This article has been written by Bhavani Rangineni.
Since the existing legal machinery dealing with debt defaults was not in line with global norms and the existing laws failed to produce the desired outcomes, the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as IBC) is considered to be one of the boldest reforms Indian Capitalism has ever witnessed in recognising itself at the global platform and preventing industrial sickness. IBC, which seeks to unify the existing legal system by creating a basic law for insolvency and bankruptcy, is undoubtedly one of the most important developments in Indian capitalism.
Like most of the existing laws, IBC too despite being promising legislation is underlined with its own set of laws violating the basic principles of equality enshrined in the Constitution. According to IBC, financial creditors are designated with more powers and are given more emphasis in the corporate insolvency resolution process compared to operational creditors, beginning with the right to participate and vote in committee meetings to the right to allocation of due debts under Section 53 of the IBC.
The IBC was enacted to boost the revival of the reorganisation framework in India by giving creditors more control. On the contrary, it fails to defend the interests of operating creditors and depicts a clear case of inequality. Hence, there is an extreme necessity to create equal opportunities by amending the existing legislation i.e., IBC. The Article studies the loophole relating to the prioritization of claims which is one of the most important aspects of insolvency laws. The study is descriptive in nature. In line with that, the paper tries to establish the dire need to amend the existing insolvency law in order to protect the interest of operational creditors.
The Corporate Insolvency Resolution Procedure (CIRP) in India required the application of many legislative instruments. Sick Industrial Companies Act of 1985, Recovery of Debt Due to Banks and Financial Institutions Act of 1993, Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act of 2002, and the Companies Act of 2013 are among them.
These laws, in general, provided for a disjointed mechanism of debt restructuring, asset takeover, and awareness in order to encourage the repayment of outstanding debts. As can be seen, the inadequate treatment of insolvency and liquidation created a great deal of uncertainty in the legal system, possibly requiring a greater need to reform the insolvency process.
All of these legal processes have resulted in a large pile-up of non-performing assets in India, with creditors waiting years to get their money back. IBC, the Insolvency and Bankruptcy Code is a major reform Indian Capitalism has ever witnessed that is an attempt to reform the insolvency process for companies allowing credit to move more freely. Though it unifies the existing legislation on Corporate insolvency and personal insolvency and resolves insolvency it has come up with its own set of flaws. IBC, distinguishes between Operational Creditors and financial creditors.
According to IBC, an individual to whom an operational debt is owed, as well as any person to whom such debt has been legally delegated or transferred, is referred to as an operational creditor and an individual who owes a financial debt, including a person to whom the debt has been legally allocated or transferred, is called a financial creditor. According to section 53 of the Code, Unsecured financial creditors have been placed above government obligations, while Unsecured operational creditors have been reduced to a residual entry which depicts a clear violation of the Right to Equality enshrined under Article 14 of the Constitution. There can indeed be distinctions but the question of the hour is, should those distinctions extend to distributions priorities in liquidation?
An operational Creditor is described as “an individual to whom an operational debt is owed, including any person to whom such debt has been legally assigned or transferred” in Section 5(20) of the IBC.
To be classified as an operational debt, the sum of the amount must fall within the definition of “claim” as specified in Section 3(6) of the Code, and such a claim must fall within the definition of “debt” as defined in Section 3(11) of the Code, and such debt must fall into one of the four categories set out in section 5(21) of the code –Goods, Services, Employment & Government.
In the case of Innovative Industries Ltd. v/s ICICI Bank, it was held that the operational creditors are those creditors to whom an operational debt is owed. An operational debt, in turn, means a claim in respect of the provision of goods or services, including employment, or a debt in respect of repayment of dues arising under any law for the time being in force and payable to the Government or to a local authority.
Financial Creditor as defined in Section 5(7) of the Code, “means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred.”
Differentiation & discrimination of creditors under IBC
For the first time, IBC differentiates between Operational Creditors and financial creditors based on the recommendations of the Banking Law Reforms Committee (BLRC). In general, Financial creditors are those that have a purely financial arrangement with the entity, such as a loan or debt security. Operational creditors are those that owe the company money as a result of a business transaction.
