How Has IBC Positioned The Different Class Of Creditors?

This article deals with the differences that have been brought along with the changes in positions of creditors under the Insolvency and Bankruptcy Code. It gives an in-depth analysis of the process and the discussions that surround this issue while looking into judgements and the after-effects brought in by this change.
Estimated Reading Time: 10 minutes

Introduction

Insolvency and Bankruptcy Code (hereafter, IBC) 2016 stands as the bankruptcy law of India, it is an act to lead the maximization of values and assets of firms and individuals. The objective of this code is to create a safer space for insolvency and bankruptcy proceedings in the country. It aims to amend and work towards the betterment of the current insolvency laws, filling up gaps and fixing fallacies wherever required; along with reducing defaulting payments of debtors and promoting entrepreneurship in India. 

Banking Law Reforms Committee (hereafter, BLRC), in its 2015 report put emphasis on the rights of creditors and put forward the idea that whenever a default is identified in the system, the control to fix that fault should lie in the hands of the financial creditors and not with the equity owners. As recognized by the BLRC, the creditors had been in a structurally weaker position earlier, and hence it became a necessity to bring about a change so that a Creditor-in-Control model could be introduced and applied. This change put absolute authority with the creditors during the time of financial distress.

The Committee of Creditors (hereafter, CoC) was then introduced to carry out the above-mentioned changes. This CoC would then become the final decision-making authority in the Corporate Insolvency Resolution Process (hereafter, CIRP). These decisions to fix the financial distress of the Corporate Debtor are then further given to the Resolution Professional. The reason as to why the financial creditors play such a major part in the decision-making process is because, in majority of the cases a large part of the dues of the Corporate Debtor are of the Financial Creditor and the formation of this committee helps in looking out for the best of their interests. This CoC can choose to, or not choose to ratify decisions with regards to the proposed resolution plan to overcome the financial obstacle, but the Resolution Professional then has to endure either one of the proposed solutions are passed with an affirmative vote of 66% of those who hold the authority to cast a vote in the CoC (i.e., Financial Creditors). 

Financial Creditors are those whose debts fall under the umbrella of ‘Financial Debt’ as defined by Section 5(8) of the IBC, differ from those whose debts fall under the ambit of ‘Operational Debts’ which is defined by Section 3(6) of the Code. The main difference between Operational Creditors and Financial Creditors is that the former are generally suppliers of goods and services while the latter are banks or professional lenders who are secured.  

The Differentiation

The question that then naturally arises is what happens to those who do not hold the authority to cast a vote in the CoC – meaning the Operational Creditors who are left behind in this dispute and are not given authority to ratify decisions. Before answering this question, understanding the role of Operational Creditors is needed. In the light of these changes brought by IBC, the only condition where the Operational Creditors can have any kind of authority is by becoming a Financial Creditor or in cases where there is no Financial Debt and the Operational Creditor meets certain criteria and thresholds put forth by the IBC. These entities have the right to initiate CIRP (under section 8 and 9 of IBC), in these situations, they can initiate the process by asking for the payment of their default money through a notice. If the payment or dispute notice as such is not provided within 10 days of this notice, the Operational Creditor may lodge an application to the Adjudicating Authority to look into the matter and initiate proceedings. An Operational Creditor (also known as insecure creditor) to prove their authenticity as the same, have to show that their dues widely fall under the following categories: 

A) Goods

B) Services

C) Employment

D) Government

In the latest amendment of IBC, and as was also upheld by the Supreme Court in the case of Essar Steel, where the Supreme Court emphasized the equality of similarly placed creditors, but did not talk about all creditors. The Court also held that the interests of Financial Creditors were to be looked after and that the maximization of the assets was a major objective of this code. 

