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Judgments Rendered By SC Under The Insolvency And Bankruptcy Code, 2016 Need Reconsideration

Judgements rendered by the Supreme Court in Innoventive (2018 (1) SCC 417) and Pioneer (2019(8) SCC416) under the Insolvency and Bankruptcy Code, 2016 need reconsideration by a larger bench to clear the muddied waters.

The judgments of the Supreme Court in Innoventive industries V/s. ICICI Bank[1] and Pioneer Urban Land and Infrastructure Ltd. V/s. Union of India [2] need a relook. Certain observations made and conclusions reached by the Supreme Court in these judgments are based on a misreading of relevant provisions of The Insolvency and Bankruptcy Code, 2016 (Code) and the Real Estate (Regulation and Development) Act, 2016 (RERA). Certain well settled principles of Contract and Insolvency and Bankruptcy laws have also been overlooked in both the judgments.

The Insolvency and Bankruptcy Code,2016 was amended by the IBC (Second Amendment) Act, 2018[3] to explain and clarify that the expression 'financial debt' as defined in section 5(8) included amounts raised from Allottees under real estate projects and the amounts raised would be deemed to have the commercial effect of a borrowing. The amendments were introduced by adding an explanation clause to section 5(8) of the Code which reads as follows:
  1. any amount raised from an Allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing;
​The consequence of treating amounts raised from Allottees as a financial debt was that Allottees in real estate projects were characterized as financial creditors. Allottees would thus be able to seek initiation of the corporate insolvency resolution process as financial creditors by filing an application under section 7 of the Code on a default having occurred.

Repelling a challenge to the constitutional validity of the provisions treating amounts raised from Allottees in real estate projects as Financial Debts, the Supreme Court, in Pioneer, held that amounts raised from Allottees did have the commercial effect of borrowing, that treating amounts raised from Allottees as Financial debts did not fall foul of Article 14 of the Constitution and the Amendment Act of 2018 was merely clarificatory in nature. The Court also held that on a default occurring, an Allottee was entitled to initiate the Insolvency Resolution process as an alternative to adopting the remedies provided under RERA.

Are Allottees entitled to initiate the insolvency resolution process without demanding return of amounts paid to the Promoter?
Whilst treating Allottees in real estate projects as Financial Creditors certain fundamentals of the law of contract and provisions of RERA have been lost sight of by the Legislature. It must first be noted that under the Code, a financial creditor is not obliged to issue a notice demanding return of money before filing an application to initiate the Insolvency process. The question that arises is whether Allottees/Purchasers under agreements for sale of immovable property can, in their capacity as “financial creditors, file an insolvency application without issuing a notice to the Promoter/Vendor demanding return of money paid under the agreement for sale.

Under the law of contract, it is presumed that time is not of the essence of a contract relating to sale of immovable property. Consequently, failure to perform within the time, if any, specified, does not give the other party the right to avoid the contract unless it is shown that parties intended time to be of the essence. In dealing with this issue, the Supreme Court in Gomathinayagam Pillai v. Pallaniswamy Nadar[4] held:
Fixation of the period within which the contract is to be performed does not make the stipulation as to time the essence of the contract. Intention to make time the essence of the contract may be evidenced by either express stipulations or by circumstances which are sufficiently strong to displace the ordinary presumption that in a contract of land stipulations as to time are not the essence.

Even if time is, at the time of entering into the agreement for sale between the parties or subsequent thereto, made the essence of a contract for sale of land, the contract does not ipso facto become void on the expiry of the time stipulated for performance. Section 55 of the Contract Act provides that in such an eventuality the contract only becomes voidable at the option of the party not in default viz: the promisee.

In the event of a Promoter/Vendor not performing his primary obligations within the time specified, the Allottee/Purchaser desirous of putting an end to the contract must therefore demand return of the monies paid to the Promoter/ Vendor. Unless he does so, the contract stays alive and both parties continue to remain liable to perform their respective obligations under the contract.

