Moratorium during Liquidation: Scope And Effect

By Richa Saraf (resolution@vinodkothari.com)

What is a moratorium?

The term has been defined in Merriam Webster Dictionary to mean “legally authorized period of delay in the performance of a legal obligation or the payment of a debt; a waiting period set by an authority; or a suspension of activity.

In Cambridge Dictionary, moratorium refers to a period of time during which a particular activity is stopped.

In Insolvency and Bankruptcy Code, 2016, Section 33(5) of the Insolvency and Bankruptcy Code, 2016 (“IBC”) stipulates “Subject to section 52, when a liquidation order has been passed, no suit or other legal proceeding shall be instituted by or against the corporate debtor:

Provided that a suit or other legal proceeding may be instituted by the liquidator, on behalf of the corporate debtor, with the prior approval of the Adjudicating Authority.”

It is a general notion that moratorium exists only at the time of corporate insolvency resolution process, the article discusses whether moratorium exists during liquidation as well. Further, based on precedents, the author has also tried to explain the exclusions and inclusions in the term “other legal proceedings” as mentioned in Section 33(5) of IBC.

Moratorium on Institution or Continuation of Suits?

The understanding, based on the interpretation of Section 33, is that there is no moratorium on continuation of suits. In case the liquidator wants to institute a fresh suit or legal proceeding, he will require specific permission from the adjudicating authority, in accordance with Section 33(5) of IBC, however, the liquidator can continue to pursue or defend an already existing proceeding, without seeking any permission from the adjudicating authority, pursuant to the powers conferred upon him under Section 35(1)(k) IBC. Here, it will be relevant to draw reference from the parent Companies Act which puts a stay not only on institution of “suit or other legal proceeding”, but also on its continuation.

In fact, in the parent Companies Act, 1956, Section 446(2) conferred an exclusive jurisdiction on the winding up court in all matters pertaining to the company before the court. Section 60(5) of IBC is akin to the provisions contained in Section 446(2)(d). The relevant extract is reproduced below:

“Notwithstanding anything contained in any other law for the time being in force, NCLT have jurisdiction to entertain, or dispose of: (a) any application or proceeding by or against the corporate debtor;… (c) any question of priorities… arising out of or in relation to the insolvency resolution or liquidation proceedings of the corporate debtor”.

There are several court rulings which have analyzed the relevance of this provision– that the winding up court has holistic powers in respect of the company under winding up, so that all matters that may affect the company under liquidation may be dealt with by the court. It can thus, be contended that age old laws have been developed with an intention to prohibit institution as well as continuation of suits or legal proceedings during liquidation.

In the book Law Relating to Insolvency & Bankruptcy Code, 2016[1], this issue was discussed and it has been clarified that:

Unlike clause (a) of sub-section (1) of section 14, sub-section (5) of section 33 does not include the word ‘continued’, which apparently implies that suits or proceedings that were instituted prior to the insolvency commencement date may be continued during the liquidation proceedings. However, the notes to clauses[2] clearly state that the “liquidation order shall result in a moratorium on the initiation or continuation of any suit or legal proceeding by or against the corporate debtor”. In view of the author, absence of the word ‘continued’ is merely a drafting glitch- since allowing the continuation of pending suits or proceedings will hamper smooth conduct of liquidation proceedings. Hence, the provision shall be read as, “. . . no suit or other legal proceeding shall be instituted or continued by or against the corporate debtor:”

In Companies Act, 1956 and 2013, approval of court was required for suits by or against the corporate debtor, but under the IBC, there is no provision for seeking leave by the other party and only the liquidator can institute legal proceedings on behalf of the corporate debtor by seeking prior approval of the adjudicating authority. The very object of Section 60(5) of IBC is to prevent multiplicity of suits in multiple fora, and therefore, it will be quite illogical to have several forums determining matters which may impinge on the assets or liabilities of the company under liquidation. There are several rulings which have discussed the intent of the moratorium. One significant ruling is Central Bank of India v. Elmot Engineering Co., 1994 AIR 2358; 1994 SCC (4) 159, wherein the Hon’ble Supreme Court cited the following para from Palmer’s Company Precedents, Part 11, 17th Edn., page 302:

“When a winding-up order is made, the Court, acting by its officer the Official Receiver lays its hand upon the assets and says, no creditor or claimant must touch these assets or take proceedings by way of action, execution or attachment pending the distribution by the Court in due course of administration. This protection is indispensable equally in winding-up and in bankruptcy to prevent a scramble for the assets, but it is not always enough. An even- handed justice requires that the Court should have power to intervene at an early stage for the protection of the assets, and this power is given by this section.”

The Apex Court, thus, explained the intent of the section:

“This section aims at safeguarding the assets of a company in winding-up against wasteful or expensive litigation as far as matters which could be expeditiously and cheaply decided by the company court are concerned. In granting leave under this section, the court always takes into consideration whether the company is likely to be exposed to unnecessary litigation and cost.”

