All was well before the National Company Law Appellate Tribunal, New Delhi [NCLAT] pronounced its decision in Binani Industries[1], wherein it held that “the ‘I&B Code’ or the Regulations framed by the Insolvency and Bankruptcy Board of India do not prescribe differential treatment between the similarly situated ‘Operational Creditors’ or the ‘Financial Creditors’ on one or other grounds”.

Prior to this decision the common understanding was that the Insolvency and Bankruptcy Code [“IBC” or “the Code”] gave an upper hand to Financial Creditors vis-à-vis Operational Creditors. This conclusion was, in fact, derived from the various provisions of the Code, for example – Section 21 which provides that the Committee of Creditors shall comprise only of Financial Creditors, and Section 53 (also known as the “waterfall” provision) which accords priority of treatment to Financial Creditors over all other classes of creditors in the matter of repayment of dues. Operational Creditors are included in these “other classes of creditors”.

The waterfall provision i.e. Section 53 of the Code is central to the issue at hand. It is reproduced below for ready reference:

“53.       Distribution of Assets

(1)          Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of the liquidation assets shall be distributed in the following order of priority and within such period and in such manner as may be specified, namely :—

(a)          the insolvency resolution process costs and the liquidation costs paid in full;

(b)          the following debts which shall rank equally between and among the following :—

(i)           workmen’s dues for the period of twenty-four months preceding the liquidation commencement date; and

(ii)          debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;

(c)          wages and any unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date;

(d)          financial debts owed to unsecured creditors;

(e)          the following dues shall rank equally between and among the following:—

(i)           any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date;

(ii)          debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;

(f)           any remaining debts and dues;

(g)          preference shareholders, if any; and

(h)          equity shareholders or partners, as the case may be.

(2)          Any contractual arrangements between recipients under sub-section (1) with equal ranking, if disrupting the order of priority under that sub-section shall be disregarded by the liquidator.

(3)          The fees payable to the liquidator shall be deducted proportionately from the proceeds payable to each class of recipients under sub-section (1), and the proceeds to the relevant recipient shall be distributed after such deduction.

Explanation.— For the purpose of this section—

(i)           it is hereby clarified that at each stage of the distribution of proceeds in respect of a class of recipients that rank equally, each of the debts will either be paid in full, or will be paid in equal proportion within the same class of recipients, if the proceeds are insufficient to meet the debts in full; and

(ii)          the term “workmen’s dues” shall have the same meaning as assigned to it in section 326 of the Companies Act, 2013.”

Financial Creditors are covered under sub-clause b(ii), (d) and e(ii) of sub-section (1) above whereas Operational Creditors fall under sub-clause (f) of sub-section (1). Hence, Financial Creditors rank higher than Operational Creditors and their dues are, therefore, required to be paid in priority over the latter.

It is interesting to note that, though Section 53 finds place in Chapter III – Liquidation Process, sub-clause (b) of sub-section (2) of Section 30 specifically makes it applicable to Chapter II – Corporate Insolvency Resolution Process. Sub-clause (b) reads thus:

“(2)        The resolution professional shall examine each resolution plan received by him to confirm that each resolution plan—

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(b)          provides for the repayment of the debts of operational creditors in such manner as may be specified by the Board which shall not be less than the amount to be paid to the operational creditors in the event of a liquidation of the corporate debtor under section 53;”

Thus, sub-clause (b) specifically imports the waterfall provision in Chapter II of the Code, with the only caveat that the resolution plan must allocate to the Operational Creditors at least the amount which they would have received in the event of liquidation of the Corporate Debtor. In other words, sub-clause (b) prescribes only a lower limit on the amount that is to be paid to Operational Creditors in a resolution process carried out under Chapter II of the Code. This minimum amount can be easily ascertained by calculating the Corporate Debtor’s liquidation value and subtracting therefrom the total dues of Financial Creditors and other persons ranking above the Operational Creditors in the waterfall provision.