The consequence of non performance of obligations under a contract when time is of the essence was considered by the Supreme Court in M/s Citadel Fine Pharmaceuticals v. M/s Ramaniyam Real Estates[5] The observations of the Supreme Court on this point are contained in paragraph 37 of the judgment, where it cites with approval the following passage from Chitty on Contracts, and read as follows:

37. In a case where time is of the essence of the contract, the consequences of non performance of such term has been very succinctly explained by Chitty on Contracts ( Volume 1 Thirteenth Edition, Sweet & Maxwell in paragraph 21-015) and the same is set out:

Consequences of time being of the essence” In determining the consequences of a stipulation that time is to be of the essence of an obligation, it is vital to distinguish between the case where both parties agree that time is to be of the essence of the obligation and the case where, following a breach of a non-essential term of the contract, the innocent party serves a notice on the other stating that time is to be of the essence.

In the former case the effect of declaring time to be of the essence is to elevate the term to the status of a condition with the consequences that a failure to perform by the stipulated time will entitle the innocent party to:
  1. terminate performance of the contract and thereby put an end to all the primary obligations of both parties remaining unperformed; and
  2. claim damages from the contract-breaker on the basis that he has committed a fundamental breach of the contract (a breach going to the root of the contract) depriving the innocent party of the benefit of the contract (damages for the loss of the whole transaction)

This principle of contract law has in a sense been incorporated in section 18 of RERA which provides as follows:
Return of Amount and Compensation
  1. If the Promoter fails to complete or is unable to give possession of an apartment, plot or building:
    1. in accordance with the terms of the agreement for sale or, as the case may be, duly completed by the date specified therein; or
    2. due to discontinuance of his business as a developer on account of suspension or revocation of the registration under this Act or for any other reason,
      he shall be liable on demand to the Allottees, in case the Allottee wishes to withdraw from the project, without prejudice to any other remedy available, to return the amount received by him in respect of that apartment, plot, building, as the case may be, with interest at such rate as may be prescribed in this behalf including compensation in the manner as provided under this Act:
      Provided that where an Allottee does not intend to withdraw from the project, he shall be paid, by the Promoter, interest for every month of delay, till the handing over of the possession, at such rate as may be prescribed
  2. …. [6]
As is evident, under this section, an Allottee can demand return of monies in case he desires to withdraw from the project. The liability to refund amounts arises on it being shown that the Promoter has failed to perform his obligations within the time specified in the agreement for sale etc. and despite a demand being made has failed to pay the amount demanded.

Section 18 of RERA has been misread in Pioneer. The misreading of this provision is evident from the following observations in Pioneer which appear in paragraph 22 of the judgment.
Importantly, under section 18, if the Promoter fails to complete or is unable to give possession of an apartment, plot or building in accordance with the terms of the agreement for sale, he must return the amount received by him in respect of such apartment etc. with such interest as may be prescribed and must, in addition, compensate the Allottee in case of any loss caused to him......[7]

The judgment in Pioneer therefore proceeds on the erroneous basis that a Promoter ipso facto becomes liable to return the amount received by him, on failure to perform his primary obligations in accordance with the terms of the agreement for sale. Section 18 mandates that a Promoter shall be liable on demand to the Allottees, in case the Allottee wishes to withdraw from the project, without prejudice to any other remedy available, to return the amount received by him ..... The crucial words shall be liable on demand to the Allottees have been overlooked in Pioneer.

Section 6 of the Code enables a person to initiate insolvency proceedings on a debtor committing a 'default'. The expression 'default' is defined in section 3(12) as follows:
3....(12) default means non-payment of debt when whole or any part or instalment of the amount of debt has become due and payable and is not paid by the debtor or the corporate debtor, as the case may be;[8]

A conjoint reading of section 18 of RERA and section 6 of the Code shows that unless an Allottee who desires to withdraw from the project, makes a demand for return of the money paid as required by section 18 of RERA and a Promoter in breach, does not return the money, no “default” is committed by the Promoter.

