In our earlier article titled, “Homebuyers now Financial Creditors: Too many cooks spoil the resolution process?“, we analysed the impact of the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2018, (“Ordinance“) on the corporate insolvency resolution process, and briefly discussed how operational creditors were adversely affected by homebuyers and their dues, now being accorded the status of financial creditors and financial debt respectively. Pursuant to the Ordinance, the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 (“Amendment“) came into force with effect from 6th June, 2018.

We now take a closer look at how and why operational creditors have been excluded from the committee of creditors (“CoC“) by the Insolvency and Bankruptcy Code (“Code“), how it compares to global practices, and whether a relook at the constitution of the CoC is the need of the hour.

BLRC’s take on Operational Creditors

The Bankruptcy Law Review Committee (“BLRC“) released a report (“Report“) in November 2015 commenting on the rationale and design of the then proposed Code. The BLRC deliberated on various aspects of the Code including the formation and composition of the CoC, concluding that members of the CoC have to be creditors both with the capability to assess viability, as well as be willing to modify terms of existing liabilities in negotiations. With this reasoning, operational creditors were intentionally left out of the CoC under the presumption that such creditors would neither be able to decide on matters regarding the insolvency of the entity, nor would they be willing to take the risk of postponing payments for better future prospects for the entity. The BLRC concluded that, for the resolution process to be swift and efficient, the Code should necessarily mandate that the composition of the CoC be restricted to only the financial creditors.

An International Perspective

In a broader perspective, this reasoning of the BLRC stands in stark contrast with the Legislative Guide on Insolvency Law (“LGIL“) proposed by The United Nations Commission on International Trade Law (“UNCITRAL“), wherein the UNCITRAL recognised that the first key objective of a resolution process is to balance the advantages of near-term debt collection through liquidation (often the preference of secured creditors) against preserving the value of the debtor’s business through reorganization (often the preference of unsecured creditors and the debtor).

The LGIL recognised that in many cases, it would not be possible or necessary to involve every creditor, especially those creditors who do not have the commercial expertise, knowledge or will to participate effectively in the process. They could not however, be ignored, as they would be important for the continued operation of the business (as suppliers of essential goods or services or as participants in essential parts of the debtor’s production process).

As a general rule, secured creditors are generally not represented on a creditor committee if they are fully secured or over-secured. In such cases, their interests are significantly different from those of unsecured creditors and their ability to participate in and potentially alter the outcome of decisions by creditors may not be in the best interests of all creditors. Recognizing this divergence of interests, some insolvency laws require secured creditors to surrender their security interest before they can participate in the proceedings and vote on any matter. Where they are under-secured, however, their interests are more likely to align with those of unsecured creditors and their participation in the committee or in voting by creditors may be appropriate, at least to the extent that they are under-secured.

An example of this would be the Company Voluntary Arrangement (CVA) mechanism under UK insolvency laws, where secured creditors are entitled to vote only in specific circumstances.

The BLRC itself in its Report has correctly stated that many possibilities are envisioned on default and that liquidation is only one option of many. It has further stated if the entity is protected as a going concern, the costs imposed upon society go down, as liquidation involves the destruction of the organisational capital of the firm. The BLRC then however expounds its firm belief that there is only one correct forum for evaluating such possibilities, and making a decision: a CoC, where all financial creditors (both secured and unsecured) have votes in proportion to the magnitude of debt that they hold.

The Report does not disclose any reasoning for ignoring the valid points raised in the LGIL nor has a fiduciary duty been expressly placed on the CoC to protect the interest of other creditors and stakeholders.

What then requires a financial creditor, especially a secured financial creditor, to prefer preserving the value of the debtor’s business through reorganization against debt collection through liquidation, which in any event provides priority to financial creditors? 

Classification of Creditors

While the Code has classified creditors into financial and operational creditors, it has given only one class the powers to decide the fate of the other class.

The reason for such classification is because creditors may have rights which are so dissimilar in nature so as to make it impossible for them to consult together with a common interest. This reasoning has been followed in both the Companies Act, 1956 and 2013. However, the Code by classifying such creditors and then making only one of them responsible for taking a decision that is binding on the other, renders such classification moot, thereby defeating the very purpose of classifying them.

Contrast this with the insolvency laws in the US which provide that for the purpose of a plan of reorganisation (“Plan“), similarly situated creditors are placed in the same class of creditors. For creditor classes that are impaired, such impaired class must either consent to the Plan or be subjugated to it. For a class to consent to a Plan, of the class members who vote, there must be more than 1/2 in number and 2/3 in dollar amount of creditors accepting the Plan. A debtor can force its plan on non-consenting classes if the Plan is “fair and equitable,” does not “discriminate unfairly” within classes, and is in the “best interests of creditors.

Similarly, under German insolvency law, the creditors vote by groups. The consent of every group is needed. Within a group the majority of creditors (as headcount) and creditors having the majority of debt need to approve the insolvency plan. The missing consent of a creditor group can be overruled by the insolvency court, if the majority of creditor groups approve the insolvency plan and the economic situation of the opposing party does not deteriorate through the insolvency plan in comparison to a regular insolvency proceeding.

Under the Code however, the only mandatory requirement in relation to dissenting creditors as well as operational creditors is to provide them with liquidation value. There is no provision requiring NCLT approval, neither is there any duty on the CoC to act in the best interests of all stakeholders or in an equitable manner. Further, the Amendment has introduced the appointment of an authorised representative for representing a class of at least ten financial creditors. However, Section 25A of the Code provides that such authorised representative must vote for each such financial creditor separately. This would mean that the majority vote of a class is not taken as the vote of the whole class but instead is counted separately.

Homebuyers rank higher than operational creditors

The legislature was quick to amend the Code to protect the interests of homebuyers by according them the status of a financial creditor, allowing each and every homebuyer irrespective of the quantum of his financial debt to a vote on the CoC. An operational creditor however even with a debt of more than 10% of the total debt is relegated only to attending meetings of a CoC with no voting rights.

This now throws operational creditors of real estate companies at the absolute mercy of financial lenders and innumerable homebuyers who are mandated, at best, to provide liquidation value to the operational creditors. The liquidation value in any event to such operational creditors would be what is left over after providing for the debts of these very financial lenders and homebuyers.

What the Amendment has effectively done therefore, is tilt the already lopsided scales further against operational creditors, ultimately leading to frequent challenges to resolution plans by operational creditors before courts and delaying the resolution process. A comprehensive overhaul of the constitution of the CoC is thus urgently required to preserve the purpose and the actual intent of the Code. A reference could be made to Section 230 of the Companies Act, 2013, where certain provisions are made that secure the interests of all creditors. This security is however, contingent on the actual appointment of operational creditors to the CoC which is the primary need of the hour.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.