INTRODUCTION:

Insolvency and Bankruptcy Code, 2016 came into existence to govern the easy exit of businesses, it has been witnessed from time to time that India has been lacking the legal framework for the companies whose businesses have been hindered and they want to exit the market although it had also been a matter of concern to determine the order of distribution of assets at the time of liquidation of the company. Previously there were no specific provisions to govern the distribution of assets amongst the creditors. But in the present era section 53 of the Insolvency and Bankruptcy code, 2016 deals with the mechanism for the distribution of assets under liquidation.

The mechanism laid down under the code is termed as “waterfall mechanism”. In a general sense, the waterfall mechanism lay put the list of stakeholders in a sequential manner to indicate the priority in getting the payments from liquidation.

HISTORICAL PERSPETIVE:

At the time of Insolvency proceedings, the Inter-se ranking amongst creditors plays an important role as it dictates the arrangement and determines the priority in which the financial offerings by the resolution applicant shall be distributed to the secured creditors. The status of determining the priority was the different pre-IBC regimes and post IBC regimes.

Pre-IBC Regime:
The Supreme Court of India in the case of ICICI Bank v. Sidco Leathers Ltd. and Others¹ addressed the issue of priority under Sections 529 and 529A of the Companies Act, 1956, which govern the ranking of creditors’ claims in a company in liquidation similar to what is given under section 53(1) (b) of the code. In this instance, the Supreme Court interpreted the meaning and scope of Section 48 of the Transfer of Property Act, 1882 to rule that the first-charge holder’s claims would persuade over the second-charge holder’s. The Supreme Court also noted that there was a lack of legislative clarity on this issue and that if the legislature had intended to reduce a right as important as the right of priority, it would have done so explicitly in the legislation.

Post- IBC Regime:
Even after the IBC came into force, there has been no clarity on this subject. Explanation: Section 53 of the IBC provides that “Each of the debts will be paid in full, or in equal proportion within the same class of beneficiaries, if the proceeds are inadequate to meet the debts in full, at each step of the distribution of proceeds in respect of a class of recipients who rank similarly.”

As a result, the IBC envisions the distribution of liquidation proceeds on a pari passu basis, or on an equal level, among the same class of stakeholders. Any agreement that upsets the priority ranking established by Section 53 of the IBC must be rejected, according to Section 53(2) of the code. Moreover, the issue of priority of inter-se secured creditors who have relinquished their security interests has not been specifically cleared by the code.

The National Company Law Appellate Tribunal in the matter of Technology Development Board v Anil Goel² held that “the moment when a secured creditor relinquishes their security interest in the liquidation estate, the sale proceeds shall then be strictly distributed as per the waterfall mechanism given under section 53 of IBC remains unpaid following the enforcement of security interest thereby when compared to a secured creditor, it has a lower priority.”

THE WATERFALL MECHANISM UNDER IBC:

The waterfall mechanism lays down that at the time of the company’s liquidation and while distributing the assets of the company the secured financial creditors shall be given the priority and the amount belonging to them shall be paid fully according to their admitted claim before initiating any distribution to unsecured financial creditors.

The Appellate Authority in its recent landmark judgment in the case of Technology Development Board vs. Anil Goel, Liquidator of Gujarat Oleo Chem Limited (GOCL) & Ors³ made it specifically held that: “Whether the Secured Creditor holds a first charge or second charge is material only if the Secured Creditor elects to realize its security interest.” “However, once a Secured Creditor opts to relinquish its security interest, the distribution of assets would be governed by Section 53(1)(b)(ii), which states that – all Secured Creditors who have renounced security interests rank equally.”

Statutory provision:
The statutory provision which sets out the order of priority for the distribution of sale proceeds from the sale of liquidation assets is categorically mentioned under Section 53 of the Insolvency and Bankruptcy Code, 2016.

According to section 53 (1) (b):
“The following debts will be ranked equally between and among them:
(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”

According to Section 53(2) of the code:
“The liquidator will overlook any contractual arrangements between receivers under sub-section (1) with equal ranking if they disturb the sequence of priority under that sub-section.”

WATERFALL MECHANISM AND MEANING OF SECURED CREDITOR:

A secured creditor is one in whose favor a “security interest” has been created by the corporate debtor.⁴ Section 52 of the code provides the secured creditors with two options:

• either to realize its security interest, or
• give away its security interest to the liquidation estate⁵

It is the duty of each secured creditor to communicate to the liquidator about his decision to either relinquish his security interest or to realize its security interest.
If the secured creditor fails to inform the liquidator of its intention within 30 days from the commencement of the liquidation process, the security interest held by such secured creditor is deemed to be relinquished.⁶
In case a secured creditor chooses to relinquish its security interest then it has to stake its claim to the liquidation estate.

CONCLUSION:

The prevailing approach towards the Secured creditors’ priority rights, established at the time of lending, supposedly provides them with a security net in the event that the firm defaults and insolvency procedures are initiated. Even after the IBC was enacted, there is nothing in the IBC that specifically addresses this issue. Furthermore, Section 53(2) of the IBC only prohibits agreements that disrupt the waterfall mechanism’s sequence of precedence. The problem of priority of inter-se secured creditors who have renounced their security interests is left unanswered. As a result, it is clear that there is still lacking legal certainty on this topic.

The intrinsic ambiguity in the topic, as well as the lack of a clear legal precedent, leaves no answer to the difficulty. It is conceivable, however, that any priority rights connected to a security interest stay tied to the security interest, and that when the security interest is abandoned, the priority rights associated with the security interest expire as well. Although it appears that lawmakers considered all issues when establishing the IBC’s liquidation waterfall, which favored secured creditors, legislators should give equal weight to the interests of other stakeholders in order to fulfill the IBC’s goals.

References:

1. (2006) 10 SCC 452.
2. Technology Development Board v Anil Goel, Company Appeal (AT) (Insolvency) No.731 of 2020
3. Company Appeal (AT) (Insolvency) No.731 of 2020
4. Insolvency and Bankruptcy Code, 2016, Section 3 (30).
5. Insolvency and Bankruptcy Code, 2016, Section 52 (1).
6. Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016, Regulation 21A.

This article is written by Shubhendra Joshi, a BBA.LL.B 4th-year student of Indore Institute of Law.