Insolvency Archives

Understanding Invoice Discounting: Legal Framework, Transaction Dynamics, and Implications under the IBC, 2016

[By Nakshatra Gujrati] The author is a student of National Law University Odisha. Introduction In the dynamic realm of financial transactions, invoice discounting has emerged as a pivotal tool for businesses seeking to optimize their working capital. Invoice Discounting, also known as Bill Discounting, entails three key participants: the seller, the customer (who is also the debtor to the financier), and the financier, commonly referred to as the factor. The financier provides this short-term relief in exchange for a predetermined commission and discount rate, forming the core dynamics of the transaction. This article explores the complexities of invoice discounting and its intersection with the Insolvency and Bankruptcy Code, 2016 (“Code”). Governed by the Factoring Regulation Act, 2011, (“Act”) the examination commences by delineating the fundamental process of invoice discounting and elucidating the roles assumed by the seller, customer, and financier. The article examines the dynamics of transactions between the financer and the customer, as well as between the financer and the seller. It scrutinizes the decisions rendered by tribunals, offering insights into the classification of customers as financial debtors and classification of sellers as operational debtors. What is Invoice Discounting Invoice Discounting, also known as Bill Discounting in trade circles, is a process where an entity can transfer its invoices (receivables) to a third-party financier, such as a bank or another financial institution. This financial entity, referred to as the “financer”, offers a bank discounting facility, providing short-term assistance in fulfilling the working capital needs of the entity that sold the outstanding bill. In return, the financer levies a designated commission and discount rate for their services. The Factoring Regulation Act, 2011 (“Act”) regulates the practice of invoice discounting, and businesses engaged in this activity are referred to as “factoring businesses”. This Act aims to validate contracts related to the assignment of receivables. The party to whom the receivable is transferred is known as the assignee, while the entity owning the receivable is termed the assignor. Invoice discounting typically involves three participants; the seller (sold goods and services to customer), the customer (also debtor of the financer) and the financier (commonly referred to as the factor). In this process the business sells its invoices to the financier, who provides cash. Afterwards when it comes time, for payment the customer pays the amount, to the financier. Invoice Discounting and Insolvency and Bankruptcy Code, 2016 The section 5(8) of the Insolvency and Bankruptcy Code, 2016 (“Code”) defines financial debt as “debt along with interest, if any, which is disbursed against the consideration for the time value of money”, including “receivables sold or discounted other than any receivables sold on non-recourse basis” as per section 5(8)(e) of the Code. Nature of transaction between the Financer and the Customer. The customer enlists the services of a financer to enhance their cash flow, facilitating timely bill payments with reduced risk and increased flexibility, given that such arrangements don’t necessitate collateral. However, a dilemma arises when the customer fails to fulfil payment obligations to the financer. The tribunal is confronted with the inquiry of categorizing the customer as either a financial creditor or an operational creditor of the financer. In the case of M/s Shree Jaya Laboratories Private Limited,(“Jaya Laboratories”) it was ruled that “an application under section 7 of the code may be maintained against the customer”. In the instant case the financer extended its services to the customer on a recourse basis. The Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 classifies the factoring services into three categories. These include (i) non-recourse factoring, where the financer has no recourse against the customer except in cases of fraud, misrepresentation, or failure to fulfill obligations; (ii) recourse factoring, wherein the customer remains liable to the financer; and (iii) limited recourse factoring, allowing the customer and financer to establish conditions for recourse through a contractual agreement. As per section 5(8)(e) of the code, financial debt includes receivables sold or discounted other than non-recourse basis. Hence, the relationship between the financer and customer is of financial creditor and financial debtor and thus an application u/s 7 of the code is maintainable against customer. Nature of Transaction between the Financer and the Seller In the recent judgment of NCLAT in Minions Ventures Pvt Ltd vs Tdt Copper Limited (“Minions Ventures”) it was held that “while discounting the invoice of sellers the financers enter into shoes of seller to become operational creditors”. It was observed that in this transaction, no funds were disbursed, let alone for the time value as a financial debt to the seller. Instead, it constituted an operational debt, as the seller provided goods and services to the customer, defining the nature of the debt between the two as operational. Similarly, this view was taken in Jaya Laboratories while dismissing application of financer against seller under section 7 of the code. Conclusion The practice of Invoice Discounting, also known as Bill Discounting, plays a crucial role in facilitating working capital needs for businesses by allowing them to convert their receivables into immediate cash through third-party financiers. The Factoring Regulation Act of 2011 regulates this financial activity, defining the roles of factoring businesses, assignors, and assignees in the process. Examining the intersection of Invoice Discounting with the Insolvency and Bankruptcy Code of 2016, it becomes evident that the nature of the transaction between the financer and the customer is one of a financial creditor and financial debtor. This is especially true when the services are provided on a recourse basis, as outlined in the Master Direction of the Reserve Bank of India. The application of Section 7 of the Insolvency and Bankruptcy Code against the customer is deemed maintainable under these circumstances. In the context of the relationship between the financer and the seller, recent judgments, such as the one in Minions Ventures, suggest that when discounting invoices, financers assume the role of operational creditors. In these cases, where no funds are disbursed as financial debt, but rather the transaction revolves

