The efficacy of any insolvency law is rightfully tested in the Liquidation end of it. The success of a Liquidation exercise essentially becomes a matter of perspective, i.e. where each stakeholder is standing in the queue when the Waterfall starts. The farther away, the more likely that it would be a dry experience.

And by definition an Insolvency Liquidation, starts with the premise that some stakeholders shall not get anything. From their perspective, the Liquidation Process is doomed from the beginning. They start the process with hope of recovering their monies and end with no hopes.

So even though the UNICTRAL Guide professes, equitable treatment, structurally equity is inconsistent with prioritization that is an integral part of any Liquidation Waterfall.

Secondly, the approach of Government in terms of dues to the Government, which has placed itself Fifth in the queue, the issue really is where should the Government have really placed itself.

The idea that BLRC expounded was to ease the insolvency and liquidation process, give the stakeholders an incentive, and towards this, may be the Government “sacrificed” its claims, for being Fifth in the queue the Government probably would invariably not get anything in the Waterfall.

And in my humble opinion, the Government did the right thing.

Thirdly, is the issue on whether there should be distinction between FC and OC? Now international experience certainly indicates that there is no distinction. But in the Indian context, there is a clear distinction between FC & OC.

Is it Feasible? Is it justified? Does it help the Insolvency Process?

One can look at the Insolvency Regulations from the Evolution perspective. The SARFESAI Act, u/s 13 to 15, had given unbridled and pretty swift rights to secured creditors. The IBC takes a step forward, and includes unsecured creditors also. Albeit, within the world of financial creditors.

So the issue can be rephrased, should it have gone ahead and included the operational creditors also in the COC?  COC however comes at a later stage, the first question that arises, should the FC and OC have equal rights to initiate a CIRP.

Here the BLRC makes some relevant observations, on both these interconnected questions. It recommended equal rights for initiating the CIRP but unequal rights when it comes to actually running the CIRP process.

And the distinction made by the BLRC on the way these two issues are dealt in the Code, is on the basis of the Fairness and Abilities that the two sets of creditors bring to the table.

It is but fair that every creditor should have a right to initiate insolvency proceedings in case they have suffered a default.

“Typically, operational creditors are neither able to decide on matters regarding the insolvency of the entity, nor willing to take the risk of postponing payments for better future prospects for the entity.”

So while a farmer who is an operational creditor because he has supplied truckloads of potatoes to a five star resort, should get a right to seek justice if the resort has defaulted on his payments, however, expecting the farmer to be on the COC, may be unfair on the insolvency process and also on the farmer itself.  The COC is mandated to deliberate on the resolution of the business and the Operational Creditors may have neither the time nor the inclination to participate in the process. And the skillsets They are interested only in the Process Output.

So in my humble opinion, the finer distinction between an FC and an OC helps the insolvency process. US, UK, and Singapore may have its own reasons for not making these distinctions, may be the farmers out there are better equipped to run businesses. Whatever!

It may not at all be linked to the willingness to “take the risk of postponing payments for better future prospects for the entity.” This factor may be completely irrelevant when the operational creditor does not have the option of “willingness”.

How does this distinction hold all the way down when the match goes to the wire, as in, Liquidation?

Firstly a secured operational creditor is an anamoly. They generally don’t exist atleast not in the Indian context. So be definition, when it comes to the Waterfall, there are three categories, besides others, “secured financial creditors, unsecured financial creditors and operational creditors”

In the COC where decision making happens there is no distinction between secured and unsecured financial creditors, they have equal say. The difference comes up in the Liquidation Waterfall.

Sec 53

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) the following debts which shall rank equally between and among the following: –

  • workmen’s dues for the period of twenty-four months preceding the liquidation commencement date; and
  • debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;

(c) wages and any unpaid dues owed to employees other than workmen for thefor the period of twelve months preceding the liquidation commencement date;

(d) financial debts owed to unsecured creditors;

(e) the following dues shall rank equally between and among the following: –

  • any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date;
  • debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;

(f) any remaining debts and dues;

(g) preference shareholders, if any; and

(h) equity shareholders or partners, as the case may be.

Section 53 (d) clearly identifies the stakeholder standing Fourth in the Queue, “financial debts owed to unsecured creditors”.

Furthemore Sec 53 does not explicitly state the word “operational creditor” rather indirectly refers to this set of stakeholder, (f) “any remaining debts and dues.”

It places the operational creditors Sixth in the Queue.

So the final issue is whether the Operational Creditor should be put Sixth while the Unsecured Financial creditor is Fourth (incidentally the Govt stands Fifth) in the Waterfall queue.

The implication of this queuing is that when the Waterfall begins, it may end even before the Fourth in the Queue reaches. Is the Prioritization Unfair to the operational creditor, who in India, happens to be the SME and MSME?

How will it affect the SME/MSME sector? And should that impact be a consideration in the Prioritization and thereby in the Insolvency Process?

Is there an economic argument to this issue? Is there an information asymmetry between the Operational Creditor and the Financial Creditor?

When a vendor supplies to a corporate, he does not know anything about the financial health, but he probably knows something about the business viability about the corporate.

Similarly, when a Creditor supplies money to a corporate, he may not know anything about the business health, but probably knows something about the financial health of the corporate.

This information asymmetry may narrow down as information flow increases in the system and trickles down to the small vendors over the next few years or may be decades. Or it may never.

In the meanwhile, operational creditors would be at a disadvantage vis a vis the unsecured financial creditor, if things go bad, and the corporate goes belly up.

Is there a way to correct this? Actually the right question is,

“Is there a way to correct this minor anomaly without complicating the insolvency process as outlined in the Code?”

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March 2024