Proceedings not covered under the ambit of moratorium:

1.    Tax proceedings:

Tax proceedings will have to be classified into two categories: pre-assessment and post-assessment proceedings. While assessment proceedings are considered to be outside the purview of moratorium, proceedings for recovery of tax would fall within the ambit of moratorium. This distinction may seem to be unfair, however, in the proceedings under the income tax act and some other analogous acts, for example under sales tax, excise etc., the proceedings for determination of the rights and liabilities of the companies and the other persons may have to be determined initially by authorities which have been specially created under the specific statute, and when it comes to recovery of dues, the winding up court should come into picture. The reason is that the legislature intended that the assets of the company in liquidation should be dealt with at one place by the NCLT who would be in the best position to distribute the funds of the companies equitably.

See Life Insurance Corporation of India v. Asia Udyog (P) Ltd., 1984 55 CompCas 187 Delhi, 1984 145 ITR 520 Delhi[3] and in Official Liquidator, Golcha Properties Private Ltd. (In Liquidation) v. Income-Tax Officer and Ors. [1974] 44 CompCas 144 (Raj); [1974] 94 ITR 11 (Raj); 1972 WLN 563.[4]

While the tax authorities may to continue the assessment proceedings to determine the quantum of their claim, however, they cannot proceed with execution, distress or recovery. Statutory authorities are included under the definition of “operational creditors” [Section 5(20) of IBC], and accordingly, they will have to file their claim with the liquidator for recovery of their dues in the requisite form. The liquidator will verify their claim, and make payment only in accordance with the priority laid down under Section 53 of IBC.

For pre-assessment proceedings, the liquidator has to continue to represent the company. In this regard, it is relevant to cite the case of Tika Ram and Sons (Private) Ltd. v. Commissioner of Income-Tax [1964] 51 ITR 403 (All)[5], where Allahabad High Court made the following observations:

“Income-tax proceedings are certainly not such proceedings which the High Court under Section 446 could possibly entertain and make the assessment itself nor could it transfer any such assessment pending before the Income-tax Officer to its own record.

……..For these reasons I would hold that assessment proceedings do not fall within the scope of “other legal proceedings” and do not automatically come to a stop the moment the company goes into liquidation………..

………the company in liquidation is still an assessee, and income-tax proceedings up to the stage of assessment do not fall within the scope of the words “other legal proceedings” as used in Section 446 of the Companies Act, 1956.”

 

For recovery of dues, the exclusive jurisdiction vests with the NCLT, and statutory authorities cannot encroach upon the same. See Damji Valji Shah v. Life Insurance Corporation of India, [1965] 35 Comp. Cas. 755; [1965] 3 S.C.R. 665, 673 (S.C.)[6], S. V. Kondaskar, Official Liquidator, and Liquidator of the Colaba Land and Mills Co. Ltd. v. V. M. Deshpande, Income-tax Officer, [1972] 83 I.T.R. 685, 699; 42 Comp.Cas. 168, 181 (S.C.)[7].

In this regard, reference may be drawn to Circular No. 1053/02/2017-CX issued by Central Board of Excise and Customs dated 10th March 2017[8], which clearly lays down that the dues under IBC shall have priority over Central Excise dues. Also, it is mentioned that when cases are pending before BIFR/ OL/ appropriate authority under IBC, then recovery measures shall not be resorted to and further, in such cases public counsel should be advised to file affidavits for first charge under Section 11E of Central Excise Act, 1944 informing the quantum of confirmed demand to BIFR/ OL/DRT/IBC Authorities.

2.    Jurisdiction of Writ Courts:

On perusal of the provisions contained in the earlier act, it may be noted that an exemption was granted to cases pending before High Courts or Supreme Court, but no such exemption has been provided for under the IBC. The issue was discussed in Canara Bank v. Deccan Chronicle Holdings Limited, [CA (AT) Insol No. 147 of 2017][9]. The appellant (i.e. the creditor) submitted that the adjudicating authority cannot exclude any court from the purview of moratorium for the purpose of recovery of amount or execution of any judgement or decree, including the proceeding, if any, pending before the High Courts and the Supreme Court of India against a corporate debtor.

The NCLAT acknowledged that clause (a) of Section 14(1) specifically does not exclude any Court, including the High Courts or even the Apex Court. However, the Hon’ble Bench there are certain constitutional provisions which must be considered. There is no provision to file any money suit or suit for recovery before the Supreme Court except under Article 131 of the Constitution; some High Courts have original jurisdiction to entertain the suits, which may include money suit or suit for recovery of money. However, the writ jurisdiction conferred on the Supreme Court and the High Court under Article 32 and Article 226 of Constitution of India, being a constitutional power, cannot be curtailed by any provision of an Act or court. Therefore, ‘moratorium’ will not affect any suit or case pending under Article 32 or 226. However, so far as suit, if filed before any High Court under original jurisdiction which is a money suit or suit for recovery, against the corporate debtor such suit will be covered by the bar imposed under Section 33(5).

