The raison d'être of Insolvency and Bankruptcy Code, 2016 (“Code”) is balance of interest and equitable distribution among stakeholder and is the very essence of insolvency process as well as liquidation process. The preamble of the Code also upholds the principle of equitable distribution. There are several judgements that have played a very significant role, such as Essar Steel and Swiss Ribbons, in upholding the said principles. However, since the inception of the Code, there seems to be an uncertainty and confusion vis-à-vis the priority of secured creditors in case of a liquidation proceeding. In a very recent judgement of National Company Law Appellate Tribunal (“NCLAT”), in Technology Development Board v. Mr. Anil Goel (“TDB Case”),NCLAT has dealt with this multifaceted issue of applicability of inter-se priorities between secured creditors and first and second ranking creditors in liquidation. While not placing emphasize on the well established and tested principle of equitable treatment of creditors and defeating the commercial basis of Inter-Creditor Agreement (“ICA”) amongst the creditors, the NCLAT provided a precedent that could potentially render more harm than good in protecting the secured creditors’ rights. The tribunal held that the rights created under ICA or subordinate agreement extinguish as soon as the secured creditor decide to participate in liquidation proceedings. It refused to acknowledge the validity of inter-se rights of secured creditors in a scenario where such secured creditor relinquishes their security interest in terms of section 52 of the Code.
This ruling has ruled out the sub-classification and preferential rights amongst the secured creditors in case the company slips into liquidation and secured creditors opt to relinquish their security interest and subscribe to participate in the common pool of assets to be realised under the liquidation process. Thus, placed all the secured creditors of the company at an equal pedestal. NCLAT has, respectfully, created more confusion and chaos in the banking system that relies extensively on ICA and priorities of ranking distress situations.
Understanding the Concept of Subordinate Charge and Priority Amongst Charge-Holders
Under Section 2(16)of the Companies Act, 2013, ‘Charge’ is defined an interest or lien created on an asset of a company as security which a charge-holder can realize in case of default. There can be a situation where multiple charges are created against the single asset through an inter-creditor or subordination agreement, provided the contract between lender and borrower allows the creation of multiple charges against the asset. In an ICA, two scenario scan be incorporated i.e. the charges created against the asset could be either pari-passu charges where all the charge holders are equally placed, or the charge created can be prioritized and ranked above among the creditors. The charge holder ranked above all shall have the priority over such asset and the charge holders ranked below the former shall have subsequent charge over the remaining asset that may be left after settling the claims of the former. That way the charges are sequential and not proportional.
As per Section 100 of Transfer of Property Act, 1882 (“TPA”), Charge is created where any immovable property of one person, by act of parties or operation of law, is made security for the payment of money to another, such transaction does not amount to mortgage and by virtue of the same, a charge is created towards repayment of loan as security. Section 48 of TPA governs priority of rights created by transfer and subordinate charge. Accordingly, where a person creates some rights in a property and such rights are incapable to exist or be exercised together, then each latter right created in absence of any special contract shall be subjected to rights previously created. This section elucidates that the first right over the said property is of the first created charge, and in absence of any special contract, would hold preference over the latter charge created over the same property.
Ambiguity in Context of Liquidation
The issue as to whether the senior ranked secured creditors would have any primacy over the subordinate secured creditors in case of distribution of liquidation proceeds, remain unclear. The liquidation waterfall provided u/s 53 of the Code provides that all the secured creditors shall be paid in proportion to its admitted claims but is silent about the distinction between class of secured creditors mentioned u/s 53(1)(b)(ii) based on ICA or subordinate agreements.
Though, the government, in 2019, came up with clarification regarding the differential treatment of secured creditors based on ICA. However, that was only in regards to CIRP and not liquidation. According to the clarification, ‘priority’ of security interest of the creditor may be considered by CoC while approving distribution of CIRP proceeds as provided in resolution plan. It made a way for the first charge holders to be considered prior to the other secured creditor while distribution of CIRP proceeds.
