[By Aakriti Rikhi]

The author is a student of National Law School of India University, Bengaluru.

 

Introduction

Section 30(2) of the IBC provides that the resolution plan must provide for a certain minimum amount to the operational creditors and dissenting financial creditors (‘FCs’). For the latter, it states that they must be paid at least the amount that they would have received, had the corporate debtor been undergoing liquidation under section 53. However, the interpretation of minimum liquidation value has been a contentious issue when it comes to payment to dissenting secured FCs. There are two positions as of now. First is that dissenting secured FCs are entitled to receive a payout as per the resolution plan and it is not necessary to pay them the value of their security interest. This position was laid down in India Resurgence Pvt. Ltd. v. M/s Amit Metaliks Ltd. & Anr. The Court here held that the amount to be paid to such creditors is to be decided by the commercial wisdom of the Committee of Creditors (‘CoC’) and a dissenting secured FC cannot claim a higher amount based on the value of their security interest.  The second position is that dissenting secured FCs must be paid the value of their specific security interest as minimum value. This position was laid down in DBS Bank Ltd. v. Ruchi Soya Industries Ltd. & Anr. The Court here held that section 30(2) ensures that dissenting creditors receive the payment of the value of their security interests as that was the legislative intent behind introducing this minimum value through the 2019 amendment. Both the decisions are conflicting and have been referred to a larger bench for consideration.

To that end, this paper analyses the issue of minimum payout to dissenting secured FCs from a law and economics perspective. It uses the Cathedral Model to argue that dissenting secured FCs have an entitlement that is protected by a liability-rule where their consent is not necessary for the relinquishment of their security interest when a plan is approved under section 30(4). Since the liability-rule mandates the payment of an objective fair value as compensation, by paying the dissenting secured FCs below this value (i.e., their security interest), Amit Metaliks has created an anomaly within the IBC framework. If not paid this value, there will be high social costs and a failure of the distributive goal envisaged by the introduction of section 30(2).

Approaching section 30(2) through the Cathedral Lens

To put forth this argument, this paper has been divided into two parts. It first lays down the framework proposed by Calabresi and Melamed and then, applies this framework to section 30(2) in a way that is consistent with the overall objective of the IBC i.e., balancing the interests of all stakeholders.

I. Laying down the basics: The type of entitlements and their general application

The Cathedral Model was developed to help decide that in a dispute between parties having conflicting interests, which interest should be entitled to prevail. It has divided entitlements into three categories: entitlements protected by property rules, entitlements protected by liability rules and inalienable entitlements. For the purposes of this paper, the first two entitlements are relevant. A property-type entitlement is one where someone who wishes to remove the entitlement from its owner must buy it by bargaining with the holder of the entitlement. It requires the consent of both the parties on the value of the entitlement. An entitlement protected by the liability rule, on the other hand, is one where someone may take away the entitlement if she is willing to pay an objectively determined value for it. This objectively determined value is determined not by the parties but by one of the organs of the state.

The application of each type of entitlement depends on economic efficiency, distributional goals and “other justice reasons”. Economic efficiency entails an outcome consistent with Pareto optimality. Pareto optimality asks that the rule that we follow should lead to such an allocation of resources that a further change could not improve the condition of those who have gained by such an allocation, that they could compensate those who have lost from it and still be better off than before. In other words, it is the most optimal situation, assuming that it is not possible to make someone better off, without making the other worse off. So, Pareto optimality’s goal is to minimize the aggregate social costs, which is the sum of damages incurred as a consequence of harm and the costs incurred in preventing this harm. The Cathedral Model does so by putting the costs on the party which can most cheaply avoid them. However, since markets do not function ideally, we do have transaction costs. In light of these transaction costs, the Model presents us with two options: market transactions or collective fiat. Either of these have to be chosen keeping in mind the economically efficient outcome. The second factor is distributional goals. These are grounds which decide the distribution of entitlements. These grounds vary with the purposes that a society seeks to achieve. Lastly, “other justice reasons” includes those reasons which cannot be described in efficiency or distributional terms but are linked with both.

