The Insolvency and Bankruptcy Code (Second Amendment) Act 2018: HOME BUYERS as FINANCIAL CREDITORS

The insolvency and bankruptcy code has been formulated with the objective of consolidating and amending the laws in relation to insolvency proceedings against corporate persons, partnership firms and individuals. Section 2 of the code enumerates the entities on which the bankruptcy code shall apply.

Part II of the insolvency and bankruptcy code applies to matters relating to the insolvency and liquidation of corporate debtors where the minimum amount of the default is one lakh rupees. A corporate debtor for the purpose of the code is a corporate person who owes a debt. A corporate person for the purpose of the code includes a company incorporated under the companies act; limited liability partnership firms; any other person incorporated with limited liability. The code specifically excludes financial service provider from the definition of “corporate person”.

The insolvency resolution process under the code can be initiated on the commission of a default by the corporate debtor. Such insolvency proceedings can be initiated by a financial creditor, an operational creditor or the corporate debtor himself.

Section 7 of the code guides the steps which need to be taken by a financial creditor while initiating an insolvency resolution process against the corporate debtor. For the purpose of the code financial creditor shall be such person to whom a financial debt is owed and also includes a person to whom such debt has been legally assigned or transferred.

Section 5 (8) elaborately defines the term “financial debt”. Recently the definition of financial debt has been widened in order to incorporate home buyers within the scope of the definition of “financial creditors” vide an amendment to the code. The amendment of 2018 has added an explanation to the section 5(8).  The amendment has introduced the amount contributed by an allottee under a real estate project as financial debt and being financial creditors, they are entitled to be represented in the Committee of Creditors by authorized representatives. Also In Nikhil Mehta and Sons (HUF) v. AMR Infrastructure Ltd., NCLAT had held that amounts raised by developers under assured return schemes had the “commercial effect of a borrowing”, as the real estate developer’s annual returns in which the amount raised is shown categorizes it as “commitment charges” under the head “financial costs”. As a result, such allottees were held to be “financial creditors” within the meaning of Section 5(7) of the Code. Hence arose the present batch of petitions by real estate developers.

The amendment was challenged before the honorable supreme court in the matter of Pioneer Urban Land and Infrastructure Limited and Anr. Vs. Union of India & Ors. WP (C) No. 43/2019, the decision in the matter was passed on 9.8.2019. In an elaborate decision by three judge bench of the honorable supreme court, the amendment to the code has been upheld.

In the present article, an attempt has been made to summarize the decision of the honorable court

  1. ARGUMENTS OF THE REAL ESTATE DEVELOPERS
  1. Violation of article 14 of the constitution of India: It was argued that the amendments created discrimination against the real estate developers. It was argued that recognizing them as operational debtor or financial debtors is totally not in consonance of the definition of the code and is discriminatory.

In the case of real estate developers, all that an allottee would have to show is that a debt is due to him, whereas in the cases of persons supplying goods or services if there exists any preexisting dispute between the operational debtor and the person who purchases the goods or avails of the services, the operational debtor would be outside the clutches of the Code. It was also argued that unequals are treated as equals as banks and financial institutions are completely different from real estate developers to treat these unequals as equals by making real estate developers financial debtors, infracts Article 14

