Set-Off Conundrum Under Insolvency And Bankruptcy Code, 2016

I .Set-Off Vis-A-Vis Insolvency And Bankruptcy Code, 2016

The issue of setting-off in IBC flows from the very objectives of the concept of ordinary set-off and IBC. In a generic sense, set-off recognizes the right of a debtor to adjust the smaller claim owed to him against the larger claim payable to his creditor. However, the implications of a set off are vastly different when the insolvency kicks in for one of the parties involved in such transaction^[2]. Under normal circumstances, a set-off pits the right of a debtor against the creditor who is also indebted. However, in the context of Insolvency the right of set off influences how effectively other creditors will be able to realize their debts through the Insolvency process. In other words, the application of set-off during the insolvency proceedings influences two enshrined paramount principles of the insolvency legislations i.e., pari-pasu principle and anti-deprivation principle.

Application of Set-off on Insolvency proceedings prior to enactment of IBC

Prior to the enactment of IBC, the insolvency and bankruptcy laws for corporate entities in India were multilayered and fragmented, spanning across various legislations including the Companies Act, 2013^[3], Provincial Insolvency Act, 1920^[4] and the Presidency Towns Insolvency Act, 1909. In the earlier regime, a corporate entity could initiate winding up under the Companies Act, 2013 when it failed to pay its debtors^[5]. In the event of the winding-up proceedings being successful, the liquidation as per the winding up order is mandated to be carried out in accordance with the Provincial Insolvency Act, 1920 [“Provincial Insolvency Act”], wherein Section 46 mandates that the debts arising from the mutual dealings between the debtor and the creditor had to be set-off against each other. Moreover, the application of set-off under Companies Act, 2013 and the Provincial Insolvency Act received judicial imprimatur of the Supreme Court in Official Liquidator of The High Court of Karnataka v.Lakshmi Kutty 1980 INSC 234^[6], where the Supreme Court while upholding the application of set-offs over the insolvency legislations categorically clarified that for effective implementation of the insolvency provisions, the Companies Act, 2013 and the Provincial Insolvency Act, 1920 had to be construed harmoniously to balance the sacrosanct pari pasu principle.

Therefore, the application of set-off over Insolvency legislation was never alien to the insolvency regime in India. Even the newly enacted IBC, although not expressly, includes several provisions, which impliedly indicates the footprints of right to set-off of debts under Insolvency legislation. However, the application of this right over IBC has raised various issues particularly during the CIRP process.

Applicability of Set-off post-enactment of IBC

Since its enactment, the Insolvency and Bankruptcy Code, 2016 [“IBC”] is the umbrella legislation for insolvency resolution of all corporate entities in India^[7]. As stated above, the IBC per se does not exclude the application of set- off over IBC. However, the enactment of different procedures of insolvency resolution has raised numerous issues over the applicability of Set-off under IBC. Accordingly, this segment of the article will deal with the applicability of Set off vis a' vis two process of insolvency resolution under IBC i.e., CIRP and Liquidation.\

A perusal of the objective of these processes evinces the clear difference between CIRP and liquidation under IBC. While the CIRP focuses on and fosters rehabilitation, revival and resolution of the corporate person, the liquidation process focuses on constellation of assets of the company under liquidation, and its distribution to the creditors from the liquidation estate in terms of the order of preference set out in IBC.

• Set-off and Corporate Insolvency Resolution Process [“CIRP”] under IBC

Prior to the Bharti Airtel Judgment, the stance taken by the NCLAT was that application of set-off under IBC contravened the statutory intent behind Section 238 of IBC^[8] and therefore, could not be applied to CIRP. Notably, in the Bharti Airtel Judgement, the Supreme Court while upholding the view taken by the NCLAT, considered the intricacies of set-off over CIRP and proceeded to cull out a few exceptions to inapplicability of set-off by harmonizing it with the objectives of the IBC. To arrive at the rationale behind the carving out of such exceptions, the Supreme Court considered the application of set-off during CIRP by majorly addressing two issues i.e. the effect of set-off over moratorium and set-off vis-a-vis resolution plan:-

1. Effect of Set-off over moratorium under Section 14 of IBC: - It is settled position of law that during moratorium period imposed post-initiation of the CIRP process, any legal proceedings etc. for recovery of debts cannot be initiated and enforced^[9]. Accordingly, the Supreme Court opined that this bar on the initiation of legal proceedings clearly ousted the application of various kinds of set-offs. However, by harmonizing and balancing the objectives of the IBC with the set-off principle, the Supreme Court has carved out exceptions for Contractual and Transactional / Equitable set-off based on the reasoning that even though the moratorium imposes bar on the initiation and execution of legal proceedings, there is no express bar on enforcement of pre-existing agreements. In other words, contractual set-off and transactional / equitable set-off which has been entered into by the parties following the due meeting of minds prior to the initiation of CIRP does not breach the moratorium under Section 14 of the IBC, as it does not amount to recovery of any property or enforcement of any security interest or legal proceeding against the corporate debtor. In particular, it was observed that these two kinds of set-offs are just another mode of discharging reciprocal obligations and their application does not involve the transfer of any assets^[10].

