services Limited v. HDFC Bank Limited and Another [Civil Appeal No(s). 4708 of 2022], has held that rents receivable can be assigned by a debtor to a creditor as actionable claim and dismissed an appeal assailing the impugned order dated May 13, 2022 (“Impugned Order”) passed by the National Company Law Appellate Tribunal, New Delhi (“NCLAT”).

Facts

Housing Development Finance Corporation Limited (“HDFC”) extended a credit facility of INR 400 Crores to Infrastructure Leasing and Financial Services Limited (“ILFS”/ “Appellant”) by way of a sanction letter dated June 22, 2018. Further, a Master Facility Agreement (“MFA”) was executed between HDFC and ILFS for securing the aforesaid credit facility. The MFA stipulated creation of an escrow account with HDFC Bank Limited (“Escrow Bank”/ “Respondent”). Further, an Assignment Agreement dated June 25, 2018 (“Assignment Agreement”) was executed between HDFC and ILFS. In terms of the Assignment Agreement, HDFC and ILFS had agreed that the authorized indebtedness of ILFS as per MFA, by way of the aforesaid credit facility together with the interest thereon was payable from the gross income and revenue to be derived from the operation of their business centre services agreements/ lease /leave and license agreement(s). It was further agreed that ‘all the receivables derived/ to be derived from the operation of the borrower’s contracts, a sufficient portion of which, to pay the principal and interest as and when the same shall become due’ in terms of the MFA was assigned and pledged and was ‘set aside for that purpose on the same day’. Power of Attorney was also executed between HDFC and ILFS (“POA”).

Further, pursuant to a petition filed on October 1, 2018 by the Union of India under Section 241 (Application to Tribunal for relief in cases of oppression, etc.) and Section 242 (Powers of Tribunal) of the Companies Act, 2013, the National Company Law Tribunal, Mumbai (“NCLT”) had ordered to supersede the existing board of directors of ILFS. Consequently, a new board of directors was constituted to take charge of the affairs of ILFS. However, by a subsequent order dated October 12, 2018, NCLT had declined to grant moratorium sought by the Union of India, similar to moratorium in terms of Section 14 (Moratorium) of the Insolvency and Bankruptcy Code, 2016 (“Code”). Thereafter, by order dated October 15, 2018 (“NCLAT Order”), NCLAT had granted appropriate reliefs in the nature of moratorium. Inter alia, the aforesaid order included stay on any action to foreclose, recover or enforce any security interest created over the assets of ILFS or those of its 348 group companies as well as stay on the acceleration, premature withdrawal or other withdrawal, invocation of any term loan, corporate loan, bridge loan, commercial paper, debentures, fixed deposits, guarantees, letter of support, commitment or comfort and other financial facilities or obligations availed by ILFS and its 348 group companies.

By e-mail dated October 16, 2018, ILFS informed the Escrow Bank about the NCLAT Order. On October 19, 2018, HDFC instructed the Escrow Bank to transfer monthly instalments from the escrow account to HDFC’s account. On October 23, 2018, ILFS informed HDFC about the NCLAT Order. Further, by letter dated October 27, 2018, ILFS called upon HDFC to reverse the debit of INR 6.24 Crores and credit the aforesaid amount back to ILFS. HDFC replied to the aforesaid letter addressed by ILFS, thereby stating that receivables (that is, rents) in respect of the secured property were assigned by ILFS in favour of HDFC and the asset ceased to belong to ILFS. Further, on January 4, 2019, ILFS called upon HDFC to reverse the amount debited by the Escrow Bank in the escrow account. Thereafter, by order dated February 4, 2019, NCLAT directed the Union of India and ILFS to approach Justice (Retired) Mr. D.K. Jain to seek supervision on the operation of the resolution process. Thereafter, pursuant to restrain orders being sought against banks and financial institutions from debiting accounts of ILFS and its group entities, on August 8, 2019, NCLAT passed an order to the effect that if any bank/ financial institution has debited any amount in violation of NCLAT Order, it will be open to Union of India and/or ILFS to apprise Justice Mr. D.K. Jain and seek appropriate reliefs.