The Insolvency Law Committee (“ILC”) in its 2018 considered this subject and concluded that valid inter-creditor provisions must be respected in the liquidation waterfall u/s 53 of the Code. However, IBBI in a discussion paper on Corporate Liquidation Process, 2019 referred the 2018 report and stated that “there is still a debate as to whether a senior secured creditor is entitled to better rights than a junior creditor in the waterfall u/s 53 of the Code”. This issue was again addressed by the ILC in its 2020 report in which it suggested that clarification may be provided by introducing an explanation to Section 53(2) to uphold the inter-se priority between the secured creditor and to make it amply clear that the ‘recipients’ as mentioned in Section 53(2) are ‘workmen’ and ‘secured creditors’ and contractual arrangement between these two classes shall be disregarded by the liquidator if it disrupt the order of priority but not within the secured creditor u/s 53(1)(b)(ii) of the Code. However, the dust around inter-se priority in liquidation still persist and no amendment is introduced in the Code till date.
Analysis of the Judgment
In TDB case, all the creditors opted to relinquish their security interest u/s 52 of the Code and agreed to receive their dues in accordance with waterfall u/s 53. The liquidator distributed the sale proceeds to the first charge holders in priority to the second charge holder which was also approved by NCLT. The issue raised before the NCLAT was whether the priority inter-se secured creditors survives or annuls in case secured creditors relinquish their interest into the liquidation estate. Setting aside the impugned order, NCLAT opined that secured creditors have two options during liquidation as provided u/s 52 of the Code i.e. to relinquish their interest u/s 52(1)(a) to the liquidation estate and receive the proceeds in the manner specified u/s 53 or to enforce their security interest outside the liquidation process u/s 52(4). It held that the question of priority in charge will only arise in the latter case and not in the former. Thus, where the secured creditors elect for the former, the priority in charge will not hold any significance and all the secured creditors will be equally placed under section 53(1)(b)(ii) of the Code, irrespective of any ranking of charges as per ICA. This NCLAT completely disregarded ICA between creditors for distribution of proceeds u/s 53 and also held that section 48 of TPA is not applicable under liquidation waterfall.The NCLAT wholly overlooked the common law principles, precedents, and ILC recommendations by applying the non-obstante clause.
Judicial Precedents Explaining Inter-Se Priority Amongst Creditors
In ICICI Bank Limited v. Sidco Leathers Ltd., (2006) 10 SCC 452 (“SIDCO”), Supreme Court, while interpreting Section 48 of TPA, held that the claim of first charge holder will prevail over second charge holder and in case where debts are due to both, first charge holder shall be given priority. Further, on the issue of inter-se priority between the secured creditors, it also held that while enacting a statute, the parliament cannot be assumed to have taken away a right in property as it is a constitutional right and right to recover money by enforcing a mortgage is also a right to enforce an interest in the property. It discussed the principle of priority of rights i.e. qui prior est tempore potiorest jure(who is earlier in time is earlier in right) as incorporated under Section 48 of TPA, and thus held that the first charge holders’ claim shall prevail over the second charge holder. The judgement also clarified that until no legislative clarity is specified on the issue, the principles of general law would hold valid, and therefore, provisions of TPA would be the governing authority for this issue. It also held that if the legislature would have intended to curb a right, it would have specifically provided it in the statute.
In the case of State of Andhra Pradesh v. Rajah Ram Janardhana Krishna, Comp Cas 950 (1966),it was held that a charge, which is created first in time, will take priority over the charge created afterward. Much later, in Jitendra Nath Singh v. Official Liquidator &Ors, (2013) 1 SCC 462,the Supreme Court stated that workmen dues are treated pari-passu with secured creditors as several cases have occurred where workmen were deprived of their debt claims after the discharge of debt of secured creditors. However, this pari-passu treatment does not infer the extinguishment of priority inter-se secured creditors.
The most imperative factor in the financial world is inter-se priority between the secured creditors. This judgement will, certainly, hamper the credit sentiments of the financial institutions that may be attempting to revive its economy. As the Code is silent on the inter-se priority of secured creditors during liquidation, the general law should have been applied to the present case as also opined in SIDCO case. This critical precedent set out by the NCLAT will undeniably lead to a status quo where second ranking holders will not agree with first ranking holders and therefore also impact the ability of borrowers to access credit. Melding security interest of differently placed creditors will disrupt the very substance of the commercial basis of having a security at the first place. May be some intervention from apex court or legislative clarity on this issue could help in resolving this dilemma.
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