Uncovering Flaws in the Waterfall Mechanism: A Study of Section 53 of the IBC, 2016

Anshika Misra

ABSTRACT:

The Insolvency and Bankruptcy Code (IBC) of 2016 revolutionized India’s approach to resolving distressed assets, providing a structured framework for insolvency proceedings. However, the issue of inter se priority among secured creditors remains a challenge within the Code, leading to uncertainty and inconsistency in its application. Despite efforts by the Bankruptcy Law Reforms Committee (BLRC) and the Insolvency Law Committee (ILC) to address this issue, ambiguities persist, complicating judicial interpretations and practical implementations. This paper examines the complexities and ambiguities surrounding inter se priority among secured creditors under the IBC. It explores the legislative framework, judicial interpretations, and international best practices to understand the root causes of the issue. Drawing insights from the UNCITRAL Legislative Guide, US Bankruptcy Code, and UK insolvency laws, the paper proposes legislative amendments and practical solutions to enhance clarity and predictability. Key recommendations include clarifying the hierarchy of secured creditors in the IBC, revising Section 53 to reflect a clear priority structure, and promoting standardized inter-creditor agreements. Additionally, establishing a centralized secured transactions registry and enhancing the role of liquidators and resolution professionals are proposed to mitigate conflicts and ensure transparency. By addressing the inter se priority issue, this paper aims to strengthen creditor confidence, enhance the efficiency of insolvency proceedings, and contribute to a more robust insolvency framework in India.

KEYWORDS: Insolvency and Bankruptcy Code, Secured Creditors, Inter se Priority, Legislative Amendments, Judicial Interpretations

INTRODUCTION:

The Insolvency and Bankruptcy Code (IBC), enacted in 2016, revolutionized India’s insolvency landscape by introducing a unified and time-bound mechanism for resolving distressed assets. It aims to enhance credit availability, promote entrepreneurship, and ensure the efficient allocation of resources. The IBC emphasizes a creditor-driven resolution process, consolidating various insolvency laws and establishing institutions like the Insolvency and Bankruptcy Board of India (IBBI) and the National Company Law Tribunal (NCLT) to oversee proceedings. Innovative provisions such as the corporate insolvency resolution process (CIRP) and the role of resolution professionals expedite resolution while safeguarding stakeholders’ interests. Despite its transformative potential, challenges persist in operational implementation and handling complex cases. Nevertheless, the IBC remains a seminal reform, driving efficiency, transparency, and accountability in India’s insolvency ecosystem, fostering investor confidence and economic growth.

The Insolvency and Bankruptcy Code (IBC), despite its transformative potential, faces complexities and ambiguities. One such challenge arises from the lack of clarity regarding the creation of inter se priority among secured creditors. While the IBC grants general priority to secured creditors in repayment, it remains silent on prioritization among them, particularly when they hold different levels of charges. This issue has been extensively discussed by the Bankruptcy Law Reforms Committee (BLRC) and the Insolvency Law Committee (ILC) in their respective reports, yet uncertainty persists. Moreover, conflicting interpretations by courts and tribunals have only added to the confusion.

This paper examines the provisions governing secured creditors’ standing under the IBC, as well as the concerns regarding their inter se priority. It aims to decipher the legislative intent by examining the BLRC and ILC reports. Furthermore, it explores international jurisprudence on this matter and scrutinizes how various judgments by the Supreme Court and tribunals have potentially misinterpreted the IBC, deviating from its objectives.

RESEARCH METHODOLOGY:

1. Literature Review: The researcher conducts a comprehensive review of existing literature on the Insolvency and Bankruptcy Code (IBC), focusing on the treatment and priority of secured creditors. This includes academic articles, expert commentaries, and relevant legislative documents. The BLRC and ILC reports are also examined, which provide foundational insights into the legislative intent and the intended framework for secured creditors’ priorities.
2. Legal Analysis: The researcher analyses specific provisions of the IBC, particularly Section 53, to understand the statutory priorities assigned to secured creditors.
3. Case Law Examination: Landmark judgments from the Supreme Court of India and various tribunals that interpret the IBC provisions concerning inter se priority among secured creditors are reviewed.
4. Comparative Analysis: International insolvency frameworks and jurisprudence in jurisdictions such as the United States, and the United Kingdom are explored.

LITERATURE REVIEW:

Despite its transformative intent, the IBC has faced several challenges and ambiguities, particularly concerning the inter se priority among secured creditors.

The BLRC report laid the foundation for the IBC, emphasizing a streamlined and efficient insolvency resolution process. It highlighted the need for a clear prioritization of claims to maximize asset value recovery. However, while it proposed a general prioritization favoring secured creditors alongside workmen’s dues, it did not provide detailed guidance on the inter se priority among secured creditors holding different levels of charges.

