The Preamble of the Insolvency and Bankruptcy Code, 2016 (the Code) reads as : “An Act to consolidate and amend the laws relating to re-organisation and insolvency resolution of Corporate Persons, Partnership Firms and Individuals, in a time bound manner for maximisation of value of assets, of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto.
The Code, being a relatively recent legislation is evolving rapidly owing to the practical difficulties in interpretation and multiple judicial pronouncements. The jurisprudence of the Code will continue to evolve in the foreseeable future to synchronise with the demand dynamics of the economy. The Code and the Regulations notified there under have already gone through multiple amendments in recent times, to fine tune the Code to suit the Indian economic context. However, still, there are multifarious nuances which are being identified and addressed through judicial pronouncements by Adjudicating Authority and Appellate Authority.
One of the most fascinating issues currently, is the classification, segmentation and prioritisation of creditors under the Code. The intent of the legislature as reflected in the preamble of the Code, was to ensure availability of credit and balance interest of all stakeholders including alteration of the priority of order of recovery. The Code through its various provisions distinctively identifies different categories of Creditors on the basis of security interest held and as well differentiates between Financial and Operational Creditors.
The premise of the Code is primarily founded upon the Bankruptcy Law Reforms Committee Report (“BLRC Report”), which was given under the Chairmanship of Dr. T.K. Viswanathan. The BLRC Report states that in a resolution process, the financial creditors have the power to choose the best solution to keep the entity as going concern. However, in liquidation, the interest of both the financial and operational creditors will be served on a best effort basis. The BLRC Report recommended that the solutions in liquidation must be evaluated on the long-term incentives of both secured creditors and non-secured creditors.
Against this background, the relevant provisions of the Code pertaining to different classes of creditors were framed. This article attempts to throw light on the provisions, recent judicial pronouncements and their consequential impact with respect to same.
Relevant Provisions of the Code
Section 3(10): “Creditor” means any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree-holder;
Section 3(11): “debt” means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt;
Section 3(30): “secured creditor” means a creditor in favour of whom security interest is created;
Section 3(31): “security interest” means right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person:
Provided that security interest shall not include a performance guarantee;
Section 5(7): “financial creditor” means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to;
Section 5(8): “financial debt” means a debt alongwith interest, if any, which is disbursed against the consideration for the time value of money and includes–
(a) money borrowed against the payment of interest;
(b) any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent…………
Section 5(20): “operational creditor” means a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred;
Section 5(21): “operational debt” means a claim in respect of the provision of goods or services including employment or a debt in respect of the 1[payment] of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority;
Distribution of assets
(1) Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of the liquidation assets shall be distributed in the following order of priority and within such period as may be specified, namely: –
(a) the insolvency resolution process costs and the liquidation costs paid in full;
(b) (ii) debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;
(d) financial debts owed to unsecured creditors;
(e) (ii) debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;
(f) any remaining debts and dues;
“The resolution professional shall examine each resolution plan received by him to confirm that each resolution plan provides for the payment of the debts of operational creditors in such manner as may be specified 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;”
Regulation 38 of CIRP Regulations:
“38(1): The amount due to the operational creditors under a resolution plan shall be given priority in payment over financial creditors.]
38(1A): A resolution plan shall include a statement as to how it has dealt with the interests of all stakeholders, including financial creditors and operational creditors, of the corporate debtor.”
In the context of above provisions, the intent of the legislation with regards to principle-based classification of creditors can be established. Application of mind is essential to identify as to whether a particular creditor is a financial creditor or an operational creditor. Further, existence of security interest further demarcates the creditors into secured and unsecured.
It is the basic tenet of the Code, to provide primacy to the financial creditors. The Committee of Creditors (“CoC”), the sole decision-making body in a Corporate Insolvency Resolution Process (“CIRP”), is comprised only of financial creditors. The BLRC Report provides rationale that the financial creditors are able to assess the overall viability of the company and be more willing to modify the terms of existing liabilities, due to which the process would be more efficient if only financial creditors are on the CoC. Whereas, to provide layer of comfort, the liquidation value due to the operational creditor is statutorily protected.
