In most jurisdictions, including that of the US and the United Kingdom, the classification of creditors is limited to security, i.e., categorizing them as either secured creditors or unsecured creditors. However, a unique feature of the Insolvency and Bankruptcy Code (IBC) of India is the distinction between the Financial and the Operational creditors. This unique distinction and the differential rights provided to them has been a subject of discussion since the enactment of the IBC. However, the recent Insolvency and Bankruptcy Amendment Act, 2019 has once again spiked up the conversation on this distinction with a focus on the non-equitable treatment of the two classes of creditors.
This discussion came into light after the NCLAT’s ruling on the case of Standard Chartered Bank vs. Satish Kumar Gupta, R.P. of Essar Steel Limited, where the court held that the proceeds from resolution plan were to be distributed as per the share of creditors in total debt without any consideration to their positions in the statutory waterfall. This ruling prompted the central government to introduce the amendment, leading to the aforementioned ruling being overturned by the Supreme Court, and restoring the hierarchy between the two classes of creditors.
This essay is an attempt to analyse few changes made by the of IBC (Amendment) Act, 2019 and discuss whether this amendment leads to a “fair and equitable” between the two different classes of creditors.
The ruling by the NCLAT in the Essar Steel Case is premised on the likelihood of prejudice in the resolution process which would operate unfairly towards the Operational Creditors. The NCLAT took note that since the Operational Creditors are not a part of the Committee of Creditors as per section 21(2) of IBC, they are not involved in the process of assessing the viability and fairness of a resolution process. On top of that, with no right to vote or without any say in the approval of such resolutions, an absurd situation is created where a different set of interested parties, essentially, control the amount that they would receive. Though eligible to prepare and submit a resolution plan according to section 30(1) of IBC, the fate of such resolution lies completely in the hand of the Financial creditors. Additionally, the judgment highlights how the law has created a strange disparity between the two classes of creditors, where even if both are unsecured, Financial creditors are giver higher priority whereas the Operational creditors usually end up with merely the liquidation value in the resolution process.
The NCLAT order ruled that the statutory waterfall as outlined in the Section 53 of the IBC, must not be brought to application for the distribution of the amount in a resolution process. Section 53 of the code establishes the priority of Financial Creditors over Operational Creditors in the distribution of the amount in a liquidation process. In the ruling, the NCLAT dictated that this priority will not be applicable in the case of a resolution process. The infamous ruling of the NCLAT, in effect, introduced principle equality between two classes of creditors, when it took the view that that Operational creditors stood on an equal footing and their claims had to be considered at par with those of Financial creditors in a resolution process. Accordingly, the ruling claimed that any resolution plan proposing to pay a higher amount to Financial creditors would be prejudicial and operate unfairly towards the Operational Creditors. The Operational creditors who were earlier subjected to a cold shoulder, were brought into the centerstage by this polarizing ruling of the NCLAT.
This ruling of the NCLAT, was, however, short-lived as the Parliament passed the IBC Amendment Act of 2019 to nullify the decision, restore the rights of Financial creditors, and fix this “upset”. Section 30(2)(b) was amended and a minimum threshold for payment to Operational creditors is established, where the Operational creditors will now receive the higher of either the liquidation value of their debt or the amount that the Operational creditors will receive if the amount is distributed as per the statutory waterfall mechanism outlined in the Section 53 of the IBC. Therefore, the amended section once again empowered the Committee of Creditors to determine the distribution of funds keeping in mind the priority provided for in the section 53 of the IBC and the security interest of the creditors.
The effect of this amendment could be explained in a much better way with the help of an example. Consider a situation where both the Operational and Financial creditor are owed a debt of INR 6 crores, and the amount that is to be distributed under the resolution plan amounts to be INR 8 crores. The principle laid down in the NCLAT ruling states that no priority would be given to the Financial creditors and the amount should be distributed equally between the two class of creditors, thereby leading to a distribution of INR 4 crores each to Financial and Operational creditors of the company. However, the amendment ensured that the Financial creditors are at the top of the priority hierarchy, and distribution according to the amended section would essentially mean that despite being owed the same amount of debt, Operational creditors would be paid INR 2 crores, whereas the Financial creditors would enjoy a full repayment of INR 6 crores owed to them. This brought back the absurd situation where even if an Operational creditor initiates Corporate Insolvency Resolution Process (CIRP) against the corporate debtor, or is owed equal or a majority of the debt, the Operational creditor still will have no voting right and would remain a spectator at best, whereas the Financial creditors are given the absolute power ensuring that the Operational creditors are left with the minimum possible repayment in lieu of any debt owed to them.