3.    Criminal Proceedings:

In criminal proceedings, particularly in the proceedings under Section 138 of the Negotiable Instruments Act, 1881, the directors or officers in default, as the case may be, are generally held personally liable, as against the civil liability of the company. The company and its directors cannot shirk their criminal liability merely on the ground that the company was already wound up and the liquidator had taken charge of the affairs of the company.

Upholding the principle laid down by the Kerala High Court in Jose Antony Kakkad v. Official Liquidator 2000 Comp Cas 811[10], in Counter Point Advt. P. Ltd., Rep. by its Director, Mr. Naresh Purushotham v. Harita Finance Limited, Rep. by its Special Legal Assistant, Miss. Gulzar Sayeeda [2006] 133 CompCas 435 (Mad); 2006 Cri LJ 2289; 2006 (2) CTC 501[11], the Madras High Court observed that:

“Though the words ‘legal proceedings’ in Section 446 of the Companies Act is wide enough to be taken in criminal proceedings also, such criminal proceedings must be in relation to the assets of the company. Criminal proceedings which are not in respect of the assets of the company but which end in the conviction or acquittal of the accused, cannot be stayed under Section 446 of the Companies Act. Proceedings under Section 138 of the Negotiable Instruments Act, 1881, can end only in the conviction or acquittal of the accused in the case and no recovery of any amount covered by the dishonoured cheques can be made in the criminal proceedings. As the proceedings under Section 138 of the Negotiable Instruments Act are not in respect of the assets of the company, the proceedings pending in the criminal Courts cannot be stayed under Section 446 of the Companies Act.”

Again, in M/s. Indorama Synthetics (I) Ltd v. State of Maharashtra and Anr.[12], having regard to the earlier decisions, and in consonance with the spirit, purpose and object of the provisions of Section 446(1) of the Companies Act and Section 138 of the Negotiable Instruments Act, similar view was taken by the Bombay High Court. Applying the ratio, it can be safely concluded that the expression “suit or other proceedings” does not include criminal complaints filed under Section 138 of the Negotiable Instruments Act.

4.   Proceedings notified by the Central Government:

Section 35(6) stipulates that the provisions of sub-section (5) shall not apply to legal proceedings in relation to such transactions as may be notified by the Central Government in consultation with any financial sector regulator, however, no such legal proceedings has been notified till date.


[1] 2016 Edition, by Sikha Bansal and Vinod Kothari.

[2]http://www.prsindia.org/uploads/media/Bankruptcy/Insolvency%20and%20Bankruptcy%20code,%202015.pdf

[3] https://indiankanoon.org/doc/327104/

[4] https://indiankanoon.org/doc/7921/

[5] https://indiankanoon.org/doc/102942/

[6] https://indiankanoon.org/doc/623299/

[7] https://indiankanoon.org/doc/38825714/

[8]http://www.cbec.gov.in/resources//htdocs-cbec/excise/cx-circulars/cx-circulars-2017/circ1053-2017cx.pdf;jsessionid=424933FE2D4B60AD42EFE3B5A66A85F2

[9] http://nclat.nic.in/final_orders/Principal_Bench/2017/insolvency/14092017AT1472017.pdf

[10] https://indiankanoon.org/doc/1731723/

[11] https://indiankanoon.org/doc/1203400/

[12] https://indiankanoon.org/doc/64892212/

Reversibility of Liquidation Order?

By Richa Saraf (resolution@vinodkothari.com)

Insolvency and Bankruptcy Code was framed with the object to provide opportunity for revival to an insolvent company, however, since the rising number of liquidation cases, as against resolution, is a cause of worry.

“After more than a year of the Insolvency and Bankruptcy Code proceedings, there have been more liquidation cases than resolution of the non-performing assets accounts. According to a data from the Insolvency and Bankruptcy Board of India, in the National Company Law Tribunal, around 78 companies got liquidation orders since February 2017[1].”- quoted in an article in Business Standard.

“An analysis of companies that have completed the Corporate Insolvency Resolution Process (CIRP) till December reveals that liquidation orders were passed for as many as 30 companies. This is three times the number of 10 cases for which resolution was approved at the culmination of the CIRP, as per latest data available with the Insolvency and Bankruptcy Board of India.[2] quoted in an article in Indian Express. Read more

Financial Creditors & Committee of Creditors: What, Why and How?

By Megha Mittal (resolution@vinodkothari.com)

IBBI issues clarification w.r.t. voting powers of CoC

Brief Background:

Pursuant to the Insolvency and Bankruptcy (Amendment) Code, 2018, the crucial reduction of voting threshold from 75% to 66% for critical matters like approval of Resolution Plan, Extension of CIRP, and all matters of section 28 of the Insolvency and Bankruptcy Code, 2016 (Code), came into effect.

However, there still prevailed ambiguity as to how to determine this threshold of 66%. What shall be the fate of those financial creditors who abstained from voting?

In this background, the Insolvency and Bankruptcy Board of India (IBBI/ Board) has issued a clarification w.r.t. voting in the Committee of Creditors.

Constitution of Committee of Creditors- What, why and how?