Additionally, priority has been endowed to secured creditors vis a vis non-secured creditors. The Code, under Section 53, lays down the order of priority of payment due to various classes of creditors, re-emphasising and drawing attention to the intended classification of creditors. The claims of the secured creditors rank pari passu with that of the dues of workmen and stand at the 2nd Rank in the waterfall mechanism, subsequent only to the payment of insolvency resolution process cost / liquidation cost.
However, the tilt towards parity amongst all classes of creditors started with the judgement dated 19th September, 2018, by Hon’ble NCLAT in “Central Bank of India Vs Resolution Professional of the Sirpur Paper Mills Ltd. & Ors”, wherein it was held that the legislators did not intend any discrimination among the same set of group such as “Operational Creditors” or “Financial Creditors”
This was furthered by Hon’ble NCLAT Judgement dated 14th November, 2018, in Binani Industries Vs Bank of Baroda, wherein, it was upheld that the Code does not prescribe differential treatment between similarly situated “operational creditors” or the “financial creditors” on one or other grounds. Additionally, it was held that it is necessary to balance financial creditors and operational creditors while emphasizing on value maximization of the Corporate Debtor and any plan if shown discriminatory against one or other financial creditor or the operational creditor can be held to be against the provisions of the Code.
However, a different perspective was thrown open on the interpretation by Hon’ble NCLT, Kolkata Bench vide Order dated 7th December, 2018 in SBI vs M/s Adhunik Alloys & Power Ltd. The moot question in the matter was to whether creation of class amongst financial creditors based on the nature of security interest is contrary to provisions of the Code. It was held that creation of classes amongst financial creditor is well known to law. It was noted that the above referred Binani Judgement pertains to treatment of “two same set of creditors who are similarly situated” and not regarding unequal creditors. Unsecured creditors who are financial creditors, cannot be equated with financial creditors who had charge by creating security interest. Hon’ble NCLT further held that classification of financial creditor considering their security interest cannot be held illegal by applying the proposition laid down in Sirpur Mills case. Hon’ble NCLT noted the objective behind the ranking of priority claims of creditors under insolvency law published by United Nations Commission on International Trade Law (UNCITRAL) and Principles for Effective Insolvency and Creditor/Debtor Regime, published by World Bank. As per key objectives and policies for having an effective insolvency system, World Bank aims to provide for equitable treatment of similarly situated creditors and recognising existing creditor rights and respect priority of claims with predictable and established process. The secured creditors claims are distinct with that of claim of unsecured creditors. Classification of Creditors is thus known to law and it is not unreasonable or unethical.
On 25th January, 2019, a landmark judgement was pronounced by the Supreme Court in Swiss Ribbons Private Limited & Anr vs Union of India. With regards to the differential treatment between financial and operational creditor, the apex court concluded that the distinction is “neither discriminatory, nor arbitrary, nor violative of Article 14 of the Constitution of India”.
The essence of the decision lay in the fact that financial creditors have a better understanding
of the business and viability of the corporate debtor owing to techno-evaluative studies conducted by them prior to lending, and a long-term interest based on the large amount of loans that are involved. Section 53 was analysed separately. This section lays down the hierarchy of claims and the priority in distribution of assets in liquidation. The Code accords primacy to secured claims (invariably the preserve of financial creditors). Unsecured claims (usually the operational creditors) are given the lowest priority. This pecking order of claims in the past, it may be recalled, was seriously distorted, especially with governmental claims of various hues ranking alongside and often ahead of financial creditors.
In summary, the SC found sufficient intelligible differentia justifying the differential treatment accorded to financial and operational creditors and concluded: “it can be seen that unsecured debts are of various kinds, and so long as there is some legitimate interest sought to be protected, having relation to the object sought to be achieved by the statute in question, Article 14 does not get infracted. For these reasons, the challenge to Section 53 of the Code must also fail”.
