Introduction

An effectively functioning lending system often finds support from a strong collateral framework. Banks/ lenders typically extend credit to borrowers when such lending can be secured by an underlying collateral security, through which, the lender could satisfy its debt in case the borrower defaults. Collateral security or security interest may take multiple forms, such as mortgage of fixed assets, pledge of shares, corporate guarantees, etc. If the borrower discharges its debt, the collateral security interest is released, if the borrower defaults, the bank/ lender may seek to enforce its interest in the collateral security.

In fact, creation of such security interests is statutorily recognized under the Indian Contract Act, 1872 and the Transfer of Property Act, 1882.

An asset of a borrower can be charged with multiple creditors, creating an inter-creditor arrangement whereby certain creditors may have a first charge over the asset, and the other creditors may have a second or a subservient charge over the asset. In such a scenario, if the borrower defaults, the debts of the creditor having first charge would be satisfied first, by sale of the charged asset. Thereafter, the debts of the creditors having a subservient charge would be satisfied from the residual proceeds. The above inter-creditor arrangement between the first and subservient charge holders has time and again been recognized contractually as well as through judicial precedents.

In the banking industry, valuation and priority of security is the most vital consideration at the time a bank undertakes any lending decisions. This plays an important factor in deciding not only the loan amount a bank undertakes to lend to the borrowers, but also other aspects like the nature of the loan, interest rates etc. All secured loans disbursed are sanctioned on an assumption that the priority of charge and value of security would be recoverable in each case, and that this ranking would be protected and preserved. Banking institutions, perform such due diligence towards ensuring that any amounts lent by them are adequately secured and recoverable, thereby, ensuring responsibility to the economic framework.

However, it seems that the Insolvency and Bankruptcy Code, 2016 (“IBC”) does not recognize the said inter-creditor arrangement of priority of charge at the time of creditor payout. 

Understanding Creditor Payout Under IBC

Before delving into the aspect of how IBC does not recognize inter-creditor arrangements, it is important to understand how creditors’ payout under IBC is determined. There exist three possible scenarios based on which creditors can get a payout for the money lent/ disbursed to a Corporate Debtor (“CD”) undergoing a corporate insolvency resolution process (“CIRP”). The first two being in a situation where the CIRP of the CD is successful, i.e., when a resolution plan submitted by an eligible resolution applicant is approved by the Committee of Creditors (“CoC”) of a CD. The third being a case where a CD is pushed into liquidation.

The first scenario is where the creditor has voted in favour of a resolution plan. Under Section 30(4) of IBC, a resolution plan is approved, if members of the CoC holding more than 66% share in the CoC vote in favour of approval of a resolution plan. The section further provides that the CoC while approving a resolution plan, may consider the manner of distribution proposed, and the order of priority amongst creditors as laid down under Section 53(1) of IBC including, the priority and value of the security interest of a secured creditor. This section allows the creditors who are assenting members of the CoC, to decide amongst themselves, the payout/ distribution of proceeds due to them. It is pertinent to note that, Section 30(4) of IBC is a “may” provision, and therefore, it is not mandatory for the assenting members of the CoC to distribute proceeds based on the order of priority and the value of security.

The second scenario is where a resolution plan is approved, however, a creditor dissents to the approval of a resolution plan. In that scenario, the minimum entitlement of a dissenting creditor is based on the provisions of Section 30(2)(b) read with Section 53(1) of IBC.  Section 30(2) was introduced in IBC with the objective of ensuring that all creditors are treated fairly in a CIRP. This provision protects financial creditors who have not voted in favour of the resolution plan, by mandating the resolution plan to give dissenting financial creditors an amount equivalent to what they would have received, had the CD been liquidated. The raison d’etre behind such a provision is that a resolution plan cannot be crammed down on a dissenting financial creditor, unless they at the very least receive the amount they would have received in liquidation of the CD.

Further, Section 30(2)(b) of IBC makes it clear that a dissenting financial creditor is to be paid “minimum liquidation value” as per Section 53 of IBC i.e., as per the waterfall mechanism. Section 53(1) of IBC states that all debts are to be paid in the “order of priority” as set out in the section, referring that debts of the class of creditors mentioned first must be satisfied in full, before proceeding to the next class of creditors as specified under Section 53(1). Resultantly, any resolution plan must conform to the mandate provided under Section 30(2)(b) read with Section 53(1) of IBC.

The third scenario is in the case of liquidation, wherein a secured creditor has two options, i.e., the secured creditor may enforce its security, by taking it outside the liquidation estate as provided under Section 52 of IBC or the secured creditor could go under the waterfall mechanism as provided under Section 53 of IBC and receive its payout therein.

IBC's Failure in Considering Inter-se Amongst Secured Creditors

Interestingly, in both the second and third scenarios, the IBC has linked payout to creditors based on the security held by them. However, the waterfall mechanism as envisaged under Section 53, IBC does not distinguish between secured creditors having first charge and secured creditors having a subservient charge. Resultantly, Section 53, IBC fails to consider inter-creditor arrangements between the secured creditors. Two judgments of the NCLAT demonstrate the same.

The first being the case of Small Industries Development Bank of India v. Vivek Raheja (“SIDBI Judgment”). In this case, SIDBI was a secured financial creditor, having a first charge over certain assets of the CD and had opted to be a dissenting financial creditor. Based on this, it sought its entitlement/ payments under Section 30(2)(b) read with Section 53(1) of IBC. The argument put forth on behalf of SIDBI was straightforward, i.e., since it had a first charge over certain assets of the CD, the amounts owed to it as a dissenting financial creditor, were to be discharged first and in priority under the waterfall mechanism i.e., under Section 53(1) of IBC, and thereafter, the subservient charge holders would claim from the residual proceeds after discharge of debt owed to the first charge holder. It was contended on behalf of SIDBI that inter se arrangement amongst secured creditors has to be respected in the waterfall mechanism, even if IBC does not explicitly state the same.

