[This guest post is authored by Shashwat Awasthi and Anushka, both studying in their fourth year at Dr. Ram Manohar Lohiya National Law University, Lucknow]
Indus Biotech v Kotak: Supreme Court on Arbitrability of Insolvency Disputes
The relationship between arbitration and insolvency has been the subject of many a discussion among the legal fraternity. This blog, for instance, has previously analyzed the impact of an IBC moratorium on arbitration proceedings. It remained to be seen, however, if it was open for a corporate debtor to defend a financial creditor’s application for insolvency by seeking a reference of the parties’ dispute to arbitration.
On 26 March 2021, the Supreme Court of India in Indus Biotech Private Limited vs. Kotak India Venture (Offshore) Fund & Ors. (Indus Biotech) settled the position on if and when insolvency disputes become inarbitrable.
This post is an attempt to decode the observations of the Supreme Court.
Kotak India Venture Fund (Kotak) had subscribed to Optionally Convertible Redeemable Preference Shares (OCRPS) issued by Indus Biotech Private Limited (Indus). Terms of conversion and redemption of the OCRPS were agreed in the parties’ Share Subscription and Shareholders Agreement (SSSA). The SSSA contained an arbitration clause.
The parties disagreed on the appropriate formula to be applied for converting Kotak’s OCRPS into paid-up equity shares and on the amount of refund, if any, thereafter.
When Indus failed to redeem the OCRPS, Kotak approached the National Company Law Tribunal (NCLT/the Tribunal) seeking the initiation of corporate insolvency resolution process under Section 7 of the Insolvency & Bankruptcy Code 2016 (IBC) [Insolvency Application]. In response, Indus invoked arbitration under the SSSA and requested the Tribunal to refer the parties to arbitration under Section 8 of the Arbitration & Conciliation Act 1996 [Arbitration Act] (Section 8 Application).
The NCLT observed that in a Section 7 petition, there has to be a judicial determination as to whether there has been a “default” within the meaning of Section 3(12) of the IBC. It was determined that a default had not occurred in the instant case. The Tribunal also noted that Indus was a solvent, debt-free, and profitable company. Considering that the dispute was purely contractual in nature, the NCLT directed the parties to resolve their dispute by arbitration; and dismissed the Insolvency Application.
Aggrieved, Kotak approached the Supreme Court by way of a special leave petition under Article 136 of the Constitution (SLP). Kotak’s primary contention was that the parties’ dispute was a matter in rem and, as such, was not arbitrable. Indus, on the other hand, argued that the NCLT had adopted the correct approach, and since there was no existence of a default under the Code, the dispute should be referred to arbitration.
Supreme Court’s decision
The observations of the Supreme Court can be divided into two heads: (1) on the overriding effect of IBC; and (2) on arbitrability of insolvency disputes
(1) Over-riding effect of the IBC
Even though the answer to this question was not a substantive question of law before the Court in the impugned case, the Apex Court reaffirmed the position that the IBC shall override all other laws as provided under Section 238 of the IBC. This observation is consistent with the rule that when two special laws have provisions repugnant to each other, then the statue later in time shall prevail.
Importantly, the Court went to describe the implication of this over-riding effect in so far as the relationship between insolvency and arbitration is concerned. The implication, as per the Court, would be that the Adjudicating Authority is duty bound to deal with the enquiry under Section 7 of the IBC by examining the material placed before it and record a satisfaction as to whether there is a default or not, even if an application under Section 8 of the Arbitration Act has been filed simultaneously.
(2) Arbitrability of insolvency disputes
The Court took a nuanced approach to the question of arbitrability and relied upon the test laid down in Vidya Drolia & Ors. vs. Durga Trading Corporation (Vidya Drolia II) to hold that an insolvency proceeding becomes in rem only after it is admitted. An admission leads to the creation of a third party right in all the creditors of the corporate debtor, thereby creating an erga omnes effect. Therefore, the Apex Court observed that the moment an insolvency application is admitted under Section 7 of the IBC, the dispute would become inarbitrable; a Section 8 Application would then not be maintainable.
On the other hand, if the NCLT concludes that the corporate debtor has not committed a default under the IBC and consequently dismisses the application, it was found that parties were then free to secure the appointment of an arbitral tribunal in an appropriate proceeding as contemplated in law.
Interestingly, the Court did not make any specific findings with regard to an application under Section 45 of the Arbitration Act, i.e. when reference is sought for an arbitration seated outside India. However, the authors believe that if the Court was of the opinion that a different standard of enquiry should be employed in Section 45 matters, then it would have expressly established that difference, considering that the present case was also characterized as an ‘international commercial arbitration’ by the Court.