On the other hand, the ILC further examined the ambiguities and operational challenges within the IBC. It acknowledged the lack of clarity regarding inter se priority among secured creditors and suggested the need for explicit provisions to address these concerns. The ILC recommended legislative amendments to resolve this issue but did not provide concrete solutions, leaving room for varied judicial interpretations.

Scholars and legal experts have extensively debated the treatment of secured creditors under the IBC. Saxena and Agarwal stated that the IBC’s silence on inter se priority has led to inconsistent judicial rulings, thereby creating uncertainty in the insolvency resolution process. They argued that this ambiguity undermines the confidence of secured creditors and affects the overall efficiency of the insolvency framework. Gupta’s work highlights the need for a more detailed statutory framework to guide the treatment of secured creditors with different levels of charges. He suggests drawing from international best practices to create a more predictable and transparent priority structure.

Cases like Essar Steel India Ltd. v. Satish Kumar Gupta and Swiss Ribbons Pvt. Ltd. v. Union of India upheld the constitutionality of the IBC but recognized the need for continuous evolution in its interpretation and application to address emerging challenges, including the prioritization of claims.

The U.S. framework offers a detailed and hierarchical structure for creditor claims, including clear guidelines for secured creditors with varying levels of charges. This predictability helps in reducing litigation and improving resolution outcomes. Additionally, the UK’s insolvency regime similarly provides explicit rules on the prioritization of claims, ensuring that secured creditors’ rights are clearly defined and respected, thereby enhancing the efficiency and fairness of the insolvency process.

METHOD:

The primary question guiding this research is: “What are the implications of the lack of clear inter se priority among secured creditors under the Insolvency and Bankruptcy Code (IBC), 2016, and how can this issue be resolved to enhance the efficiency of the insolvency resolution process in India?”

The debt recovery mechanism has never been straightforward for secured creditors, historically governed more by market customs and business practices of inter-creditor agreements. Interestingly, Section 2(16) of the Companies Act, 2013, and Section 3(4) of the IBC define “charge” as an interest or lien on a company’s property or assets as security. Charges can be exclusive, pari passu, or subordinate/priority. Before the IBC, the concept of secured creditors’ priority was recognized in other statutes. For instance, Section 48 of the Transfer of Property Act, of 1882, establishes that earlier rights take precedence over later ones unless a specific contract states otherwise. This principle was adopted in commercial laws, including the Companies Act, of 2013, and the SARFAESI Act, recognizing secured creditors’ priority rights.

During the drafting of the IBC, the Bankruptcy Law Reforms Committee (BLRC) acknowledged secured creditors’ priority rights and recommended a distinct provision to establish these rights. This was incorporated into Section 53 of the IBC, which provides a liquidation waterfall prioritizing secured creditors along with workmen’s dues. However, the Code is silent on inter se priority among secured creditors, creating ambiguity among first charge or priority charge-holders. Section 53(2) further complicates matters by allowing liquidators to disregard contractual arrangements between creditors, jeopardizing inter-creditor agreements.

Secured creditors have the alternative remedy of enforcing their security under Section 52 to satisfy their debt. Section 53 pushes high charge-holders to realize their debt by enforcing their security outside the liquidation estate. This can be done either by relinquishing their security interest to the estate and receiving sale proceeds in priority or by realizing their security interest under Section 52 and claiming unpaid debts under Section 53(1)(e), which has lower priority.

The insolvency resolution process attempted to protect secured creditors through the 2019 Amendment, ensuring payments to dissenting financial creditors are not less than the amount due in a notional liquidation. However, the lack of clarity about the priority of charges and security interest leaves financial creditors uncertain about assenting or dissenting from resolution plans. The ambiguity in the Code creates varied interpretations by courts and tribunals, frustrating the Code’s purpose of asset value maximization.

Theoretical Conundrum in the Priority of Secured Creditors:

The issue of inter se priority among secured creditors in liquidation proceedings under the Insolvency and Bankruptcy Code (IBC), 2016, presents a significant theoretical conundrum. While the IBC provides a general framework for prioritizing secured creditors alongside workmen’s dues under Section 53, it does not specifically address the inter se priority among secured creditors holding different levels of charges. This omission has led to two conflicting schools of thought, each with its rationale and implications.

Two Schools of Thought:

1. The doctrine of Priority and Equitable Ownership:

The first school of thought is grounded in the doctrine of priority, which is a fundamental principle in both common law and Indian jurisprudence. This doctrine asserts that earlier rights, such as those of the first charge holder, should take precedence over later rights. This principle is supported by Section 48 of the Transfer of Property Act, 1882 which states that if multiple rights are created over the same immovable property, the earlier right prevails unless a specific agreement states otherwise. Other statutes, including the Companies Act, 2013, and the SARFAESI Act, recognize and uphold the priority rights of secured creditors. Proponents of this view argue that respecting the priority of exclusive or first charge holders ensures predictability and fairness in the credit market. It aligns with pre-insolvency contractual rights and the expectations of secured creditors when they extend credit based on the security interest.

