CIRP

This article has been written by Nawvi K pursuing a Remote freelancing and profile building program from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction

The Insolvency and Bankruptcy Code (IBC), 2016 is often seen as the absolute game-changer in the modern business environment because it offers a comprehensive framework to deal with the challenges of insolvency and bankruptcy. The primary goal of the IBC is to achieve balanced interest between the parties that are participating in the bankruptcy resolution process. In the process of liquidation, those business debtors and secured creditors who have issued loans that are backed up with security interests have a considerable stake in the liquidation proceedings.

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Concerning this process, the IBC has implemented strong measures to protect the rights of the secured creditors to ensure they get their payments on time and are fair during the liquidation. In this article, we aim to examine the critical role played by IBCs in safeguarding secured creditors, especially during liquidation, stressing the rules and methods to prioritise their claims first.

Sections under IBC pertaining to secured creditor’s rights and priorities

According to the sections of IBC:

  • Section 3(4) defines “charge” as an interest or lien placed on the property or assets of any person or any of its undertakings, as the case may be, as security, and includes a mortgage.
  • Section 3(10) defines a “creditor” as a person who owes a debt that includes financial, operational, secured, and unsecured creditors, as well as a decree-holder;
  • Section 3(11) defines “debt” as any liability or an obligation related to a particular claim, that includes financial as well as operational debts;
  • Section 3(30) defines a “secured creditor” as a creditor in whose favour a security interest has been created;
  • Section 3(31) defines a “security interest” as a right, title, interest, or claim to a property that is created in favour of, or is provided for, a secured creditor by the transaction that 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 such interest doesn’t include a performance promise.

Having said that, it could be inferred that the following will not be exclusively covered under the ambit of security interest: a mere obligation to pay, not being an obligation that is attached to a property; a covenant that requires maintenance of asset-covered (it might include a financial covenant but not a security interest); and a negative pledge or lien.

The definitions mentioned above are a few important sections to understand in this article and this is not an exhaustive list.

Position of law in recognising rights of secured creditors prior to IBC

Prior to the implementation of the Insolvency and Bankruptcy Code (IBC) in 2016, the priority rights of secured creditors over the debtor’s secured assets were governed by various existing laws in India. These laws provided a framework for determining the precedence of secured creditors’ claims in the event of insolvency or default by the debtor.

One of the key laws in this regard was the Transfer of Property Act, 1882. This act established the concept of secured interests in property, including mortgages and charges, and outlined the rights and obligations of secured creditors and debtors. The act specified the conditions under which a security interest could be created, registered, and enforced.

Another important law was the Companies Act, 1956, which regulated the formation, operation, and dissolution of companies in India. The act included provisions related to secured lending and the rights of secured creditors in the context of corporate insolvency. It outlined the process for securing debts against company assets and established the priority of secured creditors’ claims in the event of liquidation.

Furthermore, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, played a significant role in shaping the landscape of secured lending in India. This act aimed to facilitate the securitisation of financial assets and the enforcement of security interests. It provided a comprehensive framework for creating, registering, and enforcing security interests in various types of assets, including receivables, financial instruments, and immovable property.

The cumulative effect of these laws and international norms was that the precedence of secured creditors was well-established in Indian jurisprudence. Secured creditors generally enjoyed priority over unsecured creditors in terms of repayment, and their rights were protected by a robust legal framework. However, the IBC introduced a new paradigm for insolvency resolution, aiming to strike a balance between the interests of secured creditors and other stakeholders in the insolvency process.

The BLRC recognised and pointed out the secured creditor’s priority rights during the drafting of the IBC by suggesting that the first charge-holder should have the power over the claims that were in existence during the formation of the security interest and the same suggestion was incorporated into Section 53 of the IBC, which once again talks about the waterfall mechanism that gives priority to the secured creditor and workmen’s due. However, due to a lack of clarity on the inter se precedence among secured creditors, Section 53 was considered ambiguous in interpreting the first and priority charge-holders over their rights.

On the other hand, Regulation 37 of the Liquidation Process Regulations, provides specific guidelines for secured creditors in the context of liquidation proceedings.

According to Regulation 37, secured creditors have the right to realise their security interest in the assets of the corporate debtor. However, they are required to follow certain procedures and methods as prescribed under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, or the Insolvency and Bankruptcy (IB) Code, 2016.