While the Supreme Court held that the amendment was to ensure minimum payments are being made to the Operational creditors and section 30(2) is interrelated to section 53, however, in my opinion, the court has failed to recognize the difference between the process of Resolution and that of Liquidation. A company is essentially shutting down in case of a liquidation process, and on the other hand, the creditors are working towards restructuring in a resolution process. Therefore, importing of the principles of liquidation into a resolution process is not pragmatic. Additionally, a situation where Financial creditors are taking almost the entirety of the amount that is to be distributed by their own decision itself, which is immune from the influence or any challenge by the Operational creditors, can in no way be considered justified or “fair and equitable”.
IV. Reducing the Scope of Judicial Review
Another interesting aspect of the 2019 amendment which is worth discussing in this context is the newly added “Explanation 1” to the Section 30(2) of the IBC. The explanation states that “For the removal of doubts, it is hereby clarified that distribution in accordance with the provisions of this clause shall be fair and equitable to such creditors.” The explanation introduced by the amendment which intended to act as a clarification, initially ended up confusing the legal fraternity as there were two different possible interpretations of the explanation. However, the Supreme Court settled the dust and explained the intention of the parliament. The court held that if a business decision of a company is taken by the required majority of the Committee of Creditors and it conforms with the Code and the Regulations issued, in such a case, both the Adjudicating Authority, i.e., the NCLT and the Appellate Tribunal, i.e., NCLAT, would have no jurisdiction to interfere. The explanation, therefore, narrowed down the scope of judicial review and ensured that the distribution of proceeds in the resolution plan is as per the statutory waterfall without any exception.
The deeming fiction of considering the distribution done in accordance with provisions of the Code to be fair and equitable is not only missing in the language of the Explanation, but also is questionable to the extent whether Parliament could take away the powers of a court to decide what is fair and equitable. While the Supreme Court held that the “commercial wisdom of Committee of Creditors”, subjected to certain guidelines, must determine the what qualifies to be fair and equitable, I consider that that this explanation oversteps the boundaries of separation of powers. The explanation directly grants a judicial power to the Committee of Creditors, and in essence robs the Operational creditors, who have a lack of power in the Committee of Creditors, of the protection of their fundamental rights. The explanation, in effect, reduces the resolution to a form of agreement, and it is absurd that a party who is not part of the agreement-making process or has consented to the same is bound by the said agreement. Further, while unfairly displacing the decision-making power to the Committee of Creditors, there is no parallel mechanism for the Operational creditors to present their concerns. These lack of safeguards, accompanied by the blind trust in the concept of “commercial wisdom” would ultimately lead to less mutually benefitting and holistic resolution plans approved by the Financial creditors.
The NCLAT, in the case of Binani Industries Case, emphasized “…if one type of the credit is given any preferential treatment, the other type of credit will (eventually) disappear from the market. This will be against the objective of promoting the availability of credit“. Additionally, in the Swiss Ribbons Case, the court held that the Operational creditors must get “roughly the same treatment as Financial creditors”, and the court again emphasized that the distribution between them must be “fair and equitable”. In the position restored by the IBC Amendment Act, 2019, it cannot be denied that the rights of Operational Creditors, in case of a resolution process, are largely ignored. At the same time, it can be agreed upon that the ruling of the NCLAT was radical, and it is impractical to equate secured and unsecured creditors at the resolution process. However, the parliament must give some serious thought to make sure that the rights of the Operational creditors are strengthened, and a solution which is actually “fair and equitable” is sought.
I think the first step into achieving such “fair and equitable” position would be to fix the situation of Committee of Creditor. As per the report of the Bankruptcy Law Reforms Committee, the justification behind the exclusion of Operational Creditors from the Committee of Creditors is based on the lack of their capability to assess and willingness to modify existing liabilities. However, as discussed already, by being not part of the Committee of Creditor meetings and without any access to the minutes of the meetings, Operational creditors lose the right to voice their concerns and express their disagreements. Additionally, Operational Creditors can no longer challenge the resolution accepted, and are left to the mercy of another interested party. The immediate solution must be to grant a permanent locus standi to the Operational creditors in the meetings of Committee of Creditors and fill this gap apparent Corporate Insolvency Resolution Process. Furthermore, as a party which is impacted by a resolution, they must be given a right to vote in the resolution process which can be proportional to the debt owed by the Operational creditors. This alone would come close to an equitable treatment that would ensure that the Bankruptcy Code benefits and treats both classes of creditors fairly.
Authors: Mohak Thukral is a fourth-year student at the Jindal Global Law School, O.P. Jindal Global University, Sonepat, NCR-Delhi.
Govind Sharma is a graduate from Shri Guru Tegh Bahadur Khalsa College, University of Delhi, New Delhi, and now working as a financial analyst.