Committee of Creditors” (Committee) is a committee consisting of the financial creditors of the Corporate Debtor. This Committee eventually forms the decision making body of the various routine tasks involved in Corporate Insolvency Resolution Process (CIRP), responsible for giving approval to the IRP/ RP to carry out actions that might affect the CIRP.

A major chunk of the dues of the Corporate Debtor is that of Financial Creditors and thus, to recognize their substantial interest, the Committee is formed. The power to ratify the managerial decisions taken by the RP vests upon the Committee; It is this Committee that approves/ rejects the Resolution Plan, extension of CIRP, decides upon liquidation of the Corporate Debtor, ratifies expenses borne by the RP etc. In short, all decisions having an impact on the Corporate Debtor shall first be approved by the Committee.

As per section 18 of the Code, it is the duty of the Interim Resolution Profession to constitute the Committee upon collation of all claims received against the corporate debtor and determination of the financial position of the corporate debtor. It shall consist all those financial creditors whose claims have been received within the time period stipulated in the public announcement.

Voting power of the Members

In the event of passing any resolution by the Committee, a minimum threshold of assent is required to be obtained. However, in light of these facts, the following questions arise w.r.t. fate of creditors who submit delayed claims or the determining the voting power of the members of the Committee

  • What happens when a financial creditor submits claims after the stipulated date as per public announcement?

Where a financial creditor submits its claim after expiry of the last date for submission, it shall form a part of the Committee for purposes after such submission. No decision taken prior to its inclusion in the Committee can be questioned later on.

  • How is it to be determined whether the requisite threshold is met?

While determining the percentage of votes received in favour, only those creditors then forming part of the Committee shall be considered as the total value of creditors and the votes of those creditors who abstain from voting shall be deemed to be dissenting votes.

These provisions can be better understood with the help of an illustration:

Illustration:

A corporate debtor, X Ltd. has 6 financial creditors having dues to the tune of Rs. 600 crores. By the time the last day for submission of claim expires, the claims of only 3 financial creditors being A, B and C having dues of Rs. 50 Crores, Rs. 75 crores and Rs. 125 crores, respectively have been submitted.

Thus, the IRP constitutes a committee of these 3 creditors.

After the last day for submission of claims expires, another financial creditor, D, having dues of Rs. 100 crores submits its claims. After the claim is verified, such financial creditor shall also form part of the Committee.

D, opposes a certain decision taken by the Committee prior to its inclusion. Such contention placed by D is non-maintainable as the previous resolutions passed by the Committee shall be held good because they were duly passed with requisite majority.

After D is admitted as a member of the Committee, there are a total of 4 members having total dues of Rs. 350 crores. Now, for a resolution requiring minimum 66% of the votes to be passed, members of the Committee having dues of atleast Rs. 231 crores must vote in favour of such resolution.

Assuming a situation where out of the 4 creditors, A chose to abstain from voting, A shall be deemed to be a dissenting creditor. Thus, even on such abstention, votes in favour of minimum 66% of Rs. 350 crores i.e. Rs. 231 crores shall be required and not that of Rs. 300 Crores.

Another point to be noticed is that dues of creditors not forming part of the Committee shall not be taken into account while determining the requisite percentage. In the illustration above, the remaining creditors of Rs. 250 crores shall not be taken into consideration while passing of resolutions.

Conclusion:

Considering the above, the following can be concluded:

  1. Financial creditors not forming part of the Committee shall not have any voting power w.r.t. decisions taken by the Committee unless they become a part of the Committee.
  2. Creditors abstaining from voting shall be deemed to be dissenting shareholders.

Dictated decision-making: IBBI expects to usher effective decision-making in creditors’ committee meetings

By Vinod Kothari (resolution@vinodkothari.com)

The recent IBBI circular[1] dated 10-08-2018 makes an interesting reading. While it is lamenting the fact that the hard timeline-bound regime of the insolvency process will lead to unintended corporate mortality if the bank representatives attending the creditors’ committee (CoC) meetings are not empowered to decide, the amusing undertone is that it has directed the resolution professionals to ensure the attendees in CoC meetings are decision-makers themselves. Read more

LOOK- BACK PERIOD VIS-À-VIS FRAUDULENT TRANSACTIONS

By Richa Saraf  (richa@vinodkothari.com)

Sections 45, 49, 66, 69 of the Insolvency and Bankruptcy Code, 2016 requires and empowers the Liquidator to apply to the Adjudicating Authority for appropriate orders in case of any vulnerable transactions that the Liquidator comes across during the process of liquidation. Such transactions may either be with respect to breach of applicable law, or deleterious to the interests of creditors or stakeholders, or otherwise, not transactions designed to be in good faith. The transactions, whether being undervalued or fraudulent shall be considered vulnerable to the interest of the stakeholders of the Company.

The article hinges on the crucial question of applicability of the limitation to the aforementioned sections. In this regard, we shall discuss how the provisions were imbibed in the Code, despite there being no equivalent in the Companies Act, 2013 or previous Companies Act. The general notion is that limitation should be applicable to all transactions, including fraudulent transactions referred to in Section 49 of the Code. However, the article will explain as to how undervalued transaction, done deliberately without due compliance, partakes the nature of a fraudulent transaction, and since fraud is a nullity forever, in case of such transactions, as covered by Section 49, there is no question of any look- back period at all.