Pursuant thereto, ILFS made a representation before Justice Mr. D.K. Jain on August 28, 2019. Accordingly, Justice Mr. D.K. Jain issued show cause notices to HDFC as well as the Escrow Bank. In response to the show cause notice, the Escrow Bank stated that the receivables stood assigned in favour of HDFC and monies received were not the assets of ILFS. Thereafter, a personal hearing was granted to the parties, pursuant to which, on May 12, 2020, Justice Mr. D.K. Jain recommended the Escrow Bank and HDFC to maintain the status quo in the escrow account till a final view was taken on the application filed by ILFS. In view thereof, the Escrow Bank ceased to debit any amount from the escrow account. Thereafter, on July 3, 2020, Justice Mr. D.K. Jain passed a final order holding that the actions of HDFC and Escrow Bank in debiting the amount from the escrow account amounted to violation of the order passed by NCLAT and thus, HDFC and the Escrow Bank were directed to purge themselves within two weeks. In view of the aforesaid final order passed by Justice Mr. D.K. Jain, HDFC assailed the aforesaid order before NCLAT and sought the same be set aside. Whereas, ILFS sought direction from NCLAT that INR 112,79,18,348/- appropriated from its accounts towards debt service payments were in violation of the NCLAT Order as well as the final order passed by Justice Mr. D.K. Jain.

By the Impugned Order, NCLAT held that in so far as the amount of receivables deposited in the escrow account were sufficient to meet the principal and interest (payable by ILFS) assigned by the said borrower to HDFC, no proprietary interest continued with ILFS nor could it exercise any right over that part of the escrow account which was assigned. However, NCLAT did not accede to the contention raised by ILFS that there was no assignment of the receivables, but only the creation of security interest in the receivables. Further, NCLAT observed that since there was an express assignment of lease rental, sufficient to meet the principal and interest payments, the “assignment has to be accepted as assignment” in favour of HDFC and that pledge in the Assignment Agreement did not take away the nature of the transaction documents which was assignment. NCLAT further held that the NCLAT Order did not negate the Assignment Agreement nor did it take away the proprietary right of HDFC in the lease rental receivables. However, the right over receivables deposited in the escrow account to the extent they were in excess of principal and interest, was retained by ILFS and any amount in excess of the said principal and interest transferred to or debited in HDFC’s account needed to be reversed, after adjusting the shortfall in debiting any interest or principal of any earlier months.

Aggrieved by the Impugned Order, ILFS approached the Supreme Court challenging the same.

Issue

Whether the credit facility and other ancillary loan documents executed by ILFS, pursuant to which rents payable to ILFS stood passed over to HDFC, amounts to assignment and stands outside the purview of an “asset” owned by ILFS.

Arguments

Contentions of the Appellant:

It was contended by the Appellant that MFA and other agreements executed between parties clearly indicate that the credit facility advanced to ILFS was loan repayable within 96 months. The security interest was created by ILFS and the receivables were in the nature of security for repayment of the aforesaid credit facility. Further, escrow account was created in the Escrow Bank for the purpose of facilitating the repayment of principal and interest as per the repayment schedule. However, there was no transfer of title in the receivables from ILFS to HDFC. Further, the Appellant emphasized upon the order passed by Justice Mr. D. K. Jain and submitted that HDFC and Escrow Bank were obliged to return the amount debited to the tune of INR 112,79,18,348/-.

Further, the Appellant argued that the Lease Rental Discounting facility (“Lease Rental Discounting”) as relied upon by HDFC is a type of term loan offered with security of rental income. Further, none of the clauses from the relevant documents executed between parties contain any element or mention of the sale and purchase of the debt of ILFS. Hence, the aforesaid transaction is a loan transaction leading to creation of security interest and not a sale of debt at all.

Further, it was submitted that from the provisions of the Assignment Agreement and MFA, it is absolutely clear that receivables were charged in favour of HDFC only for securing the obligations of ILFS under MFA and for the purpose of facilitation of repayment and it did not amount to a transfer of the legal title over such receivables which continues to vest with ILFS.

Contentions of the Respondent:

It was contended by the Respondent that a bare reading of the transaction documents makes it clear that the facility extended to ILFS is a Lease Rental Discounting, which is significantly different from a traditional loan transaction. It was further submitted that a Lease Rental Discounting involves the assignment/ sale of the rent receivables by the landlord to the financing entity at a discounted value in terms of the transaction documents. Hence, the assigned receivables are the property of HDFC and ILFS has no right/ title or interest in the monies/ receivables/ amount deposited in the escrow account. It was submitted that the transaction is not covered within the purview of NCLAT Order, as it was restricted to the assets of ILFS, whereas assigned receivables pursuant to Lease Rental Discounting belong to HDFC.

