Classification of Creditors: Constitutional Validity of the Insolvency and Bankruptcy Code, 2016

[Medhashree Verma and Kavya Lalchandani]

The authors are 3rd year students of National Law University Odisha, Cuttack.

 Introduction 

The long-standing dilemma regarding the constitutionality of the Insolvency and Bankruptcy Code, 2016 (IBC) has been finally settled by the Hon’ble Supreme Court of India. In Swiss Ribbons Pvt. Ltd. & Anr v. Union of India,[i]the court answered all the issues regarding the constitutionality of the IBC and stands as a perfect example of Judicial Deference to enter into the sphere of legislaturefor matters relating to the economy of the country which the legislature has the liberty to experiment with. Keeping in mind the background and the pre-existing state of laws regarding insolvency, the court observed that unification of law governing insolvency was necessary and a system of speedy disposal of insolvency matters and a fast resolution process was necessary to save the economy from rising Non-Performing Assets.

The Court also referred to the BLRC report which stated that “In such an environment of legislative and judicial uncertainty, the outcomes on insolvency and bankruptcy are poor”. Thus, in order to expedite the process of insolvency resolution and to save the financially unstable companies as a going concern, the IBC was enacted. The court stated that “The Code is thus a beneficial legislation which puts the corporate debtor back on its feet, not being mere recovery legislation for creditors”. It dealt with the following pressing issues related to the IBC:

Classification of creditors: Article 14

IBC happens to be the first insolvency legislation to have created a distinction between the creditors as operational creditors and financial creditors. The preferential treatment given to the financial creditors under the scheme of the Act to the extent of ignoring the interest of the operational creditors has been a topic of moot since the inception of the IBC. It was also contended that the classification between the two kinds of creditors is discriminatory as the debtors to the operational creditors are given a notice of demand under the provisions of the Act and are even entitled to raise a genuine dispute regarding the same while the debtors to the financial creditors are not entitled to the same. Moreover, vires of section 21 and 24 of IBC were also assailed on the ground that the operational creditors do not get a right to vote in the meetings of the committee of creditors. It was contended that there is no intelligible differentia in the classification of creditors and hence the same violates Article 14 of the Constitution. However, the Court rejected the arguments and held that the class of financial creditors is mostly limited to the banks and financial institutions who lend huge amounts to the corporate debtors. Their credit is usually secured, unlike the operational creditors who are unsecured and grant loans in small amounts.

Also, the nature of lending is different between the financial and operational creditors. The financial creditors lend money to the enterprises for working capital or on term loan which helps the corporate debtor in initiating and running the business. On the other hand, operational creditors are related to lending and supply of goods and services. The court noted that the amount that is owed to the operational creditors is generally less and contracts entered into with the operational creditors do not have clauses relating to a specific repayment schedule.

The court further observed that in the case of an operational creditor there is a larger possibility of existence of a genuine dispute and can use arbitration as a means of settling their dispute. In contrast, the financial debts lent by the financial creditors have authentic documentation maintained by the banks and the financial institutions and the defaults made can be easily verified. Furthermore, financial creditors are concerned with the financial health of the corporate debtor and are in a better position to restructure the loans and help the corporate debtor recuperate from the financial stress which the operational creditors do not and cannot do because of the nature of contract that they enter into with the corporate debtor. Thus, there exists an intelligible differentia in the classifications of the creditors which is directly related with the object of the act which is to preserve stressed entities as a going concern and implements fast resolution mechanisms for the corporate debtor.

The court observed that vires of Section 21 and 24 of IBC cannot be assailed on the ground that the operational creditors do not get a right to vote in the meetings of the committee of creditors as no resolution plan is passed by the adjudicating authority without ensuring that roughly equal treatment is given to the operational creditors as well. It is to be ensured that the minimum payment is made to the operational creditors which should not be less than the liquidation value.

Analysis:

The reasoning that the court used to justify the preferential treatment given to the financial creditors over operational creditors fails to address the fact that in some legislations may incidentally affect the rights and welfare of a party which may not have been its may concern. In the present case, this anomalous situation circles the operational creditors as the primary focus of the legislation is to give control of the stressed company to the financial creditors. This can be explained throughthe matter of Bhushan Steel ltd[ii].,in which Larsen and Toubrochallenged the claims it was supposed to receive as the operational creditor to the Bhushan Steel. Bhushan Steel owed about nine hundred crores to Larsen and Toubro. Larsen and Toubro made a move to the NCLAT and pleaded that the committee of creditors (which consists only of the financial creditors) had satisfied most of its claims. But, on the other hand the dues of the operational creditors were not settled.  It further contended out of the total amount of the total amount of 12 billion that has been earmarked for the settlement of dues of the operational creditors, 10 billion must be given to Larsen and Toubro. The Tata Steel’s resolution plan had proposed payment of 1000 crore to the operational creditors and payment of another 200 crores on pro-rata basis, depending on the “vitality in running the business” of acquired company. Formed with the objective of considering the interest of all the stakeholders involved in the resolution process, the IBC, however, is not doing justice to the operational creditors of the firm by keeping only the financial creditors in the committee of creditors.

In Swiss Ribbons Pvt. Ltd. & Anr,the court showed complete deference to the legislature with respect to the IBC and upheld the constitutional validity of the code in totality. It is suggested, that in order to make the position of the operational creditors better in the insolvency resolution process, a category of operational creditors can be created on the basis of the amount lent to the corporate debtor, out of which those who have transacted in huge amounts with the corporate debtor can be given a say in the committee of creditors to mend situations that arise in cases like Larsen and Toubro’s.

 

[i]Swiss Ribbons Pvt. Ltd. & Anr, https://barandbench.com/wp-content/uploads/2019/01/IBC-Judgment_watermark_2019-01-25-13-07-59.pdf

[ii]Larsen & Toubro Ltd. …Appellant Vs Bhushan Steel Ltd. & Ors.

https://nclat.nic.in/Useradmin/upload/3513507275b88ead46b14c.pdf.

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