Allottees in real estate projects, unlike other financial creditors are therefore not entitled to file an insolvency application in their capacity as “financial creditors” if they have not issued a notice demanding return of monies. This distinction of vital significance has not been noticed in Pioneer. As a result, certain observations have been made by the Court, which are likely to and have caused confusion in the minds of Allottees as to their rights once they file an application to initiate the insolvency resolution process as financial creditors.

15.These observations are contained in paragraph 39 of Pioneer read:
It is also important to remember that the Code is not meant to be a debt recovery mechanism [see paragraph 28 of Swiss Ribbons (supra)]. It is a proceeding in rem which, after being triggered, goes completely outside the control of the Allottee who triggers it. Thus, any Allottee/home buyer who prefers an application under section 7 of the Code takes the risk of his flat/apartment not being completed in the near future, in the event of there being a breach on the part of the developer.[9]

This observation,(relating to the Allottee taking a risk of his flat etc. not being completed in the near future) has led both, Allottees and the adjudicating authority, to believe that an Allottee who files an Application under section 7, is nevertheless entitled to the flat/apartment/plot agreed to be purchased under an agreement for sale. But that is not the legal position. The correct position in law is that once an Allottee demands return of his money, which he has to in order to be entitled to initiate the insolvency resolution process, he puts an end to the contract and is then entitled only to compensation/damages including return of monies paid and not to the flat/apartment/plot in specie. Needless to state, even this entitlement to compensation/damages is subject to the Allottee establishing that the Promoter/Vendor is in breach of his primary obligations under the contract.

Allottees Claim for Damages/Compensation in aSection 7 Application under the Code.
In Pioneer, it was rightly argued by the Petitioners that a claim for compensation/ damages could not be treated as a debt due and payable and thus could not form the basis of an Insolvency application to initiate the insolvency resolution process. For this proposition, reliance was placed on the decision of the Supreme Court in Union of India v. Raman Iron Foundry[10] wherein the Supreme Court inter alia held:
Now the law is well settled that a claim for unliquidated damages does not give rise to a debt until the liability is adjudicated and damages assessed by a decree or order of a court or other adjudicatory authority.

Pioneer however, rejected this argument by relying erroneously on the definition of claim and in doing so held
It is precisely to do away with judgments such as Raman Iron Foundry (supra) that claim is defined to mean a right to payment or a right to remedy for breach of contract whether or not such right is reduced to judgment.....

In rejecting this argument, Pioneer fails to consider the definitions of debt and default which make it evident that a default occurs when there is a failure to make payment of a debt that is due and payable. The definitions of debt and default in fact, unmistakably indicate the intention of the legislature to leave the law enunciated in Raman Iron Foundry untouched. Simply put, having regard to the definitions of debt and default and the law enunciated in Raman Iron Foundry, a claim for compensation/damages will transform into a debt due when a court/tribunal of competent jurisdiction adjudicates upon such a claim and passes a decree or order directing payment of damages assessed by it.

Pioneer does not notice that a creditor is not entitled to seek to initiate the insolvency resolution process merely because he has a claim against the alleged debtor. The right to initiate the insolvency resolution process arises only when a default occurs. A creditor seeking to initiate the insolvency resolution process will therefore have to establish that there exists a debt in respect of a claim which has become due and payable and has not been paid.

While holding that a claim for compensation/damages can form the basis of an insolvency application, Pioneer does not take into consideration that not only is there no adjudication of the liability to pay unliquidated damages, but also there is no assessment of the quantum of such damages. The adjudicating authority under the Code is not vested with the jurisdiction to adjudicate upon such matters. Even the insolvency resolution professional appointed does not have the power or jurisdiction to decide such matters. Who then decides, and at what stage, whether the claim of the Allottee for damages is justified and if so, what should be the quantum of damages? The Code is silent on these matters as the legislature never intended unadjudicated claims for compensation/damages to form the basis of insolvency applications.

