Introduction
The classification of financial and operational debts within the
context of insolvency proceedings presents a complex legal
landscape that demands scrutiny and nuanced interpretation.
Recently, the NCLAT Delhi was confronted with a peculiar case
involving intricacies of debt classification under the Insolvency and Bankruptcy Code (IBC) in India.
Through a meticulous analysis of contractual agreements and the
intent of the parties involved, the Tribunal’s judgment sheds
light on the critical importance of accurately discerning the
nature of debts in insolvency proceedings. This judgment sets the
stage for a deeper exploration of the nuanced legal principles and
implications elucidated by the case, ultimately underlining the
imperative for clear guidelines and pragmatic approaches in
navigating the complexities of CIRP under the IBC. This article
explores the facts and findings of the Tribunal in the case and
analyses why the issue involved in the case is significant in the
current Insolvency Regime.
Background of the Case
Unicast Autotech Pvt. Ltd. (the Corporate Debtor) specializes in
manufacturing aluminium die casts, while Uno Minda Limited
(Respondent 1) is engaged in providing automotive solutions to
original equipment manufacturers (OEMs). A Business Support
Agreement (BSA) was executed between the Corporate Debtor, its
promoters, and Respondent 1. The BSA aimed to facilitate the sale
of a 100% stake in the Corporate Debtor and to provide raw material
funding and critical working capital requirements. According to the
agreement, all funds lent were to be treated as unsecured debts to
the Corporate Debtor, payable solely by the promoters. The case
revolves around the classification of a debt owed by Respondent No.
1 to the Corporate Debtor as either financial or operational. The
main issue in the present case is whether the funds provided were
for working capital needs, including payments for raw materials,
thereby constituting financial debt, or if they were merely for the
supply of goods, constituting operational debt.
The Appellant argued that the funds provided were not a direct
financial debt to the Corporate Debtor but were used for payments
to suppliers on behalf of the Corporate Debtor. They referred to
various clauses in agreements such as the Business Support
Agreement (BSA), Share Purchase Agreement (SPA), and deed of
guarantee to support their argument.
On the other hand, Respondent No. 1 contended that the funds
provided were indeed for working capital requirements, including
raw material procurement, at the instruction of the Corporate
Debtor, thus constituting financial debt. The Tribunal rejected the
argument that the agreements were solely between the Promoter Group
and Respondent No. 1, asserting that the Corporate Debtor was a
party to the agreements and had consented to them.
The Tribunal analyzed the agreements and deeds presented by both
parties, noting clauses indicating financial assistance provided by
Respondent No. 1 for the benefit of the Corporate Debtor. These
agreements were jointly entered into by the Promoters, the
Corporate Debtor, and Respondent No. 1, with the Corporate
Debtor’s consent. The Tribunal pointed out that the intent
behind the agreements was clear: to provide working capital to the
Corporate Debtor, including making payments for raw materials on
its behalf. They reasoned that raw materials are inherently part of
working capital, and any financial assistance for this purpose
should be considered financial debt.
Differentiating Financial Debt and Operational Debt under
IBC
Operational debt and financial debt differ primarily in their
nature under insolvency laws. Section 5(21) of the IBC defines an
operational debt as a claim for the provision of goods or services,
including employment, or a debt for the repayment of dues arising
under any law for the time being in force and payable to the
Central Government, any State Government, or a local authority.
On the other hand, Section 5(8) of the Insolvency and Bankruptcy
Code (IBC) provides an inclusive definition of “financial
debt.” It states that financial debt includes a debt along
with interest, if any, which is disbursed against the consideration
for the time value of money.
Further, the IBC distinguishes between financial creditors and
operational creditors based on the nature of their claims in the
insolvency process. Financial creditors are entities that lend
money to a company. They have a primary claim on the assets of the
company in case of insolvency. Operational creditors are entities
that provide goods and services to a company in their ordinary
course of business. For instance, the wholesale vendor whose spark
plugs are stocked by the car mechanic and who receives payment only
after the spark plugs are sold qualifies as an operational
creditor. They have a secondary claim on the assets of the company
in the event of insolvency after the claims of financial creditors
have been addressed.
Section 21 of the IBC provides for the Committee of Creditors,
where sub-section (2) noticeably includes financial creditors and
excludes operational creditors as its members. In the Banking Law
Reforms Committee Report, 2015, it is reasoned that,
“Ordinarily, operational creditors are neither able nor
willing to make decisions on the entity’s insolvency or to
incur the risk of delaying payments in exchange for the
entity’s prospects. The Committee concluded that the Code would
stipulate that the creditor’s committee should be limited to
only the financial creditors in order for the process to be quick
and effective.”
The Committee justified the preference for financial creditors
by suggesting that the creditors committee is tasked with
evaluating the viability of an entity and negotiating changes to
liabilities which is understood by financial creditors. Operational
creditors may lack the expertise or willingness to participate
effectively in these decisions. Therefore, restricting the
committee to financial creditors is deemed crucial for expediting
the insolvency process and achieving favorable outcomes.
Implications of the Judgment
From the above discussion, it is evident that there is a
disparity in the authority given to financial creditors compared to
operational creditors under the Insolvency and Bankruptcy Code
(IBC). This discrepancy underscores the importance of accurately
classifying debts as operational or financial during the Corporate
Insolvency Resolution Process (CIRP). The case, Rajeev Kumar Jain
vs. Uno Minda Ltd. and Anr., presents a nuanced understanding of
the what qualifies as financial debt. A plain reading of the
definition of financial debt under Section 5(8) of the Code would
give an idea that financial debt is any debt with interest
disbursed against time value of money and has an effect of
commercial borrowing. However, this plain reading of the term would
not have sufficed in this case. On the face of it, the debt would
appear to be operational since raw materials are employed for the
purpose of operations of a company. However, the nature and terms
of the transaction in this particular case made it imperative for
the Tribunal to analyze the Agreement involved and categorize the
debt accordingly. The judgment underscores that financial debt is
not limited to the direct disbursement of funds to the debtor but
extends to any financial assistance provided for the debtor’s
benefit, such as covering working capital needs. The Tribunal
scrutinized the agreements holistically, emphasizing the parties
involved and the intentions behind the transactions.
This approach ensures that the substance of the agreements,
rather than their form, determines the classification of debt. The
judgment is peculiar as adopts a pragmatic stance by prioritizing
the economic reality of the transactions over formalistic
arguments. It recognizes that the ultimate aim is to facilitate the
resolution process by accurately classifying debts. The judgment
has broader implications for insolvency resolution processes, as it
sets a precedent for accurately classifying debts and ensuring
equitable treatment of creditors.
Concluding Remarks
The Insolvency regime in India is evolving which emphasizes the
need for clear guidelines and regulations to prevent abuse and
ensure transparency in insolvency proceedings. The case of Rajeev
Kumar Jain vs. Uno Minda Ltd. and Anr. sheds light on the intricate
dynamics between financial and operational debts in insolvency
proceedings. By delving into the specifics of agreements and
transactions, the judgment highlights the importance of accurately
classifying debts to ensure fair and effective resolution
processes. It highlights the importance of adopting a pragmatic
stance to facilitate efficient and fair resolution processes,
ultimately contributing to the stability and integrity of the
financial system. This classification of debt is important to
determine the priority of payments and the allocation of assets in
insolvency proceedings.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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