Section 53 of the IBC, which deals with the distribution of assets, has a major role to play in the CIRP, and it essentially gives out the allocations of payments which are to be made to the Creditors. The change, which is that of the differences between the holding of the Creditors now have a major difference, a disbalance of authority where the Financial Creditors seem to have an overpowering hand over the Operational Creditors. Post this, the system which is currently in place is that of a Financial Creditor interest-based procedure where the authority and information both remain with the CoC. This structure is largely based on a committee which consists of secure banks who put in their contribution in the form of either loans, liability or as such, and these entities would be the one reigning full control over the decisions made to fix a condition of financial distress, which further translates to Operational Creditors having no control of how the resolution goes through. The only given condition where Operational Creditors can hold any sort of accountability is by forming a committee of their own, but this is subject to the conditions where the Corporate Debtor has no financial debt or all the Financial Creditors are related parties of the Corporate Debtor, a situation with very rare probability of occurrence. 

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Impact

The above-mentioned circumstances have led to major controversies and deliberations taking place, questioning the decision to take away authority from the Operational Creditors. The major argument that has been put forth is that of disenfranchisement of Operational Creditors, as there is no given support structure or incentive for people to work with Corporate Debtor as a supplier of goods and services.  

The change that has taken place is the placing of Operational Creditors below the Financial Creditors, who now do not have any rights over particular assets, and it is growingly tough for them to get their money back. As this also makes the system very Financial Creditor centric, the entities who have been placed lower lose any right to have a say or even hold those on a higher pedestal accountable. The CIRP works on a process where the Resolution Professional gives the CoC the power to allocate the liquidated funds, and the actual allocations of said funds are never made accessible to the Operational Creditors, which, needless to say, leads to a system with an absence of checks and balances. This, when in contrast to the conditions pre-amendment where the Operational Creditors received at least the liquidated value of their operational debt leads to a hesitant approach for newcomers to take over endeavours of Operational Crediting. 

Another major impact, which shall be discussed below, is that of disputed claims, which have begun to look like a major disadvantage for anyone who is not a part of CoC and needs access to the allocation of the resolution. 

Discussion

This controversy has not only led to national level debates but also has had international involvement in terms of researchers studying this issue and giving it perspectives in varying degrees and levels. Before looking further into these discussions, the judgements and decisions of the Supreme Court, which were given to substantiate and be in line with the IBC are necessary to look at, to understand the very meaning of what this change might look like and what are the reasons driving this change. These reasons can be majorly be understood by the Essar Steel, Binani Industries and Swiss Ribbon Judgements. 

In the case of Committee of Creditors of Essar Steel India Limited v Satish Kumar Gupta, the Supreme Court effectively held that the equal treatment of all creditors was not necessary, those who have financial debts should be placed higher than those who have operational debts. 

Further, in the case of Binani Industries v. Bank of Baroda, the Supreme Court went ahead but also stated that it is important to give the Operational Creditors the equal position, just not the authority. “…if one type of credit is given preferential treatment, the other type of credit will disappear from market. This will be against the objective of promoting availability of credit”, which shows that the Supreme Court does identify the risks which come with placing one kind of creditor over the other. The reason behind giving the Financial Creditors authority is the fact that we actively need to look into maximizing their assets while the Operational Creditors do not have that sort of holding with the Corporate Debtor. Even though this does seem like a good start and an attempt to bring about equality in the law, the Supreme Court re-emphasized on this provision in Swiss Ribbons Pvt. Limited v. Union of India, where the challenge on the constitutionality of this difference between the creditors was valid and the Supreme Court said that this difference is valid and necessary. 

To look into some of the discussions and arguments that arose from this differentiation, this survey suggests that most people believe and can see a potential disbalance between the creditors coming to force, and also states that it would further disincentivize the system eventually leading to a lack of Operational Creditors. As was mentioned in the Legislative Guide for Insolvency Laws, issued by United National Commission on International Trade Laws, the system is supposed to work actively to facilitate participation of Creditors in insolvency issues, and all kinds of Creditors should have committees of their own to find representation in Insolvency issues. Yet, it emphasizes on the importance of giving them equal holdings in the issues as well a paradox which has not been quite addressed as of now. 