2. Effect of set-off over Resolution Plan: - The Supreme Court has categorically dealt with this issue while dealing with the submissions by the Appellant in the Bharti Airtel matter, wherein it was contended that the reference to Section 53 of IBC under Section 30(2)(b)(ii) of IBC per se depicts intention of the legislature for the application of the Liquidation Regulations over CIRP, of the Corporate Debtor where there is explicit provision for Set off i.e., Regulation 29 under Liquidation Regulation. However, the Supreme Court rejected this contention on the plain reasoning that if such was the intention of the legislature there would have been an express provision akin to Regulation 29 under Chapter II Part III^[11]. Hence, the Supreme Court rejected the application of set-off on Resolution Plan.

Accordingly, the Supreme Court, in the Bharti Airtel case, has clarified that the application of set-off i.e., Contractual and Transactional / Equitable set-offs during the CIRP is limited to only one circumstance, i.e., during the admission of the claim by the Resolution Professional.

Set-off and Liquidation under IBC

While the application of set-offs is restricted during the CIRP, the right to set-off remains unaffected during liquidation. The jurisprudence regarding this follows from the fact that the unsecured creditors rank much lower in the waterfall mechanism provided under Section 53 of IBC and do not have any specific right as provided to the secured creditor under Section 52 of the IBC to remove its security from the liquidation estate. Pertinently, in light of the above the treatment of set-offs during liquidation is significant to the unsecured creditor for ensuring their interests^[12].

Therefore, the conjoint reading of Section 36(4)(e) of IBC with Regulation 29 of the Insolvency and Bankruptcy Board of India(Liquidation Process) Regulations, 2016, provides the exclusion of the claim, subject to mutual set-offs from the liquidation estate of the creditor. Accordingly, the applicability of Set-off during acts as a shield for the protection of the interest of the unsecured creditor^[13].

II. Set Off Via Lens Of Bharti Airtel Judgement

The applicability of set-off during CIRP had been an entangled issue for a long time as there were differing views taken by the NCLAT & benches of NCLT. For instance, whilst the National Company Law Appellate Tribunal in SimbhaoliSugars Limited v. Pramod KumarSharma, RP of Uniworld Sugars Pvt. Ltd. & Ors. [Company Appeal (AT) (Ins.) No. 776 of 2023^[14]] had taken the view that non-applicability of setoffs is recognized under Regulation 29 of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 to CIRP. While on the other hand NCLT Chandigarh in Pramod Kumar Sharma v. ED&FMan Sugar Limited, London UK [CA No. 235 & 236/2018 in CP (IB) No. 120/ALD/2017], had recognized the application of such principles during CIRP^[15].

The Supreme Court recently in Bharti Airtel Case has finally settled the issue on the applicability of setoff under IBC. The Supreme Court while dismissing the Appeal filed by Airtel under Section 62 of IBC vide its judgement dated 3^rd January 2024 upheld the order of NCLAT, wherein the NCLAT castigated the applicability of the set offs during CIRP under IBC on the ground that the applicability of set offs during CIRP is against the objectives of the IBC. The Supreme Court, while approving the view of the NCLAT has categorically defined the applicability of set-offs under IBC by carving out certain exceptions over its application.

Various kinds of set-offs and their applicability on the CIRP

The Supreme Court while deciding the Appeal filed by Airtel has observed that Set-off is a right of a debtor to adjust the small claim owed to him against the larger claim payable to the creditor and substantiated this scenario with principles of economics and equity. Furthermore, the Supreme Court vide the Bharti Airtel Judgement discussed and defined various kinds of Setoffs as stipulated in the table below^[16]:

Furthermore, the Supreme Court while deciding Bharti Airtel Judgement has categorically held that the principle of set-off is not applicable during the CIRP process. However, the Supreme Court carved out contractual and transactional / equitable set-off as an exceptions to the application of the principle during CIRP process by the following rationale:

• Applicability of Insolvency set-off during CIRP Process: - The Supreme Court has inter-alia held application of Insolvency set-off over CIRP will lead to the infringement of two of the paramount principles of IBC i.e., pari pasu and anti-deprivation. The doctrines emanate from the provisions under Section 53 r/w Section 52 of IBC and envisage ensuring that all the creditors get their proportional dues by preventing any one creditor from getting more than their deserved share. These principles will be violated as allowing set-off would lead to reduction of pool of assets available for distribution, as it would result in assets being transferred in favor of a single creditor having the right to set-off instead of being distributed collectively amongst the body of creditors. Resultantly, the application of such a set off would lead to deduction of dividend payable and grant priority to a single creditor and thereby, infringing of pari pasu and anti-deprivation principles. Recently, the NCLAT in Mr. Devaranjan Liquidator of Kotak Urja Pvt. Ltd. v. Principal Commissioner, Income Tax and Ors.^[17] has also reiterated the ratio of the judgement of Supreme Court in Bharti Airtel Judgement and held that the application of insolvency set-off during moratorium period is not permitted in terms of the statutory provisions of IBC and such an application will basically tantamount to the preferential payments to such creditor.

