The Insolvency and Bankruptcy Code, 2016 (IBC), since its enactment, has been a subject of great discussion and debate, both in the Industry as well as in the legal fraternity. This strong divide continues between those who consider it a necessary step (based on the abysmal rates of recovery of defaulted loans) and those who classify it as a ‘draconian legislation’. Given the division of views, it was expected that the IBC would be subject to legal and constitutional challenges.

This piece relates to one such challenge, and the first such judgement, on the constitutionality of provisions of the IBC.

The Supreme Court says: Do not examine constitutional validity

Interestingly, the Supreme Court, apprehending the largescale consequences of such challenges, advised the High Court of Gujarat in its order dated January 25, 2018 passed in Shivam Water Treaters Private Limited Vs Union of India & Ors[1], not to enter into the debate around the constitutional validity of the IBC. The Supreme Court observed that, “The High Court is requested not to enter into the debate pertaining to the validity of the Insolvency and Bankruptcy Code, 2016 or the constitutional validity of the National Company Law Tribunal.

Challenge of Constitutional Validity before the High Court at Calcutta

In November 2017, a challenge to constitutionality of provisions of the IBC was initiated before the High Court at Calcutta[2]. After hearing arguments, the High Court reserved its judgement on the issues on December 15, 2017, which was well before the order of the Supreme Court in the Shivam Water Treaters case. The challenge arose consequent to an order of the Kolkata bench of the National Company Law Tribunal, which admitted an insolvency resolution petition filed by a financial creditor (Sberbank of Russia) against a corporate debtor (Varrsana Ispat Limited).

A director and shareholder of the corporate debtor challenged the constitutionality of various provisions of the IBC including Section 7, 8 and 9 of the IBC claiming that there was an absence of a nexus between the object sought to be achieved by the IBC and the classification created between a financial and an operational creditor.

The constitutionality was also challenged on the ground that operational creditors were not given a say on the committee of creditors. The petitioners argued that the failure to appropriately recognise ‘secured creditors’ was also a failure of the legislation to recognise a necessary classification. It was argued that an operational creditor could well be a secured creditor, who should be afforded better rights than other creditors (including financial creditors) who were not secured. Thus, the petitioner found fault in the exclusion of ‘operational creditors’ from the committee of creditors.

In the course of the arguments, a ground was also taken that the IBC compromises the principles of natural justice vis-à-vis the promoters of the corporate debtor. This was based on the fact that the IBC did not contemplate examination of ‘disputes’ in respect of financial creditors and a mere ‘default’ was sufficient for admission of a petition against the corporate debtor under Section 7 of the IBC.

In Defence of the IBC

Cyril Amarchand Mangaldas (through the author), representing the financial creditor, addressed arguments presenting before the court the report of the Bankruptcy Reforms Committee chaired by Dr T.K. Viswanathan. The court was taken through the change in regime being effected by the IBC: the shift in emphasis from a debtor-in-possession to a creditor-in-possession and from the rights of secured creditors to the relevance of financial creditors.

In the course of the proceedings, it was argued before the court that the relevance of ‘secured creditors’ is only at the stage of recovery and not at the stage of resolution of insolvency. A ‘secured creditor’ who has sufficient cover, may not always be invested (or interested) in the betterment of the corporate debtor. Even if the corporate debtor were to go into liquidation, the secured creditor would be safe in the knowledge that its security cover would ensure recovery of its debt.

The court was taken though Section 24 of the IBC which allowed participation by operational creditors if they represented more than 10 per cent of the debt of the corporate debtor, thus excluding only marginal players. Limiting their right to vote on the committee of creditors is also founded in good reason since financial creditors are largely institutional in nature, on whom a greater degree of confidence can be reposed to act in the larger interests of all stake holders.

It was emphasised to the court that the ‘divine right’ of the promoters to continue to control a corporate debtor could be respected only till such time that the corporate debtor was continuing to honour its debts. In case of defaults, such control would rightfully move to the creditors and the promoters could not then claim to be aggrieved.

The Judgement:

After hearing detailed arguments, the court agreed with the arguments of the respondents, upheld the constitutional validity of the IBC and dismissed the challenge mounted. The principal observations of the court are summarised below:

  • The classification made by the IBC between financial creditors and operational creditors is based on reasonable differentia and does not offend any provision of the Constitution of India.
  • The rationale provided for the difference in treatment between financial creditors and operational creditors is a plausible view taken for an expeditious resolution of an insolvency issue of a company and cannot be said to offend any provisions of the Constitution of India.
  • The contentions of breach of principles of natural justice were misplaced.

The Future:

The judgement of the High Court at Calcutta is the first instance and a landmark in the developing jurisprudence around the IBC. The constitutionality of the IBC has been upheld for the very first time, but this challenge is unlikely to be the last. Even in the Shivam Water Treaters case, the Supreme Court had specifically observed that its order requesting the High Court of Gujarat not to enter into the debate pertaining to the validity of the IBC, would not debar the petitioner from challenging the constitutionality of the IBC before the Supreme Court itself.

The door for future challenges remains open.

* The author appeared and argued before the High Court at Calcutta, in the case discussed in this piece.

[1] SLP No.1740/2018

[2] Akshay Jhunjhunwala & Anr. Vs. Union of India through the Ministry of Corporate Affairs & Ors. W.P. No. 672 of 2017 in the High Court at Calcutta.