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Equality of Creditors Under the IBC: A Myth?

Abstract

It is often a matter of debate as to why operational creditors are not given the same rights and benefits as financial creditors under the Insolvency and Bankruptcy Code, 2016.

In this article, the author has gone through the definitions of the 2 types of creditors as defined in the Code as well as the various aspects that distinguish these categories of creditors from each other. The author also gives various reasons for financial creditors being in a better position compared to the operational creditors and tries to justify the rationale behind financial creditors being in such an advantageous position.

The author also discusses the third unidentified type of creditors which have been recently introduced by the 2016 amendment and the impact of this Amendment on the submission of claims by creditors.

The Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as IBC”) replaced various overlapping insolvency laws in the country when it came into effect. The confidence of creditors had been hampered over a period of time on account of the various inefficient laws existing at the time. The recoveries initiated by creditors under the contract laws or other special laws in place, such as the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (hereinafter referred to as “SARFAESI”) had not been able to achieve desirable outcomes. The provisions of the Sick Industrial Companies (Special Provisions) Act, 1985 and the winding up of companies under the provisions of the Companies Act, 2013 were not producing any favourable outcomes as well. The Insolvency and Bankruptcy Code, 2016 was a landmark codification replacing these various fleetingly ineffective insolvency laws in the country which gave the creditors a new hope.

Types of Creditors Under the IBC

The Insolvency and Bankruptcy Code, 2016 segregates “creditors” into 2 categories, namely, “financial creditors” and “operational creditors”.

Under section 5(7) of the IBC, a financial creditor is defined as “any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred”.

A financial debt is defined under Section 5(8) as “a debt along with interest, if any, which is disbursed against the consideration for time value of money and includes-

  1. Money borrowed against payment of interest;
  2. Any amount raised by acceptance under any acceptance credit facility or its de-materialized equivalent;
  3. Any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;
  • The amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed;
  • Receivable sold or discounted other than any receivable sold on non-recourse basis;
  • Any amount raised under any other transaction, including, any forward sale or purchase agreement, having the commercial effect of borrowing;
  • Any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;
  • The amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clauses (a) to (h) of this clause.”

Similarly, Section 5(20) of the IBC defines an operational creditor as “any person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred“.

An operational debt refers to “a claim in respect of the provisions of goods or services including employment or a debt in respect of the repayment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority

A clear distinction between financial creditors and operational creditors was drawn by the Bankruptcy Laws Reforms Committee in its Report. The report stated as follows:

The Code differentiates between financial creditors and operational creditors. Financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or debt security. Operational creditors are those whose liabilities from the entity comes from a transaction on operations…The Code also provides for cases where a creditor has both a solely financial transaction as well as an operational transaction with the entity. In such a case, the creditor can be considered a financial creditor to the extent of the financial debt and an operational creditor to the extent of the operational debt.”1

Financial Creditors Versus Operational Creditors: Who Is In A More Advantageous Position?

  1. Initiation of Insolvency Proceedings:

Both the types of creditors i.e. financial creditors and operational creditors can initiate insolvency proceedings, but financial creditors can initiate insolvency proceedings even for disputed debts. This ability is to initiate insolvency proceedings for disputed debts is not possessed by operational creditors. Section 8 of the IBC provides for twoconditions which the operational creditor has to fulfill in order to initiate insolvency proceedings under Section 9. These conditions are:

  1. The operational creditor has served a demand notice to the corporate debtor stating that the debtor has committed a default in debt; and
    1. No dispute exists between the parties in relation to the payment of debt.

Interpretation of the word “dispute” is crucial to any section 9 application. Section 5(6) provides that “A dispute includes a suit or arbitration proceedings relating to

  1. the existence of the amount of debt;
  2. the quality of goods or service; or
  3. the breach of a representation or warranty.”

Hence, this is an inclusive definition having a very broad interpretation.

The word “dispute” as used in Section 8 of IBC has been interpreted by the Apex Court in Mobilox v. Kirusa2. Kirusa used to provide various services to Mobilox in relation to conducting tele-voting for a television show. There existed a Non-Disclosure Agreement (hereinafter referred to as “NDA”) between the parties in relation to their contract. Mobilox claimed that Kirusa had breached the NDA and hence withheld several payments.

Kirusa sent a notice to Mobilox under Section 8 of the IBC. In response to the said Notice, Mobilox stated that the existence of a pre-existing dispute barred an application under Section 9 of the IBC. The main question before The Supreme Court was whether conflicts arising out of NDAs were enough to constitute a ‘dispute’ or did a ‘dispute’ compulsorily have to be in the form of a suit or arbitration. The Supreme Court held that conflicts arising out of the NDA was enough to constitute a ‘dispute’ and hence, the application made by Kirusa under Section 9 was not maintainable.

This principle of conflicts, which not necessarily led to a suit or arbitration, made way into the legislation through the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018.

Therefore, if the debt has not been admitted by the corporate debtor and is disputed as defined under section 5(6) or section 8(2) of the IBC, an insolvency application of the operational creditor may be rejected. Financial creditors can initiate insolvency proceedings even with the existence of a pre-existing dispute.

