An Expert Explains: In IBC discussion paper, question of distribution of proceeds among creditors

Under the IBC, a resolution applicant submits a plan to deal with the outstanding debts of a company by bringing proceeds under the plan. A committee of financial creditors votes on the financial viability & feasibility of the resolution plan. The quantum & manner of distribution under the Code has long been an issue of discontent for unsecured & junior creditors.

How are proceeds distributed among creditors under the IBC?

A company may have various creditors — public sector banks, private lenders, non-banking financial companies, trade creditors, vendors, workmen, employees, governments, etc. The Code puts these creditors into different categories based on the nature of debt. Banks, bond issuers, and lenders are classified as financial creditors. Trade creditors & vendors are classified as operational creditors. Financial creditors are further categorised as secured and unsecured creditors, based on the security furnished by the borrower company.

Section 53 of the Code prescribes an order of priority in which proceeds will be distributed to the creditors based on the liquidation value. As per this waterfall mechanism, secured financial creditors rank the highest in the order of priority. They are followed by unsecured financial creditors, government dues and, finally, operational creditors.

The creditors receive proceeds (even if in surplus over the liquidation value) under the resolution plan in order of the above mentioned priority. Hence, financial creditors like banks have the first claim until exhaustion. Proceeds may be extinguished at the level of financial creditors itself, leaving almost nothing for other creditors in the waterfall mechanism.

What does the discussion paper propose?

The discussion paper acknowledges concerns among creditors regarding inequitable distribution. It says there is a need to devise an objective formula so that the distribution is fair and equitable for all creditors. Therefore, it proposes a statutory scheme wherein the liquidation value will be distributed in accordance with the waterfall mechanism under Section 53. However, any surplus over such liquidation value shall be pro-rated amongst all the creditors in ratio of their unsatisfied claims.

What is the impact of this proposal?

First, it impacts the inter-creditor distribution in an attempt to bring fairness and equity. As of now, a secured financial creditor is statutorily entitled to have his claim satisfied in priority to an unsecured financial creditor. The proposal seeks to dilute that statutory entitlement.

Say, the liquidation value is Rs 100 and the proceeds under the resolution plan are Rs 150. The claim of secured creditors is Rs 120 and that of other creditors is Rs 200. Under the present regime, secured creditors will receive their claim in full, i.e., Rs 120, and the balance proceeds of Rs 30 out of the resolution plan shall be distributed to other creditors pro-rata.

As per the proposal, secured creditors will only receive Rs 100, and the balance Rs 50 out of the resolution plan shall be distributed proportionately amongst all creditors. Hence, there is a dilution to the extent of unsatisfied claims of Rs 20 for the secured creditors.

Secondly, even inter se the same class of creditors, the proposal is bound to change the quantum of distribution. For example, it may be agreed by the committee of creditors that fully secured financial creditors will receive a higher quantum of proceeds than partially secured financial creditors. If the proposal is enacted into law, this distinction of distribution based on coverage and quality of underlying security is also diluted.

What is the jurisprudence on the subject?

The Supreme Court in the case of CoC, Essar Steel India Limited versus Satish Kumar Gupta (CA No. 8766-67 of 2019) was faced with a challenge to a ruling by the National Company Law Appellate Tribunal (NCLAT) holding that securities and security interest are irrelevant, and that financial creditors must be equitably paid irrespective of the security interest.

The Supreme Court reversed the NCLAT finding and emphasised on the importance of valuing security interests separately from unsecured creditors. It held that the security interest of the financial creditors ought to be protected. The Supreme Court upheld the actions of the Committee of Creditors in paying secured creditors amounts based on their value of the security in preference to other creditors.

Further, Section 30(4) of the Code provides that the CoC while approving a resolution plan can take into account the value of security interest of a secured creditor. The United Nations Commission on International Trade Law (UNCITRAL) Legislative Guide on Insolvency Law states that secured creditors may receive payment in value of their security interest while other unsecured & junior creditors may receive nothing.

How will the proposal impact the insolvency regime and credit markets in India?

The proposal seeks to partially undo what the Supreme Court held in the Essar Steel case. It is interesting to note that the report of the Banking Law Reforms Committee in 2015 (which served as a precursor to the IBC) saw the Code as a tool to strengthen the bond market and credit environment. However, the proposal may have a detrimental effect on both.

With the value and quality of security interest being no longer the only determining factor for distribution of proceeds, lenders may want to lend on financially tighter terms, or may demand higher and better security cover so as to cover larger liquidation values.

The Code was also seen as promoting resolution over liquidation. However, in the proposed scenario, it will be more beneficial for the secured creditors to push the company towards liquidation so that they can realise the full value of their security rather than sharing it with other junior creditors or creditors having inferior security interests under a resolution process. The Supreme Court has observed how ignorance of security interests could result in a stymying of the resolution process itself.

Whether the proposal makes the distribution process fairer and more equitable will depend on which class of creditor one belongs to.

(The author is an advocate based in New Delhi.)