Using these factors, the authors contend that when the cost of establishing the value of an entitlement by negotiation is high, then a voluntary transaction will not be able to occur due to high transaction costs. In such a scenario, it is better that collective fiat should prevail, instead of a mutually beneficial transfer. While this provides us with the economic justification for preferring a liability rule over a property rule, there are distributional reasons for doing so as well. As per the authors, the choice of a liability rule is often made because “it facilitates a combination of efficiency and distributive results”[iv]. Distributional reasons play an integral role in deciding the compensation value in a liability-rule as we shall see in the next section.

Keeping the above framework in mind, the next section provides an analysis of section 30(2) of the IBC as a liability-rule type entitlement of the dissenting secured FCs.

II.   Analyzing Section 30(2) of the IBC as a liability-rule

Section 30(2) in effect, allows the resolution applicant to bypass the consent of dissenting FCs by paying them a minimum payout. It is a liability-rule type entitlement, protecting the dissenting FCs and preventing a blanket cramdown of their rights and interests. It is not an entitlement protected by property-rule because Section 30(4) only mandates that 66% of the CoC must have voted in favor of the plan. For the rest, it mandates a minimum payout. If it were a property-rule entitlement, it would have required all resolution applicants to negotiate with the dissenting creditors and ensure that they also assent to the plan, thereby mandating 100% of the CoC to assent for the plan to be successful. The reason behind using a liability-rule here is same as that discussed in the previous section: to avoid transaction costs. In our case, it is not feasible for a resolution applicant to negotiate with each and every one of the creditors to get them to agree to the resolution plan. This would entail the spending of excessive time and resources, which would dilute the value of the corporate debtor and its assets. Further, there is a high chance of a holdout problem arising since each creditor may not reveal the true valuation that they attach to their security interest or entitlement. So, it is impractical to have individual negotiations take place due to transaction costs. Therefore, this is a typical situation wherein valuation derived through market processes will be either unavailable or too expensive, as compared to the use of collective valuation by an external authority.  This sets the economic efficiency justification for protecting the entitlement of dissenting secured FCs through a liability-rule.

The determination of objective value to be paid to the dissenting secured FCs under this rule should be the value of their specific, exclusive security interest because the value of damages (minimum payout to these creditors) cannot be below the harm caused to them as per Pareto optimality. The harm here is the forced relinquishment of their security interest in favor of revival of the corporate debtor. If the damages are below the harm, then Pareto optimality will not be satisfied as the social costs will be high due to high losses for the dissenting secured FCs and high gains for the successful resolution applicant and the assenting financial creditors, thereby leading to unjust enrichment of the latter.

On the grounds of distribution as well, the determination of minimum payout to dissenting secured FCs should be the value of the security interest. As per the Model, there are distributional reasons for deciding the objective value. It is not based on the victim’s (i.e., the dissenting secured FC’s) valuation. Rather, there are distributional reasons as to why the interest of dissenting secured FCs should be protected by specifying a minimum payout. The reason is the respect for the pre-insolvency bargain struck between secured creditors and the corporate debtor. The distinction between secured and unsecured creditors is well recognized in the IBC discourse as the former are considered to be superior due to the importance of secured credit. As recognized in DBS Bank, “secured credit is important for commerce as it reduces credit risk and carries lower interest due to lower loss value in the event of a failure”. As a result, the pre-insolvency bargain cannot be ignored and this is why, it becomes important to pay the dissenting secured FCs, the value of their security interest.

Conclusion

The decision in Amit Metaliks has discouraged lenders to distressed companies from filing insolvency applications for fear of being unfairly crammed down under a resolution, even if their debts are protected by exclusive security. This paper seeks to remedy this through the application of the Cathedral Model. This is because section 30(2) confers a liability-rule protected entitlement upon dissenting secured FCs and by undercompensating these creditors by paying them below the harm suffered by them, Amit Metaliks has created an anomaly in the scheme of the IBC. This anomaly can be remedied through the application of the Cathedral Model to pay the dissenting secured FCs, the value of the harm inflicted i.e., the forced relinquishment of their security interest.

[i] Guido Calabresi, A. Douglas Melamed, ‘Property Rules, Liability Rules, and Inalienability: One View of the Cathedral’ [1972] Harvard Law Review 1089, 1092.

[ii] ibid.

[iii] ibid 1093.

[iv] ibid 1110.