The conclusion reached in Pioneer that a disputed claim for compensation/damages can form the basis of an Insolvency application does not appear to be correct. If not reconsidered, Pioneer will lead to unjust results and serious adverse consequences for entities who have not committed any default.

Scope of inquiry in Insolvency Applications filed by Financial Creditors including Allottees:
Another consequence of treating Allottees as “financial creditors” is that if an Allottee initiates Insolvency proceedings, it is the adjudicating authority under the Code which will have to conduct an inquiry to decide whether the insolvency resolution process should be initiated against the Promoter. What then is the scope of an inquiry when an Allottee seeks to initiate the insolvency process as a Financial Creditor and the entity sought to be put through this ignominious process argues that there exists a genuine dispute and no default has thus been committed?

In Innoventive, the Supreme Court has observed that in the case of an application by a financial creditor
the adjudicating authority has merely to see the records of the information utility or other evidence produced by the financial creditor to satisfy itself that a default has occurred. It is of no matter that the debt is disputed so long as the debt is 'due' i.e. payable unless interdicted by some law or has not yet become due in the sense that it is payable at some future date. It is only when this is proved to the satisfaction of the adjudicating authority that the adjudicating authority may reject an application and not otherwise.[11]

The observation It is of no matter that the debt is disputed so long as the debt is 'due' is rather perplexing. Can any Court or Tribunal find that a debt is due without an inquiry to ascertain whether a dispute raised by the alleged debtor is bona fide and based on substantial grounds? If such was the law, it would be sufficient for anyone to make a monetary claim and ensure that an entity was put through the insolvency resolution process. To lead a person who is alleged to be a debtor down the insolvency resolution path, although the claim of the creditor is disputed, without an inquiry to ascertain whether it is a bona fide dispute raised on substantial grounds is manifestly unjust.

It has always been the law that the insolvency or winding up process cannot be commenced when there exists a bonafide dispute raised on substantial grounds relating to the claim of the creditor who seeks to initiate the liquidation or insolvency resolution process.

This position in law has been enunciated by the Supreme Court inter alia in M/S Madhusudan Gordhandas & Co. V/s. Madhu Woollen Industries Pvt [12] The court held
Two rules are well settled. First, if the debt is bona fide disputed and the defence is a substantial one, the court will not wind up the company.

In Amalgamated Commercial Traders V/s. A.C.K. Krishnaswami[13], the Supreme Court hearing an appeal from an order directing winding up of a company reiterated the position that a winding up petition is not a legitimate means of seeking to enforce payment of the debt which is bona fide disputed by the company. On finding that the debt was bona fide disputed, the Court allowed the appeal and set aside the order directing winding up of the Company.

Recently, in Jignesh Shah v. Union of India[14] the Supreme Court whilst referring to a judgment of the Bombay High Court which was rendered in a Winding Up Petition filed under section 433(e) and 434 of the Companies Act inter alia held
Also, the moment there is a bona fide dispute, the debt is then not 'due'.

Although, in Jignesh Shah the Supreme Court was considering provisions relating to Winding Up under the Companies Act, the provisions of the Code including the definitions of debt, default and financial debt show the intention of the legislature to maintain this position in law. To initiate the Insolvency Resolution process, it must be established that there is a debt due and payable that has not been paid viz. a default has been committed.

It is therefore settled law that if there exists a bona fide dispute raised on substantial grounds, it cannot be said that there is a “debt due. It is axiomatic that if there is no “debt due, there cannot be a default. And if no default has occurred, the adjudicating authority under the Code is not empowered to commence the Insolvency resolution process. The fact that in a given case the application is filed by a financial creditor makes no difference to this legal position as the definition of default and debt applies to both, financial and operational creditors.

