Redeemable preference shares not debt under IBC

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– SC reinforces the distinction between ‘debt’ and ‘share capital’ for the purpose of IBC

– Sourish Kundu | resolution@vinodkothari.com

Introduction

The Supreme Court in a recent judgement in the matter of EPC Constructions India Limited v. M/s Matix Fertilizers and Chemicals Limited, has categorically clarified that holders of Cumulative Redeemable Preference Shares (“CRPS”) are classified as investors rather than creditors (more specifically, financial creditors) and are therefore not entitled to file for insolvency under Section 7 of the IBC, since non-redemption of these shares do not qualify as a “default” under the Code.

In an article titled “Failed Redemption of Preference Shares: Whether a Contractual Debt?”, written way back in May, 2021, in the context of SC judgment in Indus Biotech Private Limited v. Kotak India Venture (Offshore) Fund (earlier known as Kotak India Ventures Limited) & Ors, we  concluded, on the basis of the provisions of section 55 of the Companies Act, 2013 (“Act”) and related judicial precedents around the meaning of “debt”, that there can be no debt associated with a preference share and, where there is no ‘debt’, there is no question of it being a ‘financial debt’.

The findings of the SC in EPC Constructions judgement resonate with our views as explained in the article. However, we delve deeper into the aspect with analysis of the ruling as below, as to on what basis it was concluded that preference shares cannot be considered as ‘debt.

Brief facts of the case

The appellant entered into a contract for construction of a fertilizer complex with  the respondent, pursuant to which certain amounts  became due and payable by the respondent to the appellant, The receivables under the contract was converted into NCRPS, and such conversion was duly approved by the respective boards. Eventually, in course of certain events, the appellant filed a Section 7 petition against the respondent, on account of failure to pay the redemption amount on account of maturity of CRPS. The application was dismissed by NCLT, and then NCLAT on grounds that the CRPS cannot be termed as debt. The application then came for appeal before SC.

Below is a discussion highlighting the rationale for which dues pertaining to preference shares were not held to be financial debt.

Actions speak about “intent”: Conversion of receivables into CRPS conclusive of intent

It was contended by the Appellant that the true nature of the transaction should be unveiled in order to determine whether such preference shares should be treated as debt or not. The fact that there were outstanding receivables, which had become due and payable, the Appellant argued that conversion of the same into preference shares was in a way ‘subordination of debt’, i.e. debt which is having lower priority than other debt in terms of payment, and was with the objective of maintaining the debt-equity ratio. As clear from the communication between the parties, the CRPS merely acted as a temporary tool for borrowing, providing Matix “a pause point” under the arrangement entered by way of exchange of emails. Therefore, the substance of the transaction should be given weightage, and an expansive interpretation of the term “commercial effect of borrowing” should be applied, as was interpreted by the Apex Court while classifying home buyers as FCs.[1] In fact, the SC, in another matter[2] delved into the real nature of a transaction while determining whether a debt is a financial debt or an operation debt.

On this, the Court noted that the preference shares were issued upon conversion of outstanding receivables. The board of the preference shareholder exercised its commercial wisdom in accepting the shares, given the low recovery prospects. Therefore, what was actually a financial debt, extinguished owing to such conversion, and hence the appellant cannot pose as a financial creditor.There is no question of there being any underlying contrary intent as the only intent was to convert the debt into preferential shareholding[3]. The SC, therefore, remarked:

“There is no question of there being any underlying contrary intent as the only intent was to convert the debt into preferential shareholding. The egg having been scrambled, . . .  attempt to unscramble it, must necessarily fail.”

Debt vs. preference shares: Redeemable preference shareholder not a creditor

The SC placed reliance on the relevant provisions of the Companies Act, particularly Sections 43, 47, and 55, and held that preference shares form part of the company’s share capital and not its debt capital. Consequently, preference shareholders cannot be treated as creditors, nor can they initiate insolvency proceedings under Section 7 of the IBC, which is reserved for financial creditors.

The Court noted that –

“It is well settled in Company Law that preference shares are part of the company’s share capital and the amounts paid up on them are not loans. Dividends are paid on the preference shares when company earns a profit. This is for the reason that if the dividends were paid without profits or in excess of profits made, it would amount to an illegal return of the capital. Amount paid up on preference shares not being loans, they do not qualify as a debt.” (Emphasis added)

Dividends on preference shares are payable only out of profits or proceeds from a fresh issue of shares for redemption. Thus, only a profit-making company can redeem its preference shares, as profits accrue after all expenses, including interest on borrowings. To suggest that preference shareholders become creditors upon default, even when the company has no profits, would distort this basic principle. [4] As aptly stated in “Principles of Modern Company Law”[5]:

“The main difference between the two in such a case may then be that the dividend on a preference share is not payable unless profits are available for distribution, whereas the debt holder’s interest entitlement is not subject to this constraint; and that the debt holder will rank before the preference holder in a winding-up.”

