L. Viswanathan and Gaurav Gupte*
One of the objectives of the Insolvency and Bankruptcy Code, 2016 (Code), as stated in its preamble, is to ‘balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues.’ The Code itself has several provisions which strike a balance between the interests of the several stakeholders in the insolvency process, including that it recognises the rights of creditors of all types. Further,while recognising the rights of all creditors, the Code does not make uniform prescriptions for all creditors; rather, it takes into account the relative situation of the creditors. In ‘ensuring equitable treatment of similarly situated creditors‘, the Code meets a key objective of an effective and efficient insolvency law as laid down in the Legislative Guide on Insolvency Law prepared by the United Nations Commission on International Trade Law (UNCITRAL).2
In practice, several questions need to be addressed to ensure equitable treatment of creditors. For instance, should financial creditors (FCs) and operational creditors (0Cs) be treated at par, irrespective of the nature of the debt? In determining payment under a resolution plan, can you disregard the security interests and inter se priorities of the FCs? Is it equitable to propose similar treatment for FCs who have crystalised debt and FCs who have contingent debt, say in the nature of guarantees? What about home buyers who belong to the same class as FCs, but whose interests may be completely different from lenders? Can different treatment be proposed for OCs based on the amount of debt? These questions are not merely abstract jurisprudential questions, but have deep economic and social implications as well.
The lawmakers in India have been alive to the challenges posed by the competing claims of creditors and balancing the same in order to reach an equitable outcome. Where required, the Code has been amended, including by way of the recent Insolvency and Bankruptcy Code (Amendment) Act, 2019 (2019 Amendment). The Insolvency and Bankruptcy Board of India (IBBI) has also been reviewing the IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (CIRP Regulations) and has introduced amendments to address emerging issues. In addition, the National Company Law Tribunal (NCLT), the National Company Law Appellate Tribunal (NCLAT) and the Supreme Court of India have significantly contributed to the development of the law.
With this background, this article examines the application of the principles of equity to creditors in the context of the corporate insolvency resolution process (CIRP). The article specifically examines such application to creditors in different classes (vertical equity) and creditors in the same class (horizontal equity).
The principle behind vertical equity is enshrined in section 30(2)(b) of the Code. Section 30(2)(b), as amended by the 2019 Amendment, requires that every resolution plan:
‘(b) provides for the payment of debts of operational creditors in such a manner as may be specified by the Board which shall not be less than –
(i) the amount to be paid to such creditors in the event of a liquidation of the corporate debtor under section 53; or
(ii) the amount that would have been paid to such creditors, if the amount to be distributed under the resolution plan had been distributed in accordance with the order of priority in sub-section (1) of section 53, whichever is higher…
Explanation 1. – For the removal of doubts, it is hereby clarified that a distribution in accordance with the provisions of this clause shall be fair and equitable to such creditor.’
Section 30(2)(b), as originally enacted, only required that OCs should receive a payment not less than the amount to be paid to such creditors in the event of a liquidation of the corporate debtor (CD) (hereinafter, the ‘liquidation value due to OCs.’) In this respect, the provision was similar to provisions in insolvency laws of other jurisdictions, namely the United States (US) and the United Kingdom (UK).
