Financial Exposure of Secured Creditors and the Relevance of Vertical Comparison in Resolution

[Richa Saraf is a Legal Advisor at Vinod Kothari Consultants Pvt. Ltd.]

An effective conduct of the corporate insolvency resolution process calls for an insight into the ranking of claims of various creditors. In most resolution plans, one finds that the financial creditors are paid a particular value as settlement of claims, and no specific provision exists as to how this amount is to be proportioned amongst various secured and unsecured creditors. Moreover, it is unclear if there will be any priority at all.

The more popular understanding is that any priority under section 53 of the Insolvency and Bankruptcy Code, 2016 is available only in the case of liquidation, and the law does not stipulate for any preferential treatment between the claims of secured and unsecured during the resolution process. Yet it is a well-established principle that while undertaking a resolution process of an entity, its creditors shall not be placed in a situation worse than what would have been in case the entity were to be liquidated. After all, failing this, there would be no point in resolving the entity. A comparison between a creditor’s entitlement in the resolution plan and in a hypothetical liquidation is referred to as “vertical comparison”.

Although there is no explicit provision calling for such a vertical comparison, inference may be drawn from section 6 of the UK Insolvency Act, 1986, which provides for challenge of decisions approving a voluntary arrangement on the ground that such arrangement has the effect of unfairly prejudicing the interests of a creditor, member or contributory of the company under Section 4A. The said rule was emphasised by David Richards J in Re T & N Ltd. (2004) as follows:

While I am wary of laying down in advance of a hearing on the merits of any scheme or [company voluntary arrangement (CVA)] any particular rule, there is one element which can be mentioned at this stage. I find it very difficult to envisage a case where the court would sanction a scheme of arrangement, or not interfere with a CVA, which was an alternative to a winding up but which was likely to result in creditors, or some of them, receiving less than they would in a winding up of a the company, assuming that the return in a winding up would in reality be achieved and within an acceptable time-scale: see Re English, Scottish and Australian Chartered Bank [1893] 3 Ch 385.

In Prudential Assurance Co Ltd v. PRG Powerhouse Ltd. (2007), while deliberating on the fairness of a company voluntary arrangement (CVA), Etherton J. said:

In broad terms, the cases show that unfairness may be assessed by a comparative analysis from a number of different angles. They include what I would describe as vertical and horizontal comparisons. Vertical comparison is with the position on winding up (or, in the case of individuals, bankruptcy). Horizontal comparison is with other creditors or classes of creditors.

Also, in Mourant & Co Trustees Ltd v. Sixty UK Ltd (In Administration) (2010),while relying upon the views expressed in Re T & N Ltd (above) and Powerhouse case (above), the Court stated as follows:

(c) In assessing the question of unfairness, a number of techniques may be used, including what may be described as – vertical and horizontal comparisons. A vertical comparison is a comparison between the position that a creditor would occupy and the benefits it would enjoy in a hypothetical liquidation, as compared with its position under the CVA. The importance of this comparison is that it generally identifies the irreducible minimum below which the return in the CVA cannot go.

Further, in the case of HMRC v. Portsmouth City Football Club (2010),the Court considered the validity of a CVA by examining whether it contravened the general principles of insolvency law by unfairly giving preferential treatment. Several parameters were laid down to regard a CVA as unfairly prejudicial:

(a) When considering whether or not any disadvantage resulting from the CVA is unfair, the court will consider both “vertical” and “horizontal” comparisons;

(b) When considering the results of a “vertical” comparison, if creditors in general, or a specific class of creditors, stand to receive less in the proposed CVA than they would have in liquidation, the CVA is likely to be regarded as unfair; and

(c) In relation to any “horizontal” comparison, the fact that the creditors were treated differently is something that would call for close scrutiny, but any differential treatment does not automatically make the CVA unfair.

The concepts of unfairness and prejudice are questions of fact. A court is extremely likely to find unfair prejudice and interfere in a CVA if it ‘fails’ the vertical comparison, i.e. if some creditors are to receive less in a CVA than they would on winding-up. It is, therefore, crucial that the company can demonstrate that the CVA will deliver a better result for creditors than a winding up to ensure the vertical comparison test is ‘passed’. 

Similar provisions also exist in the insolvency laws of US. Section 1129 (a) of Chapter 11 of the US Code lists down the minimum requirements which the reorganisation plan shall meet in order to be confirmed. One such requirement is:

(7)With respect to each impaired class of claims or interests-

(A) each holder of a claim or interest of such class-

(i) has accepted the plan; or

(ii) will receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date.

It is, thus, not possible to use a CVA (or for that matter, resolution plan) to modify any rights or to alter the priority of payment of a charge holder by unilaterally modifying any of the contractual provisions. It is unreasonable and unfair in principle to treat the secured creditors on par with unsecured creditors. Secured claims rank ahead of unsecured claims and the status should be maintained even in the event of insolvency, as regards the application of the proceeds of realisation of the assets, subject to certain preferred expenses such as resolution process costs.

Richa Saraf

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1 comment

  • CVA under UK insolvency is akin to scheme of composition under Companies Act 2013. IBC provisions have no parellels in UK insolvency law. Section 53 of IBC which deals with vertical stacking if applied to Resolution Plans creates an anomoly. Voting to Resolution plan is by majority in terms of value under IBC not in terms of number as in UK insolvency or Companies Act 2013 of India. In other words Majority in value may bulldoze a plan that may abrogate the contracts of minority creditors, as in many cases under vertical stacking Unsecured creditor recieves nothing in liquidation. Such interpretation may lead to every creditor demanding security virtually killing credit markets. I don’t think insolvency resolution under IBC is meant to create absurd results.


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