In the context of a CIRP, initiation under Section 7 requires a “default”, a debt that has become due and payable. The Supreme Court observed that since preference shares are redeemable only out of profits or fresh issue proceeds, no “debt” arises unless such conditions exist; consequently, there can be no default under Section 7.

Difference between preference shareholder and a creditor was concisely captured in “A Ramaiya’s Guide to the Companies Act”[6]:

“It must be remembered that a preference shareholder is only a shareholder and cannot as a matter of course claim to exercise the rights of a creditor. Preference shareholders are only shareholders and not in the position of creditors. They cannot sue for the money due on the shares undertaken to be redeemed, and cannot, as of right, claim a return of their share money except in a winding-up. In Lalchand Surana v. Hyderabad Vanaspathy Ltd., (1990) 68 Com Cases 415 at 419 (AP), where a preference shareholder was denied redemption in spite of maturity, he was not allowed to file a creditor’s petition for a winding-up order under s. 433(e) of the 1956 Act. An unredeemed preference shareholder does not become a creditor.”

A financial debt necessarily involves disbursal against the consideration for time value of money, typically represented through interest.[7] While interest may not be a sine qua non in every case[8], there must at least be an element of consideration for the time value of money. In the present case, no such disbursal or consideration existed and hence, the claim failed to meet the threshold of a financial debt.

As such, preference shares do not fall within the ambit of “financial debt” under Section 5(8)(f) of the Code, and equating them with financial creditors would distort the fundamental distinction between shareholders and creditors[9].

Whether accounting entries/recognition as “liability” would make a difference

It was contended that financial debt is an admitted liability in the books of accounts of Matix.

However, the SC[10], held the treatment in the accounts due to the prescription of accounting standards will not be determinative of the nature of relationship between the parties as reflected in the documents executed by them. Further the IBC has its own prerequisites which a party needs to fulfil and unless those parameters are met, an application under Section 7 will not pass the initial threshold. Hence, by resort to the treatment in the accounts this case cannot be decided.

Our Analysis

While the judgment firmly settles that preference shareholders cannot be treated as creditors, since shares represent ownership and not loans, the question often arises why such instruments, though debt-like in spirit and accounting treatment, are not “debt” under law. The rationale goes beyond mere nomenclature.

Ind AS 32 [Para AG25 to AG28] clarifies that in determining whether a preference share is a financial liability, or in other words, a debt, or simply an equity instrument, the shares has to be assessed against the rights attached to it, and whether it signifies a character of financial liability. In other words, if a preference share is redeemable at a specific date in the future at the option of the shareholder, such instrument carries a financial liability and is treated as such. However, it should be noted that every law has to be read in a given context. Treatment under accounting standards is more from the perspective of the financial position of the issuer. However, in case of IBC, the question is of rights – as a creditor will have right to file an application under section 7, but a shareholder will not have such right; similarly, a creditor will have a higher priority under section 53, while a shareholder stands in the lowest step of the priority ladder.

Therefore, the context in which accounting standards operate cannot be superimposed while interpreting the rights and liabilities under laws like the Code. Therefore, preference shares, depending on their terms of issuance may be classified as a liability for the purpose of complying with accounting principles, however, that cannot be said to be confer such preference shareholders the status of a creditor, and consequently, entitling them to file CIRP application under the Code.

Hence, there is a fundamental difference between “debt” and “shares” – a “debt” once converted into “shares”, moves from one end of the spectrum to another, and cannot retain its original nature and rights under the Code.

[1] Pioneer Urban Land and Infrastructure Ltd. and Another v. Union of India and Others ((2019) 8 SCC 416)

[2]  Global Credit Capital Ltd and Anr. v. Sach Marketing Pvt Ltd and Anr. (2024 SCC OnLine SC 649)

[3] Commissioner of Income Tax v. Rathi Graphics Technologies Limited (2015 SCC OnLine Del 14470), where it was held that, where the interest or a part thereof is converted into equity shares, the said Interest amount for which the conversion is taking place is no longer a liability.

