When Does Debt Become Financial Debt & Operational Debt Under IBC? Supreme Court Explains

In a significant development, the Supreme Court on Thursday (April 25) held that debt would be treated as an operational debt only if the claim subject matter of the debt has some connection or co-relation with the 'service' rendered by the creditor to the debtor."Where one party owes a debt to another and when the creditor is claiming under a written agreement/ arrangement providing for rendering 'service', the debt is an operational debt only if the claim subject matter of the debt has some connection or co-relation with the 'service' subject matter of the transaction.", the Bench comprising Justices Abhay S. Oka and Pankaj Mithal said.In the present case, a certain amount (Rs.53,15,000) was deposited by the creditor with the corporate debtor in the form of a security deposit. The creditor has to render service to promote the beer manufactured by the corporate debtor. For rendering such a service, the corporate debtor had to pay Rs. 4,000/- per month to the creditor. Moreover, the security deposit amount deposited with the corporate debtor needs to be refunded to the creditor with an interest @21% p.a.Affirming the National Company Law Appellate Tribunal's (“NCLAT”) decision which had declared the creditor's security deposit amount held by the corporate debtor as a 'financial debt', the court by taking reference to the agreement between the parties observed that only the claim of Rs. 4,000/- per month paid to the creditor by the corporate debtor in exchange of services would be treated as an 'operational debt', but the claim of the security deposit amount as it would be treated as a 'financial debt' as the corporate debtor was under an obligation to refund the amount which carries payment of interest to the creditor.“Assuming that both the agreements are genuine in the sense that they reflect the true nature of the transaction, the only claim under the agreements which will have any connection with the services rendered by the first respondent will be the claim of Rs. 4,000/- per month as provided in clause (1) of both the agreements. Only this claim can be said to be concerning the provision of services. Therefore, by no stretch of imagination, the debt (security deposit amount) claimed by the first respondent can be an operational debt.”, the Judgment authored by Justice Abhay S Oka observed.The Court held that when there exists a liability upon the corporate debtor to refund the security deposit amount to the creditor along with an interest, then the security deposit amount kept with the corporate debtor would be treated as 'financial debt', making the Financial Creditor eligible to initiate the Corporate Insolvency Resolution Process (CIRP) under the IBC based on a valid 'claim' under Section 3(6) of IBC.Supreme Court Explains Test To Determine Debt as 'Financial Debt' or 'Operational Debt' According to the Court, the test to determine whether the debt is a 'financial debt' or 'operation debt' is by ascertaining the real nature of the transaction reflected in the written agreement. Explaining the test, the court opined that if the creditor is claiming the debt from the corporate debtor for rendering the 'service', then the debt would be considered an operational debt, however, when the debt is disbursed for the time value of value having the commercial effect of borrowing, then the debt would be treated as a 'financial debt'. “Where one party owes a debt to another and when the creditor is claiming under a written agreement/ arrangement providing for rendering 'service', the debt is an operational debt only if the claim subject matter of the debt has some connection or co-relation with the 'service' subject matter of the transaction.”, the Court observed. Testing the law on the fact of the case, the court held that only Rs. 4,000/- paid to the creditor by the corporate debtor for promoting the beer manufactured by him would be treated as an 'operational debt', thereby holding that the security deposit amount kept with the corporate debtor wouldn't be treated as an operational debt but financial debt.Security Deposit Amount Has 'Commercial Effect Of Borrowing', Reflects Corporate Debtor's Account Statement Moreover, the Court recorded that since the financial year account statements of the corporate debtor denote the interest paid to the creditor on the security deposit amount as under the head of 'long-term loans and advances' and 'other long-term liabilities', therefore, it was held that the amount raised under the agreement has the commercial effect of borrowing as the corporate debtor treated the said amount as borrowed from the creditor. Based on the above premise, the appeal was dismissed by allowing the Resolution Professional to continue the CIRP process by taking into account the security deposit amount as a 'financial debt' under the IBC.The Court summarized the conclusions as follows :a. There cannot be a debt within the meaning of sub- section (11) of section 5 of the IB Code unless...

When Does Debt Become Financial Debt & Operational Debt Under IBC? Supreme Court Explains

Yash Mittal

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