[Surbhi Soni is a third year student at the National Law School of India University, Bangalore]
The Insolvency and Bankruptcy Code 2016 adopts the conventional court-mediated contract enforcement mechanism for debt resolution and restructuring of a corporate debtor. The basic principle of such resolution is that it mirrors the application of a predetermined (or ex ante) contractual bargain between the creditors and the corporate debtor. It has been referred to as a negotiation behind the Rawlsian ‘veil of ignorance’.
In Committee of Creditors of Essar Steel India Ltd v Satish Kumar Gupta, the Supreme Court clarified regulation 38(1a) of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 and section 30(2) of the Code to hold that ‘equitable treatment of all classes of creditors’ does not amount to paying them an equal amount in the corporate insolvency resolution process (CIRP). The Court upheld the ex ante contractual position, and reversed the National Company Law Appellate Tribunal’s (NCLAT) decision. The NCLAT had held that the resolution plan approved by the committee of creditors (CoC) could be modified for being discriminatory and failing to treat operational creditors (OCs) at par with financial creditors (FCs). The Court, in reversing NCLAT’s ruling, maintained the distinction between the two types of creditors.
Corporate Restructuring: US, UK and India
In the United States, pursuant to chapter 11 of the Bankruptcy Code, 1978, the incumbent management of the company continues and steers the company through the restructuring. This is known as the debtor-in-possession model, and vests faith in the fiduciary duties of the management. Conversely, the UK follows a trustee model, wherein appointed receivers take charge of corporate restructuring under the Insolvency Act, 1986. To ensure fair and objective governance at this crucial stage, the pre-insolvency management is ousted from the process. The Indian model of corporate restructuring is markedly different from that in the aforementioned jurisdictions. Once insolvency proceedings are triggered, a trustee-resembling (interim) resolution professional (RP) works under the shadow of the CoC. The RP’s scope of authority is quite limited compared to a trustee’s, since section 28(1) provides a list of decisions for which she requires the prior approval of the CoC.
Statutory protections for operational creditors in status quo
The Essar Steel Court’s differential treatment of operational creditors is not unprecedented. In fact, it is inspired by the Code itself. At crucial places, the Code defers to the authority of FCs to the exclusion of operational creditors. First, OCs are not members of the CoC. The CoC is vested with the ultimate responsibility of approving a resolution plan under section 30(4) of the Code, based on its feasibility and viability, which is finally presented for confirmation before the National Company Law Tribunal (NCLT). However, if their debts exceed 10 percent, OCs have an entitlement to notification and attendance of the meetings of CoC (section 24(3)(c)). Second, if the company is liquidated, under the waterfall mechanism, OCs are paid after financial creditors, workmen, government taxes, etc., are paid off, as their claims fall in the category of ‘any remaining debts and dues’ under section 53(1)(f). Further, even policy guidance for the Code was biased towards FCs. The precursor to IBC, the BLRC Report (Vol. I, p. 105) itself suggested that, between two reasonably similar proposals, the CoC must choose the one that minimises adverse impact on non-secured creditors. However, if a proposal with a much higher realization value is tabled, the CoC must be indifferent to adverse impact on non-secured creditors.
Since OCs are thus excluded from the process of corporate restructuring, the Code guarantees them a certain minimum in every approved resolution plan. Thus, under section 30(2)(b)(i), every resolution plan must provide for the OCs to receive the minimum amount they would receive, if the corporate debtor was liquidated. However, due to the hierarchy of the waterfall mechanism, the statutory minimum is extremely inadequate. It further becomes redundant in cases where the OCs’ dues under the waterfall would amount to nil. For instance, in State Bank of India v Alok Industries(March 2019), the resolution plan submitted to and approved by the NCLT Ahmedabad stated that ‘since liquidation value is estimated for the Corporate Debtor (Rs. 4,433 crores) is insufficient to cover the financial creditors in full, the liquidation value that is due to the operational creditors including the government dues (“OC”) is calculated as NIL. Resultantly, no payments are proposed to be made to OC’ (paragraph 21). In such cases, acquirers often pay a limited amount to OCs whose debts fall below an arbitrarily-determined minimum threshold. Thus, in Alok Industries, OCs with debt below Rs. 3 lakhs were compensated in full, while OCs with a debt corpus of about Rs. 592 crores were not given any amount.