[4] Lalchand Surana v. M/s Hyderabad Vanaspathy Ltd. (1988 SCC OnLine AP 290)

[5] (Tenth Edition) at page 1071

[6] (18th Edition, Volume 1 Page 879)

[7]  Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and Others ((2020) 8 SCC 401)

[8]  Orator Marketing v. Samtex Desinz (Civil Appeal No. 2231 of 2021)

[9] Radha Exports (India) Private Limited v. K.P. Jayaram and Another ((2020) 10 SCC 538)

[10] Relied on State Bank of India v. Commissioner of Income Tax, Ernakulam ((1985) 4 SCC 585)

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– Sikha Bansal, Senior Partner | resolution@vinodkothari.com

The proceedings in Bhushan Steel now take a U-turn, as the SC ruling has upheld the resolution plan of SRA. Earlier, the SC had ordered liquidation of the CD. 

Here is a quick round up of important takeaways from the verdict:

  1. CoC has a vital interest in the resolution plan and that such an interest would continue till the Resolution Plan is actually implemented. If it is argued that the CoC cannot act in any manner after approval of resolution plan, then it can lead to a limbo or an anomalous situation where, say, the plan could not be implemented for any reason, leaving the creditors high and dry. Notably, the cloud of uncertainty exists until finality is given by the SC under section 62. Until then, CoC remains interested. 
  2. Appeal to SC can be made only if it was appealed against before the NCLAT. Also, appeal to SC is available only on questions of law pertaining to any of the five grounds specified in Section 61 of the IBC – and, for no other reason.
  3. A clause in the resolution plan empowering the CoC to merely extend the implementation timeline by a specified majority and neither providing for withdrawal nor modification, cannot be stated to be an open ended or indeterminate plan solely at the discretion of the resolution applicant.
  4. CCDs are equity. Courtesy: SC rulings in Narendra Kumar Maheshwari, IFCI Limited v. Sutanu Sinha and Others. Also, if CoC has exercised its commercial wisdom in the matter, judiciary has nothing to interfere with.
  5. For issues like distribution of profits arising during CIRP, look at the RFRP and the resolution plan. Unless there is a specific provision with regard to such distribution to be made to creditors, the money shall remain with CD. Also, in this case, the resolution plan explicitly contemplated that SRA shall take over the assets and liabilities of the CD as a ‘going concern’, which would include the profits or losses that may be generated by the company during CIRP.
  6. Where a creditor was classified as contingent creditor by SRA and the plan was approved by CoC; and ambivalent stance was taken by the concerned creditor, then the commercial wisdom of CoC cannot be challenged.
  7. Payments to creditors against pre-CIRP dues must be done only in accordance with the resolution plan and with the express agreement of the CoC.
  8. Decisions pertaining to the resolution plan and dues thereunder fall under the “commercial wisdom” of CoC. Where CoC exercises commercial wisdom, the decision  is deemed to be non-justiciable by this Court in view of ruling in K. Sashidhar. 
  9.  Once the resolution plan has been approved by the CoC and NCLT, permitting any claims to be reopened which were not a part of the RFRP/resolution plan will open Pandora’s box, and will do violence to the provisions of IBC. SRA cannot be forced to deal with claims that are not a part of the RfRP issued in terms of Section 25 of the IBC or a part of its Resolution Plan. Courtesy: SC ruling in Essar Steel and Ghanshyam Mishra.

Ruling available here: https://api.sci.gov.in/supremecourt/2020/7358/7358_2020_1_1501_64744_Judgement_26-Sep-2025.pdf

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Widening the Net of Fast-Track Mergers – A Step Towards NCLT Declogging

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– Barsha Dikshit and Sourish Kundu | corplaw@vinodkothari.com

Introduction

The recent notification of the Companies (Compromises, Arrangements and Amalgamations) Amendment Rules, 2025, (‘Amendment’) by the MCA represents a significant move towards further declogging the burden of NCLTs and promoting a more business-friendly restructuring environment. By introducing minor procedural refinements and widening the classes of companies eligible for FTM, the amendments make this route accessible to a larger segment of the corporate sector. 

The fast-track merger (FTM) route was introduced under Section 233 of the Companies Act, 2013 (“the Act”), allowing certain classes of companies to get the schemes approved by Regional directors having jurisdiction over the Transferee Company instead of filing of application/ petition before NCLTs having jurisdictions over transferor and transferee company and getting the same approved after following lengthy proceedings. Basically, the FTM route was designed to ease the burden of NCLTs, with a simplified process and a deemed 60-day timeline for completion, making it a quicker and a more cost-effective alternative.