The Judgment in Innoventive has incorrectly restricted the scope of inquiry in insolvency applications filed by financial creditors including Allottees beyond what the legislature clearly intended. Relying on the observation in Innoventive that:
it is of no matter that the debt is disputed so long as it is due, the adjudicating authority (NCLT) has been initiating the insolvency resolution process without an inquiry relating to the bona fides of the dispute raised by the alleged corporate debtors. This kind of an approach to insolvency applications filed by financial creditors is best illustrated by the decision of the NCLAT in Marg Limited v. Tata Capital Financial Services Ltd[15] which was hearing an appeal from an order passed by the NCLT admitting an application under section 7 of the Code.

In dealing with an argument that disputes between the parties were pending adjudication in arbitration proceedings, the NCLAT relying on Innoventive observed:
As the question of 'existence of dispute' does not arise in a petition under section 7 of the I&B code, the application cannot be rejected on the ground of 'existence of dispute' due to pendency of arbitration proceedings.....

The NCLAT dismissed the appeal after holding that the existence of a dispute was not relevant in an Insolvency Application filed by a financial creditor. Such an approach is plainly unjust.

.Both, in Innoventive and Pioneer, it is a misreading of the definition of 'debt' contained in section 3(11) of the Code which has led the Court to lay down as a matter of law that even if the claim is disputed and it is contended that there is no debt due and payable, a financial creditor's application can be admitted to initiate the insolvency resolution process without an inquiry to ascertain whether there is a probable defense to the claim of the financial creditor.

In paragraph 27 of Innoventive it is inter alia observed:
For the meaning of debt we have to go to section 3(11), which in turn tells us that a debt means a liability or obligation in respect of a claim and for the meaning of a claim, we have to go back to section 3(6) which defines claim to mean a right to payment even if it is disputed.

This is where the misreading of the definition of debt has occurred. The definition of debt as contained in section 3(11) of the Code reads:
debt means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt;[16]

The key words which is due have not been noticed in paragraph 27 of Innoventive. These words evidently relate to the expression debt. A debt must therefore be due, before it can be said that a default has been committed due to non-payment of a debt that has become due and payable. And it is only when a default is committed that a person is entitled to initiate the insolvency resolution process as provided in section 6 of the Code.

To hold that a person is in default, without an inquiry into the dispute raised to ascertain whether the dispute is raised bona fide and on substantial grounds and/or without an adjudication on the merits of the dispute, is a violation of the most fundamental of natural justice principles viz. audi alteram partem.

Innoventive therefore, is not in accord with the judgments in Madhusudan Gordhandas, Amalgamated Associate Traders and Jignesh Shah and incorrect in its construction of the provisions of the Code.

The Supreme Court needs to urgently reconsider the judgments in Innoventive and Pioneer as entities are being pushed into the Insolvency resolution and liquidation process on the basis of disputed and often unsubstantiated claims of financial creditors and in particular, Allottees, who are filing Insolvency applications with gay abandon in an attempt to take over the management and control of real estate companies. Initiating the insolvency resolution process at the instance of financial creditors, including Allottees, without an inquiry to ascertain whether the dispute has been raised bonafide and on substantial grounds is a travesty of justice.

End-Notes:
  1. 2018 1 SCC 417
  2. (2019) 8 SCC 416
  3. 26 of 2018
  4. AIR 1967 SC 868
  5. 2011 (9) SCC 147
  6. Section 18 of RERA
  7. Pioneer Urban Land and Infrastructure Ltd. V/s. Union of India –(2019) 8 SCC 416-Paragraph 22
  8. Section 3(12) of The Insolvency and Bankruptcy Code, 2016.
  9. Pioneer Urban Land and Infrastructure Ltd. V/s. Union of India –(2019) 8 SCC 416-Paragraph 39
  10. (1974)2 SCC 231
  11. Innoventive industries V/s. ICICI Bank (2018) 1 SCC 417 - Paragraph 30
  12. Ltd (1971) 3 SCC 632.
  13. (1965) 35 Company Cases 456
  14. (2019 ) 10 SCC 750
  15. Company Appeal (AT) (Insolvency) no. 219 of 2018
  16. Section 3(11) of The Insolvency and Bankruptcy Code, 2016

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