Inter-se Ranking of Creditors – Not Equal, but Equitable

-Megha Mittal, Associate and Prachi Bhatia, Legal Intern 

(resolution@vinodkothari.com)

Insolvency laws, globally, have propagated the principle of equitable distribution as the very essence of liquidation/ bankruptcy processes; and while, “equitable distribution” is often colloquially read as “equal distribution” the two terms hold significantly different connotations, more so in liquidation processes – an ‘equitable distribution’ simply means applying similar principles of distribution for similarly placed creditors.

Closer home in India, the preamble of the Insolvency and Bankruptcy Code, 2016 (‘Code’/ ‘IBC’) also upholds the principles of equitable distribution – thus balancing interests of all stakeholders under the insolvency framework. Judicial developments have also had a significant role in holding such equity upright[1]. However, in the recent order of the Hon’ble National Company Law Appellate Tribunal, in Technology Development Board v. Mr. Anil Goel[2], the Hon’ble NCLAT has refused to acknowledge the validity of inter-se rights of secured creditors once such security interest in relinquished in terms of section 52 of the Code.

In what may potentially jeopardize interests of a larger body of secured creditors, the Appellate Authority held that inter-se arrangements between the secured creditors, for instance, first charge and second charge over the same asset(s), would not hold relevance if such secured creditors choose to be a part of the liquidation process under the Code – thus placing all secured creditors at an equal footing. The authors humbly present that the instant order may not be in consonance with the established and time-tested principles of ‘equitable’ treatment of creditors. The authors opine that contractual priorities form the very basis of a creditor’s comfort in distress situations – as such, a law which tampers with such contractual priorities (which of course, are not otherwise hit by avoidance provisions) in those very times, will go on to defeat the commercial basis of such contracts and demotivate the parties. This, as obvious, cannot be a desired outcome of a law which otherwise delves on the objective of ‘promotion of entrepreneurship and availability of credit’. The authors have tried putting their perspective in this article.

Analysis

In the instant case, the liquidator distributed sale proceeds to the first charge holders in priority to the Appellant, a second charge holder. The issue raised before the Hon’ble Tribunal was whether the liquidator could appropriate all proceeds to satisfy claims of first charge holders instead of a pari-passu distribution to all the secured creditors. All the creditors in questions had relinquished their respective security interests under section 52 of the Code, and as such subscribed to participation in the common pool of assets to be realised under the liquidation process. Hence, the moot issue was whether the priority inter-se secured creditors would continue to operate once the security interests have been relinquished.

 The schematics of the Code categorise secured creditors in two types – (i) those who desire to go before the Company Court; and (ii) those who like to stand outside the winding up.[3] The category in which the secured creditor will fall is dependent on the path taken by it in the event of liquidation – either to relinquish its security interest to the liquidation estate and receive proceeds from the sale of assets as per waterfall mechanism engrafted in sec 53 or realise security interest as provided in sec 52. The difference between these two sections is that under sec 52 the security interest can be exercised only in relation to the asset which has realisable security interest while under sec 53 the secured creditor will get his claim settled from the proceeds of the sale of all the pooled liquidation assets.[4] The secured creditors who relinquish their claims follow only liquidation costs under the waterfall mechanism under section 53 of the Code[5], standing in priority to a secured creditor who chose to enforced his security and has unpaid part of claim.

Whether ‘relinquishment’ makes any difference

At the outset, it may also be noted that the position would remain the same, irrespective of whether the asset is realised or relinquished by secured creditor. In fact, as noted in ‘Secured Creditors under the Insolvency Code: Searching for Equilibrium’, by Vinod Kothari and Sikha Bansal[6], realisation and relinquishment cannot be so drastically different as to lose their alternative mutuality. The self-help realisation of a secured asset by a secured creditor may be a good guide to understanding the sweep and extent of a relinquishing secured creditors’ priority in the common hotchpot, viz., the liquidation estate.

The authors there categorically state:

“relinquishment cannot allow the secured creditor to go beyond the value of his own secured asset and give him a disproportionate right in the common hotchpot – the liquidation estate. In essence, we get a strong view that priority under section 53(1)(b) in case of relinquishment is not substantially different from a ‘substitution’ option – that is, making the asset a part of the common pool and claiming priority over the value of the asset. But then, the key element in case of relinquishment also is the value of the asset. In essence, the option of realisation under section 52 or relinquishment under section 53(1)(b) will both have to be delimited by the value of the secured asset.

         …

Therefore, if a secured creditor, or even all secured creditors, relinquish security interest, their collective claim for pay-off under section 53(1)(b) would be limited to the value of the secured asset or secured 134. Any payment to a secured creditor beyond such ‘value’ would tantamount to respecting a right which never existed. The principle will apply in both the cases – the ‘priority’ entitlement of the secured creditor would be limited to the ‘value’ of secured asset and would be subject to ceding a proportion in favour of the workmen. As such, section 53(1)(b) cannot be used so as to have the full cake while paying for only a part of it.”