This article explores the key changes introduced through Amendment, the opportunities they create for faster and more economical reorganisations, and the practical considerations and potential challenges that companies may face while opting for this route.

Additional classes of companies can opt for the fast-track route: 

Section 233 of the Companies Act, 2013 read with Rule 25 of the CAA Rules, 2016, presently allows the following classes of companies to undertake mergers under the fast-track route:

  • Two or more small companies;
  • Merger between a holding company and its wholly-owned subsidiary;
  • Two or more start-up companies;
  • One or more start-up companies with one or more small companies.

Often referred to as the “RD Route” in general parlance, the key features of a FTM, include the elimination of NCLT approval, replaced instead by confirmations/approvals from the RoC, OL, members/creditors representing 90% in value, and lastly an order by the jurisdictional RD confirming such merger. [Read the procedure here]

The key change introduced is to extend the benefit of the RD route beyond the presently eligible companies to include the following additional classes:

  1. Scheme of arrangement between holding (listed or unlisted) and a subsidiary company (listed or unlisted) – regardless of being wholly-owned

Until now, only mergers/demergers between WOS(s) and holding companies were permitted under the existing fast track route. However, pursuant to the recent Amendment, merger/demerger between subsidiaries (not limited to wholly-owned ones) and their holding companies are also allowed under FTM route. This effectively removes the ‘wholly-owned’ limitation and extends the benefit to any subsidiary, whether listed or unlisted.

However, it is worth noting that the fast track route will not be available in cases wherein the Transferor company (whether holding company or subsidiary) is a listed company. That is to say, while subsidiaries can be merged with/demerged into a holding company or vice versa under the fast track route, this is only permissible when the transferor company is not a listed company. 

  1. Scheme of arrangement between two or more Unlisted Companies

Another significant addition is to allow fast track schemes between two or more unlisted companies subject to certain conditions as on 30 days prior to the date of inviting objections from regulatory authorities u/s 233 (1) of the CA, 2013:- 

  1. None of the companies involved should be a section 8 company;
  2.  total outstanding loans, debentures and deposits for each company must be less than ₹200 crores , and 
  3. There must be no default in repayment of any such borrowings. 

All the aforesaid conditions are required to be satisfied on two occasions viz. within 30 days prior to the date of inviting objections from the regulatory authorities u/s 233(1) and on the date of filing of declaration of solvency in form CAA-10. The latter is to be accompanied with a certificate of satisfaction of the conditions above, by the auditor of each of the companies involved, in a newly introduced form CAA-10A, which will form part of the annexure to the respective declarations of solvency. 

It is pertinent to note here that no common shareholding, promoter group, or common control is required between the unlisted companies seeking to merge under this route. In other words, even completely unrelated unlisted companies can now opt for a fast track merger, provided they meet the financial thresholds and other prescribed conditions.

  1. Scheme of arrangement between two or more Fellow subsidiaries

As of now, inter-group arrangements, like schemes between two or more fellow subsidiaries, were excluded from the purview of the FTM route. However, the Amendment now brings schemes between fellow subsidiaries – i.e., two or more subsidiary companies of the same holding company – within the scope of Section 233, provided that the transferor company(ies) is unlisted. Notably, the requirement of being unlisted is applicable only to the transferor company/ies. That is to say, the Transferee Company can be a listed company.

While the amendments have commendably widened the ambit of fast-track mergers to include mergers between fellow subsidiaries and step-down subsidiaries, a regulatory overlap with SEBI LODR framework may still persist. Under Regulation 37 of the SEBI LODR read with SEBI Master Circular dated June 20, 2023, listed entities are required to obtain prior approval from stock exchanges before filing a scheme of arrangement. This requirement is waived only for mergers between a holding company and its wholly-owned subsidiary. 

Given that earlier fellow subsidiaries/ step down subsidiaries were not permitted to opt FTM Route, in an informal guidance, SEBI clarified that this exemption does not extend to structures involving step-down subsidiaries merging into the ultimate parent, thereby requiring compliance with Regulation 37 in such cases. 

Accordingly, while the Companies Act now permits fellow subsidiaries and step-down subsidiaries to utilize the fast-track route, the benefit of exemption from prior SEBI/stock exchange approval may not be available, particularly in cases where the transferee company is listed. Unless SEBI extends the exemption framework, listed entities may still need to follow the standard approval process under Regulation 37, which could offset some of the intended efficiency gains of the FTM mechanism

  1. Reverse Cross-Border Mergers involving Indian WOS of foreign companies

While cross-border mergers are governed under Section 234 of the Act and Rule 25A of the CAA Rules, it is amended to absorb the merger between a foreign holding company and an Indian wholly owned subsidiary, currently covered under sub-rule (5) of Rule 25A, into Rule 25 itself to make the index of companies eligible under the FTM route more comprehensive and complete. 