The actual implication of these provisions is seen in cases where the Financial Debt of a Corporate Debtor exceeds its Liquidation Value by a considerable margin and the Resolution Plan offers a sum that is insufficient to repay the entire Financial Debt. In such cases, by virtue of the waterfall provision, nothing remains to be paid to Operational Creditors as the resolution amount gets exhausted in repaying the debts/sums ranking higher than the dues of Operational Creditors under Section 53. Only when the resolution amount exceeds the dues of Financial Creditors does the question of repaying the Operational Creditors arise. At least, this is what the aforesaid provisions imply.

The decision in Binani Industries, however, virtually rewrites these provisions and declares that the dues of Financial and Operational Creditors must get “similar treatment” in a resolution process, and that Section 53 cannot be relied upon while approving the Resolution Plan. The following extracts from the aforesaid decision deserve to be quoted:

“3.         ……………………

e.           It follows from the above:

i.            The liabilities of all creditors who are not part of ‘Committee of Creditors’ must also be met in the resolution.

ii.           The ‘Financial Creditors can modify the terms of existing liabilities, while other creditors cannot take risk of postponing payment for better future prospectus. That is, ‘Financial Creditors’ can take haircut and can take their dues in future, while ‘Operational Creditors’ need to be paid immediately.

iii.          A creditor cannot maximise his own interests in view of moratorium.’

iv.          If one type of credit is given preferential treatment, the other type of credit will disappear from market. This will be against the objective of promoting availability of credit.

v.           The ‘I&B Code’ aims to balance the interests of all stakeholders and does not maximise value for ‘Financial Creditors’.

vi.          Therefore, the dues of creditors of ‘Operational Creditors’ must get at least similar treatment as compared to the due of ‘Financial Creditors’.”

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“29.       We agree with the submissions made by Mr. Arun Kathpalia, learned Senior Counsel that Section 53, including explanation given therein cannot be relied upon while approving the ‘Resolution Plan’. …”

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“48.       If the ‘Operational Creditors’ are ignored and provided with ‘liquidation value’ on the basis of misplaced notion and misreading of Section 30(2)(b) of the ‘I&B Code’, then in such case no creditor will supply the goods or render services on credit to any ‘Corporate Debtor’. All those who will supply goods and provide services, will ask for advance payment for such supply of goods or to render services which will be against the basic principle of the ‘I&B Code’ and will also affect the Indian economy. Therefore, it is necessary to balance the ‘Financial Creditors’ and the ‘Operational Creditors’ while emphasizing on maximization of the assets of the ‘Corporate Debtor’. Any ‘Resolution Plan’ if shown to be discriminatory against one or other ‘Financial Creditor’ or the ‘Operational Creditor’, such plan can be held to be against the provisions of the ‘I&B Code’.”

The aforesaid decision presents the following problems. Firstly, it virtually rewrites the provisions of the Code by excluding the applicability of Section 53 from resolution process carried out under Chapter II of the Code, contrary to the plain and unambiguous language of Section 30(2)(b). Secondly, it fails to recognize the legislative intent in creating a distinction between two classes of creditors, viz. Financial Creditors and Operational Creditors and instead, virtually erases the said distinction, once again over-stepping the limits of its jurisdiction and wrongly exercising law-making powers. Thirdly, it relies on conjectures and extraneous considerations for bolstering its position. There is no factual basis for observing that Operational Creditors will “refuse to supply goods or render services on credit” or “ask for advance payment for such supply of goods or to render services” if their dues are not given priority.

There are many other grounds on which the aforesaid decision can be questioned, but that is not the intent of this article. The fact remains that the aforesaid decision, rightly or wrongly, places Financial and Operational Creditors on an equal footing, thus virtually erasing the distinction specifically carved between these two classes of creditors by the provisions of the Code. Shortly after it was pronounced, the above decision was upheld by the Supreme Court of India through an unreasoned order[2] and has thus attained finality.