The test of arbitrability
Until recently, the decision of the Supreme Court in Booz Allen and Hamilton Inc. v. SBI Home Finance Ltd. (Booz Allen) served as the primary guide on arbitrability. In Booz Allen, the Supreme Court used a rights-based approach, among other things, to formulate a test. Disputes involving rights in personam (i.e., rights enforceable against a particular person) were held to be arbitrable. Disputes involving rights in rem (i.e., rights enforceable against the whole world at large) were characterized as being inarbitrable. Interestingly, the Court listed ‘insolvency disputes’ among a class of disputes that are inarbitrable.
However, the Booz Allen test was overly broad and indeterminate, mainly due to a lack of a precise differentiation between the mere involvement of rights in rem and erga omnes effect of such rights. The test has thus been rightly criticized by noted arbitration scholars such as Ajar Rab.
Kotak relied on the Supreme Court’s decision in Swiss Ribbons Pvt. Ltd. & Anr. vs. Union of India & Ors. (Swiss Ribbons) to support its argument on non-arbitrability of insolvency disputes. However, it is argued that a simple reading of the decision would highlight why Kotak’s reliance on Swiss Ribbons was misplaced.
The Court had clearly observed that the IBC gets triggered only on admission of an Insolvency Application; and upon such admission the proceeding becomes a matter in rem.
In December 2020, the Supreme Court devised a more nuanced four-fold test of arbitrability in Vidya Drolia & Ors. vs. Durga Trading Corporation. This test fills the void created by Booz Allen by aptly reconciling the “rights-based approach” and the “effects-based approach”. Therefore, any further reliance upon Booz Allen has arguably become redundant.
As per the test in Vidya Drolia II, a dispute would become inarbitrable when:
(I) it relates to actions in rem or actions that do not pertain to subordinate rights in personam that arise from rights in rem.
(II) it affects third party rights; has erga omnes effect; requires centralized adjudication, and mutual adjudication would not be appropriate and enforceable.
(III) it relates to the inalienable sovereign and public interest functions of the state; and
(IV) it is expressly or by necessary implication non-arbitrable as per mandatory statute/s.
As mentioned earlier, the Supreme Court in Indus Biotech expressly relied upon the exhaustive test laid down in Vidya Drolia II in order to recognize that an Insolvency proceeding becomes in rem only when it affects third party rights and has an erga omnes effect.
Non-existence of default and effect on a Section 8 Application
The Court in Indus Biotech correctly observed that NCLT’s finding on the question of default must be based on an objective assessment of the whole situation and the material placed before it. If the NCLT reaches a conclusion that a default does not exist, then it would leave the field open for the parties to secure appointment of the Arbitral Tribunal in an appropriate proceeding as contemplated in law.
Sound approach towards arbitrability
The authors are of the opinion that the Court has taken a sound and progressive approach towards the question of arbitrability, by choosing not to tread on the ambiguous path laid down by Booz Allen and instead choosing to follow the latest and more nuanced test laid down in Vijay Drolia II.
Instead of making blanket observations, rendering an entire category of disputes inarbitrable, the Court has provided some much-needed clarity as to when would insolvency proceedings create third party rights and truly become in rem in nature. This is also consistent with the proposition that disputes should become inarbitrable only when they create an erga omnes effect and not due to the mere involvement of rights in rem.
A tenancy, for instance, is a right in rem. However, a dispute purely for licensing fees is an inter partes matter, i.e., between the landlord and the tenant. It has no effect erga omnes and should be amenable to arbitration. Similarly, an insolvency proceeding becomes in rem only when it effects third party rights, i.e., upon admission, and if there is no admission, such disputes are fully capable of being settled by arbitration.
Prevention of Dressing Up of Claims
It is settled law that genuine claims for oppression and mismanagement (O&M), under the Companies Act 2013, cannot be resolved by arbitration. This is mainly because (i) these are matters in rem; and (ii) certain reliefs available in O&M proceedings simply cannot be granted by an arbitrator. However, the Bombay High Court in Rakesh Malhotra vs Rajinder Kumar Malhotra & Ors. held that courts can reject an O&M petition and refer the dispute to arbitration if it is found that the O&M Petition does not disclose an actual O&M dispute and is simply “dressed up” as one, i.e. with a view to evading the arbitration clause.
By holding that an insolvency proceeding becomes in rem only upon admission, the Court in Indus Biotech has arguably put in place a system which would prevent the “dressing up” of reliefs in so far as insolvency disputes are concerned. A financial/operational creditor would no longer be able to evade or wriggle out of the arbitration clause by merely filing an Insolvency Application. The NCLT would necessarily have first determine the existence of a default under the IBC and, if it answers in the negative, the dispute can indeed be referred to arbitration.
The question as to when do disputes actually become inarbitrable has often confused courts in India. The Apex Court’s decision in Indus Biotech would thus go a long way in guiding future determinations on similar matters.
 Swiss Ribbons Pvt. Ltd. & Anr. vs. Union of India & Ors. [2019 SCC OnLine SC 73] at Paragraph 52