Analyzing the Conundrum of Priority inter-se Secured Creditors during Liquidation

[Nishant Nagori and Divyani Saldi are 2^nd year students at Rajiv Gandhi National University of Law, Punjab]

The raison-d’être of Insolvency and Bankruptcy Code, 2016 is to balance the interest of all the stakeholders during the insolvency as well as liquidation process. However, the National Company Law Appellate Tribunal (“NCLAT”) recently in Technology Development Board v. Anil Goel provided a critical precedent that could potentially render more harm than good in upholding the secured creditors’ rights. The tribunal held that in case the secured creditors relinquish their security interest in the liquidation estate, the distribution of assets would undertake in accordance with section 53(1)(b)(ii) of the Code and no sub-classification among the secured creditors would hold weight. NCLAT thus ruled out the preferential rights amongst secured creditors as soon as their security interest is relinquished, and kept all the secured charge-holders at an equal pedestal.

This stance taken by NCLAT is a stark shift to the common law principles on charge-holders, and contrary to the recommendations of the Insolvency Committee Report of 2018 (“the ILC Report”) which dealt with the aforementioned issue. This post aims to analyze the present judgment with a critical lens and provide an overview around the unresolved conundrum of priority inter-se secured creditors. 

Understanding Creation of Charge and Priority amongst Charge-holders

Section 2(16) of the Companies Act, 2013 defines charge as an interest or lien created on the property or assets of a company as security which is realizable in case of default. Multiple charges on a single asset can also be created by creditors through an inter-creditor/subordination agreement, provided the contract between lender and borrower allows the creation of multiple charges. Two possibilities could arise in case an inter-creditor agreement is created: The charges created could either be a pari-passu charge i.e. equally placed charge-holders; orthe charges can be prioritized and ranked among the creditors through their consent. Thus, the creditor whose charge is prioritized first will be the first charge-holder, and the creditor who holds the subsequent charge will be the second charge-holder and so on.

The aforementioned agreements hold significance in case the company defaults on the repayment of debt. As pari-passu charge-holders are similarly placed, the proceeds will be distributed in proportion to their debt. Per contra, if the charge-holders have specified in advance the priority among competing charges, the distribution mechanism from the proceeds of an asset will be in accordance with the priority in charge. Therefore, the claims of first-charge-holders will be firstly paid in full, and only thereafter the remaining balance, if any would be rendered to subsequent charge-holders. 

Background of the Judgment

In the present case, Anil Goel, the liquidator, ignored the claims of the Technology Development Board who was admittedly a second-charge holder and distributed the sale proceeds from liquidation towards the other respondents who were first-charge holders.

The rationale given by Goel for not extending proceeds towards the Technology Development Board was that settling claims of first-charge holders (first in priority) leaves nothing to satisfy the claims of subsequent charge-holders. It is pertinent to mention that all the secured creditors who are parties to the present case relinquished their security interests.

Thus, the moot point was whether the priority inter-se secured creditors sustains or nullifies as soon as secured creditors relinquish their interest into the liquidation estate. Setting aside the impugned order, NCLAT opined that secured creditors have two options during liquidation process according to section 52 of the Code: to realize the security interest present on the secured asset; or to relinquish the security interest among the common pool of assets to be liquidated also known as the ‘liquidation estate’.

It was held that the significance of priority in charge would arise only in the former case, and not the latter. Thus, in the event of secured creditors relinquishing their security interest into the liquidation estate, the priority in charge will not hold any significance and all the secured creditors will be equally placed under section 53(1)(b)(ii) of the Code, irrespective of the ranking of their charges. 

Critical Analysis

In this part, we shall argue that the position of the NCLAT to divest the priority inter-se secured creditors during relinquishment of security interest is flawed and has set a wrong precedent with far-reaching implications. The NCLAT completely disregarded the common law principles, earlier precedents, and ILC recommendations by applying the non-obstante clause which would not be applicable at the first place. 