 Therefore, if a secured creditor, or even all secured creditors, relinquish security interest, their collective claim for pay-off under section 53(1)(b) would be limited to the value of the secured asset or secured

Judicial Precedents and the ILC Report

While the Code provides the secured creditors with the option to proceed under the Code (or not), it is important to note that the Code is silent on treatment of sustainability and validity of inter-se rights and priorities of secured creditors. Hence, reference may be drawn to the long-standing judicial precedents and reports issued by expert committees.

The question whether the first/second ranking amongst secured creditors at all remains, or all secured creditors will be of the same ranking, has been discussed by the Hon’ble Supreme Court, in context of similar provisions under the Companies Act, 1956, in the case of ICICI Bank v. Sidco Leathers Ltd,^[7] The Apex Court held that –

“ …. Section 529-A of the Companies Act does not ex facie contain a provision (on the aspect of priority) amongst the secured creditors and, hence, it would not be proper to read thereinto things, which the Parliament did not comprehend. The subject of mortgage, apart from having been dealt with under the common law, is governed by the provisions of the Transfer of Property Act. It is also governed by the terms of the contract.

 xxx

 ….Merely because Section 529 does not specifically provide for the rights of priorities over the mortgaged assets, that, in our opinion, would not mean that the provisions of Section 48 of the Transfer of Property Act in relation to a company, which has undergone liquidation, shall stand obliterated.” (emphasis supplied)

 The observations of the Hon’ble Supreme Court were also adopted by the Insolvency Law Committee Report in it is report dated 26^th March, 2018[8] (‘ILC Report’) wherein the Committee comprehensively dealt with the issue of subordinate claims. The Committee concluded that “a plain reading of section 53 was sufficient to establish that valid inter-creditor and subordination provisions are required to be respected in the liquidation waterfall under section 53 of the Code”[9]

While the Report further stated that the valuable property rights of secured creditors[10] that would be extinguished if the inter-se rights were to nullify on account of relinquishment of security interest under the Code, the Hon’ble NCLAT, in the instant matter, held that the non-obstante clause of section 53 of the Code would override such property rights granted under the Transfer of Property Act and/ or any other central/ state laws. The authors humbly submit that such an argument should not sustain as it would be in stark contrast with the order of the Hon’ble Supreme Court in ICICI Bank Limited v. Standard Chartered Bank & Ors[11] wherein the Apex Court was pleased to hold that –

“72. Apart from the fact that there is no provision of the Code which abrogates security interest during insolvency resolution, the field continues to be occupied by settled law protecting sanctity and inter-se priority rights amongst creditors on the basis of security interest inter alia under the Transfer of Property Act, 1882. These principles and provisions, not being in conflict with the provisions of the Code, are not overridden on account of Section 238 of the Code – the latter coming into play only in the event of conflict.

73…… Respectfully, an insolvency law must protect and preserve the pre-insolvency rights and differential bargains entered into by the creditors” (Emphasis Supplied)

Going further back in time, it is important to note that the Hon’ble Supreme Court in Workmen of M/s. Firestone Tyre and Rubber Co. of India (P.) Ltd. v. Management and Ors[12] identifying the valuable right of property of the first charge holder held that-

“Such a valuable right, having regard to the legal position as obtaining in common law as also under the provisions of the Transfer of Property Act, must be deemed to have been known to the Parliament. Thus, while enacting the Companies Act, the Parliament cannot be held to have intended to deprive the first charge holder of the said right. Such a valuable right, therefore, must be held to have been kept preserved.”

 Not only during the pre-IBC regime, Supreme Court in Standard Chartered Bank v. Satish Kumar Gupta, R.P. of Essar Steel Ltd. & Ors has upheld differential treatment of a financial creditor which did not have any charge or security on the project assets but had advanced large sums on the basis of pledge over the shares of an offshore entity  and a corporate guarantee extended by the corporate debtor. Further, even if the corporate guarantee were to be enforced, such creditor would at best stand as ‘secured creditor’ only to the extent of the value of shares of the offshore company as on the date of enforcement of the guarantee and an unsecured creditor with respect to rest of the loan advanced by it. The SC, in Essar, has deliberated extensively on global authorities, guides, and declared that “equitable” does not mean equal distribution; it means distribution which does justice to every stakeholders involved in the process.”

Treating all secured creditors at par, without looking at the priority they struck with the debtor before insolvency, would not only undermine the well-settled commercial/legal principles, but also go against the verdict of SC.

