Flat buyers under IBC: Creditors or consumers?

The Indian bankruptcy regime is developing very fast. There is a risk that the law may soon diverge from the original policy intent. One such example is the recent regulation by IBBI creating a third category of creditors - other than financial or operational creditor. Commentators have suggested that flat buyers would fall under this third category. This comes in the backdrop of recent decisions of NCLT and NCLAT that have left flat buyers jittery about their future once the real estate company enters corporate insolvency resolution process (CIRP).

There are two separate issues here. First, the Bankruptcy Law Reforms Committee (BLRC) in its report had only envisaged two categories of creditors (financial and operational) for the purposes of CIRP. But the ambiguous language of Insolvency and Bankruptcy Code (IBC)
prompted IBBI to create a third category of creditors. This third creditor can neither trigger the CIRP, nor be on the Committee of Creditors (CoC). Second, BLRC had categorically stated that not all assets present within the insolvent company shall form part of the liquidation. Whether the corresponding provisions of IBC will protect flat buyers of insolvent real estate companies remains to be seen.

The third creditor

There are multiple ways in which creditors could be classified: financial versus operational, secured versus unsecured etc. The BLRC had to decide how to classify creditors in different contexts. One such context was CIRP - who will trigger it? Who will be on the CoC? Faced with these questions, the BLRC report noted that both the debtor and the creditors should have the power to trigger CIRP. However, a creditor could trigger the CIRP only on clear evidence of default. Since the process of establishing default would have to be different for financial and operational creditors, the BLRC had to classify creditors into these two categories. In this policy scheme, no third category of creditors was envisaged.

The two way classification was also useful in determining the composition of the CoC. The BLRC report notes:

The Committee deliberated on who should be on the creditors committee, given the power of the creditors committee to ultimately keep the entity as a going concern or liquidate it. The Committee reasoned that members of the creditors committee have to be creditors both with the capability to assess viability, as well as to be willing to modify terms of existing liabilities in negotiations. Typically, operational creditors are neither able to decide on matters regarding the insolvency of the entity, nor willing to take the risk of postponing payments for better future prospects for the entity. The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors.

In spite of the clear policy rationale for having only two types of creditors (financial and operational) for the CIRP process, the ambiguous language of IBC has now caused confusion.

Ambiguity in IBC

First, most Indian statutes have only one section for definitions. In contrast, IBC has three sections with the title "Definitions" - section 3, 5 and 79. While section 3 is for the entire Code, section 5 is only for Part II (corporate insolvency) and section 79 is only for Part III (personal insolvency). The word "creditor" is defined in section 3(10) to include "any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decreeholder". This inclusive definition suggests that under IBC there could be creditors other than "financial creditor" and "operational creditor". This doubt is further entrenched because various sections within Part II (corporate insolvency) use "creditor" as well as "financial creditor" and "operational creditor". This drafting gives the impression that the legislature has used the word "creditor" to include more than just financial and operational creditor in CIRP.

Second, Indian statutes usually use a negative definition while making binary classifications. For instance, under FEMA there are only two kinds of transactions: "capital account transaction" and "current account transactions". To achieve this, the law provides a principle-based definition of "capital account transaction". Then it defines "current account transactions" simply as "a transaction other than a capital account transaction". Similarly, IBC could have also defined "financial debt" and then defined "operational debt" as any debt other than "financial debt". That would have ensured that there is no third category of debts (and creditors). Unfortunately, IBC provides principle-based definition for both "financial debt" and "operational debt", thus creating scope for a third category of debts.

These legislative ambiguities seem to have prompted IBBI to create a third category of creditors, contrary to the orginal policy intent.

Consumers, not creditors

Some commentators have opined that certain flat buyers would fall under this third category of creditors. Simultaneously, IBBI has categorically denied media reports suggesting that flat buyers will now be part of CoC. On the other hand, NCLT has ruled that flat buyers are not "operational creditors" either. In view of these differing view points, it would be useful to first understand the basics of a simple flat purchase transaction.

Most buyers pay the real estate developer in advance for delivery of the property at a future date. The problem begins when the developer defaults in delivering the property on time. Buyers resort to various legal actions either to get possession of the property or to get their money back. Clearly, in these cases the buyers are not creditors of the real estate company. They are merely consumers of its services. Just like a pre-paid mobile customer is a consumer of the telco.

In one exceptional case - Nikhil Mehta v. AMR Infrastructure - NCLAT held the concerned flat buyers to be "financial creditors". But this was because of an exceptional clause in their agreement. The developer had contractually agreed to pay a monthly amount to the buyers till the property was delivered to them. In view of this unique clause, NCLAT held that these flat buyers were "financial creditors" of the developer company. This is not a principle of general applicability. Therefore, it can be concluded that all flat buyers are consumers but not necessarily financial creditors.

Consumers under IBC

If flat buyers are consumers of the real estate company, what happens to them if a bank triggers CIRP against the real estate company? This is an important question with practical implications. Although the BLRC did not discuss this issue specifically, it had explicitly recommended that "not all assets that are present within the entity, from the start of the IRP, can be considered for liquidation." Accordingly, section 36 of the IBC excludes "assets held in trust for any third party" from being included in the liquidation estate.

It could be legitimately argued that the funds and properties held by the insolvent real estate company in trust for the third party consumers (flat buyers) should get the protection under section 36. In that case, these funds and properties cannot be taken away by the creditors (like banks) of the real estate company. However, section 18 of the IBC suggests that the interim resolution professional cannot take control and custody of these assets. In view of this contradiction, it needs to be seen how the jurisprudence on "assets held in trust" develops to provide effective remedy to aggrieved flat buyers under IBC.

Conclusion

When IBC was enacted, policymakers realised that unforeseen challenges are likely to crop up during its implementation. That is why section 242 of IBC empowers the Central Government to remove difficulties faced during implementation. However, if necessary, the government can always streamline the law by suitably amending it. In view of the above complications arising out of the insolvencies in the real estate sector, policymakers need to consider if IBC is currently equipped to handle the challenges ahead or would an amendment be necessary to equip it suitably.

Pratik Datta is a researcher. This piece appeared in Ajay Shah's Blog. You can read it here.