• Applicability of Statutory set-off during CIRP Process: - The Application of the Statutory set-off to CIRP was rejected by the Supreme Court due to the fact that the application of statutory set-off as provided under Order VIII Rule 6 of CPC will have no application over IBC because of its overriding effect by way of Section 238 of IBC.

• Applicability of Contractual Set off during CIRP Process: - The contractual set-off which has been entered into by the parties following consensus ad idem prior to the commencement of CIRP is applicable during the CIRP process because its application does not breach the moratorium imposed under Section 14 of the IBC, as it does not amount to recovery of any property or enforcement of any security interest or legal proceeding against the corporate debtor. In other words, it was observed that this kind of set-off is just another mode of discharging reciprocal obligations and does not involve the transfer of any assets^[18].

• Applicability of Transactional / Equitable Set off during CIRP Process: - The Supreme Court held that in a scenario where a claim and set-off are so closely linked in such a manner that it can be considered as one transaction, it would be inequitable and unfair that if the claim of one is allowed without adjusting the counter-claim. However, the claim in such equitable set-off ought to be quantifiable and unquestionable monetary claim and which does not require adjudication of disputed questions of law and facts. . Furthermore, the Supreme Court also observed that such transactional Set-off will not also eclipse a moratorium under Section 14 of IBC because it will merely be used as a shield rather than sword.

Separately, the Supreme Court, while dealing with the issue reiterated that the right to Set off remains unaffected during liquidation. The jurisprudence regarding this flows from the conjoint reading of Section 36(4)(e) of IBC with Regulation 29 of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016, and provides the exclusion of the claim subject to mutual set-offs from the Liquidation estate of the creditor. Accordingly, the applicability of set-off during liquidation acts as a shield for the protection of the interest of the unsecured creditor.

III. Critical Analysis

There is no doubt that the judgement of the Supreme Court in Bharti Airtel Case has brought a definitive shift in the Indian insolvency landscape by eliminating the hanging uncertainties over the application of the principle of set-offs in CIRP process under IBC. In this much anticipated verdict, the Apex court has crafted a balance between the equitable rights of the creditor and the principle enshrined under IBC. Therefore, this groundbreaking decision paves the way for smoother resolution processes and provides a significant relief to both corporate debtors and creditors. However, there are certain areas of the judgement which demands clarification which are discussed hereinbelow: -

Firstly, for instance, the first exception carved out by the Supreme Court for the application of set off in CIRP process i.e., the Contractual Setoff can be subject to grave misuse by the creditors as there can be a situation where one of the creditors can exercise its right to set-off just prior to the initiation of CIRP to preclude the corporate debtor and the other creditors of their receivables and consequently, force the corporate debtor to the urge of corporate death.

And lastly, the second exception carved out by the Supreme Court for the application of Set off in CIRP process i.e., the Transactional / Equitable Set off is also quite blurry on its application, as where the transaction is of a scattered nature establishing a commonality in such a transaction may lead to prolonged delay due to the unended litigation on such aspect.

References:

• 2024 INSC 15 (“Bharti Airtel Limited Judgement”)
• New South Wales, Law Reform Commission, report 94, AT 4 (February 2000); John McCoid II, Set off: Why Bankruptcy Priority?. 75 Virginia Law review, 15, 19-20 (1989); Rory Derham, Derham on the law of Set-off
• Presidency Towns Act, No. 111 of 1909
• Companies Act, 2013 @ Section 271; Companies Act, 1956 , Acts of Parliament, 1956 @ Section 433
• Provincial Insolvency Act, No. 5, Central Government Act, 1920
• Section 271, Companies Act, 2013
• Official Liquidator of The High Court of Karnataka v. Lakshmi Kutty 1980 INSC 234
• IBC Preamble; Understanding the IBC: Key Jurisdictions and Practical Considerations- A Handbook, Insolvency and Bankruptcy Board of India, at 14,
• The Insolvency and Bankruptcy Code (“IBC”), 2016 Act, No. 31 of 2016 @ Section 238
• Bharti Airtel Limited Judgement Note @ Para30-34
• Company Appeal (AT) (Ins.) No. 977 of 2023
• Insolvency and Bankruptcy Board of India (Liquidation Process), 2016 @ Regulation 29
• The Insolvency and Bankruptcy Code (“IBC”), 2016 Act @ Section 52&53
• The Insolvency and Bankruptcy Code (“IBC”), 2016 Act @ Section 36
• Company Appeal (AT) (Ins.) No. 776 of 2023
• CA No. 235 & 236/2018 in CP (IB) No. 120/ALD/2017, NCLT Chandigarh
• Bharti Airtel Limited Judgement @ Para 3-7
• Bharti Airtel Limited Judgement @ Para 30