The additional compliances applicable in such instances are the requirement to obtain prior approval from the RBI, and submission of declaration in form CAA-16 at the stage of submitting application, in case the transferor holding company happens to share a land border with India.

Implications and Potential Practical Challenges

NCLTs are overburdened with the Companies Act cases and IBC cases. As a result, scheme of arrangement cases often receive limited attention and are subject to significant delays. The recent amendments are undoubtedly a step forward in simplifying and accelerating mergers/ demerger processes. However, certain aspects of implementation may give rise to procedural challenges that warrants careful consideration: :

  1. Seeking approval of shareholders and creditors particularly when the transferee company is a listed company

Section 233(1) of the Act requires approval of the members holding 90% of the total number of shares. This threshold has been observed to be onerous, not just practically, but also duly recognised in the CLC Report, 2022, as the requirement is approval by those holding 90%cent of the company’s total share capital and not 90% of shareholders present and voting. This threshold becomes particularly difficult to achieve in the case of listed companies and may significantly delay the approval process, thereby defeating the very objective of fast-tracking mergers.

This was a practical difficulty faced by companies going through this route, as the approving authority i.e. the RDs, of different regions, did not take a consistent approach, some of them warranting compliance with the letters of law. However, with practice it has been observed that obtaining approval of the requisite majority as present and voting is also accepted as sufficient compliance. 

Here, it also becomes important to note that the approval threshold is more stringent in case of FTMs, as compared to arrangements under the NCLT route, which requires a scheme to be approved by three-fourths in majority in an NCLT convened meeting, but the same is again offset by the time and cost involved. 

  1. Scheme where transferor company(ies) / demerging undertaking has immovable properties

The NCLT, constituted under Sections 408 of the Companies Act, 2013, is a quasi-judicial body whose orders carry significant statutory weight and are widely recognized by authorities such as land registrars for purposes like property registration and mutation. Concerns may arise w.r.t. the validity of the RD’s order on such schemes. In this regard, it is to be noted that Regional directors function as an extended administrative arms of the Central Government and orders issued by the RD, are legally on par with those of the NCLT. However, an area of concern remains w.r.t. transfer of immovable property as such a transfer is required to be registered with the local registrars, where practically, RD approved schemes may not be having the same effect as that of NCLT approved scheme.

  1. Deemed Approval within 60 Days

Section 233 (5) of the Act requires RD’s to either approve the Scheme within the period of 60 days from the date of receipt of scheme or to file an application before NCLT, if they are of the opinion that such a scheme is not in public interest or in the interest of the creditors.

The section also provides that if the RD does not have any objection to the scheme or it does not file any application under this section before the Tribunal, it shall be deemed that it has no objection to the scheme, and the Scheme will be considered as approved. This “deemed approval” mechanism is in line with international practices, where intra/inter-group restructurings are not typically required to undergo intensive regulatory scrutiny, and schemes are considered approved once sanctioned by shareholders and creditors. For instance, the Companies Act of Japan (Act No. 86 of July 26, 2005) and the Companies Act, 2006 (UK) does not require specific approval of any regulatory authority, except in certain specific circumstances. 

It is also important to note that the RD does not have the power to reject a scheme outright. As held by the Bombay High Court in Chief Controlling Revenue Authority v. Reliance Industries Ltd., that the order of a Court itself constitutes an instrument as it results in the merger and vesting of properties inter-se the merging parties. In cases of deemed approval, there seems to be a gap on whether the shareholder and creditor approved scheme is to be itself construed as the instrument of transfer, as there is no explicit approval order of the RD sanctioning the scheme. On the other hand, if the RD believes the scheme is not in public or creditor interest, the appropriate course is to refer the matter to the NCLT. In such cases, the fast-track process effectively resets, and the scheme follows the standard route before the NCLT, potentially undermining the objective of speed and efficiency that the fast-track mechanism aims to achieve.

  1. Power of RD vis-a-vis NCLT

For schemes sanctioned by the NCLT, any amendment or variation thereto can be carried out by making an application to the tribunal, by way of an interlocutory application, and NCLT, after considering the observations of the regulatory authorities, if any, has the power to pass necessary orders. That to to say, for the Schemes originally sanctioned by the NCLT, any amendment thereto will also be done by NCLT and not any other forum. Here, a question may arise as to whether the RD, which is the ultimate authority to approve fast track schemes, has similar power, or it has to refer the application seeking amendments to the schemes originally approved by it to the NCLT?