Section 1129(a) of Chapter 11 of the United States Bankruptcy Code (US Code) sets out the minimum requirements which a proposed reorganisation plan should meet in order to be confirmed by the courts. Section 1129(a)(7) of the US Code provides that:
‘each holder of a claim or interest will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under Chapter 7 of this Title on such date.’3
This test codified under section 1129(a)(7) of the US Code is known as the ‘best interest of creditors test’ and is an individual guarantee to each creditor that it will receive at least as much in the reorganisation as it would have in case of liquidation.4
In the UK, whilst there is no explicit statutory provision regarding vertical equity, courts have applied the principle of vertical equity while evaluating voluntary arrangements. Section 6 of the Insolvency Act, 1986 provides that any voluntary arrangement may be challenged, inter alia, by a creditor of the company on the grounds that the voluntary arrangement ‘unfairly prejudices the interests of a creditor, member or contributory of the company.’ Courts have assessed fairness of voluntary arrangements against the benchmark of ‘the irreducible minimum below which the retune in the voluntary arrangement cannot This benchmark is determined by comparing what a creditor would receive in the voluntary arrangement vis-a-vis what that creditor would receive in the alternative to the voluntary arrangement, that is, liquidation of the company. In a landmark judgement In Re T&N Ltd., 6 it was held that:
‘I find it very difficult to envisage a case where the court would sanction a scheme of arrangement, or not interfere with a voluntary arrangement, which was an alternative to a winding up, but which was likely to result in creditors, or some of them, receiving less than they would in a winding up of a company, assuming that the return in a winding up would in reality be achieved and within an acceptable time-scale.’
This principle of assessing fairness has also been upheld in Prudential Assurance Co. Limited v. PRG Powerhouse Limited.7
Indeed then, the principle of vertical equity enacted in section 30(2)(b) of the Code that OCs should receive a payment not less than the liquidation value due to OCs, is in line with the international practice. In practice, the amounts proposed to be paid under successful resolution plans have often been insufficient to satisfy even the claims of the secured FCs in full. Consequently, the liquidation value due to OCs would be nil and no provision for any payment to them would be made.
However, the NCLAT found this position to be discriminatory. In Binani Industries Limited Baroda (hereinafter v Bank of `Binani Industries’), the NCLAT laid down the following principles to be taken into account while evaluating a resolution plan:
‘i. The liabilities of all creditors who are not part of ‘Committee of Creditors’ must also be met in the resolution.
ii. The ‘Financial Creditors’ can modify the terms of existing liabilities, while other creditors cannot take risk of postponing payment for better future prospectus. That is, ‘Financial Creditors’ can take haircut and can take their dues in future, while ‘Operational Creditors’ need to be paid immediately.
iii. A creditor cannot maximise his own interests in view of moratorium.
iv. If one type of credit is given preferential treatment, the other type of credit will disappear from market. This will be against the objective of promoting availability of credit.
v. The ‘I&B Code’ aims to balance the interests of all stakeholders and does not maximise value for ‘Financial Creditors’.
vi. Therefore, the dues of creditors of ‘Operational Creditors’ must get at least similar treatment as compared to the due of ‘Financial Creditors’.’
The NCLAT observed that:
‘the ‘I&B Code’ or the Regulations framed by the Insolvency and Bankruptcy Board of India do not prescribe differential treatment between the similarly situated ‘Operational Creditors’ or the ‘Financial Creditors’ on one or other grounds.’
‘a discriminatory plan … is against the basic object of maximization of the assets of the ‘Corporate Debtor’ on one hand and for balancing the stakeholders on the other hand.’
The NCLAT further observed that:
‘If the operational creditors are ignored and provided with liquidation value on the basis of misplaced notion and misreading of Section 30(2)(b) of Code, then in such case no creditor will supply the goods or render services on credit to any corporate debtors. All those who will supply goods and provide services, will ask for advance payment for such supply of goods or to render services which will be against the basic principle of the Code and will also affect the Indian economy.’
This position was further reinforced by the NCLAT in the case of Standard Chartered Bank v. Satish KuMar Gupta, R.P. ofEssar Steel and v. Ors.,9 wherein the NCLAT observed that:
‘In the present case, we have noticed a huge discrimination made by the ‘Committee of Creditors’ in distribution of proposed amount to the ‘Operational Creditors’ qua ‘Financial Creditors’. Majority of the ‘Financial Creditors’ have been allowed 99.19% of their claim amount, whereas ‘NIL’ i.e. 0% in favour of the ‘Operational Creditors’. Such distribution is not only discriminatory but also arbitrary.’
