The insolvency laws in India prior to 2016 have always created obfuscation in the minds of general public due to fragmented nature making it urgent for the legislature to step-up and introduce a comprehensive legislation in relation to insolvency and liquidation proceedings in India. The Insolvency and Bankruptcy code (IBC), 2016 was introduced after brainstorming of several committees and considerations from various countries. It felt like a solution to all problems pertaining to insolvency laws as it was a consolidated and comprehensive solution which was lacking earlier. As a result, India leapt to 63rd position in ease of doing business index. The recoveries under the code were significantly efficient in comparison to earlier models. The feature that made the code distinct and enticed more people to invest in business is the creditor friendly regime that was resorted by the code. However, there are still some areas where it is likely uncertain and even the courts have not able to silence the conundrum.
The code still has a number of issues which are required to be addressed to ensure smooth functioning of liquidation proceedings. One such is the position of secured creditors with respect to inter se priority under the code. The code explicitly mentions the order in which distribution of assets must take place but it is completely silent on the order to be upheld in a case where the secured creditors are holding different level of charges and priority among themselves to realize the amount to which they are entitled. There have been attempts made to address the confusion and uncertainty relating to this issue with the help of reports of committees such as ILC ( Insolvency law committee) and BLRC (Bankruptcy Law Reforms committee) which discussed the issues and tried to establish a clear stance. There have been judgements where the courts tried to tackle this issue but did not succeed and added more to the ambiguities to inter se priority of secured creditors.
In this article, an attempt has been made to analyze provisions monitoring the status of secured creditors currently and also analyze the reports from different committees to understand the situation clearly. The article also intends to demystify various judgements of Indian courts to understand that how courts have tried to tackle with this issue and understand the two approaches primarily adopted by the courts. Moreover, the also aims to give an international perspective that how different countries have come to terms with this issue. Finally, there have been some recommendations and suggestions regarding the approach that can be incorporated and what is way forward.
LEGAL POSITION IN INDIA
Before diving deep into the study, it is important to understand the meaning of word ‘charge’ and ‘inter se priority’. The Companies Act, 2013 and Insolvency procedure code, 2016 both define ‘charge’ as an interest or lien created on the property or an undertaking of a person, including mortgages. The charge created by the company can be exclusive as well as on an equal footing with other secured creditors. The same issue was discussed by the Hon’ble Supreme Court in India. The case of ICICI Bank vs Sidco Leathers Ltd. is attributable to inter se priority of charges in regime prior to the enactment of code. In the said case, the Hon’ble Court interpreted Sections 529 and 529A of the companies act, 1956, observed that treatment of workmen’s dues and secured creditors’ debts can be pari passu, but it does not mean inter se priorities between secured creditors will be negated. The court highlighted that the Companies Act, 1956 is silent about the inter se priority of secured creditors. Even though the general rule states that special statutes to prevail over general statute in case of contradiction, the court affirmed that the specific provisions set forth in the Transfer of Property Act, 1882 will prevail. Section 48 of the transfer of property Act, 1882 states that if a person makes an attempt to create or transfer rights at different times, the right created later will be after right created earlier at the time of realization unless governed by a specific contract with different terms. In simple terms, the first charge holder has priority over subsequent charge holders where debts are owed to both.
Furthermore, the Securitization and Reconstruction of Financial assets and Enforcement of Security Interest Act, 2002 also enhanced the contours of secured lending in India. These acts were cumulatively amplified the well-established principle of precedence of secured creditors over unsecured creditors in terms of repayment. However, Insolvency code also reiterated the secured creditor’s position but also attempted to counter balance the interest of secured creditors and other stakeholders in the insolvency process. Section 53 of insolvency code also known as waterfall mechanism which uphold the priority of workmen dues and secured creditors but is also silent on inter se precedence among secured creditors. After the critical examination of position of secured creditors propounded that the creditors at least receive the returns they expected on their investments. The code gives two alternatives for recovering their debts under section 52.
- Secured creditors who can give up their security interest to the liquidation estate and are entitled to receive money from the pool in which liquidator contributes by selling assets of the company. It will follow section 53 for the preference of payment and secured creditor will be entitled to receive proceeds from sale of assets along with workmen’s due in priority.