To say the least, the decision in Binani Industries has opened the flood-gates for reopening of previously concluded cases as well as filing of fresh applications and appeals, by Operational Creditors, alleging “discrimination” and seeking “parity” with Financial Creditors. The Binani Industries decision has neither defined nor circumscribed the otherwise broad concept of “discrimination” when used in relation to Financial and Operational Creditors, leaving it rather vague and elusive.

Shortly afterwards, a landmark decision was delivered by the Supreme Court of India in Swiss Ribbons[3] upholding the constitutional validity of various IBC provisions including, inter alia, the waterfall provision i.e. Section 53. It was also expressly held that the classification between Financial and Operational Creditors is neither discriminatory, nor arbitrary, nor violative of Article 14 of the Constitution of India, and that there is obviously an intelligible differentia between the two classes of creditors which has a direct relation to the objects sought to be achieved by the Code. While upholding the validity of Section 53, the Court observed as under:

“84.       It will be seen that the reason for differentiating between financial debts, which are secured, and operational debts, which are unsecured, is in the relative importance of the two types of debts when it comes to the object sought to be achieved by the Insolvency Code. We have already seen that repayment of financial debts infuses capital into the economy inasmuch as banks and financial institutions are able, with the money that has been paid back, to further lend such money to other entrepreneurs for their businesses. This rationale creates an intelligible differentia between financial debts and operational debts, which are unsecured, which is directly related to the object sought to be achieved by the Code. In any case, workmen‘s dues, which are also unsecured debts, have traditionally been placed above most other debts. Thus, it can be seen that unsecured debts are of various kinds, and so long as there is some legitimate interest sought to be protected, having relation to the object sought to be achieved by the statute in question, Article 14 does not get infracted. For these reasons, the challenge to Section 53 of the Code must also fail.”

Though the above passage is quite clear, it still does not countenance Binani’s exclusion of Section 53 from Chapter II of the Code. What follows from a combined reading of both judgments is, that even though there exists intelligible differentia for differentiating between Financial and Operational Creditors, they would still be treated at par for the purposes of repayment of dues pursuant to a Corporate Resolution Insolvency Process under Chapter II of the Code. This presents an inherent contradiction leading to uncertainties in the outcome of resolution process.

The situation is further confounded by the following paragraphs of the Supreme Court’s decision:

“46.       The NCLAT has, while looking into viability and feasibility of resolution plans that are approved by the committee of creditors, always gone into whether operational creditors are given roughly the same treatment as financial creditors, and if they are not, such plans are either rejected or modified so that the operational creditors‘ rights are safeguarded. It may be seen that a resolution plan cannot pass muster under Section 30(2)(b) read with Section 31 unless a minimum payment is made to operational creditors, being not less than liquidation value. Further, on 05.10.2018, Regulation 38 has been amended. Prior to the amendment, Regulation 38 read as follows:

“38.       Mandatory contents of the resolution plan.— (1) A resolution plan shall identify specific sources of funds that will be used to pay the—

(a)          insolvency resolution process costs and provide that the [insolvency resolution process costs, to the extent unpaid, will be paid] in priority to any other creditor;

(b)          liquidation value due to operational creditors and provide for such payment in priority to any financial creditor which shall in any event be made before the expiry of thirty days after the approval of a resolution plan by the Adjudicating Authority; and

(c)          liquidation value due to dissenting financial creditors and provide that such payment is made before any recoveries are made by the financial creditors who voted in favour of the resolution plan.”

Post amendment, Regulation 38 reads as follows:

“38.       Mandatory contents of the resolution plan.— (1) The amount due to the operational creditors under a resolution plan shall be given priority in payment over financial creditors.

(1-A)      A resolution plan shall include a statement as to how it has dealt with the interests of all stakeholders, including financial creditors and operational creditors, of the corporate debtor.

xxx xxx xxx”

47.         The aforesaid Regulation further strengthens the rights of operational creditors by statutorily incorporating the principle of fair and equitable dealing of operational creditors‘ rights, together with priority in payment over financial creditors.