The NCLAT then held that:
‘Sub-clause (b) of sub-section (2) of Section 30 of the ‘I&B Code’ mandates that the ‘Resolution Plan’ must provide for the payment of the debts of ‘Operational Creditors’ in such manner as may be prescribed by the Board which shall not be less than the amount to be paid to the ‘Operational Creditors’ in the event of a liquidation of the ‘Corporate Debtor’ under Section 53. That means, the ‘Operational Creditors’ should not be paid less than the amount they could have received in the event of a liquidation out of the asset of the ‘Corporate Debtor’. It does not mean that they should not be provided the amount more than the amount they could have received in the event of a liquidation which otherwise amount to discrimination.’
Similarly, the NCLAT did not permit a distinction between secured and unsecured FCs. It observed that:
`it is evident that there is no distinction made between one or other ‘Financial Creditor’. All persons to whom a financial debt is owed by the ‘Corporate Debtor’, which debt is disbursed against the consideration for time value of money, whether they come within one or other clause of Section 5(8), all of such person form one class i.e. ‘Financial Creditor’ they cannot be sub-classified as ‘Secured’ or ‘Unsecured Financial Creditor’ for the purpose of preparation of the ‘Resolution Plan’ by the ‘Resolution Applicant’.’
Thereafter, the NCLAT held that:
‘the ‘Financial Creditors’ cannot be discriminated on the ground of ‘Secured’ or ‘Unsecured Financial Creditors’ for the purpose of distribution of proposed amount amongst stakeholders in the ‘Resolution Plan’ by the ‘Resolution Applicant’.’
When dealing with a constitutional challenge to the treatment of OCs in Swiss Ribbons Pvt. Ltd. &Anr. v. :nion of India & Ors.,10 the Supreme Court (SC) observed that:
‘The NCLAT has, while looking into viability and feasibility of resolution plans that are approved by the committee of creditors, always gone into whether operational creditors are given roughly the same treatment as financial creditors, and if they are not, such plans are either rejected or modified so that the operational creditors’ rights are safeguarded.’
However, the SC also went on to state that:
`It may be seen that a resolution plan cannot pass muster under Section 30(2)(b) read with Section 31 unless a minimum payment is made to operational creditors, being not less than liquidation value.’
It may be implied from the above observation of the SC that the minimum payment of liquidation value to OCs was sufficient to hold a resolution plan to be in compliance with the Code thereby reinforcing vertical equity.
Further, section 30 as amended by the 2019 Amendment, recognises a distinction between FCs who vote in favour of a resolution plan (assenting creditors) and FCs who do not vote in Vertical and Horizontal Equity in Corporate Processes 61 favour of a resolution plan (dissenting creditors) and provides that a resolution plan should provide for ‘the payment of debts of financial creditors who do not vote in favour of the resolution plan, in such manner as may be specified by the Board, which shall not be less than the amount to be paid to such creditors in accordance with sub-section (1) of section 53 in the event of a liquidation of the corporate debtor.‘ Thus, section 30 guarantees minimum liquidation value to dissenting creditors.
The erstwhile regulation 38(1)(b) of the CIRP Regulations had similarly mandated the payment of the liquidation value to the OCs and the dissenting FCs. However, the NCLAT had, in Central Bank of India v. Resolution Professional of Sirpur Paper Mills Ltd.11 held that regulation 38(1)(b) was ultra vires the Code as it had the effect of discriminating between two sets of creditors similarly situated, by discriminating between assenting creditors and dissenting creditors. The NCLAT observed that:
‘…the Board may make regulation but it should be consistent with the I&B Code and rules made therein (by Central Government) to carry out the provisions of the Code. Therefore, we hold that the provisions made by the Board cannot override the provisions of I&B Code nor it can be inconsistent with the Code. Clause (b) and (c) of Regulation 38(1) being inconsistent with the provisions of I&B Code, and the legislators having not made any discrimination between the same set of group such as ‘Financial Creditor’ or ‘Operational Creditor’, Board by its Regulation cannot mandate that the Resolution Plan should provide liquidation value to the ‘Operational Creditors’ (clause (b) of regulation 38(1)) or liquidation value to the dissenting Financial Creditors (clause (c) of regulation 38(1)). Such regulation being against Section 240(1) cannot be taken into consideration and any Resolution Plan which provides liquidation value to the ‘Operational Creditor(s)’ or liquidation value to the dissenting ‘Financial Creditor(s)’ in view of clause (b) and (c) of Regulation 38(1), without any other reason to discriminate between two set of creditors similarly situated such as ‘Financial Creditors’ or the ‘Operational Creditors’ cannot be approved being illegal.’