- Secured creditors have another option of enforcing the security interest themselves have the power to do so in compliance with Regulation 37 of the Liquidation Process Regulations. Moreover, if a secured creditor choses to realize his security interest without liquidator and fails to receive the amount, he will stand lower in priority list and can recover the amount to which he is entitled as prescribed in section 53(1)(e)(ii) of the code.
RECOMMENDATIONS FROM ILC
The observation made by the Supreme court in ICICI Bank vs Sidco Leathers Ltd. was adopted by the Insolvency Law Committee Report dated 26th march, 2018 wherein the committee suggested that a plain reading of Section 53 would justify that valid inter- creditor and subordinate provisions are required to be respected in the liquidation waterfall under section 53 of the code. Later on, IBBI in its 2019 discussion paper on corporate liquidation process recalled 2018 report and exclaimed that preference between a senior creditor and junior creditor in the waterfall under section 53 of the code remains a point of contestation. The confusion was again brought to notice in 2020 by ILC and it was suggested by the committee that whole confusion can be clarified by inserting a explanation under section 53(2) to uphold the validity of inter-creditor and subordinate agreements. The Government however did not accept the recommendations made by ILC and there was no amendment with respect to position inter-creditor agreement was introduced.
Even though ICL report failed to leave any mark in the code but it was beginning of a new pattern where NCLTs started recognizing inter- creditor agreements between secured creditors. However, the validity of these inter-creditor and subordinate agreement was brought before the NCLT in the matter of technology Development Board v. Mr. Anil Goel clarified the position by declaring that waterfall under Section 53 does not recognize inter- creditor and subordinate agreements. The court held that the very essence of liquidation/bankruptcy process is equal distribution and affirmed that the secured creditors are to be treated at par and all such agreements are to subside.
JURISPRENTIAL APPROACH OF THE COURTS
The priority of charges is well established under the principle of common law, known as rule of priority of charges which implies that “first come, first serve”. It clearly means that in a case where there are multiple lenders (secured) have a claim over the asset, the one who registered the charge first must realize it over others. However, in cases arising out of liquidation proceeding under the Insolvency and Bankruptcy code, there are still many questions which are unanswered till now, particularly inter se priority between secured creditors. As a result of such uncertainty, two major schools of thought arose in determination of position of secured creditors.
The first school of thought propounds the rule of equitability; it does not concern itself with the value of the debt but with the nature security interest itself. This rule clearly upholds the precedence of first charge holders over anyone in the liquidation process. This simply re-iterates that a person who has a sole and first claim over an asset should have a right to recover their dues than one who agreed to subsequent charge. This practice find it roots in customary practices of the credit market and were frequently used by courts in pre-insolvency regime. The second school of thought is aligned with insolvency code. The code was enacted with an intention to push proceeding to deliver a resolution plan at its earliest and to ensure the rights of creditors at its best. The model on which India relies requires co-operation of creditors to reach a resolution. It contends that prioritizing one secured creditor or any kind of preferential treatment over another could be detrimental for the whole process and can unnecessarily cause delay in the resolution.
The Indian courts have not rigidly stuck to one approach and followed a very inconsistent approach. The Essar Steel case is a prime example, where the supreme courts recognized the doctrine of priority and emphasizing the sanctity of security interest. However, followed by a shift in Supreme Court’s approach in the case of Amit Metaliks. The court dismissed the preferential treatment conferred to first charge holders earlier and not as a means to protect the dissenting shareholders, but as a step towards uniform and equitable treatment. The ruling had major ramifications. This ruling also dismissed the exclusive owners’ footing and bringing all of them in the same footing as of other creditors. The only option available to claim higher priority was to enforce their security interest outside the resolution process. This approach was reprimanded since it neglected adverse impact on secured creditors. Later on, in the case of Gujarat Oleo Chem Ltd. the court again reinstated its position and ruled that charges are to be treated as sequential (based on order of creation) but was overturned later. The inconsistent pattern is testimony to the tussle between older credit customs and newer insolvency priorities. However, again in the case of DBS Bank Ltd Singapore vs Ruchi Soya industries limited, the issue raised regarding whether the dissenting creditors are entitled to minimum value of their security interest. The core issue was whether the amended section i.e. section 30(2)(b)(ii) was applicable in this case. The court held that Section 30(2)(b)(ii) renders assurance to a dissenting creditor and would be entitled to receive the same amount it would have received in liquidation proceedings. The court’s opinion differed in comparison to stance in Amit Metallics limited and due to the difference it was referred to a larger bench.