Deciphering the intent of incorporation of provisions relating to vulnerable transactions:

The concept of “fraudulent preference” existed both in Companies Act, 1956 and 2013, however, the provision pertaining to undervalued and fraudulent transaction is a unique incorporation in the Code, adopted from the UK Insolvency Act, 1986. The Bankruptcy Law Reform Committee, referring to Section 243 of UK Insolvency Act, 1986, recommended that a provision voiding transactions defrauding creditors should be included. It is further, pertinent to note that the Committee, while discussing the intent behind insertion of this provision in the statute, observed that the provision for fraudulent transactions should not have any time- bar. The relevant extract from Interim Report (page 98-99) of the Committee is reproduced below:

“In the UK, Section 423 of the IA 1986 voids transactions at undervalue if such transactions have been entered into with the intention of putting the assets beyond the reach of, or otherwise prejudicing the interests of a person who is making or may make a claim against the company. While the scope of this provision is similar to that of the provision avoiding transactions at undervalue (Section 238, IA 1986), Section 423 actions differ in that they do not have any time limit for the challenged transactions, and is available in and outside formal insolvency proceedings. The inclusion of such a provision in the CA 2013 would reinforce the protection given to creditors under avoidance law by permitting the liquidator to set aside transactions entered into prior to the one year period ending in the company’s insolvency. This is necessary to guard against the siphoning away of corporate assets by managers who have knowledge of the company’s financial affairs in cases where a long period of financial trouble, extending over a year, ends in insolvency.

**

A provision invalidating transactions defrauding creditors similar to Section 423 of the IA 1986 should be inserted in CA 2013. Such provision would apply without any time limits and should be available in and outside formal insolvency proceedings.

It is clear that the analogous provision in the UK law does not have any limitation period, and also, there is no limitation period with reference to Sections 49 and 66 in the language of the law itself. Here, it is relevant to cite Report of Insolvency Law Committee (March, 2018), by virtue of which an amendment was made to exclude time limit from Section 69 of the Code:

“24.1. Section 69 of the Code provides for punishment for transactions defrauding creditors by the corporate debtor or its officers “on or after the insolvency commencement date”. However, as per sub-section (a), if the transaction results in a gift or transfer or creation of a charge or the accused has caused or connived in execution of a decree or order against the property of the corporate debtor, the accused shall not be punishable if such act was committed five years before the insolvency commencement date or if she proves that she had not intended to defraud the creditors. In this respect, the pre-fixing of the offence with “on or after the insolvency commencement date” is erroneous. Further, pre-fixing the same phrase in sub-section (b) is also erroneous, as the transaction involves concealment or removal of any property within two months from the date of any unsatisfied judgement or order for payment of money. Thus, the Committee decided that the phrase “on or after the insolvency commencement date” be deleted from section 69.”

Additionally, vulnerable transactions are generally considered to be transactions of a continuing nature, having their adverse and prejudicial impact on the ongoing financial position of the Company, which has already slipped into distress, and therefore, the concept of any look-back period or claw-back period shall not be applicable, since it cannot be contended that a transaction, done with a deliberate, culpable design, becomes washed of its gullibility merely because the liquidation proceedings are initiated certain number of years after the date of commission of the relevant transaction.

Distinction between Section 45 and Section 49:

Both Sections 45 and 49 pertains to avoidance of undervalued transactions, the only difference being that Section 49 deals with undervalued transactions undertaken with malafide or wrongful intent, while for Section 45; the presence of any motive is not required. The reference in Section 49 to transactions covered by section 45 is merely for the factual ambit of transactions covered by the section, and the additional element of intent marks the crucial difference between the two sections.

Moreover, while a look- back period has been provided for undervalued transactions under Section 46, there is no limitation period for fraudulent transactions covered under Sections 49 and 66 of the Code. The intent being “once a fraud, always a fraud”, a time- honored doctrine clearly applies. The maxim “fraud vitiates every transaction into which it enters applies to judgments as well as to contracts and other transactions” is a part of common law jurisprudence, largely based upon equitable doctrines and has been has been upheld by courts repeatedly in several cases such as The People of the State of Illinois v. Fred E. Sterling, 357 Ill. 354; 192 N.E. 229 (1934), Allen F. Moore v. Stanley F. Sievers, 336 Ill. 316; 168 N.E. 259 (1929), and further, In re Village of Willow brook, 37 Ill.App.2d 393 (1962), wherein it  was observed “It is axiomatic that fraud vitiates everything.”.

Fraud destroys the validity of everything into which it enters, and that it vitiates the most solemn contracts, documents, and even judgments, is well settled, and has been time and again reiterated in various judgments in broad and sweeping language. If both the sections were to encompass a time-limit then it would defy the whole purpose, and the reason for incorporating two separate provisions in the Code would fail. The basic essence is that any person who has done any wilful act should not be allowed to get away by citing reasons such as lapse of time.