The powers vested in financial creditors under Section 21 of the Code are broad enough to dominate & discriminate against operational creditors. This is because Section 21 establishes a Committee of Creditors, which will be formed by the Insolvency Resolution Professional after the Insolvency Resolution Professional has gathered all of the claims against the corporate debtor and will vote on an insolvency resolution and repayment plan against the corporate debtor.
Section 21(2) specifically excludes operational creditors and requires all financial creditors of the concerned corporate debtor as members of the CoC, with the exception of certain groups of financial creditors or their representatives who are associated parties to the corporate debtor.
Powers of Committee of Creditors that is made up of financial creditors
- Section 21(9) – The CoC has the right to provide some financial details to the RP (Resolution Professional) during the CIRP procedure, as long as the information is specifically relevant to the corporate debtor.
- Section 22(2) – The CoC may appoint a new interim resolution professional or substitute the current interim resolution professional at their first meeting by a majority vote of not less than 66 percent of the total voting share of the financial creditors who are all members of the CoC.
- Financial creditors who are members of the CoC have the right to vote at CoC meetings depending on their voting share and the amount of financial debt owed by the corporate debtor.
- The financial creditors’ CoC will vote on and approve the Resolution and Repayments Plan, subject to the final approval of the NCLT in question.
- Prior approval of the CoC by a vote of not less than 66 percent of the total voting shares is needed to be obtained by the resolution professional during the course of CIRP, for the purposes of carrying out the acts outlined in Section 28(1):
- To collect excess interim finance in excess of the sum agreed at the CoC meeting.
- To provide interests as a form of protection over the properties of the Corporate Debtor.
- Where the corporate debtor is a corporation, to restructure the resources of the corporate debtor by buybacks, the issuance of new classes of securities or additional securities or the redemption of securities already issued.
- To keep track of the improvements the corporate debtor has made in terms of ownership.
- To conduct related party transactions and issue guidance to the corporate debtor’s financial institutions in the event of a debit transition in excess of the agreed-upon volume.
- To make adjustments to the corporate debtors’ Board of Management and Administration, as well as modifications to the corporate debtors’ or subsidiaries’ constitutional nature of instruments.
- To assign financial or operating debts, as well as rights under material contracts, to someone other than in the ordinary course of business.
- Change the appointment or terms and conditions of the corporate debtor’s statutory or interim auditors, or any other stated staff.
In the code, an OC’s privileges are restricted to initiating a corporate insolvency procedure against the corporate debtor, as well as notice and attendance at each CoC meeting if the OCs’ total dues are 10% or more of the debt. The final right is to appeal an order authorising a resolution plan under section 31 on the grounds that the corporate debtor’s debts owed to OCs have not been adequately addressed in the resolution plan in the manner stated by the Board.
Hence, it is very much evident that an Operational Creditor is discriminated against as he cannot be a member of CoC and also doesn’t enjoy any of the above-discussed rights of FC’s. In addition, Section 24(3)(c) limits the right of an operational creditor to attend such a CoC meeting, stating that operational creditors whose aggregate dues are at least 10% of the total debt payable by the corporate debtor may attend the CoC meeting but not participate or vote, as per Section 24(4).
Justification of discrimination by BLRC
The difference in their rights is justified by Banking Law Reforms Committee in its report as the drafter’s aim was to protect the interest of all stakeholders through a process that focuses on the restructuring of the debt and revival of the company first and only when it fails that the seek to liquidate all its assets. And OCs are generally uninterested in the revival of the company but keen on liquidation.
While the Banking Law Reforms Committee explains why the Code differentiates between financial and operational creditors in terms of powers and priority, it remains silent when we see instances where such broad powers granted to financial creditors are improperly used and fail to protect the interests of operational creditors by imposing an arbitrary resolution.
Even when the sum owed exceeds the liquidation value and the liquidation value is completely depleted while paying financial creditors and other groups ranking higher in the order than the Operational Creditor, who receives no payment at all, the Code remains silent.
Prioritisation under Sec 53 – waterfall mechanism
The income from the disposal of a corporate debtor’s liquidation assets must be allocated in a certain order of priority, according to Section 53 of the IBC. The costs associated with the insolvency settlement process and liquidation are at the top of the list, followed by workmen’s dues for the 24 months prior to the liquidation commencement date and debts owed to the secured creditor(s), which are tied for second place.