(Ir)relevance of Section 53

Section 53 (2) of the Insolvency and Bankruptcy Code, 2016 provides:

“Any contractual arrangements between recipients under sub-section (1) with equal ranking, if disrupting the order of priority under that sub-section shall be disregarded by the liquidator” (Emphasis supplied)  

The stress is clearly on the words “with equal ranking”. If there are security interests of equal ranking, and parties have contracted that one will be paid in priority to the other, such contract will be disregarded in liquidation. The whole stance in liquidation proceedings is to ensure equitability. However, the idea of proportionality is only as far as claims of similar ranking are concerned. Further, a second charge is a charge on residual value, that is, value left after paying off the first charge holder. The first charge holder has a charge on the asset; the second charge-holder has charge over the remainder of the asset, remaining after settling the claims of the first charge holder. In that sense, the charges are sequential, and not proportional[13].

Thus, to argue that subordinate creditors shall enjoy the same rights as first charge holders, by virtue of section 53 of the Code would not sustain, as the law itself provides equal footing to creditors only with “equal ranking”.  Creditors with ‘unequal ranking’ cannot be put in equal footing.

Global Position

The Indian jurisprudence in this regard is not unique. Global authorities have recognised as well as emphasised on the need for protecting respective contractual bargains entered into between debtors and creditors. The UNCITRAL Legislative Guide on Insolvency Law puts it straight – “

“4. Ensuring equitable treatment of similarly situated creditors

7. The objective of equitable treatment is based on the notion that, in collective proceedings, creditors with similar legal rights should be treated fairly, receiving a distribution on their claim in accordance with their relative ranking and interests. This key objective recognizes that all creditors do not need to be treated identically, but in a manner that reflects the different bargains they have struck with the debtor.”

Further, “Equality of distribution is the theme of a Bankruptcy Act and a prime bankruptcy policy. The bankruptcy system is designed to distribute an estate as equally as possible among similarly situated creditors. Thus, creditors of equal status must be treated equally and equitably.[14]”

Under section 506 of the US Bankruptcy Code, an under-secured creditor’s claim into two parts: he has a secured claim to the extent of the value of his collateral; and he has an unsecured claim for the balance of his claim. See In re Kelvin Ray Moore [Case no. 01-22864 SBB].

Similarly, the UK Insolvency Act states that in bankruptcy, a debt is secured to the extent that the person to whom the debt is owed holds any security for the debt (whether a mortgage, charge, lien or other security) over any property of the person by whom the debt is owned – section 383.

Conclusion

The creation of inter-se rights between secured creditors is possibly one of the most prevalent transaction in the credit world. Also, the fundamental difference between ‘pari-passu charges’, ‘first charges’, ‘residual charges’ is well-known. If a party creates first charge on properties of the debtor, contemplating a situation that in case the debtor goes in distress, the creditor will have first right on that property, what is the use of such a contract, if the same property is made fungible on insolvency of the debtor? Thus, intermixing security of differently-placed creditors and disregarding differential rights of such creditors will shake the very foundation of commercial basis of having a ‘security’ at the first place.

Priority rights bargained by secured creditors while entering into contracts, are meant to be silver lining in the cloud. Disrespecting the priority rights in insolvency will lead to chaos and would go on to demotivate availability of credit at low prices. Just as recently happened in Gujarat Urja Vikas Nigam Limited[15], where the debtor was allowed to retain a valuable contract needed for its survival as because the deprivation was sought only because of insolvency of the debtor; similarly, a creditor cannot be (and should not be) deprived of its valuable priority rights solely because the debtor is in insolvency.

[1] See, Standard Chartered Bank v. Satish Kumar Gupta, R.P. of Essar Steel Ltd. & Ors; Binani Industries Limited v. Bank of Baroda & Anr;  Swiss Ribbons Pvt. Ltd. & Anr v. Union of India & Ors,

[2] https://nclat.nic.in/Useradmin/upload/1116383502606bf2db5f368.pdf

[3]Allahabad Bank vs Canara Bank, 2000, https://indiankanoon.org/doc/677551/

[4] See http://vinodkothari.com/wp-content/uploads/2019/01/Relinquishment-of-Security-by-a-Secured-Creditor.pdf

[5] Sec 53 (1)(b)(ii)

[6] Chapter 13 – (Page 129 to 141) https://www.ibbi.gov.in/uploads/whatsnew/2020-10-01-210733-43cms-9224c9b668aac0d6149a5d866bfb4c79.pdf

[7] [(2006) 10 SCC 452] https://indiankanoon.org/doc/1450918/

[8] https://www.ibbi.gov.in/uploads/resources/ILRReport2603_03042018.pdf

[9] Para 21.6

[10] Under section 48 of Transfer of Property Act

[11] https://www.livelaw.in/pdf_upload/pdf_upload-365672.pdf

[12] https://indiankanoon.org/doc/1129598/

[13] See detailed discussion on distribution to secured creditors under liquidation – http://vinodkothari.com/wp-content/uploads/2020/04/Section-53-of-IBC.pdf

[14] American Jurisprudence, 2d, Volume 9

[15] https://ibbi.gov.in/uploads/order/79e3093d3be5f907a06411924f0a6b62.pdf