The SARFAESI Act provides a framework for banks and other financial institutions to enforce their security interests in assets pledged as collateral for loans. It empowers secured creditors to take possession of the collateral, sell it, or lease it out in order to recover their dues. The Act also includes provisions for the appointment of a receiver to manage and dispose of the secured assets.

On the other hand, the IB Code provides a comprehensive framework for insolvency resolution and bankruptcy proceedings in India. It includes provisions for the protection of secured creditors’ rights and interests. Under the IB Code, secured creditors can file claims against the corporate debtor and participate in the resolution process. They are entitled to receive payment of their dues from the proceeds of the liquidation of the corporate debtor’s assets.

It’s important to note that the methods available to secured creditors for realising their security interest may vary depending on the specific circumstances of the case, the nature of the security interest, and the applicable laws and regulations. Secured creditors are advised to seek legal counsel to ensure that they follow the correct procedures and comply with all relevant requirements when enforcing their security interests in the context of liquidation proceedings.

The amendment of the IBC in the year 2019 also ascertained safeguarding the rights of secured creditors by demanding payments to dissenting financial creditors that are no less than the amount that is owed to them during potential liquidation circumstances.

The same could be observed through a landmark judgement rendered by the Hon’ble Supreme Court in the case of ICICI Bank Ltd. vs. Sidco Leathers Ltd. & Ors. Appeal (Civil) (2006). In this case, the order of priority to claim between the secured creditors in a bankruptcy proceeding is explained. The immovable property of Sidco Leathers Ltd. is the subject of both Punjab National Bank’s and ICICI Bank’s first and second charges, respectively, in this case. The issue emerged when the company was wound up and the official liquidator had been instructed “to release dividends in accordance with Section 529A of the Companies Act, 1956,” which acknowledges secured creditors’ and workers’ claims equally.

However, the bank’s contention was different; it stated that the first charge holder’s claim should proceed over the second charge holder’s claim in accordance with Section 48 of the Transfer of Property Act 1882. The Supreme Court ruled that Section 19(19) of the Recovery of Debt Due to Banks and Financial Institutions Act of 1993 shall override the laws that are inconsistent in taking away the right to property as per Section 48 of the Transfer of Property Act of 1882.

With the above-mentioned case, it could be inferred that the legality of the Transfer of Property as a general law supersedes the provisions of the Companies Act of 1956, i.e., a special law that doesn’t recognise inter-se precedents on charges.

Position of law in recognising rights of security creditors post to IBC

The position of Indian laws is in parlance with that of international laws. The Insolvency Law Committee (ILC) and the Bankruptcy Law Reforms Committee (BLRC) have critically examined the position of the secured creditors, especially during the liquidation process and these reports underline the necessity of a strong insolvency and bankruptcy system for debt financing, which ensures creditors receive the returns they expect on their investments.

As per the Insolvency Law Committee (ILC) reports, Section 52 of the Insolvency and Bankruptcy Code, 2016 (IBC) provides secured creditors with two options for recovering their debts. These options are elaborated as follows:

  1. Realisation of security interest outside liquidation procedures:
    • Secured creditors have the right to realise their security interest through foreclosure or enforcement of their security rights without involving the liquidation process.
    • This option allows secured creditors to recover their debts by selling or disposing of the collateral securing their loans without going through the formal insolvency resolution process.
    • However, secured creditors must comply with the terms and conditions of their security agreements and applicable laws while enforcing their security interests.
  2. Surrender of security interest to liquidation estate:
    • Secured creditors can choose to surrender their security interest to the liquidation estate, effectively giving up their claim to the collateral.
    • This option is typically exercised when the value of the collateral is insufficient to cover the outstanding debt, or when the secured creditor believes that it is not commercially viable to enforce their security interest.
    • Upon surrender, the collateral becomes part of the liquidation estate, and the secured creditor becomes an unsecured creditor for the remaining amount of their debt.

The choice of option depends on several factors, including the value of the collateral, the enforceability of the security interest, and the commercial viability of enforcing the security rights. Secured creditors should carefully evaluate these factors and make an informed decision that maximizes their chances of recovering their debts.