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Revisiting the Second Proviso to Section 7(1), IBC, 2016: In Re Manish Kumar Ruling

[By Pranav Karwa and Gaurav Karwa] Pranav is a student at the National Law University, Jodhpur and Gaurav is a student at the West Bengal National University of Juridical Sciences. Recently, in the case of Manish Kumar v Union of India (“Manish Kumar Ruling”), the Supreme Court upheld the constitutional validity of all the provisos added to Section 7(1) of the IBC, 2016 (“Code”) via the IBC Amendment Act, 2020 (“the Amendment”). The second proviso to Section 7(1) of the Code introduced a new threshold for filing an application to initiate CIRP by Home-Buyers. As per the proviso, the allottees under a real estate project can apply to initiate the CIRP process only if not less than 100 allottees file it under the same real estate project or one-tenth of the total number of allottees under the same real estate project, whichever is lower. Various writ petitions were filed by real-estate creditors challenging the constitutionality of the Amendment, including the provisos added to Section 7(1) of the Code. The primary allegation in these petitions was that the Second and Third proviso to Section 7(1) violates Article 14 and 19(1) (g) of the Constitution of India. It was also alleged that the impugned provisos are in clear violation of the Supreme Court verdict in Pioneer Urban Land and Infrastructure Ltd. and Anr v. Union of India as in that case, it was observed that Home-Buyers are deemed financial creditors without any restriction imposed on them for initiating CIRP. The authors highlight the key observations by the Supreme Court in Manish Kumar Ruling and in the backdrop of this decision, examine the utility of the Second Proviso to Section 7(1). The authors conclude by suggesting certain better alternatives which comprehensively address the mischief sought to be resolved by the Second Proviso to Section 7(1). Manish Kumar Ruling While setting aside the petitioners’ arguments in the Manish Kumar Ruling, the Supreme Court observed that there is no real discrimination against Home-Buyers. The Court opined that an intelligible differentia exists between Home-Buyers and other financial creditors as there is the heterogeneity, numerosity, and individuality in decision-making in the case of Home-Buyers. In the Court’s view, the Second Proviso to Section 7(1) of the Code acts as a deterrent for individual homebuyers filing frivolous claims before the NCLT. Thus, the Apex Court held that the Second Proviso to Section 7(1) of the Code is constitutionally valid and just because the proviso causes some inconvenience and difficulties to the Home-Buyers is not reason enough to strike it down. Overall, the Manish Kumar Ruling is a major setback for Home-Buyers who want to initiate a CIRP under Section 7(1) of the Code, individually or in small groups. However, on a positive note, the Court has clarified that not all the Home-Buyers, applying under Section 7(1), must have pending dues against real-estate project developers. It will be enough if the total dues satisfy the threshold limit of ₹1 crore. Examining the Utility of Second Proviso to Section 7(1) It is the view of the authors that the Second Proviso to Section 7(1) of the Code was not necessary in light of the already existing safeguards in the Code which prevent initiation of CIRP by frivolous claims Various concerns of the project developers could have been addressed by alternate mechanisms, which were not taken into account by the Court in the Manish Kumar Ruling. There are safeguard mechanisms already existent under the Code to ensure that there is a check on mala fide applications, where a single home buyer intends to change the real estate developer’s management. For instance, penalties ranging from ₹1 lakh to ₹1 crore on fraudulent or malicious initiation of proceedings are provided under Section 65 of the Code. Further, as held in Naveen Raheja v Shilpa Jain & Ors, the NCLT also reserves the power to impose additional costs on such mala fide applications. Moreover, Section 75 of the Code envisages a penalty ranging from ₹1 lakh to ₹1 crore in the scenario where the financial creditor under Section 7(1) omits to disclose any material fact in the application. Thus, merely the fact that a single real estate allottee is filing a complaint does not mean that the Code is being used as a debt recovery mechanism, as there already exist sufficient safeguards to ensure that the NCLT does not entertain the malicious application. Furthermore, an observation by the Supreme Court in Pioneer Urban gives more power and discretion to the NCLT to filter patently frivolous and malicious applications; the Court said that “when a home buyer makes an application, the NCLT’s satisfaction will be with both eyes open – the NCLT will not turn Nelson’s eye to genuine defenses raised by real estate developers.” Moreover, it was also observed by the Supreme Court that as soon as the tribunal admits an application, it becomes a proceeding in rem from a proceeding in persona. Therefore, after the initiation of the proceeding, the entire matter goes out of the individual allottees’ control and becomes a collective action. In this light, the fear that an individual Home-Buyer may use the Code to force the real estate developer’s liquidation is unfounded and without any backing. This is because, after the constitution of the Committee of Creditors, the issue of whether liquidation or corporate restructuring is to take place is decided collectively by voting in the Committee of Creditors. Lastly, the Second Proviso is not an unambiguous provision free of all anomalies. For instance, that the Amendment, introducing the Second Proviso to Section 7(1), does not clarify as to whether the prescribed limit of 100 or 10% of the total number of allottees, whichever is less, is to be satisfied only at the stage of initiation of CIRP or whether it must be maintained throughout the proceedings. The consequence of such ambiguity is that the real-estate developers will take advantage of the same and may strike an out-of-court settlement with one or more allottees, rendering the proceedings infructuous.