In light of the aforesaid, it can be concluded that while an undervalued transaction is a matter of fact, for which intention does not matter, however, when the intention to cause a prejudice to the creditors is embedded in such undervalued transaction, the transaction comes within the offence of Section 49. If a transaction, so imbibed with malafide intent, was subject to the same fate and the same limitation as a transaction mentioned in Section 45, then Section 49 would not have any relevance at all. On the contrary, it can be pointed out that Section 49 was inserted specifically for the so-called willful defaulters, for which the limitation of time, mentioned in Section 45, cannot be relevant at all. Thus, it will not be correct to say that there is any claw-back for willfully undervalued transactions under Section 49 and fraudulent conduct of business under Section 66.

Subordination of Operational Creditors under IBC: Whether Equitable?

Vinod Kothari and Sikha Bansal

The authors can be reached at resolution@vinodkothari.com

 

  1. Why this Article?

Section 53 of the Insolvency and Bankruptcy Code (IBC) puts unsecured financial creditors above the claims of the governments. These unsecured financial creditors may, actually, be even related parties, and therefore, the underlying financial transaction may be in the nature of accommodation provided by promoters or majority shareholders, often at the instance of lending banks. At the same time, there is no specific mention of the priority status of operational creditors, who are, therefore, left in the residual category of “any remaining debts and dues”, which is 2 notches below unsecured financial creditors.

Financial creditors in this case are unsecured; so are operational creditors. The law, however, puts one class of unsecured creditors two places ahead of the other, in the priority order of distribution. Is this subordination of unsecured operational creditors justified? Or, is it equitable? Is there an economic argument to contend that the suppliers of goods and services who supplied on credit, and therefore, contributed to working capital, should have lower ranking claim to their money than working capital financiers or other unsecured lenders?

This significant question is discussed in this article in the light of global insolvency laws.

  1. The Significance of Insolvency Priorities

Prioritisation of debts in liquidation, technically speaking, is specifying the stacking order in which different creditors of the insolvent debtor would be paid their dues.

Prioritisation of claims, commonly known as liquidation waterfall, is one of the most important aspects of insolvency laws, and has evolved globally over the decades of jurisprudence. Insolvent liquidation is obviously a case of shortfall of assets as against the claims, and therefore, who gets paid first, or does every get to share proportionally, is the key question. If food on the dining table at home is short, we will all share what we have, but we sometimes give priorities to children or the elderly. However, in insolvency waterfall, the concept of prioritisation is that unless the one ahead in the queue has eaten belly-full, the next person in the queue does not get to eat even a morsel. Hence, it is not merely a question of “how much”, it is a question of “whether at all”. Therefore, priority in distribution in liquidation is not merely a matter of place in the queue – it is whether a stakeholder gets paid at all, or how much it gets paid. Thus, the recovery rate, and therefore, loss given default (LGD –as bankers call it), is directly connected with the prioritisation.

Since the claim that a claimant files in liquidation proceedings is a property right of the claimant, the prioritisation deals with property rights; hence, any casual or unprincipled approach to prioritisation may be fatal to the inherent property rights of the claimants.

  1. Principles of Prioritisation

Priorities are specified considering the following fundamental factors –

(i) Contractual priorities: The priorities specified often recognize and respect different commercial bargains which creditors would have struck with the debtor. As stated in the UNCITRAL Legislative Guide on Law of Insolvency, this is to “preserve legitimate commercial expectations, foster predictability in commercial relationships and promote equal treatment of similarly situated creditors”. The preservation of contractual priorities in liquidation is based on the principle of certainty, such that creditors are certain of their rights at the time of entering into the contract. For instance, in secured lending, which is in the nature of an inter-creditor and debtor-creditor agreement, the secured lenders are given the first right on the secured assets, and in case the assets are relinquished, then preferential right on the aggregate cashflows of the entity.

(ii) Social considerations: Prioritisation policies very often reflect legitimate considerations for certain sections of the society or in public interest. For example, the workmen, and the employees. In India, the priority status was given to workmen after elaborate discussion by the Supreme Court in the case of National Textile Workers v. P.R. Ramkrishnan and Others, 1983 AIR 75 : 1983 SCR (1) 9, on workmen’s rights to be heard in winding up proceedings.

(iii) Sovereign considerations: Sometimes claims of the State or the Crown are given priority as preferential unsecured claims on the ground of protection of public revenue.

Given the varied nature of claims and obvious conflict arising on the question of their prioritisation, the UNCITRAL Legislative Guide on Law of Insolvency, therefore states –

“While many creditors will be similarly situated with respect to the kinds of claims they hold based on similar legal or contractual rights, others will have superior claims or hold superior rights. For these reasons, insolvency laws generally rank creditors for the purposes of distribution of the proceeds of the estate in liquidation by reference to their claims, an approach not inconsistent with the objective of equitable treatment.

Therefore, equitability is the key underlying principle to fixation of priorities.