Thus, it was held that the Code did not make any such discrimination and the regulation cannot mandate the resolution plan to provide liquidation value to the dissenting creditors. Vide an amendment dated October 5, 2018, the IBBI amended regulation 38(1) of the CIRP Regulations to omit the requirements regarding payment of the liquidation value to the dissenting creditors. With the 2019 Amendment, the requirement has been introduced in the Code itself and cannot be challenged on the grounds of being ultra vires.
The 2019 Amendment has come into effect after the above judgments of the NCLAT and the SC. Section 30(2)(b)(ii) introduced by the 2019 Amendment, together with the explanation to the section provides that distribution of any amounts under a resolution plan in accordance with the liquidation waterfall in terms of section 53 would be fair and equitable distribution. Accordingly, the principle of vertical equity has been statutorily recognised.
Section 30 of the Code does not expressly make any provision for ‘horizontal equity’. The question has arisen whether resolution plans may provide for differences in treatment within the classes of FCs or OCs. For instance, in Binani Industries.12 , it was observed that:
‘…it will be evident that the ‘Financial Creditors’ such as, ‘Edelweiss Asset Reconstruction Company Limited’, ‘IDBI Bank Limited’, ‘Bank of Baroda’, ‘Canara Bank’, ‘Bank of India’ and ‘State Bank of India’ has been provided with 100% of their verified claim, the ‘Resolution Applicant’ (‘Rajputana Properties Private Limited’) has given lesser percentage to Export-Import Bank of India (72.59%) and State Bank of India-Hong Kong (10%). Discrimination has been made on the ground that some of the ‘Financial Creditors’ are direct exposure to the ‘Corporate Debtor’ or some of the ‘Financial Creditors’ to whom the ‘Corporate Debtor’ was guarantor. Even the guarantors who are treated to be the ‘Financial Creditors’, such as ‘IDBI Bank Limited (Dubai Branch)’, ‘Bank of Baroda (London)’, ‘State Bank of India (Bahrain)’, ‘Syndicate Bank’ have been provided with 100% proposed payment of their verified claim but the ‘Export-Import Bank of India’ and the ‘State Bank of India (Hong Kong)’ who are similarly situated have been discriminated.’
Taking into account the above facts, the NCLAT held that ‘but such ground cannot be taken to discriminate between two same sets of the Creditors namely the ‘Financial Creditors’ who are similarly situated as guarantors.‘
However, in the case of State Bank of India v. Adhunik Alloys & Power Ltd13. the resolution plan provided for a distinction between FCs based on the nature of the security interest held by them. The NCLT, Kolkata Bench observed that ‘creation of class amongst the financial creditors is known in law and being applied in cases in which successful resolution plan was approved‘. The Tribunal distinguished the Binani Industries case by noting that:
‘Hon’ble Appellate Tribunal has discussed at length about the discrimination amongst similarly situated creditors and not unequal creditors. What is held in the said judgment is that “two same set of the creditors namely financial creditors cannot be discriminated”. So, unsecured creditors who are financial creditors cannot be equated with financial creditors who had first charge by creating security interest and the creditors who had 2nd charge or 3rd charge etc. the challenge in the case in hand is not similar to the facts set out in the above said case.’
