Deviation in Asset Distribution: Conundrum of Waterfall Mechanism under IBC

[By Manas Shrivastava & Adaysa Hota]

The authors are students at National Law University Odisha.

 

INTRODUCTION

During a company’s liquidation proceedings, a secured Creditor has been presented with two options under the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as “IBC”) “relinquish its security interest to the liquidation estate and receive proceeds from the sale of assets by the liquidator” or “realise its security interest”. If the secured creditor realises its security interest outside the liquidation proceeding, two circumstances follow. Firstly, where the enforcement of a security interest results in a sum by way of proceeds that is greater than the amount owed, they must give the liquidator any surplus funds in addition to their share of the costs associated with the liquidation procedure. The previous situation is straightforward, but the complexity arises in the second situation, where the proceeds of realisation are insufficient to cover the debt, and the liquidator must pay the secured creditor’s outstanding debts in accordance with Section 53. Furthermore, in accordance with Section 52, as stated above, the secured creditor may also choose to relinquish its security interest but this too must be done in the manner specified under Section 53.

This is where the waterfall mechanism for liquidation comes into play, i.e. when a corporate debtor is unable to repay all its creditors, the entire sum due. The remaining amount of debt and number of creditors is the Rubicon of the waterfall mechanism. The debt, thus befitting the term “waterfall”. Although the waterfall mechanism is considered to be the heart of the IBC, it was introduced in the Companies Act, 2013.

COMPARING THE WATERFALL MECHANISM UNDER COMPANIES ACT 2013 AND IBC 2016

Since the inception of the IBC, there has been a debate raging on whether the mechanism under the Code is essentially the same as that enshrined under Section 326 of the Companies Act, 2013. And if the answer to that is yes, scholars argue that the redundancy must be done away with. Even the Supreme Court has recently considered this matter. But, before we try to find the answers to these questions, it is imperative to understand the mechanism, separately, from the context of IBC as well as the Companies Act 2013.

One can decipher from the provisions that there are several tiers of creditors, and priority will be granted in accordance with their order. For instance, under the IBC, secured creditors rank second while government obligations rank fifth. But while the Act lays the mechanism for winding up of the company, the Code focuses only on liquidation.

Insolvency Resolution Procedure (IRP) and liquidation costs are paid with the highest priority under section 53 of IBC. Thereupon, “workmen’s dues for twenty-four months preceding the liquidation commencement date” and “debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52” are placed in the same hierarchy for repayment.

Herein lies the second distinction between the waterfall mechanisms used by IBC and CA. In contrast to the Code, payment of workmen’s compensation and a secured creditor who has achieved its security interest is not pari passu from the outset under section 326 of the 2013 Act. They will be in the same hierarchy only after paying any outstanding workmen’s compensation and accumulated vacation pay from the two years before the winding up order. The Proviso to Section 326(1) requires the company to reimburse the above-mentioned sum to workers or “in case of their death, to any other person in his right” before repayment to the secured creditors within thirty days from the sale of assets.

Thirdly, IBC’s waterfall mechanism requires payment of “wages and any unpaid dues owed to employees other than workmen for twelve months preceding the liquidation commencement date,” whereas CA only allows four months. Thereafter IBC ranks unsecured creditors for repayment but CA has no such provision for such creditors.

IBC at fifth position ranks, “any amount due to the Central and State Governments 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” and “debts owed to a secured creditor for any amount unpaid following the enforcement of security interest” equally. Whereas, CA provides for payment of the preceding year only.

Additionally, IBC houses provisions for payment of the debt owed to unsecured creditors and to Secured Creditors if they relinquish their security interest and opt for preferential payment, whereas CA fails to do so. Furthermore, the IBC Amendment Act of 2019 has added provisions for operational creditors and dissenting financial creditors in the waterfall mechanism, which the CA has yet not recognized.

DEVIATION SHOWN BY THE COURTS FROM THE PATH OF THE WATERFALL MECHANISM

The supreme court in various cases has upheld the validity of the waterfall mechanism under IBC, but still, there is a current trend going on where the courts are deviating from following the waterfall mechanism while distributing the assets.

In a recent case of State Tax Officer v. Rainbow Papers Limited (hereinafter “Rainbow Papers”) where the court clearly showed a deviation from the waterfall mechanism under section 53 of IBC 2016. The case deals with state legislation, where the state tax authority has a security interest against the corporate debtor thus, making the state tax authority as “secured creditor”. The court carved this exception under section 48 of Gujarat Value Added Tax Act, 2003 which provides a first charge to state tax authority, on the property of a corporate debtor, which goes against the mechanism. Similarly, in the case of Jet Aircraft Maintenance Engineers Welfare Association v. Ashish Chhawchharia (hereinafter “The Jet airways case”) the court deviated from following it and held that until the onset of the insolvency, the company has to pay the whole provident fund to the workers and employees and the gratuity payment. It is pertinent to note that under section 53(1)(b) of IBC, these payments are limited to a period of 24 months only, which causes extra liability for the companies and is not according to the mechanism.

THE EXCEPTION OF “PUBLIC INTEREST”

The above two exceptions were carved out by the court by adhering to some other statute however, recently the court deviated from following the waterfall mechanism by citing the reason of “public interest”. In the matter of Union of India v. Infrastructure Leasing & Financial Services Limited (hereinafter “IL&FS case”), the NCLAT declined to implement the waterfall distribution of profits as specified in Section 53 of the IBC in the name of “public interest.” The court believed that when a company conducts its affairs in a way that is detrimental to the public interest, the competent tribunals may issue decisions pertaining to a management change or a debt restructure to allow for a cash infusion to rebuild the trust of the public stakeholders. The legal basis behind this order is section 241 of the Companies Act 2013, which provides the power to the tribunal “to make ‘any order’ as it may think fit to end the matters complained of”. However, while exercising its power to make any order the court went outside the purview of IBC, as the code has no provision to carve out an exception solely based on “public interest”.

The meaning of the phrase “public interest” depends on the context in which it is used. The black law’s dictionary defines public interest as “Something in which the public, the community at large, has some pecuniary interest, or some interest by which their legal rights or liabilities are affected”. In a situation when the issue itself is outside the scope of the Code and neither the legislation nor the tribunal in any matter under the Code has recognized “public interest” as an exception, it is problematic on the part of the tribunal to create an exception.

CONCLUSION AND THE WAY AHEAD

The IL&FS case is one of its kind cases where the court didn’t follow the IBC but rather carved out an exception under section 241 of the Companies Act. The case cannot act to set a precedent, as the issue before the court was novel and no principle of the code applied to it. It can be said that any conclusion by the court, in this case, will be restricted to this case only, and the distribution of assets will be based on the waterfall mechanism and as per the landmark case of Essar Steel India Ltd. v. Satish Kumar Gupta.

In conclusion, that even though the outcome of the IL&FS case is restricted to that case only, the current trend shown by the courts to deviate from section 53 of IBC raises questions on the issue. As the code is in the nascent stage, there is a requirement for change in the code to make space for the need to introduce a proper resolution framework for Group Companies in India.

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