The Supreme Court of India (“Supreme Court”), vide its judgement jointly in the matter of Moser Baer Karamchari Union Through President Mahesh Chand Sharma v. Union of India and Others [Writ Petition (C) No. 421 of 2019], Manoj Kumar Nagar v. Union of India [Writ Petition (C) No. 777 of 2020], and Raj Kumar Verma v. Union of India [Writ Petition (C) No. 712 of 2020], has upheld the constitutional validity of Section 327(7) of the Companies Act, 2013 (“Companies Act”) which provides inapplicability of Section 326 (Overriding preferential payments) and Section 327 (Preferential payments) of the Companies Act, on a company undergoing liquidation under the Insolvency and Bankruptcy Code, 2016 (“IBC”).

Facts

By way of a writ petition under Article 32 (Remedies for enforcement of rights conferred by this Part) of the Constitution of India (“Constitution”), Moser Baer Karamchari Union (“Petitioner 1”), Manoj Kumar Nagar and Raj Kumar Verma (collectively, “Petitioners”) challenged the vires of Section 327(7) of the Companies Act (“Impugned Section”) as being arbitrary and violative of Articles 14 (Equality before law) and 21 (Protection of life and personal liberty) of the Constitution. Petitioner 1 had also prayed to issue a writ, direction or order in the nature of mandamus so as to leave the statutory claims of the “workmen’s dues” out of the purview of waterfall mechanism under Section 53 (Distribution of assets) of IBC. Impugned Section, which was introduced by Clause 19(a) of the Eleventh Schedule of IBC, puts a statutory bar on the applicability of Sections 326 and 327 of the Companies Act to liquidation proceedings under IBC. The writ petitions are against the Union of India (“Respondent”).

Issue

Whether the Impugned Section is constitutionally valid.

Arguments

Contentions of the Petitioners:

The Petitioners contended that Clause 19(a) of the Eleventh Schedule of IBC, which inserted the Impugned Section in the Companies Act, is unreasonable and violative of Article 14 of the Constitution.

The Petitioners also contended that the legislature intended to provide ‘overriding preferential payments’ to workmen pari passu to the claim of secured creditors. In order to support this contention, the Petitioners had cited various committee reports, inter alia, Eradi Committee Report, the Report of Expert Committee on Company Law, 2005, etc. It was a result of these committee findings that Section 326 of the Companies Act was amended to provide that the wages/ salaries payable to the workmen for a period of 2 years was protected in the case of winding up. Further, the workmen’s due and dues owed to secured creditors, as per Section 325(1) (Application of insolvency rules in winding up of insolvent companies) of the Companies Act, ranked pari pasu. The Petitioners submitted that Section 53 of IBC provided for waterfall mechanism which completely altered the system under Sections 325 to 327 of the Companies Act, and further Clause 19(a) of the Eleventh Schedule of IBC made Sections 326 and 327 of the Companies Act, inapplicable to a company in liquidation under IBC.

The Petitioners also contended that there was an unreasonable classification between distribution of workmen dues for liquidation of a company (i) under the IBC and (ii) under the Companies Act, which was created by the Impugned Section. The workmen’s due for a period of 2 years preceding the liquidation commencement date and the debts owed to secured creditors in event of them relinquishing their security are now ranked as pari passu. Further, IBC excludes all sums due to workman or employee from the provident fund, pension fund, and gratuity fund from being included in the liquidation estate.

Contentions of the Respondent:

The Respondent contended that, through a catena of judgements: Manish Kumar v. Union of India [(2021) 5 SCC 1], Swiss Ribbon Private Limited v. Union of India [(2019) 4 SCC 17] (“Swiss Ribbons Case”) and, Small Scale Industrial Manufacturers Association (Registered) v. Union of India [(2021) 8 SCC 511], the Supreme Court had advocated the principle of ‘judicial hands-off’ when it came to economic legislations. They also contended that in economic matters, a wider leeway was given to the law-makers and the court allows for experimentation in such legislation based on practical experiences and other problems seen by the law makers.

The Respondent further contended that in Swiss Ribbons Case, the Supreme Court had upheld the constitutionally validity of the scheme of IBC. Further, reliance was also placed to the judgment of the Supreme Court in the case of Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta [(2020) 8 SCC 531], where it was held that the principle of “equality for all” cannot be stretched to treat financial and operational creditors on par as this would defeat the entire objective of the IBC. It was also held that amendment made to the IBC, that guaranteed a minimum of liquidation value to the operational creditors, was not ultra vires Article 14 of the Constitution.