Observations of the Supreme Court

The Supreme Court observed that by virtue of POA executed by ILFS on June 25, 2018, ILFS had irrevocably nominated, constituted and appointed HDFC as its true and lawful attorney on its behalf and that the relevant clauses of the POA enabled HDFC to appropriate the proceeds received towards the discharge of the aforesaid facility and to receive all rents and all other sums in respect of such premises.

Further, the Supreme Court relied upon a plethora of judgments including Yellapu Uma Maheshwari v. Buddha Jagadheeswararao [(2015) 11 SCR 849] and Assam Small Scale Industries Development Corporation Limited v. J.D. Pharmaceuticals [2005 Supp (4) SCR 232] to conclude that in order to understand the nature of transactions entered into between parties, the same has to be determined on the basis interpretation of the transaction documents in its entirety and the substance therein and not merely on the nomenclature given in the transaction documents.

In particular, the Supreme Court observed that Lease Rental Discounting is a new kind of financial agreement by which a banker allows credit facilities to a commercial property owner, whereby it can be ensured that the asset owner is given access to credit. In such an arrangement, a substantial portion or the entire rent or receivables which the owner would be entitled to are made-sold or assigned, absolutely to the creditor bank with the intention that the borrower’s liabilities are discharged automatically from the proceeds payable in respect of the property. Considering that the owner is a debtor of the bank, the latter becomes the creditor of the tenant or the lessee as the case may be.

Further, the Supreme Court observed that the relevant clauses from the Assignment Agreement clearly set aside the rents payable to ILFS, in favour of the assignee, that is, HDFC. Further, relevant clause from the escrow agreement records that all receivables to which the borrower would be entitled would be deposited in the escrow account and further, that, the lessees or tenants of the properties owned by the borrower be instructed to pay such an amount in the escrow account itself. Furthermore, the escrow agreement authorizes only the lender (that is, HDFC) to instruct the Escrow Bank to transfer the amounts and permits the Escrow Bank to appropriate amounts towards adjustment arising out of the facility liability. Further, the POA categorically entitles HDFC to appropriate the proceeds deposited towards the discharge of the borrower’s liability under the aforesaid facility. Hence, the bank/ lender virtually steps into the shoes of the borrower and by the terms of the POA is also authorized to let out the premises in case due to an unforeseen situation an existing lessee or tenant vacates it or is unable to pay.

Hence, basis conjoint reading of all relevant transaction documents and ascertaining their interpretation in its entirety, the Supreme Court arrived at the conclusion that parties intended assignment of debt, that is, the rents payable.

Further, the Supreme Court considered it necessary to determine as to whether such amounts payable on a future date are to be considered property and, therefore, capable of transfer. In this regard, it was observed that as per Section 5 (“Transfer of property” defined) of the Transfer of Property Act, 1882, all manner of property is capable of transfer. Furthermore, Section 6 (What may be transferred) of the Transfer of Property Act, 1882 provides as to what kinds of properties or actions are not transferable, that is, personal claims in the nature of tortious claims and choices in action cannot be transferred.

Thereafter, the Supreme Court analyzed the definition of actionable claims as envisaged under the provisions of the Transfer of Property Act, 1882 as well as Sections 130 (Transfer of actionable claim), 131 (Notice to be in writing, signed) and 132 (Liability of transferee of actionable claim) of the Transfer of Property Act, 1882 which deal with transfer of actionable claims. Upon in-depth analysis, Supreme Court arrived at the conclusion that rents receivable can be assigned by a debtor to a creditor as actionable claim.

Decision of the Supreme Court

In view of the submissions made by parties and the above-mentioned observations, Supreme Court held that in the present case, the rents payable by the tenants, lessees and licensees are debts, which stood transferred to HDFC.

Therefore, Supreme Court held that rents receivable can be assigned by a debtor to a creditor as actionable claim. In view of the aforesaid decision, the present appeal filed by ILFS stood dismissed.

VA View:

The present judicial pronouncement rendered by the Supreme Court gives clarity on those issues which were unsettled and hence, are no more res integra.

More particularly, this judgment sets outs the precedent that when a borrower avails credit facilities and executes an assignment agreement by way of Lease Rental Discounting which is secured against the rent receivables from the property in question, would tantamount to transfer of right, title and interest in the rental amounts in favour of the lender and not merely creation of security interest. Therefore, Supreme Court has clarified that rents receivable can be assigned by a debtor to a creditor and the same shall come within the purview of actionable claim as per the provisions of the Transfer of Property Act, 1882.

For any query, please write to Mr. Bomi Daruwala at [email protected]