Operational Creditors under IBC: Addressing the ‘Nil Payment’ Paradox

[Lakshya is a student at National Law University Odisha.]

In 2018, Insolvency and Bankruptcy Board of India (IBBI) amended Regulation 38 of the IBBI (Insolvency Resolution Process for Corporate Persons) Regulations 2016, intending to provide priority payment to the ‘operational creditors’ (such as vendors, real-estate developers etc.) (OCs) as a means to compensate for their absence in the committee of creditors (CoC), which is formed as part of the corporate insolvency resolution process (CIRP), whose composition comprises only financial creditors. 

Despite these statutory protections, recent resolution plans have demonstrated a rather troubling trend of allocating a ‘nil’ or a proportionately lesser amount to the OCs during the CIRP, effectively rendering these provisions toothless.

A striking illustration of this trend can be seen in the case of Vadraj Cement Limited (earlier ABG Cement), which was involved in a liquidation proceeding before the High Court of Bombay against Beumer Technology Limited.

After the transfer of jurisdiction to the NCLT Mumbai, the bench gave its order that the OCs (other than government and workmen) shall be paid nil amount towards ‘full and final discharge of their claim since the liquidation value of the corporate debtor is not sufficient to discharge the claims of the secured financial creditors’.   

This raises concerns about the judiciary’s inconsistent application of its own precedents and regulatory mandates, which specifically require providing priority payment to OCs while balancing the CoC’s commercial wisdom. 

Statutory Protections under the IBC

Section 53 of the Insolvency and Bankruptcy Code 2016 (IBC) is referred to as the waterfall mechanism, which allows the creditors to be distributed the assets in a particular hierarchy, referred to as the liquidation scheme. It enables the creditors to receive an amount under the liquidation scheme or the CIRP, whichever is higher. Section 30(2)(b) of the IBC provides the procedure for the disbursement process and is read with Regulation 38(1A) and (1B) of the IBBI, which mandates that the dues of operational creditors shall be paid in priority.

Additionally, Section 30(2)(f) of the IBC mandates that ‘every resolution plan shall conform to all the regulations circulated by the board’. Therefore, it can be inferred that the regulation formed by the board to provide priority payment shall be upheld by the CoC as well as the courts. 

In Ghanshyam Mishra and Sons v. Edelweiss Asset Reconstruction Co, the court duly enforced Section 53 of the IBC, which holds that some amount, either under the liquidation scheme or CIRP, must be paid and cannot be mitigated to nil, as it is the obligation of the corporate debtor to settle the claims of its creditors. Thus, neither the courts nor the CoC can distinguish between different types of creditors based on importance and provide a higher amount of repayment accordingly. 

Limits of the CoC’s Commercial Wisdom

The IBC respects the commercial judgment of the CoC, especially after the recognition of its wisdom and autonomy in Swiss Ribbons vs. Union of India. The judgment held that once the CoC has approved a resolution plan, the NCLT is bound by it and should respect the competence of the financial creditors, which is referred to as their ‘commercial wisdom’. The NCLT is prohibited from interfering with the CoC’s commercial wisdom and cannot reject a plan unless there is a statutory provision in its absence. 

However, this principle of deterrence has certain limits, which have been critically examined in the case of K Sashidhar v. Indian Overseas Bank, wherein the judgment has made it crystal that statutory dictates cannot be overridden by commercial choice. The CoC cannot approve a plan that violates Section 30 on the plea of business expediency. If a resolution plan wholly ignores or undermines a class of creditors, that may go beyond “business judgment” and into illegality. As one NCLT decision noted, while CoC can decide how much to pay each class, it cannot extinguish a class’s entitled share.

In Essar Steel, the court emphasized that CoC’s decision-making must reflect “reasons which evince a balancing of interests of all stakeholders.” 

Additionally, if there are several instances where the CoC arbitrarily allocates a nil amount and is subsequently approved by the court, it would discourage the OCs from continuing to supply goods and services to the corporate debtor or any business per se. Due to such disruptions, it would force the OCs to collect advance payment, alter credit terms, or disengage from transactions in even minor financial difficulty, crippling the credit system.

USA v/s India

In contrast to the IBC’s creditor-in-control model, the US Chapter 11 of the Bankruptcy Code of 1978 operates on a ‘debtor-in-possession’ principle, which allows the distressed companies to retain control of operations during reorganization, which fosters continuity. The chapter puts an automatic stay on all creditors' actions and prohibits them from pursuing collection efforts, providing the debtor with operational stability to negotiate a viable restructuring plan that balances creditor recovery while preserving the business as a going concern. 

In addition, it is the prerogative of the US trustee to appoint a committee of creditors holding unsecured claims whose prime function is to take part in negotiation and provide an advisory opinion on the resolution plan being prepared by the debtor.

The Uneven Playing Field And Path To Reform

This inclusive structure empowers the unsecured and operational creditors, regardless of their claim size, to actively participate in the negotiations, which allows for early settlement of their claims, thereby leaving a much larger share for the other creditors. The author believes that creditors in India should follow a similar structure.

While the composition regarding the financial creditors in India is similar, excluding the OCs from the committee and granting them no voting rights becomes manifestly arbitrary, as banks and leading institutions dominate the CoC, wielding ‘significant power’ over the approval of the plan. At the same time, the OCs have no seat at the table and only ‘symbolic’ rights.

Possible Reforms

The commercial wisdom of the CoC is paramount, but it is important to ensure that all the stakeholders are equitably represented and are not disregarded during the approval of the resolution plan. 

One option is to allow the OCs to elect a committee headed by the representative with the largest number of operational claims to consult with the RP, or to create a sub-committee or class within the CoC. Such would allow for a mutual formulation of the resolution plan, which is formed in accordance with the concerns of all the classes of creditors. This would allow the small traders and vendors to voice out their concerns without their fate being decided by a dominant bloc of leading banks and institutions. This would require an amendment under Section 21 of the IBC and related rules for granting voting rights to operational creditors. The same can be achieved by taking precedence of the IBC amendment that gave each homebuyer a vote as a financial creditor.

After such establishment, class voting can be introduced as a means for the approval of the resolution plan. A similar structure has been defined under Section 230 of the Companies Act 2013. For voting, any resolution plan could require a majority in number and 75% by value in each major class of creditor. Further, if any dissenting class votes against and blocks the plan, the NCLT could approve it only if it’s fair and equitable, ensuring that the dissenters get at least their liquidation value or higher, applying the waterfall mechanism simultaneously. 

Another option is to publish the CoC minutes of the meeting, which must show reasoned decision-making towards the allocation of claims. Any vague or formulaic approval notes, if seen as a part of the MoM, shall come under judicial glare, and it shall be the prerogative of the RP to take notice of the same and inform the NCLT in such instances. 

A last option to implement is judicial scrutiny of all ‘zero allocation’ cases, which should be subjected to high judicial scrutiny, and a ‘reverse burden’ principle must be adopted by the courts wherein the CoC must justify the nil allocation and how the same is commercially justifiable. 

Conclusion

The ‘nil’ payment paradox, starkly illustrated in the case of Vadraj Cement Limited, is more than just a procedural flaw; it is a fundamental breach of the very promise made by IBC upon its enactment, which is the revival of businesses and equitable treatment of all the stakeholders.  

Allowing this fracture to exist between the CoC’s commercial wisdom and mandatory waterfall rules cripples the credit confidence of the OCs. Instituting OC representation, class voting, along with publication of CoC minutes and reverse-burden judicial scrutiny, will protect suppliers, enhance transparency, and restore market confidence in India’s insolvency regime.