It is a settled principle of law that the authority having the power to approve, only has the authority to allow changes therein. Thus, in case of FTMs, if schemes are originally approved by RD, application for amendment thereto may also be preferred before the RD, unless, the RD itself is on the opinion that the matter requires consideration by the Hon’ble Tribunal. 

  1. Regulatory Approvals in Case of Cross-Border Mergers

Regulation 9(1) of the FEMA (Cross-Border Merger) Regulations, 2018, provides that mergers complying with the prescribed framework are deemed to have RBI approval. Yet, as a matter of process, notices of such schemes must now be served on all relevant regulators, including the RBI, SEBI, IRDAI, and PFRDA, for their comments or objections. This strengthens oversight but could also lengthen timelines, as companies may need to wait for regulator clearances before giving effect to the scheme.

  1. Administrative Capacity of RD Offices

A further consideration is the capacity of RD offices to process the increased number of cases that the expanded FTM eligibility is expected to generate. While there are nearly 30 NCLT benches handling merger matters across India, there are only seven RDs, each with jurisdiction over multiple states and union territories. The RD already endowed with oversight of conversion of public company into private company, approval in case of alteration of FY, rectification of name, etc., in addition to the widened ambit of FTMs. This concentration of responsibility may create administrative bottlenecks, and timely disposal will be critical to preserve the efficiency advantage of the fast-track route.

Conclusion

The Amendments mark a progressive step towards making corporate restructurings quicker and more efficient by widening the scope of Fast Track Mergers, introducing financial thresholds for unlisted companies, and streamlining procedural requirements. Importantly, a specific clarification has now been inserted to state that these provisions shall, mutatis mutandis, apply to demergers as well, thereby removing any interpretational ambiguity on the subject, modifying the forms as well. If implemented effectively, these changes have the potential to substantially declog the NCLTs while giving companies a smoother, time-bound alternative for reorganizations.

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– Team Resolution | resolution@vinodkothari.com

Far reaching changes, several strategic initiatives, bold moves to overcome impact of jurisprudence that did not seem to serve the policy framework – these few words may just approximately describe the IBC Amendment Bill. The Bill has been put to a Select Committee of the Parliament, and may hopefully come back in the Winter Session. However, the mind of the Government is clear: if a bold legal reform has faced implementation challenges, the Government will clear the roadblocks. Some extremely crucial amendments might soon see the light of day, providing much-required clarity on priority of creditors, role of AA, group insolvency, among others.

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Done, dented, damaged: The IBC edifice, even before it’s 10

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– Sikha Bansal, Senior Partner | resolution@vinodkothari.com

What was ushered in as a new era of legal reforms in the country, with keen interest from all over the world, is now a bruised, battered structure, even before it cuts its cake for the 10th time.

The BLRC Vision

When the Bankruptcy Law Reforms Committee first put the Insolvency and Bankruptcy Code, 2016 (“IBC”) into its mould, they envisaged it as a tool in the hands of creditors who should decide on the fate of a defaulting firm. As they put it, “The appropriate disposition of a defaulting firm is a business decision, and only the creditors should make it.” Needless to say, they also recognised that decision-making has to be quick – as delays lead to value destruction. Indeed, the design and structure of IBC was promising enough – a unique categorisation of creditors as financial and operational creditors (found no-where in the world) with financial creditors, a creditor-driven resolution process, strict hardbound timelines, an irreversible liquidation outcome, a well-thought of priority waterfall, and a court-appointed liquidator taking the corporate debtor to the death pyre.

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Fizzled out at NCLAT: No fizz for interest on unpaid MSME dues

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Neha Malu and Prerna Roy | resolution@vinodkothari.com

NCLAT in the matter of SNJ Synthetics Limited v. PepsiCo India Holdings Private Limited, rejected the section 9 application filed by an MSME operational creditor on the ground that the amount of default (excluding interest accrued as per sec 15 and 16 of MSMED Act) was less than the limit stipulated under section 4 that triggers IBC proceedings.

Brief Background:

The operational creditor in the present case was an MSME supplier which filed a section 9 application for an operational debt of 1.96 Crores which included 1.05 Crores as interest for the delayed payment in terms of the provisions of section 15 and 16 of the MSMED Act.