Policy reasons for differential treatment
Corporate restructuring is tilted in the favour of financial creditors as, first, it respects predictability of ex ante contractual bargains struck between different creditors and the corporate debtor (Legislative Guide on Insolvency Law (2004), page 13, paragraph 7). Such predictability in turn serves the goal of economic efficiency: by honoring security interests of financial debts, credit is made more accessible. When financial institutions are reassured about repayment, their likelihood of issuing credit on favourable terms such as low interest rates and long maturity periods is enhanced. This supports financial expansion of corporations, and strengthens financial systems of the country (Essar Steel, page 91). Second,it is feared that FCs would prefer voting for liquidation rather than restructuring and debt resolution of the corporate debtor if all types of creditors are treated equally and not equitably (Essar Steel, page 89). Thirdly, at the level of quotidian functioning of a corporation, operational creditors have a much better chance of reciprocating payment defaults by corporate debtor, by stopping the supply of goods and services to it (Essar Steel, page 89). This is in contrast to the FCs who enter into long-term contracts and cannot exit at will. Their recovery mechanism is tied to the broader financial system where they must undertake disclosures of non-performing assets and restructuring their loans by incurring haircuts. Finally, as a matter of practice, as noted by the Supreme Court in Swiss Ribbons Pvt Ltd v Union of India (paragraph 27), the quantum of dues of FCs is usually much higher compared to that of operational creditors.
Impact of differential treatment
Thus, while there are obvious benefits to the precedence granted to FCs, the fallouts of the system are manifold as well. Operational creditors are, as a class, likely to reinvent business models. The NCLAT in Binani Industries Limited v Bank of Baroda (2018) noted that ‘if one type of credit is given preferential treatment, the other type of credit will disappear from market. This will be against the objective of promoting availability of credit’ (paragraph 17). Thus, OCs may demand advance payments for provision of goods and services, or they may simply be more reluctant to provide large amounts of credits. This is because credit markets function such that creditors are likely to adjust to favoured creditor classes. Since unsecured creditors do not have adequate protection anymore, especially after Essar Steel, functioning as OCs will be viewed with skepticism. It is needless to say that FCs are parochial to their approach to CIRPs. They are bound to principally focus on debt recovery, indifferent to its effects on various other stakeholders, whether operational creditors, or employees.
When, for example, Alok Industries Ltd. was speculated to be heading towards liquidation, 12,000 of its employees sought relief before the NCLT. They maintained that lenders (CoC) readily steer towards liquidation where their financial expectations are ill-met, oblivious to its collateral damage. This offers insight into the fact that the CoC is often oblivious to the non-financial concerns of a company. Thus, it will be unwise to suggest that CoC, as presently conceived, may be apprised with and entrusted with the job of protecting business models of OCs. Further, in the sectors which operate with a much higher level of operational credit than financial credit (such as the airlines sector), OCs playing a second fiddle and enhanced risk exposition is simply unviable. Trust between corporations forming a supply chain has resulted in very strong businesses in the past. However, as presently conceived, the Code erects barriers to how far that relationship can grow.
An empirical case for protection of OCs
The Essar Steel Court referred to the Insolvency Committee Report 2018 to substantiate its decision to uphold the differentiation between difference classes of creditors. The Report stated that, at the time of drafting, ‘most of the resolution plans are in the process of submission and there is no empirical evidence to further the argument that operational creditors do not receive a fair share in the resolution process under the current scheme of the Code’ (paragraph 18.5). Decided almost 20 months after the Report, the Court in Essar Steel did not attempt to inquire into empirical data of resolution processes, and was convinced that the statutory minimum ensured to the OCs is a sufficient safeguard. The data below is a compilation of five resolution plans approved by the NCLT.[i] It illustrates a need to revise our fundamental assumptions about rights of operational creditors in CIRP. It seeks to provide evidence of treatment of OCs in resolution plans, the lack of which convinced the Insolvency Committee as well the Supreme Court to maintain the status quo with respect to OCs. With the exception of the Bhushan Steels Ltd acquisition, OCs categorically come out worse-off from CIRPs.