2. The doctrine of Equitable Treatment and Group Solution:

The second school of thought emphasizes the principle of equitable treatment, which aims to ensure that all creditors, particularly those sharing a common collateral, are treated similarly during insolvency proceedings. This perspective is based on Equitable Treatment and the idea that creditors with similar legal standings or interests should receive proportionate treatment to avoid disproportionate losses or benefits. It also focuses on Group Solution which supports a more collective treatment of creditors, focusing on maximizing the overall recovery for all stakeholders rather than strictly adhering to pre-insolvency priority rights. Advocates of this view argue that giving equal treatment to all secured creditors helps in achieving the broader goals of the IBC, such as the revival and value maximization of the distressed entity. It seeks to prevent any single creditor from disproportionately benefiting at the expense of others, which could undermine the collective resolution process.

Judicial Interpretations of Inter Se Priority among Secured Creditors:

The ambiguity regarding inter se priority among secured creditors in the Insolvency and Bankruptcy Code (IBC), 2016, has resulted in various judicial interpretations. The evolving jurisprudence reflects the struggle to balance the principles of priority and equitable treatment, with courts and tribunals offering different perspectives on how secured creditors’ claims should be handled. Here are some significant cases that illustrate this evolving landscape:

1. Essar Steel India Ltd. v. Satish Kumar Gupta:

In this landmark case before the Supreme Court of India in 2019, the insolvency resolution of Essar Steel raised questions regarding the treatment of secured creditors. The court, in its decision, upheld the priority of secured creditors in the distribution of assets, emphasizing their right to receive higher payouts than unsecured creditors. This decision initially seemed to endorse the traditional view that secured creditors should be prioritized based on their security interests, aligning with the first school of thought. It highlighted that secured creditors should receive at least the liquidation value of their claims, promoting the principle of equitable treatment within the broader framework of the IBC.

2. India Resurgence Arc Pvt. v. M/S. Amit Metaliks Limited:

This case, heard by the Supreme Court in 2021, involved the resolution process of a company where dissenting financial creditors challenged the resolution plan approved by the Committee of Creditors (CoC). The court ruled that the legislative intent behind the IBC amendments was to ensure equitable treatment of creditors. It emphasized that dissenting financial creditors should receive a fair share, but not necessarily any special priority over other secured creditors. This decision marked a shift towards the second school of thought, promoting equitable treatment over strict adherence to pre-insolvency priority rights.

3. Technology Development Board v. Anil Goel:

In this case, before the NCLT Ahmedabad in 2021, the priority of secured creditors during the liquidation process of Gujarat Oleo Chem Ltd. was addressed. The tribunal held that the charges should be sequential rather than proportional, effectively giving priority to the first charge holders over subsequent charge holders. Although this decision reinforced the first school of thought, it was later overturned by the appellate tribunal, highlighting the ongoing judicial divergence.

4. Technology Development Board v. SASF:

This ongoing case before the Supreme Court involves the dispute between secured creditors regarding the priority of claims under the IBC. The decision in this case is expected to provide further clarity on the issue of inter se priority among secured creditors. The outcome could either solidify the trend towards equitable treatment or reaffirm the traditional priority rights of secured creditors.

5. Binani Industries Ltd. v. Bank of Baroda:

In this case, before the NCLAT in 2018, the resolution process of Binani Industries raised questions about the treatment of dissenting secured creditors. The tribunal ruled that all creditors, including dissenting secured creditors, should be treated equitably and receive their due share of the resolution proceeds. This decision supported the principle of equitable treatment, reinforcing the importance of fairness in the resolution process.

6. State Tax Officers v. Rainbow Papers Ltd.:

In 2022, the Supreme Court addressed critical questions about the priority of secured creditors in the insolvency proceedings of Rainbow Papers Ltd. The court provided a nuanced interpretation of the IBC, emphasizing the need to harmonize the principles of equitable treatment with the traditional doctrine of priority. This decision highlighted the Supreme Court’s effort to balance the conflicting principles and provided much-needed clarity on how inter se priority should be handled.

International Perspective on Priority Rights of Secured Creditors:

1. UNCITRAL Model Law:

The UNCITRAL Model Law on Cross-Border Insolvency provides a framework for insolvency proceedings with a focus on fair and efficient administration. It emphasizes the principle of equitable treatment for similarly situated creditors, including secured creditors. The Model Law suggests three approaches to handling secured creditors:

1. Libertarian Approach: This approach allows secured creditors to enforce their security outside the insolvency proceedings, thus not participating in the voting process for the resolution plan. This respects the pre-insolvency contractual rights of secured creditors.
2. Group Solution Approach: This approach creates a separate class for secured creditors, recognizing their priority rights but still integrating them into the resolution process to ensure a coordinated approach to asset distribution.
3. Hybrid Approach: This combines elements of the first two approaches, allowing secured creditors to enforce their security interests but also granting them a say in the insolvency proceedings if their claims remain unsatisfied.

