Significance of Prior "Contract" Under Operational Debt: The Recent Conundrum

The authors are Soumya Sinha and Bhabesh Satapathy, third and second year students, respectively, at National Law University, Odisha.

This post was first published in Centre for Business and Commercial Laws(CBCL) Blog NLIU, Bhopal.

INTRODUCTION

The birth of the Insolvency and Bankruptcy Code, 2016 ("IBC") in India has not only alleviated the pain of Financial Creditor ("FC") but also Operational Creditor ("OC"). By various judgments and amendments the scope of operational debt defined u/s 5(21) of the IBC has been augmented. In many recent rulings, various authorities and courts have talked about the scope of advance payment for the goods and services under the umbrella of the operational debt. The recent NCLAT’s decision in Chipsan Aviation Limited v. Punj Llyod Aviation Limited has created a debate concerning the significance and necessity of a prior contract on the basis of which an operational debt is considered u/s 5(21) of the IBC. NCLAT through its ruling held that advance payment for goods and services without a prior valid contract can still be considered as an operational debt under IBC. This stance has sparked more confusion regarding the prerequisites of an operational debt under IBC.

In this article, the authors seek to critically analyze the Chipsan Aviation case and argue on the necessity of a valid contract to transfer goods or services in an operational debt under IBC.

BACKGROUND

The appellant, Chipsan Aviation Private Limited (“Operational Creditor”) had advanced an amount of Rs. 60 Lakhs to the respondent, Punj Lloyd Aviation Limited, the Corporate Debtor (“CD”) for aviation related services. However, the services were not rendered by the CD. In addition, the advance payment made by the appellant was also not refunded. But an advanced payment was reflected in the respondent’s balance sheet as a current liability. The circumstances led to an issuance of demand notice under Section 8 of the IBC and filing of a petition under Section 9 of IBC, seeking initiation of Corporate Insolvency Resolution Process (“CIRP”) against the CD over the default. The plea by the appellant was rejected by NCLT Delhi. It was held that advance payment would not come under the ambit of operational debt. However, establishment of operational debt would be dependent on the contract. The stance taken by NCLT was appealed by the OC before the NCLAT.

The NCLAT had given its decision in favor of the appellant allowing advance payments to be termed as operational debt u/s 5(21) of the IBC. Further, it was held that even in the absence of any contract between the OC and CD, the advance payment would still constitute operational debt. It had put reliance on the Supreme Court’s judgment in the case of Construction Consortium Ltd v. Hitro Energy Solutions Pvt. Ltd, where it was held that Section 5(21) of IBC needs to be interpreted in a broad manner covering all aspects of advance payment.

UNDERSTANDING OPERATIONAL DEBT U/S 5(21)

Section 5(21) of the IBC expounds operational debt as “A claim in respect of the provisions of goods or services”. Moreover, the word “claim” has been defined under the Section 3(6) as either “a right to payment or a right to remedy for breach of contract". Here, if Section 5(21) is read with Section 3(6), then it is deduced that operational debt requires a claim for the payment of goods or services which implicitly has a nexus with a valid contract for the providing the same. This stance has been reaffirmed in the case of Mr. Harrish Khurana v. M/S One World Realtech Private and Construction Consortium Ltd v. Hitro Energy Solutions Ltd where it was held that "An operational debt should include only those debts which are arising from a contract in relation to the supply of goods or services from the corporate debtor".

Thus, the essentials of an operational debt are that there must be a debt in respect to which a claim arise which should be either for the remedy for breach of an underlying contract between OC and CD for providing goods or services, or for the payment of the goods or services which have already been supplied under a valid contract.