Unsecured financial creditors are prioritised over government claims under Section 53 of the Code. These unsecured financial creditors could also be associated parties, so the underlying financial transaction could be in the form of the accommodation offered by promoters or majority owners, often at the request of lending banks. Simultaneously, there is no mention of operational creditors’ priority status, leaving them in the residual group of “any remaining debts and dues,”
Analysis of the position of operational creditor through judgements
Binani Industries Judgement
In this case, the financial creditor, Dalmia Cements, submitted a resolution proposal against Binani Cements that was found to be discriminatory because it neglected the interests of the operational creditor, Ultra Tech Cements. As a result, the NCLAT’s ruling, which was upheld by the Supreme Court, stated that in a resolution phase, financial and operational debts must be treated equally, and any resolution plan found to be discriminatory or failing to safeguard the interests of operational creditors must be rejected by the adjudicating authority in violation of the code.
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 the ‘I&B Code’, then in such case no creditor will supply the goods or render services on credit to any ‘Corporate Debtor’. 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 ‘I&B Code’ and will also affect the Indian economy.
Therefore, it is necessary to balance the ‘Financial Creditors’ and the ‘Operational Creditors’ while emphasizing on the maximization of the assets of the ‘Corporate Debtor’. Any ‘Resolution Plan’ if shown to be discriminatory against one or other ‘Financial Creditor’ or the ‘Operational Creditor’, such plan can be held to be against the provisions of the ‘I&B Code’.
Although the decision in the Binani Industries Case, as pronounced by the NCLAT, Delhi and upheld by the Supreme Court, is well-defined and seeks to address the nonsensical discrepancy between these two groups of creditors, one question remains unanswered: whether operational creditors are prioritised over financial creditors to be paid on an immediate basis, and If Section 53 of the Code (waterfall mechanism) cannot be relied upon to authorise a resolution proposal, is it legally valid and in violation of Article 14 of the Constitution?
Essar Steel Judgement
In the following case, the Supreme Court ruled that the principle of “equality” should not be interpreted to mean that under a settlement agreement, all creditors must be entitled to equal recovery. The Supreme Court stressed that operating creditors were envisioned as a distinct class of creditors in the IBC. Furthermore, certain safeguards were incorporated into the IBC to ensure equal and equitable treatment of operational creditors’ dues, such as priority in recovery of dues and mandatory disclosure in a resolution plan regarding the treatment of operational creditors’ interests.
As a result, in Essar Steel, the Supreme Court held that the CoC could accept resolution plans that included differential payments to financial and operational creditors. While the Supreme Court in Essar Steel overturned the NCLAT’s principle of fair treatment for all creditors, it did recognise the operational creditors’ position in holding the corporate debtor a going concern. As a result, the Court recognised the importance of safeguarding their rights. The decision in Essar Steel upholds the CoC’s absolute independence in determining how funds are distributed.
However, such a decision should demonstrate proper consideration of the IBC’s goals, which are: maximising the value of the corporate debtor’s assets; and (ii) balancing the interests of all stakeholders. It’s worth noting that ArcelorMittal’s final resolution strategy resulted in a 20% recovery for operational creditors with admitted claims, compared to an 89 percent recovery for almost all secured financial creditors.
This was a major departure from the Supreme Court’s decision in Swiss Ribbons, which based its decision on the “roughly fair” treatment of operational and financial creditors’ debts. It continues to be debatable whether such a large disparity in recovery may be deemed “equitable” for operational creditors.
The Supreme Court correctly upheld the principle of equality among “similarly placed creditors” (rather than “all”), as well as the constitutionality of the amended Section 30(2)(b) of the IBC in Essar Steel. This included owing operating creditors a minimum of liquidation value. The Supreme Court, on the other hand, has refused to properly recognise the interests of operational creditors and to establish accompanying guidelines to ensure that they are handled equally in an insolvency resolution phase under the IBC.