48.         For all the aforesaid reasons, we do not find that operational creditors are discriminated against or that Article 14 has been infracted either on the ground of equals being treated unequally or on the ground of manifest arbitrariness.”

Here, the Supreme Court is seen to be supportive of the Binani ratio that the dues of Financial and Operational Creditors are to be treated on equal footing. In fact, the Supreme Court has gone one step further and observed that the amended Regulation 38 ensures priority of repayment to Operational Creditors over Financial Creditors.

One quick glance at the amended Regulation 38 shows that it directly militates against the provisions of the Code. The term “priority” used in amended Regulation 38 can only mean that the dues of the Operational Creditors shall be accorded priority over the dues of Financial Creditors. The “priority” accorded to Operational Creditors by amended Regulation 38 overrides the concept of a minimum payment prescribed in Section 30(2)(b). Besides, it also violates Section 53 of the Code by practically reversing the order of priority set out in Section 53.

In the face of these ambiguities and contradictions, it would be safe to say that the question of applicability of Section 53 to Chapter II of the Code was not in issue before the Supreme Court and hence, the above observations cannot be taken as a precedent. However, the decision in Binani Industries is still good law, as also the basis for challenge by Operational Creditors to Resolution Plans that do not provide for repayment of their dues at par with the dues of Financial Creditors. This is leading to absurd consequences, which can be best described by the following hypothetical example.

Let’s say, the Financial Debt of a Corporate Debtor stands at Rs. 100/- and the Operational Debt stands at Rs. 50/-. The resolution process commences, and the liquidation value (in other words, the maximum realizable value from the sale of assets) of the Corporate Debtor is fixed at Rs. 50/-. In these circumstances, if the Corporate Debtor were to be liquidated under Chapter III, the waterfall provision would ensure that the entire Rs. 50/-, so raised from sale of assets of the Corporate Debtor, will be spent towards repaying the Financial Debt and nothing will be left to repay the Operational Debt.

Now, say, this Corporate Debtor undergoes resolution process under Chapter II and a resolution plan is approved by the Committee of Creditors, which allocates a sum of Rs. 50/- towards repayment of dues of creditors of the Corporate Debtor. In these circumstances, on a conjoint reading and application of Section 30(2)(b) and Section 53 of the Code, it will be open for the Resolution Applicant to allocate the entire sum of Rs. 50/- towards (part) repayment of the Financial Debt, leaving no amount for repayment of the Operational Debt.

With the new interpretation given to the aforesaid provisions in Binani Industries, the Operational Creditor is now at liberty to challenge the above resolution plan on the ground of “discrimination”. However, there is no clarity on;

• what must be done once such challenge is made?
• how should the resolution amount be distributed between the Financial and Operational Creditors?
• whether the amount should be divided equally or on pro rata basis depending on their dues?
• whether Financial Creditors get priority in repayment over Operational Creditors or is it the other way around?
• who should take a bigger hair-cut, the Financial Creditors or the Operational Creditors?

There is also no clarity or guidance available for future Resolution Applicants and Committees of Creditors, who are affected by the seemingly confounding and/or contradictory views put forth in Binani Industries and Swiss Ribbons. These contradictions raise questions galore, and till such time these questions are conclusively answered by the Supreme Court of India, the battle between Financial and Operational Creditors is unlikely to end.

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[1] Binani Industries Ltd. v. Bank of Baroda & Anr., Company Appeal (AT) (Insolvency) No. 82 of 2018, vide Judgment dated 14.11.2018.

[2] Rajputana Properties Pvt. Ltd. v. Ultra Tech Cement Ltd. & Ors., Civil Appeal No. 10998 of 2018, vide Order dated 19.11.2018.

[3] Swiss Ribbons Pvt. Ltd. v. Union of India, Writ Petition (Civil) No. 99 of 2018, vide Judgment dated 25.01.2019.

– Prithu Garg (Partner)