International Perspective
The insolvency and Bankruptcy code in India has founds its inspiration from international models such as UNCITRAL Model Law and English insolvency laws. The general rule globally embodies that the priority ought to be given to secured creditor over other creditors as well as balance the interests of secured creditors. The rights of the secured creditors are protected in in both liquidation as well as resolution proceedings. The UNCITRAL recommends pedagogy for handling secured creditors in insolvency proceedings-:
- Libertarian approach: This model excludes secured creditors from voting during resolution process and focusses on creditor autonomy by allowing them to enforce their security outside liquidation process.
- Group Solution Approach: This works on classification of creditors into different classes as per their requirements and interests.
- Hybrid approach: conflate ideas of libertarian model and also allow the secured creditors, who have enforced their right outside the process, to vote in proceedings.
India primarily follows a libertarian approach through IBC. However, as per UNCITRAL model, the committee of creditors do not include secured creditors unlike India which grants them voting rights as well.
USA’s Bankruptcy laws, being debtor centric allows more freedom to creditors as they are not obligated to stick to the plan unless they have been granted the rights of security interest and proceeds. Similarly, in the UK position of secured creditors is protected by rule of priority as well as dissenting shareholders are also protected under UK’s insolvency laws. The international stance is clear on protecting the priority and exclusivity of the secured creditors. Whereas, IBC follows a different code of conduct by upholding equal rights of all secured creditors. These aspects of the IBC makes the voices of priority and dissenting creditors feel less.
RECOMMENDATIONS
The current regime of insolvency code with respect to secured creditors entails restriction. The exclusive owners and first charge holders are withheld of their priority rights which are encouraged in international scenario. The whimsical approach of the Supreme Court and NCLT led to such a situation. The purpose behind section 52 is to render an opportunity to secured creditors to make a well informed rational choice to the best of their abilities by referring to the liquidation and resolution value. The position regarding the the valuation of security interest is still dubious even though the BLRC Report recommended to frame new clause stating the valuation of security from the date of creation. ILC suggested to add an explanatory note under Section 53 clarifying that security extends only to the undervalue of security interest and rest are to be treated as unsecured creditors.
The norms in the commercial world sits right with inter-creditor agreements which dictates the inter se priority between secured creditors. The question of unequal treatment of second -charge holders can be taken out of the picture as the second charge holder are subordinate to exclusive owners and thereby it is equitable to be unequal. Moreover, the second class holders are well informed about their rights at the time of entering into agreements. After considering IBC and section 48 of the Transfer of Property Act, it can be percieved that it was never the intention of lawmakers to deprive first charge holders. ILC has reiterated a number of times to validate the inter-creditor agreements through an amendment in Section 53(2).
The Indian insolvency regime focuses more on the recovery of security debts than on security interests which is contrary to the International standards. By the Amendment of 2019 dissenting financial creditors was given a voice to incorporate doctrine of equitability which proved detrimental to the interests of the exclusive charge holders. The doctrine of equitability in its true sense can be upheld if the secured creditors are classified on the basis of their nature of debt and valuation of the security interset.
CONCLUSION
As there is lot of ambiguity regarding the inter se priority of creditors, it is of paramount importance to add an explanation-to-explanation clause in Section 53 stating the recognition of inter-creditor agreements. Moreover, there is an immediate need for sub classification based on different charges and valuation of securities, as it will make the process faster and fairer and more people will be intrigued to invest in the business. The confusion which subsists in judiciary regarding the priority or equitability needs to be resolved by the courts. The intention behind Insolvency and Bankruptcy code was to prompt investment by fragmenting different laws and it succeeded in doing so, but it has been more than 8 years the legislature failed to devise a plane to establish the priority rights among creditors. India needs to step-up with the best possible practices otherwise, it would demotivate creditors in investing in Indian businesses. The best solution would be to bring India closer to best global practices, which would stabilize India’s position.
Author -Dhruv Jauhari (6th Semester)
KIIT School of Law, Bhubaneswar