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The main argument that comes into play here is that of the differential position in India. Even in the system promoted by the United National Commission on International Trade laws, the Financial Creditors would be slightly on a higher place, but it does not explicitly take away all authority from the Operational Creditors, which happens to be the case in the current scenario. It is important to let the Operational Creditors to have some level of leverage to pass or not pass a resolution as they too have vested interests in the financial distress of the Corporate Debtor. There has to be a fair and equitable holding, even if there is a difference. The justification by the IBC, talking about ‘maximization of value assets’ and ‘resolving conflicts in a short time’ is acceptable, but still does not explain the different positioning of creditors. It indeed is a further disappointing stance taken to curtail the rights and authority of these Creditors merely on the basis of the debts they provide. 

One major aspect which is generally overlooked is that of disputed claims. The Resolution Professional gets to finally ratify who gets the allocation of the payments, and under this system it is usually proposed by the Financial Creditors, which means that the Operational creditors have no holding or authority to put forward their opinions, and neither can they ask for a change because they are not give the access to look into these allocations. Those who have disputed claims, under IBC now are in a disadvantaged position where claiming their payment becomes a challenge.  

Conclusion

Throughout this article, the main objective has been to put forward the differences brought between the Functional Creditors and Operational Creditors. Given the justifications and explanations provided by the Supreme Court and IBC itself, the major objective behind this entire change has been to maximize the profits and reach a viable solution at the earliest. Even though this started off as a good-willed change, the numerous harms were ignored. The Operational creditors, who should ideally have a say and authority to make decisions in CIRP have been shunned off with no power to look after their own interests. Even though the Financial Creditors have a higher stake in place specially during a situation of financial distress, it is unjust to not give any authority to the Operational Creditors. The impacts of this change are just the incentivization of Operational Crediting, which would further lead to an imbalance in the system with regards to Operational Debts, these entities becoming minorities in a system where they should hold the second-highest authority, if not equal. Apart from this, when we take away the power and make the entire system confidential and inaccessible to the Operational Creditors, it becomes a biased resolution method, where only the interests of Financial Creditors are looked after. 

This has been majorly debated and has received conflicting results and perspectives all across the globe, which only means that there is a lot of space for further change. Even though the objective behind this capitalistic change was not to actively suppress the Operational Creditors, the outcomes and the after-effects do not look very good or fair. Suggestions and constructive criticism have been pouring in, but the change has still managed to be here for a long time now, which only leads to ambiguity amongst the Operational Creditors as to whether anything will be changing to provide them better representation or not. 

Sources

  1. Manisha Paranjape, Abhijeet Kamath, ‘Composition of Committee of Creditors Under The IBC – A Comparative Study’ (Mondaq, 31 August 2018) <https://www.mondaq.com/india/insolvencybankruptcy/731884/composition-of-committee-of-creditors-under-the-ibc-a-comparative-study>
  2. Keith Tully, ‘What is the difference between secured and unsecured creditors?’ (RealBusinessRescure, 8 January 2021) <https://www.realbusinessrescue.co.uk/articles/directors-advice/what-is-the-difference-between-secured-and-unsecured-creditors>
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  7. Megha Mittal, ‘Financial Creditors and Committee of Creditors- What, Why and How?’ (vinodkothari, 15 September 2018) <http://vinodkothari.com/2018/09/financial-creditors-committee-of-creditors-what-why-and-how/>
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  10. Sudip Mahapatra, Misha Chadna, Pooja Singhania, ‘Operational Creditors In Insolvency – A Tale Of Disenfranchisement’ (Mondaq,3 August 2020) <https://www.mondaq.com/india/insolvencybankruptcy/971940/operational-creditors-in-insolvency-a-tale-of-disenfranchisement>
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  12. Namrata Chakraborty, ‘The Battle of Priority between Financial Creditors and Operational Creditors Under The IBC 2016 – A Revisit to Binani Industries and Swiss Ribbons Rulings’ (latestlaws, 5 August 2020) <https://www.latestlaws.com/articles/the-battle-of-priority-between-financial-creditors-operational-creditors-under-the-ibc-2016-a-revisit-to-binani-industries-and-swiss-ribbons-rulings/>

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