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15 November, 2017
WHAT SORT OF CREDITOR ARE YOU?
We have highlighted before the unusual distinction in the drafting of the IBC between financial creditors and operational creditors.
It is a distinction not seen in other developed jurisdictions, where all claims are generally distinguished only by whether they are secured or not, and, if secured, by the relative priority accorded by the nature and timing of grant of the security interest. Elsewhere, unsecured claims generally rank pari passu with other unsecured creditors rather than having a higher priority in a liquidation, and having greater rights during a corporate insolvency resolution process (CIRP), if financial as opposed to operational (ie trading) in nature.
Having been so closely involved in the formulation and the drafting of the IBC we understand the thinking behind the distinction as it has been adopted by the IBC, but it is giving rise to some unfortunate consequences in practice, which we believe are simple to rectify and should be on the priority list for early amendment or explanatory regulation.
The first issue arises from the way in which the distinction between financial debt and operational debt is drafted; the two have separate definitions with the unhelpful result that some debts may fall between the two stools – ie may not be readily classified as either financial debt or operational debt, and as a result lack the ability to trigger a CIRP or participate in it as fully as was intended or prove for their debts. The cases which have highlighted this issue are to do with the rights of prospective homeowners who have made advance payments towards the purchase of real property (apartments etc) but who do not apparently have locus either as financial creditors or operational creditors.
We have advised on other matters (not as yet before the NCLT) where foreign joint venture parties or investors are similarly concerned that the nature of their claim is difficult to classify under the IBC, and therefore where their rights against a company in difficulty are actually or potentially compromised not by the distress of their counterparty but by what appears to be odd drafting in the IBC. Given the intention of the IBC to improve the ease of doing business in India and facilitate realisations by all creditors that cannot have been intended.
The best solution we can suggest is to redefine operational debt/operational creditors as all claims/claimants which are not defined in the IBC as financial debt/financial creditors. This would maintain the integrity of the structure chosen for the IBC (ie the distinction between financial and operational debt/ creditors) but avoid any risk that a claim might fall under neither category and therefore be lost however legitimate it may be.
We also suggest that as of now all foreign investors or creditors need to review their contracts with Indian counterparties so that, pending such a refinement of the drafting of the relevant definitions under the IBC, they are as well protected as they can be by the terms and conditions of their contract – by making as clear as possible that their claims would qualify either as financial debt or operational debt and therefore mitigating the risk that they will not be able to enforce and prove effectively under the IBC if their counterparty becomes financially distressed. They need to be mindful that, absent any rights under the IBC, they are woefully short of any other means to enforce against the recalcitrant Indian obligor, and therefore need to make the most of their rights under the IBC.
HOW CAN YOU DEMONSTRATE DEFAULT IF YOU ARE AN OPERATIONAL CREDITOR?
A key part of the infrastructure which is intended to underpin the IBC is that there are comprehensive and reliable Information Utilities, through which it is transparent and easy to prove a payment default by an Indian debtor.
These Information Utilities are understandably slow to come on stream and in the meantime it has become apparent that proving a payment default in a sufficient manner to satisfy the requirements of the IBC relating to triggering a CIRP can be very tricky.
Because they are deprived of other remedies – the IBC is intended to take their place – we understand that unpaid operational creditors have been making more applications than financial creditors and the corporate debtors combined, which was not really expected or intended.
Two issues have arisen, which also seem easy to address effectively; one is to do with disputed claims, the other is to do with the paperwork required by a foreign operational creditor to demonstrate non payment.
In summary, a CIRP may only be commenced by an operational creditor if it has not received notice of a dispute from the debtor. Many of the cases both before the NCLT and the courts to date have been to do with whether a claim can be made under the IBC if it either has been disputed or there are grounds to dispute the amount claimed. It was never intended that the NCLT look into the merits of the dispute in question, and generally it has stood back from doing so, but it has become clear that if it is demonstrated that there is a credible dispute (which, of course, a well advised and astute debtor may be able to do) an application for the commencement of a CIRP cannot be filed. Under English law, the courts will not make a winding up order where the relevant debt is genuinely disputed and there is plethora of helpful case law where the courts have considered what constitutes a genuinely disputed debt.
Rarely is a disputed claim arising from normal commercial dealings between trading counterparties not payable at all; more likely the quantum will be in dispute. As long as what is due exceeds the materiality threshold specified in the IBC, a claim ought to be allowed as a basis for an application to commence a CIRP and the operational creditor should seek to rely on the undisputed amount in the making of its application; this is the approach followed elsewhere and we suggest that it would be easy for the NCLT, if necessary reinforced by some clarificatory regulation as to the paperwork to support an application, to adopt this approach and dramatically reduce the scope for corporate debtors to postpone or frustrate well founded applications based on specious or artificial disputes.
The second issue is to do with how a foreign creditor demonstrates non payment; it seems that the creditor must demonstrate non payment by showing bank statements from an Indian bank to the NCLT along with the other paperwork required to apply for a CIRP to begin. This is obviously extremely difficult and a very real block on the utility of the IBC from the foreign creditor perspective. Again it cannot have been intended, is a real hurdle making it harder than ever to do business with an Indian counterparty, but would be easy and quick to fix.
This is going to be of particular relevance to and an issue for foreign joint venture investors in India which do not otherwise have a presence on the ground in India seeking payments due from the joint venture. It will also limit the appetite for non-Indian purchasers of receivables due from Indian companies to purchase on a factoring basis such receivables and therefore reduce the availability of credit to India.
For further information, please contact:
Clive Barnard, Partner, Herbert Smith Freehills
Clive.Barnard@hsf.com