  1. Prioritisation: Global Perspective

Globally, the principles, as discussed above, are followed in countries like USA, UK, Singapore and even India (under the Companies Act, 2013). For instance, as follows –

  • The Insolvency Act, 1986 of United Kingdom

Under the Insolvency Act, 1986, read with relevant rules, a secured creditor puts a value on security, and the office-holder can redeem the property at such value. Hence, a secured creditor has a superior right over the secured asset.

Section 175 read with section 386 and schedule VI to the Act and relevant rules, prescribes preferential debts which shall be paid in priority to all other debts. The preferential claims, such as debts due to inland revenue, customs and excise, social security contributions, contribution to occupational pension schemes, etc. rank above the claims of body of unsecured creditors. Such rank equally among themselves after the expenses of the winding up and shall be paid in full, unless the assets are insufficient to meet them, in which case they abate in equal proportions. Also, such preferential debts have priority over the claims of holders of debentures secured by, or holders of, any floating charge created by the company, and shall be paid accordingly out of any property comprised in or subject to that charge.

As is evident, there is no distinction between creditors as financial or operational.

  • Title 11 of the US Code

Section 706 read with sections 507 and 510 of the dictates the order in which distribution of property of the estate. First, property is distributed among priority claimants, as determined by section 507, and in the order prescribed by section 507. Second, distribution is to general unsecured creditors. Third distribution is to general unsecured creditors who tardily file. Fourth distribution is to holders of fine, penalty, forfeiture, or multiple, punitive, or exemplary damage claims.

Section 507 accords first priority to allowed administrative expenses and to fees and charges assessed against the estate. “Involuntary gap” creditors, are granted second priority, followed by wages, consumer creditors, and taxes (including employment taxes and transfer taxes).

Consumer creditors refer to those who have deposited money in connection with the purchase, lease, or rental of property, or the purchase of services, for their personal, family, or household use, that were not delivered or provided. This can be equated to home-buyers, customers who paid advances for the purchase of goods/services, etc.

Once again, there is no distinction between financial and operational creditors.

  • Singapore Companies Act

Section 328 of the Singapore Companies Act (as also the Singapore Bankruptcy Act, 1995) gives the order of payment if the winding up order is passed in respect of the company. In all modes of liquidation (voluntary and compulsory), all unsecured creditors share ratably in the assets of the company subject to exceptions for secured and preferential debts. Secured creditors stand outside the liquidation and if the security is inadequate, they may prove as unsecured creditors for the balance. Priority has been given to costs and expenses of winding up, various payments to workers and employees and taxes.

Here too, the law makes no distinction as to financial and operational creditors.

  • The Companies Act, 2013, India

Section 326 of the Companies Act, 2013 prescribes overriding preferential payments, i.e. workmen’s dues and unpaid dues of secured creditor who has realized its security. Subject to the provisions of section 326, section 327 specifies priority for debts like government dues, employee dues, etc. Such debts (as specified in section 327) shall rank equally among themselves and be paid in full, unless the assets are insufficient to meet them, in which case they shall abate in equal proportions, and shall have priority over the claims of holders of debentures under any floating charge created by the company, and be paid accordingly out of any property comprised in or subject to that charge.

  1. Creditor classification under the Insolvency and Bankruptcy Code, 2016

IBC makes, for the first time, distinction between financial and operational creditors, while simultaneously retaining the conventional classification of being secured or unsecured. The unique distinction between financial and operational creditors under IBC is based on a recommendation of BLRC which states –

“The Committee deliberated on who should be on the creditors committee, given the power of the creditors committee to ultimately keep the entity as a going concern or liquidate it. The Committee reasoned that members of the creditors committee have to be creditors both with the capability to assess viability, as well as to be willing to modify terms of existing liabilities in negotiations. 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. The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors.”

Therefore, it was the “capability to assess viability, and willingness to modify terms of existing liabilities in negotiations”, which inspired BLRC to prefer the financial creditors over the operational creditors. The financial creditors were presumed to be strong creditors able to decide on matters regarding the insolvency of the debtor and who are willing to take the risk of postponing payments. The operational creditors are not expected to bear the burden of postponing payments, let alone foregoing the claims, partly or wholly.  This argument may, questionably, be relevant for determining the eligibility to be on the creditors’ committee. But should the distinction continue right upto distribution priorities? For example, related parties do not have a place on the committee of creditors, but that does not deny their right in the waterfall, where they are at par with other unrelated parties. This, in turn, paves way for unscrupulous debtors and their related creditors to misuse the machinery for their benefit, at the cost of unsecured operational creditors.

The irony is, the unsecured operational creditors, being placed last, will get a soupçon only after the financial creditors have filled up their bellies, to the extent the plate has to offer. In fact, in many cases, the operational creditors might end up no payment at all, because most insolvencies are deep enough. All because of the prioritisation contemplated under section 53, as discussed below – which besides being applicable in liquidation, is also relevant for ascribing liquidation values under resolution plan.