During the pendency of the matter, the parties reconciled accounts and revised the principal to around ₹77.37 lakh. Pursuant to directions from the AA, the CD paid this amount, which the OC accepted while continuing to press for interest at 24% pa in terms of section 16 the MSMED Act. Note, section 15 of the MSMED Act  makes it mandatory for the buyers to make payments to MSME suppliers on or before the agreed-upon date in writing. However, this period cannot exceed 45 days from the date of acceptance or deemed acceptance of the goods or services. If no such agreement exists, payment must be made within 45 days from the day of acceptance or deemed acceptance.

Section 16 prescribes that, upon failure to pay within the stipulated period, the buyer is liable to pay compound interest at three times the RBI notified bank rate. Crucially, this obligation applies notwithstanding any agreement to the contrary. Section 17 further confirms that both the principal and such interest are payable by the buyer.

The AA dismissed the application, holding that CIRP could not be initiated solely on the basis of unpaid interest, once the principal amount had been settled. NCLT observed:

“In the present case, the principal amount stands paid, therefore the CIRP cannot be initiated solely on the basis of the claim of interest component…”

On appeal, the NCLAT upheld this view and further stated:

“… We also notice that the Appellant has relied on the provisions of other laws like MSME Act or Interest Act to justify their claim of interest payment. Without making any observation on the merits of their contention, we would only like to add that neither the Adjudicating Authority nor this Appellate Tribunal is the appropriate forum for making any such determination on the liability of the Respondent- Corporate Debtor to pay interest under the MSME Act or Interest Act.”

While there may be facts specific to the case, for instance, comments of the NCLAT on the interest claim being unsubstantiated despite downward revision of principal, and whether the process was being abused as a debt recovery process, the only point of discussion in this article is whether only the interest component in case of an operational debt, particularly the interest arising under statute, can form sole basis for initiation of CIRP.

Interest as operational debt- A grey area?

While interest is explicitly included in the definition of financial debt under section 5(8) of IBC, the definition of operational debt under section 5(21) makes no such explicit reference. “Operational debt” u/s 5(21) is defined as:

“operational debt” means a claim in respect of the provision of goods or services including employment or a debt in respect of the payment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority.

This distinction in statutory language has raised questions on inclusion of interest on delayed payments as part of operational debt for the purpose of initiating insolvency proceedings, even though there are clear stipulations under the MSMED Act[1].

However, in so far as the interplay between IBC and MSMED Act is concerned, with respect to the statutory interest, judicial decisions indicate that for the purpose of interpretation, such interest, unless mutually agreed upon or expressly admitted, is not regarded as forming part of operational debt under section 5(21) of the Code.

In Vedic Projects Pvt Ltd v. Sutanu Sinha Resolution Professional for Simplex Projects Ltd., NCLAT New Delhi confirmed the view of the AA and held that,

“10. With regard to claim under the MSME, the Adjudicating Authority has observed that NCLT is not appropriate Forum to consider the issue pertaining to the interest, claimed by the Appellant under Section 16 of the MSMED Act.”

Further, NCLT Mumbai in KBC Infrastructures Pvt. Ltd v. Shapoorji Pallonji band Company Pvt. Ltd., held that in the absence of mutual agreement or any promise to pay interest for delayed payment, the claim of OC for treating the interest payable under MSMED Act as operational debt cannot be sustained. The Tribunal held:

“...However, it is now settled in the context of the Code that if interest is not agreed upon between the parties, it cannot form a part of ‘operational debt’ within the meaning of Section 5(21) of the Code and that no such interest can be claimed in an application under Section 9 of the Code. Interest under Section 16 of MSME Act can be claimed before the MSME Facilitation Council (MSEFC) in terms of Section 18 of the MSME Act. Thus, the correct forum for such claims shall be the MSEFC and not this Tribunal…”

A similar view was also taken by NCLAT in Coal India Ltd v. Gulf Coil Lubricants India Ltd. & Anr, NCLT Mumbai in the matter of Skoda Auto Volkswagen India Pvt. Ltd. v. Susee Automotive Pvt. Ltd.and  NCLT New Delhi in Lakshya Infrapromoters Pvt. Ltd. v. The Indure Pvt. Ltd.

However, in other cases wherein the OC was not an MSME, the treatment of interest has seen divergent views.

In Prashant Agarwal v. Vikas Parasrampuria, the NCLAT held that when interest terms are clearly mentioned in the invoices and remain undisputed, such interest forms part of the debt and must be considered while computing the default threshold under Section 4 of the IBC.

