The Costs and Benefits of Creditor Control under Insolvency Law

[Guest post by Enakshi Jha, who is a graduate from NALSAR University of Law and is currently working at a corporate law firm in Mumbai]

The principal benefit of a creditor controlled insolvency law is the efficiency it brings to the market and the advantages it holds for entrepreneurship. First, as a model spearheaded by the persons whose money is at stake (section 6 of the Insolvency and Bankruptcy Code, 2016 (“IBC”)) allows creditors to initiate insolvency proceedings), creditors are bound to take effective action to recover their dues. Further, under section 12, this model assures them of a timely mechanism to recover their money themselves, instead of relying on lengthy court proceedings. This can also serve as an incentive for them to lend money again, despite having witnessed insolvency in their prior experiences.  It also helps in bringing down the cost of credit in the market, because when more creditors are willing to provide financing to businesses, the cost for each will reduce due to increased supply (in the form of lower interest rates and longer repayment periods). This will lead to competition amongst lenders and ultimately allow many small businesses to enter the market, leading to healthier competition at multiple levels, which ultimately benefits the consumer (in this case the corporate debtor). Such measure can also have a positive impact on investor confidence, leading to more growth in the market, which means creditors will get their dues and interest in a timely manner, with a lower chance of default in payment.

Secondly, this move is also helpful to other stakeholders in the debtor company, such as the employees or shareholders. Ensuring control of creditors enables the Resolution Applicant (i.e. one who proposes a resolution plan) and the Committee of Creditors (“Committee”) to formulate more efficient means of recovery and allows them their much-needed space for re-organizing the business in the hope of recovering pending dues, provided it is approved by the Adjudicating Authority (being the National Company Law Tribunal (“NCLT”)). The Committee can approve a Resolution Applicant’s plan by passing it with a 75 percent majority of the financial creditors under section 30(4). If such measures are successful due to a timely interjection, they will also prove to be beneficial to the employees and shareholders of the company. Hence, such a model has the potential of partially safeguarding their interests as well.

Shifting this onus on the creditor from the debtor also gives the creditors an incentive to take a greater interest in developments relating to, and performance of, the debtor. In this situation, unlike the past where creditors could only pursue separate suits for recovery, there is greater scope for recognizing the red flags that could lead to insolvency and, in a way, this provides for a buffer where creditors can also act as whistle-blowers to safeguard their own money and interests. This, in turn, can draw public and investor scrutiny, forcing the debtor company to pull up its socks to stave off a possible insolvency.

Allowing the creditor to trigger insolvency proceedings (under section 6) that ultimately leads to the appointment of a Resolution Professional (who is a third party) to whom the management will report during the period of moratorium can best diffuse the tension and ensure the management does not commit any wrong or action leading to greater inability to repay its dues. Further, the management or board of directors also cede their powers to the Resolution Professional, thereby falling directly under the control of the creditors under section 28 of the Code.  The Committee of Creditors also has the right to replace Resolution Professionals where they feel he/she is not performing their duty under section 27. This tool can be used to ensure absolute transparency in the process (as seen through the lens of the creditors).

An added benefit of creditor-control is that the Code attempts to establish a level playing field for both secured and unsecured creditors, as the definition of “creditor” under section 3(10) includes both classes. Further, under section 53(1)(b), upon initiating liquidation, assets are divided equally between unsecured creditors and debts owed to a secured creditor when it has relinquished his security. Doing away with a classical separation between creditors also eases implementational problems of recovery as, often, financial creditors such as banks may find that the secured assets are no longer available and any inventory that could serve as collateral is not of much value. This may lead to further dispute between the creditors, leaving unsecured creditors with minimal chances of recovery of debts. Previously, even when any recovery occurred through a sale of assets, it was often stalled by pending litigation or income tax disputes and continued for years, furthering the divide between creditors.

On the other hand, there are also certain flaws with this model. First, the Creditors Committee does not give operational creditors the right to vote, as section 21 remains silent on operational creditors’ right to vote (unless they form the Committee themselves). Section 24(4) grants voting power to the financial creditors but does not include operational creditors within its ambit. They can merely attend meetings, if they are above the specified threshold, but have no voting power. By keeping their involvement away, operational creditors may lose any faith or incentive to help in ensuring that the debtor’s business is run properly, and this could hamper any plan for revival as proposed by the Committee or Resolution Applicant.

Secondly, under section 28(3), every decision taken by the Committee needs to be passed by a 75 percent majority vote, instead of a simple majority. While such decisions are binding on all creditors and the debtor, this threshold may be cumbersome to attain when all creditors are not in agreement with each other and may lead to a delay in the proceedings, and in practical implementation.

Thirdly, while anyone can propose a plan for revival within 180 days, the Code does not provide any clarity regarding the structure or minimum requirements of this plan, leaving it ambiguous. It could include sale of assets, management changes or a mixture of both, but this has not been elucidated. It is important to be cognizant of the requirements set forth under section 30(2) that specify the skeletal structure of the Resolution Plan. This provision merely specifies broad parameters, and does not clarify any available options or methods for implementing the same. While this provides flexibility to the plan, it remains precarious as the resolution plan is contingent upon its approval by the NCLT. If the NCLT finds the renewal plan too ambitious or risky, under section 33(1)(b) it may reject the same, leading to an automatic liquidation, instead of revival of an insolvent company. Conferring the creditors with the power to choose between revival and liquidation can also be dangerous as they may only see short term returns, in terms of repayment of debt, and not the potential of growth later or the scope of renewal, unless there has been a conversion of debt to equity and creditors have an incentive to focus on long term benefits. Hence, while the intent of the Code is to be celebrated, there may be possible obstacles in implementation.

– Enakshi Jha