  1. Prioritisation of Creditors under Section 53

Section 53 is the relevant section dealing with priorities in liquidation under the Code. The stakeholders have been distinguished and ranked as follows –

  1. IRP and liquidation costs;
  2. Workmen’s dues (for 24 months), and secured dues, if the security has been relinquished;
  3. Employees’ dues (for 12 months);
  4. Unsecured financial creditors;
  5. Government dues, and unpaid dues to secured creditor, if the security has been realized;
  6. Remaining debts and dues [which include, unsecured operational debts];
  7. Preference shareholders;
  8. Equity shareholders.

Notably, distinction under section 53 is a two-fold distinction – (i) secured/unsecured, and (ii) operational/financial. As regards secured creditors, it does not matter whether the creditor is financial or operational, since section 53(1)(b) uses the expression “secured”, and there is no indication as to the nature of debt (financial/operational) owed to such secured creditor. However, when it comes to unsecured creditors, unsecured financial creditors appear in the 4th rank; but unsecured operational creditors come in the 6th rank.

  1. Equitability of Prioritisation under section 53

As seen above, the unsecured financial creditors have been raised above government dues, while unsecured operational creditors merely become a part of the residual entry. It is important to question as to what could be the basis for this discrimination? Contractually, unsecured financial creditors and unsecured operational creditors stand in the same ranking. Now, if the statute pushes the operational creditors to two notches below the unsecured financial creditors, it is important to question the vires of the statute in doing so.

The idea of BLRC to distinguish financial and operational creditors for constitution of committee of creditors is still understandable. The objective might have been based on the consideration that the operational creditors are many, and diversified, and therefore, they may not be in a position to vote on a resolution plan. In any case, many of them may not have the financial acumen required to understand and vote on resolution plans. But if the discussion stretches to priority ranking in the waterfall as well, then there are essential questions of principle to be raised.

The BLRC, in its report [page 14], states –

“The Committee has recommended to keep the right of the Central and State Government in the distribution waterfall in liquidation at a priority below the unsecured financial creditors in addition to all kinds of secured creditors for promoting the availability of credit and developing a market for unsecured financing (including the development of bond markets). In the long run, this would increase the availability of finance, reduce the cost of capital, promote entrepreneurship and lead to faster economic growth.”

The BLRC recommendation, as above, justifies the preferential treatment of unsecured financial creditors over government dues but does not provide any reasoning for not treating unsecured financial and operational creditors at par.

  1. Economic argument of operational creditors

As such, the prioritisation under section 53 fails to consider and appreciate the following –

(i) An economy runs not merely on the financial system, but on the system of supply of goods and services. Goods and services are supplied for credit, which is why operational creditors arise. Supply of goods and services on credit becomes a part of the working capital for the entity, which exactly serves the same purpose as served by financial lenders.

(ii) Supply of goods and services on credit is a crucial part of the economy. The base of the economy of any country is its real sector; financial sector is important, but not at the cost of the real sector. Suppliers of goods and services, including MSMEs, are a part of the real sector.

(iii) How will MSMEs continue to supply goods and services on credit to their customers, if they were to be told that if the customer goes into a default, all the money will go first to bankers, and money will be paid to the suppliers only if there is a surplus left?

 

  1. Concluding Remarks

For the reasons discussed above, the distinction between unsecured creditors, inter-se, does not appear to be intelligible; or even if it is intelligible, it lacks economic rationale. The approach for prioritisation under section 53 does not seem to be consistent with the umbrella objective of equitable treatment.

The vires of distinction between financial and operational creditors has already been challenged before the courts, with Calcutta High Court upholding such distinction [refer, Akshay Jhunjhunwala & Anr. v. Union of India through the Ministry of Corporate Affairs & Ors., W.P. No. 672 of 2017], and the Supreme Court directing the High Courts to refrain from entering the debate [refer, Shivam Water Treaters Private Limited v. Union of India & Ors., SLP No.1740/2018]. However, the way the distinction has percolated the priorities under section 53, is yet to be taken up for discussion and debate.

Can Liquidator’s Outreach Grab Guarantor’s Assets?

By Sikha Bansal  & Shreya (resolution@vinodkothari.com)

 

*The Article was first posted on the IndiaCorpLaw Blog (https://indiacorplaw.in/2018/07/can-liquidators-outreach-grab-guarantors-assets.html)

In Punjab National Bank v. Vindhya Vasini Industries Limited, [C.P. ( IB)-1170(MB)] the issue before the National Company Law Tribunal (“NCLT”), Mumbai Bench was whether a property belonging to the guarantor of the corporate debtor can be liquidated in the liquidation proceedings of the corporate debtor. The NCLT referred to section 60(2) of the Insolvency and Bankruptcy Code, 2016 (the “Code”) and held that the assets of the guarantor can be subjected to liquidation by virtue of the said section. The rationale given by the NCLT was that the financial debt in question was intricately linked with the property of the guarantor mortgaged under the same loan agreement on the basis of which the financial debt in question was sanctioned and hence cannot be segregated in the process of liquidation proceedings. Read more