The Insolvency Law Committee Report of 2018

The issue of subordination agreement and its treatment within the liquidation waterfall was extensively analyzed in paragraph 21 of the ILC Report 2018. The report clearly states that as the Code is silent on the validity of priority inter-se secured creditors, the inter-creditor/subordination agreement will hold valid to govern their relationship. Moreover, the report clarified that section 53(2) of the Code which states that “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” would not apply in case of inter-se secured creditors. Section 53(2) is provided to disregard agreements disrupting priority in the context of equal ranking rendered in section 53(1)(b) viz., workmen dues and secured creditors, and does not extend towards the priority, if any among secured creditors in section 53(1)(b)(ii). Hence, the committee opined that in case of relinquishment of security interest where, the proceeds must initially be extended to first-charge holders to waive off their debt completely, and thereafter to the subsequent charge holders. 

Judicial Decisions and Common Law Provisions

The landmark pre-IBC stance on this issue was discussed in ICICI Bank v. Sidco Leathers Ltd. (“Sidco”). The Supreme Court in this case was encountered with the interpretation of section 529 and section 529-A of the Companies Act, 1956 which dealt with liquidation waterfall of stakeholders, particularly workmen dues and secured creditors. The SC reasoned that workmen dues are treated pari passu with secured creditors as various instances have occurred where workmen were deprived of their debt claims after the discharge of debt of secured creditors. However, this pari-passu treatment does not automatically imply the invalidation of priority inter-se secured creditors.

The judgment shed light upon section 48 of the Transfer of Property Act, 1882 (“TOPA”) which incorporates the doctrine of priority of rights, i.e. qui prior est tempore potior est jure (he who is earlier in time is earlier in right, hence superior in law), and thus claims of first-charge holder prevail over those of second-charge holder. The judgment clarified that until no legislative clarity is provided on the issue, the principles of general law would hold valid, and therefore, provisions of TOPA would be the presiding authority for this issue. It also held that if the legislature would have intended to curtail a right as crucial as this, it would have specifically provided it in the statute. 

However, in the recent case, NCLAT rejected the Sidco case and the doctrine of priority of rights under TOPA due to the overriding effect of section 53 of the Code. It held that the non-obstante clause under section 53 of the Code would override all Central and State legislations and the Sidco case as well which was adjudicated prior to the enactment of the Code. 

The aforementioned reasoning is erroneous and in utter disregard of the prior position taken by the Supreme Court in ICICI Bank Limited v. Standard Chartered Bank. Paragraph 72 of this judgment specifically provide that the TOPA protects the sanctity and inter-se priority rights amongst creditors is not in conflict with the provisions of the Code. Therefore, section 238 of the Code (overriding effect of the Code over contrary provisions with other statutes) would not be applicable as it comes into play only in the event of conflict.

As the Code is silent on the preferential rights of inter-se secured creditors during liquidation, the general law (TOPA) would be applicable as also opined in the Sidco case. In addition, the NCLAT also failed to consider the recommendations of the ILC Report which after a comprehensive review, came to the conclusion to honor the preferential rights of creditors.

Moreover, the NCLT while providing its judgment in the same case opined that the rationale behind prioritizing the first charge-holders over the subsequent charge-holders is to uphold the “parity and proportionality” principle of liquidation proceedings. The ranking of security interest directly affects the value accrued out of a defaulted loan. Therefore, ignoring the priority established and pushing back all of them at an equal pedestal erodes the recovery rate of the ones higher in ranking. This unbalances the interest of all the stakeholders which is inconsistent with the primary precept of the Code.

Concluding Remarks

The creation of charge and its priority thereof is a crucial step to protect the rights and interests of the secured creditors. The Report of the Expert Committee on Company Law clearly asserts that “rights and priorities of creditors established prior to insolvency under commercial laws should be upheld to preserve the legitimate expectations of creditors and encourage greater predictability in commercial relationship.” Therefore, the status quo ante upon this issue must be taken into consideration and the Supreme Court must provide a comprehensive stance to resolve the predicament of secured charge-holders. Alternatively, legislative clarity on the issue could help in resolving the quandary of priority inter-se secured creditors once and for all. 

– Nishant Nagori & Divyani Saldi