2.  United States Bankruptcy Code (Chapter 11):

The U.S. Bankruptcy Code, particularly Chapter 11, offers robust protection for secured creditors. Creditors are classified into secured and unsecured categories. Secured creditors have the right to retain their lien and receive deferred payments equal to the present value of the collateral. If a plan is not accepted by all classes, the court can still confirm it (cramdown) provided it meets certain criteria, including ensuring secured creditors receive at least the value of their collateral. This provision halts all collection actions against the debtor’s assets, protecting the secured creditors’ interests by maintaining the collateral’s value during the proceedings.

3. United Kingdom Insolvency Act:

The UK Insolvency Act 1986, alongside the Enterprise Act 2002, provides a clear framework for the priority of secured creditors. During administration, an administrator cannot interfere with secured creditors’ rights without their consent or court approval. This ensures secured creditors’ interests are preserved. In liquidation, secured creditors are prioritized in the distribution of assets, reinforcing their rights over unsecured creditors. The Act distinguishes between floating and fixed charges, with fixed charge holders having priority over floating charge holders in asset distribution.

SUGGESTIONS:

Given the complexities and ambiguities surrounding inter se priority among secured creditors under the Insolvency and Bankruptcy Code (IBC), 2016, several measures can be proposed to address these issues effectively. These suggestions aim to harmonize the principles of equitable treatment with the traditional doctrine of priority, ensuring greater clarity and predictability in insolvency proceedings.

1. Legislative Amendments:

1. Clear Definition of Priority: Amending the IBC to explicitly define the inter se priority among secured creditors. This should include provisions that recognize different levels of charges (first charge, second charge, etc.) and clearly state their order of priority during both the liquidation and resolution processes.
2. Revisiting Section 53: Modifying Section 53 to incorporate a detailed hierarchy among secured creditors, ensuring that high charge-holders are given their due priority over subsequent charge-holders. This would align the IBC with the established principles under the Transfer of Property Act, of 1882, and other commercial law.

2. Incorporating International Best Practices:

1. Adopt UNCITRAL Legislative Guide Approaches: Integrating the approaches outlined in the UNCITRAL Legislative Guide, particularly the group solution approach which creates a separate class for exclusive creditors. This would ensure that secured creditors with primary charges are distinctly recognized and prioritized.
2. Learn from US and UK Models: The US Bankruptcy Code (Chapter 11) and UK insolvency laws provide clear bifurcation of creditors based on their claims and ensure that secured creditors retain their liens or receive equivalent payments. Adopting similar provisions could enhance predictability and fairness in the Indian context.

3. Judicial Clarity and Consistency:

1. Precedent Harmonization: The Supreme Court and appellate tribunals should strive for consistency in their judgments regarding secured creditors’ priority. Establishing a dedicated bench or a specialized committee to handle insolvency cases could help in creating uniform jurisprudence.
2. Clarifying Judicial Interpretations: Issuing practice directions or guidelines based on landmark judgments (like Essar Steel and Rainbow Papers) can help lower courts and tribunals interpret the IBC consistently.

By implementing these suggestions, the IBC can be refined to better address the issue of inter se priority among secured creditors, ensuring a more predictable, fair, and efficient insolvency resolution framework.

CONCLUSION:

The Insolvency and Bankruptcy Code (IBC), 2016, has transformed India’s insolvency framework by establishing a structured and timely process for resolving distressed assets. However, the issue of inter se priority among secured creditors remains unresolved, causing significant uncertainty. Despite the Bankruptcy Law Reforms Committee (BLRC) and the Insolvency Law Committee (ILC) addressing this issue, ambiguities persist, leading to inconsistent judicial interpretations and complicating the resolution process.

The lack of explicit provisions in Section 53 of the IBC regarding the hierarchy of secured creditors, especially those with different levels of charges, has created confusion. This has resulted in divergent court rulings, hindering the Code’s objectives of value maximization and efficient recovery.

International practices, such as those from the UNCITRAL Legislative Guide, US Bankruptcy Code, and UK insolvency laws, offer valuable insights. These systems clearly distinguish and protect secured creditors’ priority rights, ensuring predictable outcomes. Incorporating similar principles into the IBC could enhance its effectiveness.

To address these issues, legislative amendments are essential. Clarifying inter se priority among secured creditors in the IBC and revising Section 53 to reflect a clear hierarchy will provide the necessary clarity. Promoting standardized inter-creditor agreements and establishing a centralized secured transactions registry can further mitigate conflicts and ensure transparency.