Swiss Ribbon Case
In the following case, The Supreme Court expressly considered whether the absence of representation of organisational creditors on the CoC was a violation of Article 14 of the Constitution in Swiss Ribbons (protection from discrimination). The Supreme Court based its decision on the reasoning for the exclusion of operating creditors from the CoC, which was based on the Bankruptcy Law Reforms Committee’s (hereinafter “BLRC”) report, which was the precursor to the IBC. Financial creditors, according to the BLRC, could determine the feasibility of a resolution plan because workers had been trained to do so.
Operational creditors, on the other hand, are only interested in retrieving the money they owe for their goods and services and are usually unable to determine a company’s profitability and feasibility. However, such a reason seems flimsy. The BLRC assumes that, precisely because financial creditors have the ability to determine a plan’s effectiveness and feasibility, they will do so and base their decision to accept or reject a plan primarily on those factors.
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. 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. Further, on 05.10.2018, Regulation 38 was amended. The aforesaid Regulation further strengthens the rights of operational creditors by statutorily incorporating the principle of fair and equitable dealing of operational creditors ‘rights, together with priority in payment over financial creditors.
For all the aforesaid reasons, we do not find that operational creditors are discriminated against or that Article 14 has been infracted either on the ground of equals being treated unequally or on the ground of manifest arbitrariness.
The Binani & Essar Steel Judgements strike at the heart of the stated aim of IBC to “to balance the interests of all the stakeholders. But the Supreme Court upheld the Constitutional validity of Sec 53 in Swiss Ribbons Pvt. Ltd. v. Union of India and the claim of the distinction between financial Creditor and Operational Creditor was rejected on the basis of the grounds of intelligible differentia under Article 14 of Constitution of India, deteriorating the purpose of the Code.
Violation of Article 14 of the Constitution
The differentiation leading to discrimination of Operational Creditors in the insolvency process is in contravention to the principles of natural justice and Equality enshrined in the Constitution. The IBC’s self-proclaimed mission is to “maximise the value of the corporate debtor’s properties” and “balance the interests of all stakeholders.” In light of this, the complete disenfranchisement and disrespect for the operational creditors’ interests appear unjustifiable.
Unfortunately, rather than considering options to ensure that operational creditors are treated fairly, the Parliament has tried to further restrict their rights. This was accomplished by adding a statement that delivery in compliance with IBC Section 30(2)(b) would be considered “fair and equitable.” Though the reasoning of BLRC in differentiating the Operational Creditors is Understandable, the differentiation to the extent of prioritization under Sec 53 of IBC is unjustifiable.
Under the Code, the distinction between financial and operational creditors is fundamental. When both Operational and Financial Creditors are unsecured it is evidently a case of discrimination and not differentiation. Any creditor’s ultimate objective, whether financial or operational, is to maximise recovery. The IBC provides no incentive mechanism to promote such a shift and ensure that financial creditors do not behave exclusively in their own self-interest.
An economy is based on the provision of goods and services, not just the financial system. Operational creditors emerge when goods and services are provided on credit. The supply of goods and services on credit becomes a part of the entity’s working capital, serving the same function as financial lenders.
The real sector of any country’s economy is its foundation; the financial sector is significant, but not at the expense of the real sector. The real sector includes suppliers of goods and services. In spite of serving the purpose of the code i.e., to balance the economy, the Code deteriorates it by differentiating the Operational Creditors. The differentiation, discriminating between Operational Creditors doesn’t serve the purpose of the code in any manner and the distinction based on the recommendations of BLRC is no way intelligible, even if it is, it lacks economic rationale.
Mere Success of the development of the law of Insolvency cannot be Celebrated at the cost of the interests of Operational Creditors. The end of the war of priority between Financial and Operational Creditors is like Jackal waiting for grapes, unless and until these contradictory viewpoints are confronted with a proper and clarified statute. Hence, there is a dire need for an amendment that would be fair and justifiable to Operational Creditors. Until then the Operational Creditors are lost in the by lanes of Equality.
- Chaudhary, V.K. & Kapoor, Alka. “Corporate Insolvency Resolution Process – Brief analysis and challenges”, The Journal of Corporate Professionals (ICSI), Vol-46, Issue-9, ISSN 0972-1983, September 2016.
- Wadhwa, Rakesh. “Insolvency and Bankruptcy Code”, 2016” The Journal of Corporate Professionals (ICSI), Vol-46, Issue-9, ISSN 0972-1983, September 2016.
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