It’s important to note that the IBC also provides for the appointment of a Resolution Professional (RP) to manage the insolvency resolution process. The RP is responsible for evaluating the options available to secured creditors and ensuring that their rights are protected throughout the process. Section 53(1)(b) of the Code states that in the liquidation waterfall, secured creditors who give up their security interest are given the second-highest priority and are entitled to recover their dues in the same way as labourers.

Despite all these ongoing discussions, there has been a persistent question regarding “Whether the secured creditors who gave up their security interest shall be allowed to recover the underlying value of such security interests relinquished or the total debt of the secured creditor?” under section 53(i)(b)(ii) of the code. The review committee for IBC has laid down that the priority for recovery for the secured creditors as per this provision shall only be applied to the value of such security interest that is given up by the secured creditor and this analysis strives to increase the overall value while preserving their security interest.

On the other hand, the BLRC report suggests modifications to the current IBC procedures. A few prominent suggestions include the acknowledgment of operational creditors, including employees and workers who have past due payments. It was also highlighted that liquidation under the new code shall have a time-bound procedure that is irreversible, with operational creditors receiving the payment first, followed by unsecured financial creditors and finally secured financial creditors.

Creation of charge and security interest via rainbow papers and its application

A resolution plan as per the provisions of IBC was pronounced by the Honourable Supreme Court in the case of State Tax Officer vs. Rainbow Papers Limited as a solution to avoid compelled liquidation, which shall satisfy statutory and government dues. The issue arose when the outstanding tax as per the Gujarat Value Added Tax Act was clashing with the IBC’s hierarchy of debt payment post-liquidation. The judgment given by the court highlighted the difference between private secured obligations and government dues by emphasizing that a government institution is not deemed as a secured creditor as per the provisions of IBC. It also threw the spotlight on the prejudice against operational creditors and thereby altered the liquidation waterfall system in order to prioritise statutory dues before government dues. Overall, the judgement puts forward the IBC’s goal in handling the use of the garment in bankruptcy proceedings, which highlighted the necessity for clarification to prevent resolution applicants from compromising the code objectives.

Despite the Supreme Court’s judgement on precisely addressing this issue, there are rows of multiple confusions and questions, as a result of which the Ministry of Corporate Affairs had to publish a discussion paper that attempted to address the intention behind formulating such a definition of security interest by showing that it was done to limit the interest to the cases that arise out of such a transaction. Furthermore, it is pertinent to note that the explanation given by MCA undermines the rainbow papers, as the rainbow papers acknowledge that security interests shall be formed only through legislation.

An international perspective

The changing interpretation of the priority rule for secured creditors by the Supreme Court and various tribunals needs a detailed examination to meet international standards and overcome uncertainty. The soul of IBC could be interpreted to be significantly inspired by the UNCITRAL model and English insolvency laws. The World Bank also recognises the need to maintain uniformity and predictability in terms of preserving the secured creditor’s rights over the collateral. Very importantly, the Doctrine of Equitable Treatment, as underlined in the BLRC, directed the IBC to be consistent with international norms.

Three approaches were laid down by UNCITRAL to deal with the secured creditors:

  • A group solution approach that talks about establishing a separate class for exclusive creditors.
  • A hybrid approach that allows unsatisfied creditors to vote in the same manner as unsecured creditors.
  • The libertarian principles that permit security enforcement without any voting rights. Although the IBC borrows certain libertarian ideas, it treats secured creditors differently throughout the Corporate Insolvency Resolution Process (CIRP).

Other claims are dealt with only in relinquishment situations and it is in accordance with the SARFESI Act that permits that collection in both CIRP and liquidation proceedings; instead of using the group solution approach, it classifies the primary and secondary charge holders in the same manner.

Conclusion

Ultimately, bankruptcy and the IBC of 2016 are important aspects of India’s legal system, particularly concerning how secured creditors are handled in bankruptcy proceedings. Before the implementation of IBC, there was ambiguity concerning secured creditors’ precedence. Following the creation of IBC, judicial rulings and legislative modifications were made to clarify. The evolution of bankruptcy legislation demonstrates a conscious effort to reach a compromise that benefits both sides.
To put it simply, the IBC serves as an example of how India’s bankruptcy laws have evolved via a constant process of modification and change. In order to create a strong and fair insolvency environment, it is critical that stakeholders adhere to legal principles, guarantee clear interpretation, and follow international standards as they negotiate the difficulties of bankruptcy processes.

References

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