India: The Conundrum Of Distribution Under IBC

Last Updated: 22 August 2019
Article by Ravi Charan

The Insolvency & Bankruptcy Code 2016 ("Code") was enacted with a view to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, limited liability partnerships, 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.

It has been a little over two and half years since the Code was enacted. Since then, a plethora of litigation on issues including the interpretation of the Code have given sufficient reasons for the lawmakers to plug the gaps in the Code. The intent of the lawmakers is clear and evident with the pace at which the amendments are being introduced to address the dynamic industry in debt resolution and to ensure that the Code does not end up being yet another obsolete piece of legislation overtime.

One such issue has been the treatment of operational creditors vis-a-vis the financial creditors.

Under the Code, the liabilities of a company have been classified under three board categories, that is; financial liabilities which are based on financial contracts; operational liabilities which are based on operational contracts; and statutory liabilities which are amounts payable to government departments/authorities. The Code envisages initiation of Corporate Insolvency Resolution Process ("CIRP") by the National Company Law Tribunal (Adjudicating Authority) on an application made by the corporate debtor or operational creditor. Financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or a debt security, whereas the operational creditors are those whose liability from the entity comes from transaction on operations. The Code differentiates between financial creditors and operational creditors since their liabilities arise from different underlying contracts.

Section 5(7) of the Code defines Financial Creditor as "a 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) of the Code defines Financial Debt as a "debt along with interest, if any, which is disbursed against the consideration for time value of money and includes-

  1. Money borrowed against payment of interest;
  2. Any amount raised by acceptance under any acceptance credit facility or its de-materialized equivalent;
  3. Any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;
  4. The amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed;
  5. Receivable sold or discounted other than any receivable sold on non-recourse basis;
  6. Any amount raised under any other transaction, including, any forward sale or purchase agreement, having the commercial effect of borrowing;
  7. any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account;
  8. Any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;
  9. The amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub clauses (a) to (h) of this clause".

Section 5(20) of the Code defines Operational Creditor as "any 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) of the Code defines Operational Debt as "a claim in respect of the provisions of goods or services including employment or a debt in respect of the 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".

It is evident that the law makers have chalked out distinct definitions of financial creditor; operational creditor; financial debt and operational debt for CIRP. Once CIRP is initiated, a Committee of Creditors ("CoC") is constituted which conducts the viability of reviving the corporate debtor.

An important question that has been in much debate recently is that, whether, while considering the approval of resolution plan, the CoC is empowered to decide on the distribution of the amounts amongst financial creditors and operational creditors. In this regard reference is made to the case of Standard Chartered Bank vs Satish Kumar Gupta, R.P. of Essar Steel Ltd. & Ors (Company Appeal (AT) (Ins.) No. 242 of 2019  decided on July 4, 2019 ("Essar Case") by the National Company Law Appellate Tribunal ("Hon'ble NCLAT") which  dealt inter-alia with the said aspect and held that CoC is not empowered to decide in which manner the distribution is to be made between one or other creditors.  The Hon'ble NCLAT further held that:

  1. CoC is only required to notice the viability, feasibility of the resolution plan apart from other requirements as specified by the Board and ineligibility of the resolution applicant in terms of Section 29A of the Code.
  2. Financial Creditors being claimants at par with other claimants like other financial creditors and the operational creditors having conflict of interest cannot distribute the amount amongst themselves that too keeping the maximum amount in favour of one or other Financial Creditor and providing minimum or nil amount in favour of some other financial creditors or operational creditors.
  3. The waterfall mechanism of payments as provided under Section 53 of the Code would apply in the case of a liquidation of the company and not in a scenario of resolution.

The Hon'ble NCLAT has also ruled in the Essar Case that the distribution amongst creditors has to be decided by the resolution applicant by incorporating the same in the resolution plan and not by CoC, rightly so because the CoC is an interested party and hence may be biased towards such resolution plan which gives them a preferential treatment. The remarks of the Hon'ble NCLAT were also based on the observations made by Hon'ble Supreme Court of India (Hon'ble Supreme Court) in the matter of Swiss Ribbons Private Limited & Another vs Union of India & Ors. (Writ Petition (Civil) No. 99 of 2018); wherein Hon'ble Supreme Court held that the Hon'ble NCLAT has, while looking into viability and feasibility of resolution plans that are approved by the CoC, always gone into question whether the operational creditors are being given roughly the same treatment as the financial creditors, and if they are not, such resolution plans are either rejected or modified so that the operational creditors' rights are safeguarded.  

The Essar Case was justifiably, coming from the viewpoint of equitable justice due to the operational creditors, a well-established principle of balance of all stakeholders. The inequality between distribution seems to be the bone of contention for some of the operational creditors and financial creditors, who had appealed against the Hon'ble NCLT orders in the past and were striving for equitable treatment. However, the interpretation adopted by the Hon'ble NCLAT in the Essar Case has created huge uproar amongst the financial creditors, which may lead to a situation which would render any resolution plan highly uncertain and subject to challenge before the Adjudicating Authority. Further, the bargain between the resolution applicant and the CoC once approved cannot be altered or substituted by the Adjudicating Authority or Hon'ble NCLAT at the stage of approval of the resolution plan under Section 31(1) of the Code.

In view of the above, certain amendments in the Code have been made with the enactment of the Insolvency and Bankruptcy Code (Amendment) Act, 2019 ("Amendment Act") to overcome the difficulty arising in treatment of the operational creditors. The Amendment Act has restored the position understood before the Essar Case and make resolution plans abide by the distribution priorities given in Section 53 of the Code.

The CoC has challenged the Essar Case before the Hon'ble Supreme Court and Hon'ble Supreme Court was pleased to order status-quo on the Essar Case. The outcome of the case pending before Hon'ble Supreme Court will determine the plight of operational creditors under the Code and would rewrite the tests that the resolution plans have to fulfil for them to be approved and implemented.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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