[By Samyak Jain]
The author is a student at NMIMS School of Law, Mumbai.
Waterfall mechanism under Insolvency and Bankruptcy Code (IBC or the code) prioritizes secured creditors over other stakeholders when secured creditors don’t enforce the security separately. This acts as an incentive for a lot of them to relinquish their security interest to liquidation estate. However, a situation of deadlock is created when joint charge holders over security are not able to reach a consensus about its treatment during liquidation. Tribunals have been meaning to resolve this based on the type of charge creditors hold over the security.
Debtors create interest or lien over their assets to secure repayment of the loan. This leads to the creation of a charge and it is governed as per the contract, the debtors and creditors have entered into. Contracts may allow the creation of further charge over the same security following the procedure prescribed in the contract. The further charge created may be a charge pari passu to the first charge or may hold a different ranking. Creditors often enter into contracts that allow the creation of further charges only on their consent or on the issuance of a No Objection Certificate (NOC). The distinction between both types of charge lies in the priority given to them. Charge on a pari passu basis keeps all the creditors on equal footing, whereas a charge of different ranking gives the highest priority to the first charge holder.[i] Liquidation proceedings pose a challenge for liquidators when joint charge holders are not able to collectively decide about the treatment of their security. Disagreement can exist among charge holders on whether to relinquish their security interest to liquidation estate and enjoy a higher priority in the waterfall mechanism during repayment or separately enforce the security outside the liquidation pool. Tribunals have studied cases of disagreement in both types of charge and have taken diametrically opposite stands.
First Charge Holders’ Right
Right of first charge holders came to the forefront in the case of JM Financial Asset Reconstruction Company Ltd. v. Finquest Financial Solutions Pvt. Ltd.[ii] (JM Financial case). When Reid & Taylor were undergoing liquidation proceedings, Finquest filed an application u/s 52 of the code seeking leave to sell off the secured asset as they contended exclusive first charge over it. Other secured creditors objected to the contention and claimed a pari passu charge on the asset. Being joint charge holders they demanded relinquishment of security to liquidation estate. They put forth the argument that IBC treats all secured creditors the same and does not distinguish on nature of the charge or on the ranking of respective charge. And therefore, first charge holders are not entitled to special rights. NCLAT perused section 52 of the code to resolve the issue. They emphasized over the process that after setting off the realized amount against the debts due, excess proceeds from the ‘first enforcement’ of security is to be deposited with the liquidator. The wording of the provision allows only single enforcement of the security as per interpretation. Sub-section (4) of the provision[iii] gives power to ‘a secured creditor’ to enforce the security interest through any legal mechanism applicable to it. Based on the reasoning above, NCLAT held that only one secured creditor can enforce security interest to realize its debt and observed that “If one or more ‘Secured Creditors’ have not relinquished the ‘security interest’ and opt to realize their ‘security interest’ against the same very asset, the Liquidator will act in terms of Section 52(3) and find out as to who has the 1st charge”[iv].
NCLAT recognized the right of only first charge holders to enforce the security. An excess amount after recovering the debt of the first charge holder would be required to be deposited in the liquidator’s account. Tribunal denied rights to other secured creditors in case a first charge holder exists. Despite having security to protect their debt, they are treated no different than an unsecured creditor. Also, the decision throws up a challenging question about the treatment of other secured creditors in the waterfall mechanism. What position would other secured creditors enjoy in the waterfall mechanism during distribution is unaddressed by the tribunal. In my opinion, NCLAT has erred in interpreting the provision. It failed to consider the intent of the legislature of prioritizing a secured debt. The statute accords special treatment to secured creditors for obvious reasons that they have security to enforce their debt. If this judgment’s literal interpretation of a provision is enforced, secured creditors other than exclusive charge holders will find their secured debt futile in the IBC regime.
Majority Rule among Joint Charge Holders
While the above ruling takes away the rights of secured creditors to some extent, NCLAT Delhi has seemingly taken a balanced stand in the issue of pari passu charge in the Mr. Srikanth Dwarkanath vs. Bharat Heavy Electricals Limited[v] (Dwarkanath Case).
