Dilution of Rights of Service Providers Under the Insolvency Law

In a recent judgment, i.e., on 17 January 2020, the Indian appellate insolvency tribunal, namely, the National Company Law Appellate Tribunal (NCLAT) held in M. Ravindranath Reddy v. G. Kishan, that the lease of immovable property cannot be considered as supply of goods or rendering any services and therefore the due amount cannot fall within the definition of operational debt under the Insolvency and Bankruptcy Code, 2016 (Code).

In this case, G. Kishan (Applicant) had leased his industrial premises to Walnut Packaging (Corporate Debtor). The Applicant claimed the arrears of the enhanced rent. The National Company Law Tribunal (NCLT) held that the Corporate Debtor failed to pay the rent and accordingly, the Corporate Debtor should be admitted into the rescue process available under the Code. The Corporate Debtor through M. Ravindranath Reddy filed an appeal in the NCLAT. It was held by the NCLAT that the Applicant was not an operational creditor as rent due and payable does not amount to an operational debt. One of the reasons for NCLAT coming to such a conclusion was that even though the Bankruptcy Law Reform Committee (BLRC) report considers rent-dues as operational debt, the Code did not retain the reference to rent dues in its final avatar and therefore the legislature did not intend to treat lessors as operational creditors.

The position taken by the NCLAT is contrary to the judgements in Sarla Tantia v. Nadia Health Care Ltd., and India Bulls Real Estate Co. Pvt. Ltd. v. Crest Steel & Power Pvt. Ltd. where arrears of rent has been held to be operational debt.

This narrow interpretation may adversely affect attaining the end objective for enacting the Code. Any default of payment to a key service provider by a company may provide the first hint of distress in a corporate debtor, which in turn may alert the bigger stakeholders, such as, financial creditors, of impending problems in a company. Also, we must state over here that given the scheme of insolvency law and the jurisprudence on rescue schemes enunciated by the courts, no service provider is encouraged at the first instance to approach the insolvency courts to recover their dues. The service providers are well aware that any such move may further aggravate their chances of any recovery as an operational creditor’s rights are subservient to the rights of other stakeholders, such as, employees and secured and unsecured financial creditors under the Code.

In view of the above, we have detailed below the risks of taking a limited and narrow view of the terms “operational debt” and “operational creditor” by analyzing the existing case laws and the nature of services that may be obtained by various companies, which may not satisfy the “Input-Output” test for determining whether a person is an operational creditor.

THE PRECEDENTS: AN ANALYSIS

In Sarla Tantia v. Nadia Health Care Ltd., the  NCLT Kolkata Bench relied on Mobilux Innovations Pvt. Ltd. v. Kirusa Software Pvt. Ltd  and stated that the Apex court, i.e., the Supreme Court of India (SC) has held the recovery of arrears of rent to be operational debt within the meaning of the definition provided under the Code and no further analysis is needed. In our view, this reliance by the NCLT seems to be misplaced as the SC had merely referred to the recommendations made by the BLRC and had not given any definitive finding on the issue under consideration.

In India Bulls Real Estate Co. Pvt. Ltd. v. Crest Steel & Power Pvt. Ltd., the NCLT Mumbai Bench placed reliance on Sarla Tantia case, Jindal Steel & Power v. DCM International and the BLRC report and held that there exists no iota of doubt that claim of arrears of rent is within the definition of operational debt as provided under the Code. It is pertinent to note that while the NCLT in Sarla Tantia case held that arrears of rent is operational debt, the NCLAT in the Jindal Steel case held that non-refund of security amount is not operational debt.

INPUT-OUTPUT TEST

The Code prescribes certain essential goods and services which will not be terminated or suspended or interrupted during the moratorium period to the extent that they are not directly involved in production of goods and services. The NCLT in Parmod Yadav & Anr. v. Divine Infracon Pvt. Ltd. inferred that operational debt as used in the definition of the Code must relate to the direct input to the output produced or supplied of the corporate debtor. It held that unless it is established that such goods or services have a direct relationship to input-output operations of the corporate debtor, the creditor cannot be categorized as an operational creditor.

Following this input-output test would mean that many service providers cannot take recourse to remedies under the Code. For instance, a manufacturing company may avail the services of a cloud based data storage facility, which may not relate to the direct input-output operations of the manufacturing company. In case of a default in paying for the service availed by the company, the service providers will be barred from approaching the tribunal under the Code on strict application of the input-output test.

OUR VIEW

Unlike products or goods, services are intangible and in the millennial age, a large part of the business industries are present in the service sector. Each of these services, to have a direct relationship to input-output operations of the user is impossible. The interpretation of operational debt provided in Ravindranath case and Parmod Yadav case would exclude multiple service providers from the recourse available under the Code reason of the user being insolvent, it will not have a mechanism available for its resolution as under the Code.

The orders (Sarla Tantia and India Bulls cases) stating that arrears of rent are operational debt based on the reliance on certain authorities mentioned above needs further detailed judicial consideration.  Weighing the object, literal meaning of the term “operational debt” in the Code and the novel progress in the assortment of services accessible entails a more dynamic and comprehensive interpretation to be given as to what constitutes operational debt and who would be considered operational creditors under the Code.