The Respondent also contended that initially the insolvency process in case of winding up of companies were provided under Section 325 of the Companies Act. However, Section 325 of the Companies Act was omitted with effect from November 15, 2016, on the advent of the IBC. It was, therefore, contended that as on date, the winding up procedure is not governed by the Companies Act, and that the provision of the IBC is the only applicable law to deal with such situation as it is a complete code in itself. It was also contended that an amendment with effect from November 15, 2016 was brought in the Impugned Section, wherein it has been clarified that Sections 326 and 327 of the Companies Act would not be applicable in the event of liquidation under IBC.

Observations of the Supreme Court

The Supreme Court, after a conspectus of the relevant laws and provisions of the Companies Act and the IBC, observed that the object and purpose of amending the Companies Act and to exclude Sections 326 and 327 of the Companies Act in the event of liquidation under the IBC appears that there may not be two different provisions with respect to winding up/ liquidation of a company. Therefore, in view of the enactment of IBC, it was necessitated to exclude the applicability of Sections 326 and 327 of the Companies Act which cannot be said to be arbitrary as contended by the Petitioners.

The Supreme Court also observed that merely because under the earlier regime and in case of winding up of a company under the Companies Act, 1956/2013, the dues of the workmen may be pari passu with that of the secured creditors, the Petitioners cannot claim the same benefit in case of winding up/liquidation of the company under the IBC.

With respect to Section 53 of the IBC, the Supreme Court observed that as per Section 53(1)(b), the workmen’s due for the period of 24 months preceding the liquidation commencement date shall rank equally between the workmen and the secured creditors in the event such secured creditor has relinquished security in the manner set out in Section 52 (Secured creditor in liquidation proceedings) of the IBC. Therefore, workmen’s due for the period of 24 months preceding the liquidation commencement date shall rank pari passu with the dues of secured creditors.

With respect to the exclusion of provident fund, pension fund, and gratuity fund from the liquidation estate asset by reason of Section 36(4) of IBC, Supreme Court observed that it was a conscious decision that has been taken by the legislature in its wisdom to keep out all the sums due to workmen from such provident fund, pension fund, and gratuity fund from the liquidation estate assets. It cannot be said to be violative of Articles 14 and 21 of the Constitution since IBC is altogether a complete code with different purpose than that of the Companies Act. The Supreme Court also placed reliance upon its judgment in the Swiss Ribbons Case and in R.K. Garg v. Union of India [(1981) 4 SCC 675], wherein it was held that in laws relating to economic activities, it is important to give greater latitude to them, and that judicial hands-off qua economic legislation is important.

The Supreme Court also observed that Section 53 of the IBC began with a non-obstante clause and states that notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of liquidation asset shall be distributed in the order of priority which is stipulated and within such period and such manner as may be specified. Supreme Court observed that the waterfall mechanism is based on a structured mathematical formula and the hierarchy is created in terms of payment of debts in order of priority with several qualifications. Thus, the inapplicability of Sections 326 and 327 of the Companies Act in case of liquidation under IBC was made by the Parliament in its wisdom. Thus, the Supreme Court observed that Impugned Section was not unconstitutional.

Decision of the Supreme Court

The Supreme Court, in view of the above stated reasons and provisions of law held that the Impugned Section, which made Sections 326 and 327 of the Companies Act inapplicable to a company undergoing liquidation under the provisions of the IBC, was not unconstitutional, since both IBC and Companies Act were operative in different fields and for different purpose, and there could not be two simultaneous mechanisms with respect to a company undergoing liquidation under the IBC.

VA View:

The Supreme Court of India has rightly upheld the constitutional validity of the Impugned Section.

IBC and the Companies Act are enacted for different purposes. IBC is a complete code in itself, which, inter alia, provides for the waterfall mechanism stipulating the order of priority in which the payment of claims should be made. Therefore, it was important that the Impugned Section was enacted in order to clarify that Sections 326 and 327 of the Companies Act are inapplicable in an event where a company is undergoing liquidation under the IBC. Further the difference in classification between the treatment of an operational creditor and a financial creditor has been, inter alia, upheld by the Supreme Court in a catena of judgments including in the case of Swiss Ribbons Case. Additionally, in the case of R.K. Garg v. Union of India [(1981) 4 SCC 675] it is well settled that in laws relating to economic activities, it is important to give greater latitude to them, and that ‘judicial hands-off’ qua economic legislation is important.

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

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