“It is, therefore, clear from these facts that the total amount for maintainability of claim will include both principal debt amount as well as interest on delayed payment which was clearly stipulated in the invoice itself…”

Relying on the Prashant Agarwal judgement, NCLAT in Anuj Sharma v. Rustagi Projects Pvt. Ltd., held that:

“The above judgment of “Prashant Agarwal” clearly supports the submission of learned counsel for the Respondent that for calculating the amount for maintainability of the claim, for threshold purpose, both Principal Amount and Interest has to be calculated when the interest is stipulated between the parties.”

On the other hand, in Wanbury Ltd. v. Panacea Biotech Ltd. and SS Polymers v. Kanodia Technoplast Ltd., NCLAT  denied inclusion of interest in operational debt where there was no express agreement or where interest was unilaterally imposed through invoices not accepted or signed by the corporate debtor.

In Rohit Motawat v. Madhu Sharma, Permali Walla Ce Private Limited v. Narbada Forest Industries Private Ltd, also, the NCLAT reiterated that operational creditors cannot rely on unilaterally raised invoices to claim interest, and that once the principal is paid, section 9 proceedings solely for interest are not maintainable.

Further, in Swastik Enterprises v. Gammon India Limited, clarifying on whether interest should form part of the debt amount, held that:

“4. It is submitted that the ‘debt’ includes the interest, but such submission cannot be accepted in deciding all claims. If in terms of any agreement interest is payable to the Operational or Financial Creditor then debt will include interest, otherwise, the principle amount is to be treated as the debt which is the liability in respect of the claim which can be made from the Corporate Debtor.

5. In the present appeals, as we find that the principle amount has already been paid and as per agreement no interest was payable, the applications under Section 9 on the basis of claims for entitlement of interest, were not maintainable. If for delayed payment Appellant(s) claim any interest, it will be open to them to move before a court of competent jurisdiction, but initiation of Corporate Insolvency Resolution Process is not the answer.”

Our Analysis

It appears from the judicial precedents discussed above that, in case of operational debt, the judiciary is inclined to accept “interest” as a debt eligible to initiate CIRP, only when there is an explicit contract between the parties. However, the authors also submit that in case of MSME, the intent of the provisions in sections 15 and 16 is to ensure that the payments to MSMEs are not delayed. Such interest operates in the nature of a penalty[2], and thus there can be no question of any contract between the parties. Hence, going by the judicial precedents above, such statutory imposition of interest can never enable an operational creditor to initiate CIRP against the corporate debtor.

Further, the definitions of “debt” and “default” under IBC are quite broad. While “debt” is defined as  a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt; “default” is 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. Interest arising under section 16 of the MSMED Act would squarely fall under the definition of “debt” – hence, any non-payment of such interest as per statutory timelines should be considered as a default.

Also, in case of an application being filed by operational creditor, as referred in section 9(5), the AA shall admit the application when “no notice of dispute has been received by the operational creditor or there is no record of dispute in the information utility”, and shall reject the application when “notice of dispute has been received by the operational creditor or there is a record of dispute in the information utility”. Therefore, unless there is a dispute, the AA does not have the discretion to reject the application – particularly on the grounds that such interest was not “contractually” agreed. Ofcourse, there can also be possibilities where the levy of interest by MSME is disputed by the corporate debtor, that is, there is a pre-existing dispute before the notice is given by the operational creditor under section 8 of IBC – in such cases, the AA should not admit the application, given that the very existence of such debt is in dispute.

Closing thoughts

The observation of NCLAT in the present case, read with the previous judicial precedents as well, has raised a significant concern i.e., whether statutory interest under laws such as the MSMED Act or the Interest Act is effectively excluded from consideration in insolvency proceedings?

This interpretation could have far-reaching implications. While such interest may be a rightful claim under special statutes, the exclusion of these amounts from the computation of default under section 9 in view of judicial interpretations, introduces a disconnect between substantive rights under one law and procedural access under another.

[1] See FAQs  on delayed payment to MSMEs at: https://vinodkothari.com/wp-content/uploads/2019/05/Revised-FAQs-MSME-upload-1.pdf

[2] ITAT Bengaluru in Dy. CIT (LTU) v. Bosch Ltd, held that “…we further note that as per the Section 15 of the MSMED Act, the liability of the buyer to make the payment to MSME within the period as agreed between the parties or in case there is a delay beyond 45 days from the date of acceptance or date of deemed acceptance the interest payable as per Section 16 shall be three times of the bank rate notified by the RBI. Thus as per Section 16 of the MSMED Act, the payment of interest on delayed payment is in the nature of penalty or it is penal interest…”