The Tribunal further noted that ‘…reading of the Hon’ble Appellate Tribunal’s judgment as a whole, it appears to me that different categories of financial creditors respective to their security interest cannot be held equal.‘
The approach of the Tribunal was consistent with the approach taken in other jurisdictions. In re Palisades-on-the-Desplaines Seidelv. Palisades-on-the-Desplaines et al 14 ,the US Circuit Court of Appeals had observed as follows:
‘All creditors of equal rank with claims against the same property should be placed in the same class. This is natural, logical, and a simple basis of division.
Conversely, creditors of different ranks, or creditors of the same rank but with claims against different properties, should be placed in different classes. The owners of a mortgage which is a first lien on certain property should be in a class other than one containing the owners of a mortgage which is a second lien on the same property. So, also, the holders of a mortgage, which is first lien on certain property should be in a class other than the one containing the holders of a mortgage which is a first lien on other property.
We have no hesitancy in accepting that lucid and cogent statement as a general rule, but after all, it is an interpretation of a very general expression of the law-making power which, of necessity, must be construed in the light of the respective circumstances surrounding each case in which the question arises. This fact essentially may give rise to exceptions to the rule.’
The 2019 Amendment, in section 30(4), provides that while considering the resolution plan, ‘the committee of creditors may approve a resolution plan by a vote of not less than sixty-six per cent of voting share of the financial creditors, after considering its feasibility and viability, the manner of distribution proposed, which may take into account the order of priority amongst creditors as laid down in sub-section (1) of section 53, including the priority and value of the security interest of a secured creditor, and such other requirements as may be specified by the Board…‘. This could ensure that primacy of security and priority of the creditors is maintained. Additionally, on a reading of section 30(2)(b) with section 30(4) of the Code, it becomes clear that the value of the security of a secured creditor over an asset is maintained as the creditor is afforded an option to dissent and realise the liquidation value of the security held by such creditor. Hence, the creditors who have a better value of security would not be forced to receive a lesser payment under the resolution plan.
From the language of Explanation 1 to section 30(2) which clarifies that ‘a distribution in accordance with the provisions of this clause shall be fair and equitable to such creditor‘, it appears that the courts would deem distribution in accordance with section 30(2) to be fair and equitable.
It is evident that the Indian insolvency law has adopted the principles of vertical equity and horizontal equity in the evaluation of resolution plan. While vertical equity is derived from the provisions of the Code itself, horizontal equity is a product of case law, particularly judgments of the NCLAT. The principles of vertical equity and horizontal equity are vital for the credit market. In light of the objective of the Code to promote availability of credit, these principles must be adhered to as these are core to the foundation of the credit markets.
* The authors would like to acknowledge the assistance of Ms. Misha Patel and Ms. Aishwarya Gupta in preparation of this article.
1 The Report of the Bankruptcy Law Reform Committee (2015) had recommended that one of the principles of the Code should be that the ‘Code will respect the rights of all creditors equally‘.
2 UNCITRAL, Legislative Guide on Insolvency Law (2005).
3United States Bankruptcy Code, of Chapter 11, section 1129(a).
4Hicks J. (2005). Foxes Guarding the Henhouse: The Modern Best Interests of Creditors Test in Chapter 11 Reorganizations, Nevada Law Journal, Vol. 5:3.
5Mourant & Co. Trustee Ltd. v. Sixty UK Limited (In Administration),  EWHC 1890 (Ch).
6 EWHC 2361 (Ch).
7 [200′] EWHC 10002 (Ch).
8 Company Appeal (AT) (Insolvency) Nos. 82, 123, 188, 216 and 234 of 2018.
9 Company Appeal (AT) (Ins.) No. 242 of 2019.
10 (2019) 4 SCC 17.
11 Company Appeal (AT) (Insolvency) No. 526 of 2018.
12 Supra note 8
13 C.A. (IB) No. 1086/KB/2018 & C.A. (IB) No. 1092/KB/2018 in C.P. (IB) No. 387/KB/2017.
14 89 F.2d 214 (7th Cir. 1937).
*(Author Mr. L. Viswanathan and Mr. Gaurav Gupte are Partner at Cyril Amarchand Mangaldas, Advocates & Solicitors.)