Protecting the Interests of First Charge Holders under the Insolvency and Bankruptcy Code

[Shivam Ahuja is a Final year B.A.,LL.B. at Jindal Global Law School, Sonepat]

Introduction

A charge as defined in section 2(16) of the Companies Act, 2013 is created over an asset to secure the repayment of a debt. The terms and conditions of the charge are governed by the contract between the parties. Some contracts allow for creation of a subsequent charge while some do not, while some warrant a no-objection certificate from the charge holder before the creation of a subsequent charge.Often the charges over an asset are also shared on a pari passubasis.A charge created over an asset has to be registered in accordance with section 77 of the Companies Act, 2013. Priority of charges has a significant role to play while realisation of the debt. The first charge holder is paid off first and then the second ranking charge holder and so on when the proceeds of an asset are realised to pay off debts. In other,words one can say that not only the amount of the debt, but also the priority thereof plays a significant role in determining which creditor will be paid of first.

The Insolvency and Bankruptcy Code, 2016 (IBC)provides for a robust mechanism for realisation of debts owed to creditors. While there is a difference of treatment between operational[1] and financial creditors[2] in the corporate insolvency resolution process (CIRP), there is no preference accorded to any particular class of creditors within the group of financial creditors. The committee of creditors(CoC)is formed after the submission of the claims by the creditors and the voting rights in the same are determined by the quantum of the debt the corporate debtor owes to various creditors. The proportion of the total debt determines the voting share of a creditor irrespective of whether the debt is secured or unsecured. The CoC is then required to decide on a resolution plan submitted by various resolution applicants failing which the company goes into liquidation. In the event of liquidation of a company the assets would be distributed according to section 53 of the IBC in which there is a hierarchy of payments which is more or less similar to the Companies Act winding up procedure, the principal difference being that government dues now rank lower as compared to the procedure followed under section 327 ofthe Companies Act, 2013. 

Analysis

The IBC does not provide for any preferential treatment to be given to creditors holding the first charge while preparing a resolution plan. In such a scenario,creditors holding the first charge on asset might be at the losing end after the completion of the CIRP where a resolution plan is approved. Consider a scenario where there is a piece of property on which there are multiple charges. When the company goes into a CIRP, the subsequent ranking charge holders may act in concert and have a resolution plan passed that treats them in a favourable manner to the detriment of the first charge holders. As the requirement to get a resolution plan passed has been lowered to 66 percent from 75 percent under the Insolvency and Bankruptcy (Amendment) Ordinance, 2018, this task has become even simpler.

The above situation arises because all creditors irrespective of the quality of their debt are given equal voting rights based on the quantum of the debt. If there was a provision made to give proportionately more voting rights to first charge holders such a scenario could be very well avoided.

Also, consider a scenario where a corporate debtor is aware of the financial condition of the company and has an indirect say in the CoC. For instance,the corporate debtor may create a second ranking charge on an already charged asset and show a loan in its books. By having a debt, such a creditor will have a say in the CoC, but that creditor might vote in a manner that enables actions that are beneficial to the corporate debtors and its promoters rather than to the creditor body as a whole. Even though sections 43 to 50 of the IBC provide a remedy for such a situation, no intervention may be possible if the transaction is carried out at an arm’s length basis. Also,it is for the resolution professional (RP)to identify such transactions; but if the RP misses such transactions, there is a recourse given to the creditors to file for the same but that is limited to the circumstances listed in section 47 of the IBC.

The National Company Law Tribunal (NCLT)was asked to adjudicate in a matter[3]where the resolution plan submitted for approval of the NCLT had divided creditors into two classes:one class had creditors who had the first pari passucharge on assets and the second class included creditors who had a second or subsequent ranking pari passucharge on assets. The resolution plan favoured the first class and it was argued by the opposing party that such a distinction is not allowed under the IBC as all creditors should be given equal treatment under the IBC and hence the distinction is discriminatory. The NCLT,by approving the resolution plan,held that such a distinction is allowed under the IBC as it has a rational basis for distinction based on the priority of charges and is therefore not discriminatory.   

The above discussion shows that the NCLT is not against such a distinction where first charge holders are preferred over the subsequent charge holders. However, one should understand that this preferential treatment is contingent to the resolution plan which is approved by the CoC and nowhere in the IBC or its rules is it stated that this kind of a class ought to be created for creditors holding the first charge.

Conclusion

The IBC is still work in progress.  Amidst all the amendments that are being brought to the IBC, a necessary change should be brought to protect the interest of the creditor who holds the first charge over the assets of the corporate debtor. The present mechanism leaves a loophole where the interests of the creditors holding first charge could be side-lined, especially when the threshold to approve a plan has been reduced from 75 percent to 66 percent.

The above problem can be addressed by two alternative routes. The first is to give first charge holders more voting rights than those given to secondary charge holders. This will ensure that the first charge holders have a greater say in the CIRP and hence they would themselves be capable protecting their interest. On the contrary,bringing such an amendment can give rise to another set of issues. If the first charge holders are given proportionately more voting rights that might lead to a situation where creditors holding the first charge would be willing to approve a plan where they are the ones most benefiting and would not care about the interest of the subsequent charge holders. Therefore this solution has the chances of acting as a double-edged sword.

The other alternative is to mandate such a provision in the IBC. For example sub section (2) of section 30 of the IBC provides a checklist for the adjudicating authority to consider before approving a resolution plan. Hence,a requirement such that the resolution plan should protect the interests of the first charge holders prior to that of the subsequent charge may be added. Further this requirement may not be directly inserted in this section. Section 30(f) of the IBC states that the plan submitted should conform to such other requirements as may be specified by the insolvency board. Therefore such a requirement of preferential treatment to first charge holders can also be brought by incorporating the same in the insolvency rules made under the IBC. Such a solution will protect the interest of the first charge holders without leaving scope for its misuse.

– Shivam Ahuja

[1]The Insolvency and Bankruptcy Code, 2016, section 5(7) (2016); “operational creditor” means a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred to.

[2]The Insolvency and Bankruptcy Code, 2016, section 5(7) (2016); “financial creditor” means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to.

[3]Sree Metaliks Limited v. SREI Equipment Finance and Engineering Limited, 2017 SCC OnLine NCLT 6812.