  • While citing several judgments it was argued by the counsel of the real estate developers that a claim for unliquidated damages becomes a debt only on adjudication, which does not take place when a Section 7 application is heard. The NCLT can only go into “default” and the definition of “default” is vague and ambiguous.
  • It was also that argued that an explanation can not enlarge the scope of the original provision (S. Sundaram Pillai v. V.R. Pattabiraman (1985) 1 SCC 591).
  • Accounting standards were analyzed to show that the advances received from home buyers by developers cannot, from an accounting perspective, be treated as financial liabilities and the amendments in doing so, violate the accounting standards and become manifestly arbitrary.
  • “Financial debt” and “Operational debt”, are different. Financial debt is a crystallized claim which is due, as opposed to an operational debt which may simply be a claim upon breach of contract that may be disputed and therefore not due. The home buyers may be regarded as operational creditors rather than financial creditors. It was also suggested that home buyers should only be covered under the scope of RERA as RERA is a special Act as opposed to the Code, which is a general Act.
  • Sine qua non of a “financial debt” is a loan of money made with or without interest, which must then be returned as money. This was argued to be the meaning interpreted out of section 5(8)f. By no stretch of imagination, could an allottee under a real estate project fall within Section 5(8)(f), as it originally stood and the explanation must then be read prospectively i.e. only on and from the date of the Amendment Act.
  • The challenge to Section 21(6A) and 25A of the Code: Different instructions may be given by different allottees making it difficult for the authorised representatives to vote on the Committee of Creditors and that in any case, the collegiality of the secured creditors will be disturbed
  1. JUDGMENT

1. The Amendment Act to the Code does not infringe Articles 14 while upholding so the honorable court held the following that various decisions of the honorable supreme court has firmly established that— (a) a law may be constitutional even though it relates to a single individual if, on account of some special circumstances or reasons applicable to him and not applicable to others, that single individual may be treated as a class by himself;

(b) that there is always a presumption in favour of the constitutionality of an enactment and the burden is upon him who attacks it to show that there has been a clear transgression of the constitutional principles;

 (c) that it must be presumed that the legislature understands and directed to problems made manifest by experience and that its discriminations are based on adequate grounds.

 (d) that the legislature is free to recognise degrees of harm and may confine its restrictions to those cases where the need is deemed to be the clearest;

 (e) that in order to sustain the presumption of constitutionality the court may take into consideration matters of common knowledge, matters of common report, the history of the times and may assume every state of facts which can be conceived existing at the time of legislation; and

(f) that while good faith and knowledge of the existing conditions on the part of a legislature are to be presumed, if there is nothing on the face of the law or the surrounding circumstances brought to the notice of the court on which the classification may reasonably be regarded as based, the presumption of constitutionality cannot be carried to the extent of always holding that there must be some undisclosed and unknown reasons for subjecting certain individuals or corporations to hostile or discriminating legislation.

2. The Procedure under RERA and Code to co-exist

  1. The Code and RERA operate in completely different spheres. The Code deals with a proceeding in rem. RERA on the other hand protects the interests of the individual investor in real estate projects
  2. It relation to the perceived conflict between provision of RERA and the code it was opined by the honorable court that the Code is not meant to be a debt recovery mechanism. 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 certain risks of either the flat/apartment not being completed in the near future or the allottee may never get a refund of the entire principal. The procedure of rederessal under the Real Estate Regulatory Authority is more likely to aid the allottee in getting the refund or the house as compared to the code. Thus, given the bona fides of the allottee who moves an application under Section 7 of the Code, it is only such allottee who has completely lost faith in the management of the real estate developer would take recourse under the code to NCLT.
  • Why allottees cannot be classified as operational debtors under the code

What is unique to real estate developers vis-à-vis operational debts, is the fact that, in operational debts, when a person supplies goods and services, such person is the creditor and the person who has to pay for such goods and services is the debtor.