CONTRACT NOT ESTABLISHED – DOES NOT GIVE RISE TO OPERATIONAL DEBT UNDER THE IBC

The foremost requirement for a debt to be termed as operational debt is the existence of a valid contract. This has been elucidated in numerous judgments, the most notable of which is Tejas Industries v. Gujarat Machinery (P.) Ltd in which the court emphasized upon the relationship of the operational creditor and corporate debtor. In this case, it was established that for a claim to be considered as operational debt, the existence of a formal contract between OC and OD is a prerequisite. This was further reinforced in the case of Ms. Rohita v. All That Hype Media (P.) Ltd. where the CIRP petition was dismissed since there was no legally enforceable contract between the parties. Under the Indian Contract Law, 1872, the essentials of a valid contract are outlined. A valid contract requires the establishment of an offer by one party and acceptance by the other. The term ‘offer’ is defined in Section 2(a) as “when one person will signify to another person his willingness to do or not do something (abstain) with a view to obtain the assent of such person”. Further, under Section 2(b), “when an assent is granted to the offer and the same is conveyed to the offeror, it is termed to be accepted”. However, in the present case the Draft Agreement was forwarded by the OC to the CD, which was never signed by the CD. It can be concluded that no acceptance of the offer was made. Thus, no valid contract was formed in the present case.

Further, in order to prove an operational debt in a CIRP, the OC is provided with an option between an invoice demanding payment of goods supplied to the CD or a contract for supply of goods or services as per Regulation 7(2)(b)(i) and (ii) of the CIRP Regulations 2016 . This position was strengthened in the case of G.L. Engineering Industries (P.) Ltd. v. Supreme Engineering Ltd., where it was held that the mere acknowledgement of any liability would not constitute an 'operational debt' as defined under Section 5(21). The claim for operational debt needs to be supported by evidence on record to prove that the amount claimed arises out of 'supply of goods and services'. While the contract includes all forms of contract present, the invoice generated indicates that there should be supply of goods or services between the OC and CD. In the present facts of the case, the invoice was not present since there was no actual supply of goods or services which is a requirement under Section 5(21). Further, there was no contract between OC and CD as there was no acceptance of the Draft Agreement by the CD. Therefore, the claim of operational debt under Section 5(21) cannot be proved in the present case since there is an absence of the invoice as well as the contract.

FLAWED INTERPRETATION OF ESTABLISHED PRECEDENTS BY NCLAT

In the present case, the judgment of the NCLAT has mostly relied on the Construction Consortium Limited v. Hitro Energy Solutions Private Limited, where it was held that an advance payment for providing goods or services can be considered as an operational debt u/s 5(21) of IBC. This is prima facie correct however, it is pertinent to mention that in the aforementioned case there was an underlying contract which forms the basis for the advance payment for goods or services. Here, NCLAT in a negligent manner ignored the significance of an underlying contract in an operational debt while delivering the judgment. Moreover, it is observed that in all the established precedents which have ruled that an advance payment for providing goods or services is termed as an operational debt have implicitly mentioned the importance and presence of a valid contract between OC and CD which forms the basis of an operational debt. It is evident that the presence of a valid contract is a must in all cases dealing with operational debt. The NCLAT, by ruling advance payment as an operational debt without a contract, has simply ignored the prerequisites of an operational debt under IBC. So, NCLAT while interpreting the established precedents has missed out the underlying essentials of an operational debt which were implicitly mentioned in those precedents and thus the present interpretation has several flaws and is ambiguous in nature.

CONCLUSION

The present ruling by NCLAT has put forward numerous questions with respect to the definition of ‘operational debt’ u/s 5(21) of the IBC. The Court has interpreted the definition of operational debt broadly thus, including advance payments within its ambit. However, the bench did not look into the aspect of the need of an underlying contract which is required for the operational debt to arise. In the present case, the essentials of the contract that is offered and accepted were not present. Further, it was not possible for the parties to present invoice as the proof, since there was no rendering of goods and services. The present case could fall under various other conditions but, in the absence of any contract and proof of payment, it was unfair on the part of the bench to label it as ‘operational debt’. This loophole can actually create a lot of chaos before the court while deciding whether a debt is an operational debt or not. The parties can easily misuse the non-necessity of contract under IBC. This will further dilute the essence of the provision of operational debt under the IBC.