The NCLAT did not appreciate SIDBI’s argument. Instead, it relied on a Supreme Court judgment, i.e., India Resurgence ARC Private Limited v. Amit Metaliks Limited (“Amit Metaliks”), to conclude that a dissenting financial creditor can only claim its share in the liquidation value as per its voting share in the CoC and not as per the value of the security held by it, thereby dismissing SIDBI’s argument of inter-creditor arrangement and the priority of charge held by SIDBI in the assets of the CD. Resultantly, the SIDBI Judgment held that IBC did not recognize the priority of first charge over the assets of the CD and categorized all creditors, irrespective of their charge, to be considered under the single category of “secured creditors”.  

The second judgment is the case of Technology Development Board v. Mr. Anil Goel (“TDB Judgment”). In this case, the NCLAT held that the secured creditors relinquishing the security interest under Section 52 of IBC are to be considered as ‘one class’ and are to be ranked equally for distribution of assets under Section 53(1)(b)(ii) of IBC. NCLAT also rejected the argument that there must be a sub-classification inter-se the secured creditors, thereby completely eliminating inter-creditor arrangements.

Both, SIDBI Judgment and TDB Judgment have been challenged and are pending adjudication before the Supreme Court. The Supreme Court, on June 29, 2021, stayed the operation of the TDB Judgment.

The Case of DBS Bank v. Ruchi Soya 

On January 3, 2024, a division bench of the Supreme Court passed its judgment in the case of DBS Bank Limited, Singapore v. Ruchi Soya Industries Limited (“Ruchi Soya”) wherein it held that dissenting financial creditors are to be paid the minimum value of its security interest. The judgment in Ruchi Soya is at odds with the judgment in Amit Metaliks. The issue has now been referred to a larger bench and is pending adjudication before the Supreme Court.

Need to Amend the Law

There is an urgent need to amend Section 53 of IBC for it to recognize sub-classification inter-se the secured creditors for multiple reasons. First, Section 53 of IBC and its interpretation taken in various judgments are a deviation from the thumb rule wherein inter-creditor arrangements is often seen as a cornerstone for distribution of proceeds amongst creditors having different charge over an asset of the CD. Ignoring the inter-creditor arrangement between creditors and treating creditors of different class as one single class, will result in consolidation of all securities of the CD as one single security.

If all the secured creditors are ranked equally irrespective of their inter-se priority, it would lead to perverse economic outcomes wherein a creditor secured by a weak security or a subordinate right will get benefits equivalent to a creditor secured by a strong and valuable security with exclusive rights.

Second, the judgments passed by the NCLAT, SIDBI and TDB incorrectly hold that the ratio of ICICI Bank v. SIDCO Leathers (“SIDCO Leathers”)- a Supreme Court judgment, is inapplicable to IBC. In the case of SIDCO Leathers, the Supreme Court interpreted Section 529 and Section 529A of the Companies Act, 1956 i.e., provisions related to distribution of proceeds amongst creditors in the winding up regime.

The Supreme Court in the case of SIDCO Leathers had observed that the claim of a first charge holder will prevail over the claim of a second charge holder and on occasions, where debts due to both the first charge holder and the second charge holder are to be realised from the property belonging to the mortgagor, the first charge holder will have to be repaid first i.e., the amounts would be distributed basis the security available with each of the creditors.

Additionally, in SIDCO Leathers, the Supreme Court held that the principles of inter-se priority as envisaged under Section 48 of the Transfer of Property Act, 1882 (which is a general law) would be applicable to Section 529 and 529A of Companies Act (which is a special law). It was observed that a right to property being a constitutionally protected right cannot be presumed to be taken away unless expressly provided in the statute. Keeping in mind the express language of Section 529A, the purpose of the said provision and the constitutional principle contained in Article 300A of the Constitution of India, the Supreme Court held that Section 529A of the Companies Act, does not abrogate inter-se priority amongst the secured creditors.

The ratio of the judgment passed by the Supreme Court in SIDCO Leathers was squarely applicable in the context of Section 53, IBC as well. Section 53(1)(b), IBC is pari materia to Section 529-A of the Companies Act and even in context of Section 53(1)(b), IBC, the legislature only intended to bring workmen dues and the secured creditor’s dues at par and did not intend to impact the inter-se rights of secured creditors. This provision certainly cannot be read to abrogate inter-se priority amongst secured creditors during liquidation.

Third, Section 53 of IBC as well the NCLAT judgments are at odds with the best global practices which recognize and appreciate the importance of priority of charge. In fact, the UNCITRAL Insolvency Legislative Guide recognizes and recommends that creditor rights and ranking of priority claims existing prior to commencement of insolvency should be respected. Even the Bankruptcy Law Reforms Committee borrowed the above-mentioned principles and recommended their incorporation into the IBC. This shows that inter-se priority of charges, at all stages of the lifecycle of a loan, is a paramount practice, basis on which the global lending industry functions.

Thus, there is an urgent need to amend Section 53 of IBC to formally recognize the inter-se arrangements between secured creditors. If such arrangements are not recognized by the legislature and the Courts, they will be made obsolete, thereby disrupting the existing lending eco-system in the country. 

This paper has been written by Udit Mendiratta (Partner) and Shivkrit Rai (Senior Associate).

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