  1. In the case of real estate developers, the developer who is the supplier of the flat/apartment is the debtor inasmuch as the allottee funds his own apartment by paying amounts in advance to the developer for construction of the building in which his apartment is to be found.
  2.  Another vital difference between operational debts and allottees of real estate projects is that an operational creditor has no interest in or stake in the corporate debtor, unlike the case of an allottee of a real estate project, who is vitally concerned with the financial health of the corporate debtor, for otherwise, the real estate project may not be brought to fruition. Also, in such event, no compensation, nor refund together with interest, which is the other option, will be recoverable from the corporate debtor.
  3. In an operational debt, there is no consideration for the time value of money – the consideration of the debt is the goods or services that are either sold or availed of from the operational creditor. Payments made in advance for goods and services are not made to fund manufacture of such goods or provision of such services. In real estate projects, money is raised from the allottee, against consideration for the time value of money. Even the total consideration agreed at a time when the flat/apartment is non-existent or incomplete, is significantly less than the price the buyer would have to pay for a ready/complete flat/apartment, and therefore, he gains the time value of money. Likewise, the developer who benefits from the amounts disbursed also gains from the time value of money.
  4. One other vital difference with operational debts is that the documentary evidence for amounts due and payable by the real estate developer is in the form of the information provided by the real estate developer compulsorily under RERA. It is these fundamental differences between the real estate developer and the supplier of goods and services that the legislature has focused upon and included real estate developers as financial debtors. This being the case, it is clear that there cannot be said to be any infraction of equal protection of the laws.
  5. The argument that home buyers can be categorized as “other creditors” was also rejected by the court.
  • Advances By Allottees Is “Financial Debt”

Section 3(11) of the code states that “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;  Section 3(6) defines the term “claim”

  1.  as a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured or unsecured;
  2. right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to a right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured;

“default” means non-payment of debt when whole or any part of the installment 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;

The definition of “financial debt” in Section 5(8) of the code then goes on to state that a “debt” must be “disbursed” against the consideration for the time value of money. Section 5(8)(f) of the code is described as a sub-clause which appears to be a residuary provision as it refers to the words “any amount” and “any other transaction” which means that amounts that are “raised” under “transactions” not covered by any of the other clauses, would amount to a financial debt if they had the commercial effect of a borrowing. The expression “transaction” is defined by Section 3(33) of the Code as an agreement or arrangement in writing for the transfer of assets, or funds, goods or services, from or to the corporate debtor;

the expression “any other transaction” would include an arrangement in writing for the transfer of funds to the corporate debtor and would thus clearly include the kind of financing arrangement by allottees to real estate developers when they pay installments at various stages of construction, so that they themselves then fund the project either partially or completely

  • Voting By The Allottees On The Committee Of Creditors: The honorable court held that although the allottees may not be a homogenous group, yet there are only two ways in which they can vote on the Committee of Creditors – either to approve or to disapprove of a proposed resolution plan. Sub-section 25A (3A) introduced vide amendment 2019 to the code ( the decision was passed while it was still a bill) irons out all creases that may have been felt in the working of Section 25A in that the authorized representative casts his vote on behalf of all financial creditors that he represents. A vote of more than 50% of the voting share of the financial creditors will bind all the financial creditors represented by the authorized representative.
  • Explanation Cannot Enlarge The Scope Of The Section: The honorable court held that, the explanation was added by the amendment act only to clarify doubts that had arisen, as to whether home buyers/allottees were subsumed within Section 5(8)(f). The explanation added to Section 5(8)(f) of the Code by the Amendment Act does not in fact enlarge the scope of the original Section as home buyers/allottees could be clearly subsumed within Section 5(8)(f) as it originally stood i.e. the allottees/home buyers were included in the main provision, i.e. Section 5(8)(f) with effect from the inception of the Code, the explanation being  merely to clarify doubts that had arisen.

THE HONORABLE COURT HAS ALSO PROVIDED THE FOLLOWING DIRECTIONS UNDER THE JUDGMENT

  1. States/Union Territories shall appoint permanent adjudicating officers, a Real Estate Regulatory Authority and Appellate Tribunal within a period of three months from the date of the judgment, if they have not yet appointed.
  2.  b. The NCLT and the NCLAT shall be manned with sufficient members to deal with litigation that may arise under the Code generally, and from the real estate sector in particular, by the second week of January, 2020.
  3. c. Stay orders granted shall continue until the NCLT takes up each application filed by an allottee/ home buyer to decide the same in light of this judgment.

— Advocate Ravindra Vikram, Ph: +91-94100-22521

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