[1]In the Resolution Plan of Ruchi Soya Ltd (July 2019), against the total admitted debt of Rs. 12,146 (all figures in this section are in crores), the acquirer Patanjali Ayurved Ltd paid Rs. 4,093 to FCs, satisfying 43.2% of their debt claims (9,454), while only Rs. 90 to OCs, satisfying merely 3% of their claims (Rs. 2,716).
[2] In the Resolution Plan of Alok Industries Ltd (March 2019), Reliance Industries Ltd-JM Financial Asset Reconstruction Ltd paid a total of Rs. 6,252 against the total debt of Rs. 30,279. Out of this, FCs recovered Rs. 5,052, or 17% of their debt claims (Rs. 29,614), while the OCs were given no amount at all, recovered NIL, against their debt claims of Rs. 592. The OCs with very small debt claims, below Rs. 0.3 were however, repaid.
[3] In the Resolution Plan of Essar Steel India Ltd (November 2019), finally approved at the Supreme Court, Arcelor Mittal India Pvt Ltd agreed to pay Rs. 42,000, satisfying 77.8% of FCs’ debt at Rs. 38,302.7. Against this amount, OCs with a debt corpus of Rs. 3,339 were given Rs. 1,000 (about 29%), while OCs with claims below Rs. 196 were recovered in full.
[4] In the Resolution Plan for Amtek Auto Ltd (July 2018), Liberty House Group paid Rs. 3,225 to FCs, against their admitted debt of Rs. 12,312 (26%), while OCs were paid a sum of Rs. 50 against their debt of Rs. 224 (22%).[ii]
[5] In a respite to OCs, in the Resolution Plan of Bhushan Steels Ltd (May 2018), Tata Steel Ltd paid Rs. 1,200 against the admitted operational debt of Rs. 1,332. Thus, OCs recovered 90% of their claims. FCs were paid Rs. 35,200 against their debt of Rs. 56,080, satisfying 67% of their claims.
Going forward
From the above sections, it is clear that there is merit to honouring debt claims of FCs. However, it is also apparent that OCs are not granted any proportionate protections in lieu of their deprioritized debt claims. This conflict can be resolved by ensuring OCs’ representation at the CoC. Representation of all classes of creditors is also recognized in international policy documents on insolvency. The World Bank and UNCITRAL’s Creditor Rights and Insolvency Standards recommends appointment of multiple creditor committees where creditor categories and interests are diverse (page 27, paragraph 129). Towards that, the author suggests two statutory amendments.
First, the statutory limit under section 24(3)(c) of the Code must be lifted. Thus, regardless of the percentage of debt owed, OCs must be allowed to appoint a minimum number of representatives to the CoC (proportionate to its size). Second, OCs, as a class, must be allowed to seek pro-rata voting rights in the CoC, by making a representation before the NCLT where the admitted operational debt is above 10 percent of the total debt (the present statutory threshold at which OCs are entitled attendance to CoC). Towards that, the Code must entitle OCs with a right of hearing before the NCLT once the RP has admitted debt claims. By including OCs in the CoC, the revered concept of ‘commercial wisdom of creditors’ will expand to become more representational and holistic. The fallouts of any resulting delays in the process may be outweighed by the outcome of the process: a dynamic and improved resolution plan, that, at least seeks to balance the interests of most of the stakeholders. In light of data from some resolution plans, there is a discernible need to facilitate such representation. It is then perhaps time for corporate insolvency in India to move from a Rawlsian ex ante contractual enforcement towards an inclusive ex post response to corporate crises.
– Surbhi Soni
[i] The short sample size was chosen to analyse some recent and major corporate acquisitions, each exceeding INR 10,000 crores in corporate debt. It is collected from the IBBI website and looks at resolution plans approved by NCLT, available at https://ibbi.gov.in/orders/nclt.
[ii] NCLAT had ordered liquidation of Amtek Auto Ltd after Liberty House withdrew. The Supreme Court has now reordered corporate restructuring.
