The Parliament recently approved the Insolvency and Bankruptcy Code (Amendment) Bill, 2019 (“Bill”). Among other things, the Bill safeguards the primacy of secured creditors in the priority of payments in a corporate insolvency resolution. This is a welcome move. It will hopefully remove the confusion created by the National Company Law Appellate Tribunal (“NCLAT”) in its judgment in Standard Chartered Bank v. Satish Kumar Gupta. This decision disregarded the sanctity of secured credit agreements by ignoring one of the most fundamental principles of modern corporate insolvency law – the Absolute Priority Rule (“APR”).
The APR describes the basic order of payment in corporate insolvency. It provides that the claims of a class of creditors must be paid in full before any junior class of creditors may receive or retain any property in satisfaction of their claims, unless the more senior class consents to any departure from this principle. Therefore, secured creditors have a right to receive payment in full prior to junior creditors and interest-holders receiving any value.
APR is a fundamental principle of modern corporate insolvency law. It originated in a 1913 decision of the US Supreme Court in Northern Pacific Railways Co. v. Boyd. Later in 1939, the US Supreme Court in Case v. Los Angeles Lumber held that a plan is “fair and equitable” only if it complies with APR. The rule finally got codified into section 1129(b) of the US Bankruptcy Code in 1978. Consequently, even the judiciary in US cannot confirm a plan that violates priority distributions, unless the affected parties consent to such violation. This legal certainty around priority of payments helps lenders properly calculate their expected returns on any loan at the time when the loan is made. This in turn helps reduce the cost of debt capital, encouraging entrepreneurship and economic growth.
Indian courts and tribunals dealing with corporate insolvency have consistently disregarded this basic rule. This can partly be attributed to the text of the Insolvency and Bankruptcy Code (“IBC”), which recognises APR at the liquidation stage only. The decision of NCLAT in Standard Chartered Bank v. Satish Kumar Gupta further amplified the confusion.
First, NCLAT refused to classify financial creditors into secured or unsecured for the purpose of distribution of sale proceeds. This is problematic. There are valid justifications for upholding security rights. A lender who extends credit to a debtor against a security or collateral, has the right to get hold of the collateral if the debtor defaults on repayment. This right saves the lender the cost of constant monitoring for debtor-mischief. A lower monitoring cost for the lender gets passed on to the debtor in the form of lower cost of borrowing. In contrast, unsecured creditors do not demand any collateral for extending credit. They willingly agree that in case of a default, they will get paid only after the secured creditors – lower priority. To compensate for this lower priority, unsecured creditors usually charge a higher interest rate. Therefore, they cannot complain about their lower priority.
Moreover, if the law denies debtors the power to prefer some creditors over others through security agreements, creditors would have to contractually create such priority among themselves (“subordination agreement”). The latter is cumbersome due to higher transaction costs. For all these reasons, it is important for the law to respect and uphold security interests by following APR.
Second, following the Indian Supreme Court’s observations in Swiss Ribbons, the NCLAT held that operational creditors should be given roughly the same treatment as financial creditors in a resolution plan. Accordingly, the NCLAT went on to modify ArcelorMittal’s resolution plan by applying a pro-rated distribution method such that most financial creditors (secured) and operational creditors (unsecured) have similar recovery rates (around 60.7%). This is again problematic. Pro-rated distribution is appropriate only when applied within the same class and not across different classes. Pro-rated distribution across different creditor classes is a blatant violation of the APR.
Third, NCLAT held that a resolution plan must specify the amount it proposes to pay to the financial and operational creditors. But it prohibited resolution applicants from using the statutory waterfall in section 53 for calculating the amount to be paid to each creditor. This caused immense confusion as to what order of priority should be followed in calculating the distribution. Such uncertainty in payment priority only increases the risks of extending credit. Financial creditors could adjust to this new reality only by increasing the cost of credit, hampering entrepreneurship. This would have ultimately defeated the very objective for which the IBC was enacted in the first place.
At a time when the policymakers are trying to cut rates and give a fillip to economic growth, this precedent would have made credit transactions riskier, raising the cost of credit. Fortunately, the policymakers rushed to the rescue and took remedial measures to protect the sanctity of secured credit. This is a positive move towards recognising the APR in India. Ideally, the jurisprudence should now be abundantly clear that a resolution plan would be “fair and equitable” only if it complies with the APR.
Contributed by: Shardul S. Shroff, Executive Chairman; Pratik Datta, Senior Research Fellow; Varun Marwah, Research Fellow
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