Creditor conundrum persists under the code

By Misha and Siddhant Kant, Shardul Amarchand Mangaldas & Co

A key objective of the Insolvency and Bankruptcy Code, 2016, has been to ensure early resolution of financial distress of stressed corporates, and ensuring their earliest revival. In carrying out this task, the code relies on a creditor-driven process with limited judicial intervention and a requirement to form a committee of financial creditors to help facilitate the revival, or in the eventual failure of such revival, liquidation of the corporate.

MishaPartnerShardul Amarchand Mangaldas & Co
Shardul Amarchand Mangaldas & Co

While the overall scheme of the code with respect to the “creditor in control” principle after a default is sound, the code has inadequately provided for the rights of all types of creditors within its scheme. The code primarily recognizes only two broad categories of creditors – financial creditors are those creditors who have advanced a debt against the consideration of time value of money, and operational creditors who are owed debt on account of provision for goods and services. Thus, the code provides only for rights, protections and roles for these two categories of creditors in the entire insolvency resolution process laid out under the code. Only these creditors can initiate the processes under the code; only the financial creditors have decision making power to approve or reject a resolution plan, and a resolution plan needs to provide for liquidation value for dissenting financial creditors and operational creditors.

The code, however, has fallen short of encapsulating within its scheme a whole universe of creditors who are equally affected by the defaults of corporates, but have no recourse and effective rights under the code.

Creditor rights denied

There are several types of creditors who are neither financial nor operational creditors within the meaning of the code. Flat buyers, for instance, have been one of the most talked about stakeholders whose interests have not been factored into the scheme of the code. Similarly situated are decree or arbitral award holders, whose right to payment is derived neither from a “financial debt” nor from a default on the payment for provision of goods and services. There are several such instances – for example, a creditor may be owed money on account of: a claim of damages for defective supply of goods or services; a claim for breach of contract, such as shareholders’ agreement; joint venture agreement; collaboration agreement or any commercial transaction; or a claim in tort. The list is almost endless. None of these creditors has any specific right, role or protection within the scheme of the code.

Siddhant KantAssociateShardul Amarchand Mangaldas & Co
Siddhant Kant
Shardul Amarchand Mangaldas & Co

The issue came to fore in context of flat buyers and captured the attention of the judiciary, media and general public. Flat buyers have been held to be neither financial creditors nor operational creditors by the adjudicating authority, except for those with assured returns from the builders prior to handing over the flat.

Amendment of the code’s regulations to provide for a separate form for filing of claims by such flat buyers as a category of “other stakeholders” does little to take care of the lacunae. Filing of claims means nothing when stakeholders are not afforded any protection as part of a resolution plan, nor have the ability to initiate processes under the code.

Even a subsequent amendment requiring the resolution plan to specify how it deals with the interests of other stakeholders also falls short of taking care of interests of such creditors and/or stakeholders as there is no mandatory stipulation to provide liquidation value, as is available for operational creditors. There is no reason to dis-entitle other types of creditors other than operational creditors to be assured of their liquidation value.

Unlike the previous regime where any creditor could initiate the process of winding up against a corporate, under the code only financial and operational creditors can initiate the processes, hence effectively barring any other creditor of the corporate from initiating a process that can lead to liquidation of the corporate. Yet again there does not appear to be any sound jurisprudential basis to create such artificial distinction.

The above apart, there is another practical difficulty in the implementation of the code. In terms of the transfer rules framed for transfer of pending winding up proceedings from the High Courts to the National Company Law Tribunal (NCLT), it has been specified that unserved winding up petitions must be transferred to the NCLT and must be dealt with in the same manner as if the same were filed under the provisions of the code. There are several instances where winding-up proceedings have been filed by creditors other than financial and operational creditors. In such instances, questions arise as to how such winding up proceedings would be converted into proceedings under the code.

Clearly, there is an inherent flaw in simplistic categorization of the creditors as financial and operational creditors, which is not in touch with practical realities.

The simplest solution lies in amendment of the definition of operational creditors to include all creditors apart from financial creditors. Alternately, the regulations need to be amended to provide for liquidation value to all categories of creditors. This, however, would be an incomplete solution given that it would still not give right to such other creditors to initiate the processes under the code.

Misha is a partner at Shardul Amarchand Mangaldas & Co, while Siddhant Kant is an associate at the firm


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