A ‘Waterfall’ for Insolvency Resolution
Honouring secured contracts and mimicking the liquidation waterfall could promote a judicious system of distribution of proceeds, minimising disputes
By: CKG Nair & M S Sahoo 1
The Insolvency and Bankruptcy Code, 2016 (IBC) has been a road under construction. Ministry of Corporate Affairs has recently issued a discussion paper inviting comments on the changes it is proposing to further strengthen the IBC. One proposal that has attracted considerable attention from the stakeholders is a formula-driven distribution of proceeds of a resolution plan to make it more equitable and minimise disputes. It proposes that creditors will receive proceeds up to the liquidation value for their claims in the order of priority provided in the waterfall. Any surplus over the liquidation value will be rateably distributed between all creditors in the ratio of their unsatisfied claims.
Creditors strike different commercial bargains with the company. For example, three secured financial creditors, A, B, and C have extended loans to a company. A has lent Rs.100 against security valued at Rs.10; B has lent Rs. 100 against security valued at Rs.100; and C has lent Rs.100 against security valued at Rs.200. All three are secured creditors, having different levels of security interest: A is under-secured, B is fully secured and C is over-secured. Where any of them proceeds to enforce its contract against the company, it would at best get the value of the security.
The insolvency law honours pre-existing contractual relationships between debtors and creditors. Accordingly, all secured creditors have priority claims on their respective security. In recognition of the amount of security, an under-secured creditor and a fully secured creditor have different entitlements in an insolvency proceeding. The insolvency law does not treat unequals as equals. During the rehabilitation stage, the moratorium keeps the security intact to be available to the secured creditor during liquidation, failing the rehabilitation of the company. During the liquidation stage, the secured creditor can either take away the security and sell it on its own or leave it with the liquidator to sell the security and receive the sale proceeds. That is why insolvency proceedings generally protect the secured claim to the extent of the value of security, either during the rehabilitation or the liquidation process. Where the secured creditor’s claim exceeds the value of the security, the excess is treated as an unsecured claim.
This principle is firmly ingrained in the liquidation waterfall in the IBC. At the liquidation stage, a secured creditor is entitled only to the value of the security interest, not exceeding the amount of the secured claim. Section 52 of the IBC allows a secured creditor to realise the security interest on its own. If realisation exceeds the debts due to the secured creditor, it shall tender the excess to the liquidator. Where realisation falls short of debts owed to the secured creditor, the unpaid debts shall be paid by the liquidator as per the waterfall under section 53. In the waterfall, debts owed to a secured creditor for any amount unpaid following the realisation of security interest ranks lower than the financial debts owed to unsecured creditors.
The rehabilitation process typically realises a part of the going concern surplus. It realises more than what can be typically realised through liquidation. Data show that rehabilitation, on average, realises Rs.177 if the company has assets valued at Rs.100. Assuming that the creditors have a security interest over all the assets, they would get only Rs.100 if the company is liquidated or they enforce their contracts otherwise. The surplus/excess of Rs.77 that the rehabilitation process generates is meant to satisfy the unsecured claims of creditors. How this excess should be distributed has been contentious. In 2019, the legislature and judiciary settled the law that operational creditors and dissenting financial creditors, whether secured or unsecured, shall be paid not less than what they would receive in the event of liquidation. In a sense, this replicated the liquidation waterfall in the rehabilitation process, allowing discretion to the Committee of Creditors to distribute the excess. The Committee has not been generous while exercising discretion. There is a feeling that the excess is being mostly appropriated by members of the Committee. This has been a source of dispute delaying the conclusion of the rehabilitation process.
Insolvency law generally reflects public interest choices like it has a bias in favour of rehabilitation. The policy of distribution of excess to satisfy unsecured claims should also reflect public interest choice. Since business needs both financial credit and operational credit, in the interest of availability of credit, the excess needs to satisfy unsecured claims of financial creditors and operational creditors equitably. There is even a case for treating unsecured claims of operational creditors slightly on a better footing as they do not sit on the decision-making table in India.
The proposed formula, however, does not appeal to everyone. Some argue that financial debt is essentially public money and, therefore, they should have priority over other debts. This may not be correct going beyond bank financing. Second, they emphasise the priority of secured creditors- should be paid fully irrespective of the value of the security- before unsecured claims are considered. This approach would treat unequals (A, B and C in the example above) as equals, obliterating pre-insolvency contractual rights, which is not legally tenable
These authors have been suggesting to resolve the dispute (Example: At: https://www.businessstandard.com/article/opinion/the-cinderella-of-insolvency 122061701077_1.html) by distributing liquidation value vertically among financial creditors and operational creditors, as per waterfall and any excess of resolution proceeds over the liquidation value shared horizontally among all creditors in proportion to their remaining claims. The NCLAT has, recently in Excel Engineering, urged the Government and the IBBI, to consider entitlement for operational creditors, based on the amount realised in the resolution plan over and above the LV. The discussion paper has essentially proposed a formula on these lines and equates all unsecured claims at par. In addition to expediting the conclusion of the rehabilitation process, implementing this proposal can keep the insolvency proceedings integrated, rather than making it too complex by converting it into two sub-proceedings- the resolution plan and the distribution plan, as proposed
1. Nair is Director, National Institute of Securities Markets. Sahoo is Distinguished Professor, National Law University, Delhi. Views are personal.
This article was originally published in The Business Standard, 2023 on 20th April 2023 and can be found at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4410259