  • Operational Creditors are not a part of the Committee of Creditors:

According to Section 21(2) of the IBC, only financial creditors can be a part of the Committee of Creditors (hereinafter referred to as “CoC”). Moreover, Section 24(3) states that only operational creditors having aggregate dues of atleast 10% would be given the notice of meetings. The Committee of Creditors is essential to resolution process, as the CoC possesses certain paramount powers. The CoC, inter alia, can appoint an Interim Resolution Professional (hereinafter referred to as “IRP”) as the Resolution Professional (hereinafter referred to as “RP”), replace the IRP with another RP, replace the current RP with another RP, extend the period of the Corporate Insolvency Resolution Process (hereinafter referred to as “CIRP”)and most importantly, approve the resolution plan (subject to the final approval of the Adjudicating Authority). IBC restricts the right of an operational creditor to be a part of the Committee of Creditors irrespective of the size of the claim. Hence, the operational creditors miss out on a very important part of the resolution process. The recent Amendment with effect from June 2018 has added Section 12(A) to the IBC. Section 12(A) allows withdrawal of applications made under Section 7, Section 9 or Section 10 of the Code even after the admission of the application, with the approval of 90% voting share of the Committee of Creditors. Since operational creditors are not a part of the CoC, the withdrawal of an application under Section 9 of the Code only by the approval of the CoC becomes unjust to the operational creditors.

This issue of inequality of creditors was taken up by The Supreme Court in the case of Essar Steel India Limited vs. Satish Kumar Gupta & Ors3. The Apex Court overturned the judgement passed by the NCLAT which applied the principle of ‘equality of creditors’. The Supreme Court observed that the intention of the legislation was not to keep financial creditors and operational creditors at par. The Supreme Court also mentioned that the principle of equality can only be applied to equals and the legislation does not treat financial creditors and operational creditors as equal.

  • Operational creditors as ‘unsecured creditors’:

In case the CoC fail to approve a resolution plan or demands liquidation, an Adjudicating Authority passes an order to initiate the process of liquidation of the corporate debtor’s assets. Section 53 of the Code states the

order of priority for the distribution of assets. In this order of distribution, secured creditors are given priority over unsecured creditors. Financial creditors are segregated into either secured or unsecured creditors but operational creditors are always unsecured creditors. Therefore, operational creditors are once more at a disadvantage.

Third Type of Creditors:

Another question which kept cropping up was what happens when a creditor neither meets the criteria to be a financial creditor nor an operational creditor.

There has been a lot of confusion regarding the submission of claims by creditors who were neither operational creditors nor financial creditors under IBC.

The case of Mukesh Kumar v AMR Infrastructure4 dealt with this exact situation of creditors falling under neither of the categories of creditors listed under the IBC. A number of flat purchasers wanted to initiate insolvency proceedings against the corporate debtor. The NCLT, New Delhi held that the flat purchasers being neither financial creditors nor operational creditors had no to trigger the provisions of the IBC. Accordingly, the petition was dismissed.

The NCLT, Mumbai took a contrary view while dealing with a similar situation in the case of DF Deutshe Fortait AG and Anr. v. Uttam Galva Steel Ltd5. The Bench held that there cannot be a debt other than the 2 types of debt recognized by the IBC. Any debt which is a debt against a company has to be either an operational debt or a financial debt.

The Insolvency and Bankruptcy Board of India amended the IBBI Regulations, 2016 in August 2017 to add a ‘Form F’ for submission of claims by creditors other than the categories of creditors laid down by the IBC.

Until the Amendment of 2016, only operational creditors and financial creditors could submit their claims to the IRPs. Regulation 9A of the IBBI carves out an elaborate, well detailed provision for creditors other than financial creditors and operational creditors to file their claims.

Therefore, this new amendment has come in as a relief for creditors who did not fall under the categories of creditors as defined by the IBC.

Conclusion

It is clear from the above discussion that the intention of the Code was never to put financial creditors and operational creditors at par with each other. The Code was not designed to provide the reigns of the insolvency resolution process to the operational creditors. By giving the reigns of the CIRP and the CoC to the financial creditors, the Code has established an efficient way of avoiding the personal bias brought into the resolution process by the operational creditors who are more often not interested in the revival of the corporate debtor, but rather only recovering their debt. By adding a 3rd type of creditors through the Amendment, the Code has now given creditors who fall under neither category of creditors, an opportunity to recover their debt from the corporate debtor.


1 The Report of the Bankruptcy Law Reforms Committee, Volume I: Rationale and Design, November 2015.

2 Mobilox Innovations Private Limited vs. Kirusa Software Private Limited 2017 (9) SCJ 300

3 Essar Steel India Limited vs. Satish Kumar Gupta & Ors (2020)1CompLJ1(SC)

4 Mukesh Kumar v AMR Infrastructure [2017]139CLA166

5 DF Deutshe Fortait AG and Anr. v. Uttam Galva Steel Ltd [2017]140CLA36