The most recent judicial pronouncement on the instant aspect is the Hon’ble NCLAT Order dated 4th July, 2019 in Standard Chartered Bank vs Satish Kumar Gupta, R.P. of Essar Steel Ltd & Ors, wherein it is held that on the joint reading of Section 5(7) & Section 5(8) of the Code, it is inferred that Financial Creditor cannot be sub-classified as “Secured” or “Unsecured Financial Creditor” for the purpose of preparation of Resolution Plan by the Resolution Applicant. It was further held that distribution of debt under CIRP, which is out of amount proposed to be paid by the Resolution Applicant, cannot be equated with distribution of debt under liquidation which is out of the assets of the Corporate Debtor in terms of Section 53 of the Code. A ‘Resolution Plan’ shows upfront payment in favour of the Creditors including the ‘Financial Creditors’, ‘Operational Creditors’ and the other Creditors. It is not a distribution of assets from the proceeds of sale of liquidation of the ‘Corporate Debtor’ and, therefore, the ‘Resolution Applicant’ cannot take advantage of Section 53 for the purpose of determination of the manner in which distribution of the proposed upfront amount is to be made in favour of one or other stakeholders namely— the ‘Financial Creditor’, ‘Operational Creditor’ and other creditors.
Hon’ble NCLAT observed that according to Section 30(2)(b), 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.
It was 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’.
Additionally, analysing the definition of Operational Debt, Hon’ble NCLAT held that the ‘Operational Creditors’ can be classified in three different classes for determining the manner in which the amount is to be distributed to them. However, they are to be given the same treatment, if similarly situated.
In short, Hon’ble NCLAT Order in Essar Steels has directed for equal treatment of all classes of creditors. This may have the effect of disincentivising banks/secured creditors from approaching NCLT and rather opt for liquidation of the company where they have clear cut primacy for recovery of dues. General commercial law is based on the premise that those creditors, who have given loans in exchange for a security, should be paid before those who have given unsecured loans. Secured Creditors settle with lower interest rates while unsecured loans bear a higher interest. This is because low risk in secured credit gets a low return, while unsecured loans are high risk and hence get a higher return. This core fundamental principle of commercial law has been overthrown due to the stance taken by Hon’ble NCLAT.
The Essar Steel judgement of the NCLAT gives almost as much importance to the operational creditors as to secured creditors. The Code gives operational creditors protection of liquidation value with a reason. An operational creditor cannot be equated with financial creditor since he is only exposed to one production cycle as compared to the secured financial creditors, who have taken a long-term risk in anticipation of bearing fruits of profit.
The repercussions of the Hon’ble NCLAT Essar Steel Judgement are multi-dimensional. The classification of creditors in well known in law and practised across jurisdictions. A Secured Creditor cannot be equated to an Unsecured Creditor or an Operational Creditor. As a consequence of this becoming a law, the concept of secured credit will be undermined and all banks will provide only unsecured credit and charge high rates to make up for the risk. The role of Adjudicating Authority and Appellate Authority is defined under the Code and it is established that the Adjudicating Authority should not substitute its commercial wisdom in place of CoC’s. This is a case of serious judicial activism since the commercial wisdom of the CoC is being transgressed upon. Resolution Applicant and CoC may be willing to turnaround a company only if it makes commercial sense to them. In absence of such discretion over commercial decision making, the entire substratum of the Code will collapse.
In the wake of the Essar Steel Judgement, Insolvency and Bankruptcy Code, (Amendment) Bill, 2019 has been introduced in Rajya Sabha, wherein following amendments have been suggested:
“Section 30(2)(b): provides for the payment of debts of operational creditors in such 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, and provides 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.
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 creditors.
“Section 30(4): in sub-section (4), after the words “feasibility and viability,”, the words, brackets and figures “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” shall be inserted.
The proposed amendment may provide the much sought respite to the secured creditors as the amendments aim to clarify on the payout to operational creditors and as well throw weight behind the order of priority intended under Section 53 of the Code, in the context of approval of resolution plan under CIRP. Hence, there is positive anticipation for passing of proposed amendments to the Code in clarifying the grey areas and addressing the consequences of certain judicial pronouncements and thereby putting a stop to further litigation on the aspect.
Article by- CA S.Badri Narayanan (CS, M.com)