A ‘waterfall’ for insolvency resolution

Source– The post is based on the article “A ‘waterfall’ for insolvency resolution” published in the Business Standard on 3rd February 2023.

Syllabus: GS3- Changes in Industrial Policy and their Effects on Industrial Growth

Relevance– Exit process of the business

News– The Ministry of Corporate Affairs has recently issued a discussion paper inviting comments on the changes it is proposing to further strengthen the IBC.

What is suggested by the discussion paper on strengthening the IBC?

It suggests proceeds up to the liquidation value will be distributed in the order of priority provided in the liquidation waterfall to secured and unsecured creditors.

Any surplus over the liquidation value will be ratably distributed among creditors in the ratio of their unsatisfied claims.

Creditors strike different commercial bargains with the company. All secured creditors have different levels of security interest. Some are undersecured, some are fully secured and some are oversecured.

What are the important provisions in the IBC related to realisation of debt by creditors in the insolvency process?

The insolvency law honours pre-existing contractual relationships between debtors and creditors. Secured creditors have priority claims on their respective security.

In recognition of the amount of security, an undersecured creditor and a fully secured creditor have different entitlements in an insolvency proceeding.

During the rehabilitation stage, the moratorium keeps the security intact. It will be available to the secured creditor during liquidation.

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. Insolvency proceedings generally protect the secured claim to the extent of the value of security.

Where the secured creditor’s claim exceeds the value of the security, the excess is treated as an unsecured 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, the excess has to be tendered to the liquidator.

When realisation falls short of the debt owed to the secured creditor, the unpaid debt is to be paid by the liquidator in accordance with 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.

What are the issues with the liquidation process?

Data shows that the rehabilitation process, 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 of Rs 77 that the rehabilitation process generates is meant to satisfy the unsecured claims of creditors.

The distribution of this excess has been contentious.

In 2019, the legislature and judiciary settled the law that creditors, whether secured or unsecured, should be paid not less than what they would receive in the event of liquidation.

This allows 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.

What is the way forward?

The insolvency law generally reflects public interest choices. The policy of distribution of excess to satisfy unsecured claims should also reflect public interest choice.

Business needs both financial and operational credit, in the interest of availability of credit. Therefore, excess needs to satisfy unsecured claims of financial creditors and operational creditors equitably.

There is even a case for prioritising unsecured claims of operational creditors as they do not sit on the decision-making table.

There is a need to resolve the dispute by distributing liquidation value vertically among financial and operational creditors.

Excess resolution proceeds over the liquidation value can be shared horizontally among all creditors in proportion to their remaining claims.

The National Company Law Appellate Tribunal has urged to consider entitlement for operational creditors, based on the amount realised in the resolution plan over and above the liquidation value.

The discussion paper has essentially proposed a formula on these lines and equates all unsecured claims at par. Implementing this proposal can keep the insolvency proceedings integrated, rather than making it complex.