On the passing of a liquidation order against the corporate debtor, the liquidator filed an application owing to the inability to form the liquidation estate. A liquidator could not commence the liquidation process on account of the deadlock created among secured creditors with respect to relinquishment of security interest. Multiple creditors held charge over the secured asset. Among all, 74% of the secured creditors allowed the secured asset to be a part of liquidation estate. But the liquidator still couldn’t attach the property in his pool on account of refusal from Bharat Heavy Electricals to relinquish the security. Bharat Electricals claimed itself as a superior charge holder. They demanded enforcement of security placing reliance on JM Financial case. However, the court held that the facts of the present case are different from JM Financial owing to the absence of a superior charge over security. With the presence of a charge of equal ranking, NCLAT found it apt to refer to Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (SARFAESI act) to end the deadlock. It specifically referred to Section 13(9) of SARFAESI[vi] which is used for enforcement of security. Tribunal highlighted the statutory requirement of consent from 66% secured creditors (in terms of the value of debt) of the provision to validate the decision of 74% secured creditors in the present case. NCLAT held that “the decision of 73.76% of majority Secured Creditors, who have relinquished the Security Interest shall also be binding on the dissenting secured creditors”[vii].
Analysis
The code allows secured creditors to enforce security through any law applicable and SARFAESI provides one among many ways. However, the tribunal in the Dwarkanath case did not consider another mechanism of enforcement while resolving the issue. The judgment has recognized SARFAESI act as the sole mechanism of security enforcement. It has neglected IBC’s own mechanism under Regulation 37 of liquidation regulations. The regulation allows secured creditors to realize security interest under IBC without having to refer to other statutes for enforcement. Failing to consider every perspective is likely to throw questions about the validity of the decision. In spite of this, the decision is balanced in considering the interest of all stakeholders. The majority rule rightly gives effect to the charge of equal ranking as it involves equal say of every creditor based on debt share. NCLAT may have erred in making a statement recognizing only enforcement under the SARAESI act, but has led to a sensible conclusion.
Unlike the Dwarkanath case, JM Financial decision is far from a fair conclusion. The decision has negated the concept of secured debt because it ranks secured creditors (other than first charge holders) at par with unsecured creditors during liquidation. It has made the distinction provided in the code infructuous. The same distinction was validated by the Supreme Court in Swiss Ribbons Pvt. Ltd. v. Union of India[viii]. Secured creditors (which are mostly financial creditors) enjoy a prioritized treatment for the simple fact that they infuse capital in the economy and keep the cash flow running. This justifies their distinguished treatment in IBC which the JM Financial decision has failed to honor. A fair and equitable solution would have been a preference-based realization of the debt of all charge holders. Secondary charge holders should have been allowed to recover their debt from the remaining proceeds after the first charge holder has set off against his debt. JM Financial case has given birth to joint charge holders’ predicament. Further adding to their plight, it has also left the secondary charge holder’s position ambiguous in the waterfall mechanism.
[i] Geeta Saar, ‘Charges – Definition and Some Basic Concepts’, ICSI, https://www.icsi.edu/media/portals/86/geeta%20saar/Geeta_Saar_16-Charges_-_Definition_and_some_Basic_Concepts.pdf.
[ii] JM Financial Asset Reconstruction Company v. Finquest Financial Solutions, 2019 SCC OnLine NCLAT 918.
[iii] The Insolvency and Bankruptcy Code, 2016, § 52(4), No.16, Acts of Parliament, 2016 (India).
[iv] Supra note ii, ⁋42.
[v] Mr. Srikanth Dwarkanath vs. Bharat Heavy Electricals Limited, Company Appeal (Insolvency) No.1510/2019.
[vi] Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, § 13(9), No. 54, Acts of Parliament, 2002 (India).
[vii]Supra note v, ⁋16
[viii] Swiss Ribbons Pvt. Ltd. v. Union of India, (2019) 4 Supreme Court Cases 17.