LEASING AND RENTING: DO THE IBC CONSIDER THESE TO BE OPERATIONAL DEBT?
In order for creditors to file for bankruptcy proceedings against a corporate debtor, the Insolvency and Bankruptcy Code, 2016 distinguishes between two forms of debt: financial debt and operational debt. Section 7 of the Insolvency and Bankruptcy Legislation allows creditors with financial claims to initiate the Corporate Insolvency Resolution Process (CIRP), whereas Section 9 of the same code allows creditors with operational claims to initiate the CIRP. Creditors cannot use either Section 7 or Section 9 of the Code if they have a debt that is neither financial nor operational. That's why, while thinking about whether or not to make an allegation under the Insolvency and Bankruptcy Code, it's crucial to identify the type of debt or claim at hand.
The debate has been ongoing in recent years in insolvency courts about whether or not a lease and rental payments qualify as "operational debt." Judges on various benches at the National Company Law Tribunal have reached divergent views about the matter (NCLT). Specifically, both the Delhi and Hyderabad divisions of the National Company Law Tribunal (NCLT) have ruled that lease and rent payments do not pose operational debt, whereas the Chennai NCLT, the Kolkata NCLT, and the Ahmedabad NCLT have all come to different findings, each holding that such debt would qualify as operational debt and a landlord can be treated as an operational creditor under the Code. The National Company Law Tribunal of Mumbai (NCLT Mumbai) ruled in favour of a landlord in Indiabulls Real Estate Company Pvt. Ltd. v. Crest Steel Power Pvt. Ltd., and against a hospital's claim that unpaid rent and license fees did not constitute an operational debt under the Insolvency and Bankruptcy Code (Citicare). A later appeal in Citicare was filed with the NCLAT, but it was again rejected. Despite the fact that the Honourable National Company Law Appellate Tribunal (NCLAT) has had several opportunities to deal with the issue, the developing legal precedent on the topic is not even close to being definitive.
Operational Debt: What you need to know
Before talking about how case laws have transformed the law, it's important to know what an“operational debt” is. According to the definition given in Section 5(21) of the Code, an operational debt is a claim that is associated with:
- Providing goods;
- Providing services, including employment;
- A debt that arises from any law and is owed to the government and local authorities.
The jurisprudence on the matter by the NCLAT
This legal dilemma was initially raised in the NCLAT case of Ravindranath Reddy. The question before the tribunal in its attempt to interpret the meaning of an operational debt under the Insolvency and Bankruptcy Code was whether or not the term "provision of services" in the definition could be interpreted broadly enough to encompass the act of a landlord leasing or renting space to a corporate debtor, and thus, he's an operational creditor under Code Sections 5(20) and 5(21). The query was that the Bankruptcy Law Reforms Committee Report classifies a landlord from whom a debtor rents the property and owes monthly rent on a three-year contract as an operational creditor. To begin, the tribunal applied the Bankruptcy Law Reforms Committee Report's definitions of "financial creditor" and "operational creditor" to the facts before it. An operational creditor is defined as a lessor in this report, which makes a distinction between the two sorts of creditors. Despite the BLRC's recommendation that landlords and lessors be included in the definition of operational creditors, the NCLAT made it clear that the Legislature has not completely recognized the BLRC report and that only claims in respect of goods and services have been retained. In answer to the Court's inquiry, the following material has been submitted. The NCLAT ruled that rent payments cannot be read into the contract as a necessary part of doing business. According to a judgement by the National Company Law Appellate Tribunal (NCLAT), a claim by way of debt can only be considered an operational debt if it falls into one of the three categories specified in Section 5(21) of the Code. The NCLAT reached this conclusion by interpreting Section 5(21) of the Code literally. Also, it established that debt must have its origins in a causal chain linking inputs to outputs for it to be called an operational debt. Based on the reasoning provided above, the National Company Law Appellate Tribunal (NCLAT) determined that indebtedness incurred via the leasing of real property does not constitute "operational debt" since it does not include the delivery of tangible goods or services to customers.
The NCLAT's decision in the Anup Sushil Dubey case the following year departed from its reasoning in Rabindranath Reddy and concluded that lease rents accruing from commercial usage of a cold storage unit may be regarded as an operational debt and the lessor as an operational creditor under the IBC. In the matter of Anup Sushil Dubey, this ruling was given on the Leasing out property for a "commercial purpose," as determined by the National Company Law Appellate Tribunal (NCLAT), constitutes "service" under Section 5(21) of the Code. The NCLAT reached this conclusion after the definition of "service" and the list of acts that qualify as the provision of service were deleted from the Consumer Protection Act, 2019, and the Central Goods and Services Tax Act, 2019, respectively. Based on its verdict in Mobilox Innovations Private Limited vs. Kirusa Software Private Limited, the Supreme Court provided the National Company Law Appellate Tribunal with the justification it needed to reverse its earlier ruling in the Ravindranath Reddy case. Since the Supreme Court noted in paragraph 5.2.1 of the verdict that the entity's lessor is an operational creditor to whom it owes monthly rent on a three-year lease,the NCLAT concluded that the cold storage lease costs constituted operational debt.
In the Promila Taneja v. Surendri Design Pvt. Ltd., case NCLAT issued a ruling on this same issue. After evaluating the existing law on the matter and taking into account the conflicting judgements that have been handed down regarding the problem, the NCLAT maintained the opinion that was expressed in the Ravindranath Reddy case. The NCLAT cited Code Section 3(37), which provides that "any term or phrase used in the IBC that is not defined in this Code will be deemed to have the meaning assigned to such term or expression in any of the Acts specified in this Section”. Since Section 3 (37) of the Insolvency and Bankruptcy Code does not reference the Consumer Protection Act or the Central Goods and Services Tax Act, the National Company Law Appellate Tribunal (NCLAT) decided that “Service” and “Activities” cannot be imported from those statutes. Section 5(8) of the IBC defines financial debt as "any liability in respect of any finance or capital lease under the Indian Accounting Standard or such other accounting standards as may be specified” . The NCLAT determined that this clause encompasses “any responsibility in respect of a finance or capital leasing or hire purchase arrangement”. Because of this, the National Company Law Appellate Tribunal (NCLAT) concluded that it is crystal evident from reading the previous definition that the legislature was aware of obligations deriving from leasing and made particular provisions to club it under financial debt. The NCLAT ruled, however, that no such reserve was established for working capital loans.
The NCLAT maintained the verdict in Ravindranath Reddy for the reasons listed above.
The differing opinions on the issue are made clear by studying the judgements made by the NCLAT and the different benches of the NCLT. Supreme Court has taken notice of the subject after an appeal was filed in the case of Promila Taneja. Given the varied opinions among the lower courts, it is now time for the Supreme Court to settle the question of whether or not rent defaults constitute operational debt as part of a wider examination of claims arising owing to the use of the immovable property and other linked services. In sum, the authorities' message is clear, having an open and honest conversation between landlords and tenants concerning rent payments during the coronavirus pandemic will promote collaboration and cooperation throughout the industry and assist guarantee that no one section of the chain suffers the complete weight of payment.