Revisiting the Treatment of Subordination Agreements under Section 53 of the IBC

[Ankit is a student at Jindal Global Law School.]

In the case of Technology Development Board v. Anil Goel (Technology Development), the National Company Law Appellate Tribunal (NCLAT) observed that once secured creditors had chosen to relinquish their security interest under Section 53 of the Insolvency and Bankruptcy Code 2016 (Code), there would be no priority among them at the time of liquidation. As such, all the secured creditors would be equally placed, irrespective of whether they hold the first or subsequent charge over the asset. Such a reasoning not only goes against the established norms of property and insolvency laws but poses a threat to the credit market at large. This article analyses the aforesaid case at the backdrop of certain precedents and contends that the subordination agreements between the secured creditors be respected under Section 53 of the Code.

Inter-se Priority amongst Secured Creditors

As per Section 2(16) of the Companies Act 2013 (Act), a charge refers to an interest or lien which is generated on an asset and acts a security in the event of default. In this regard, a subordination agreement establishes a priority of one debt over the other to secure the repayment from a debtor, when there are multiple charges over the same asset. If all the charge-holders are placed at an equal footing, then the charges are regarded to be on a pari passu basis. When the company goes into liquidation, all such secured creditors receive an amount from the proceeds generated, which is commensurate to their debt. However, the secured creditors can also consent to an inter-se priority of charges. Upon liquidation then, the debt of the first charge-holder would be satisfied first, before moving on to the subsequent charge-holders or creditors. Notably, Section 48 of the Transfer of Property Act 1882 (TOPA) recognises such subordination agreements and the inter-se priority amongst the secured creditors.

The Code presents the secured creditors with two choices if the corporate debtor enters liquidation. First, they can realise their security interest by opting out of the liquidation proceedings, in the manner specified under Section 52. Second, they can relinquish their security interest to the liquidation estate and accept an amount, as per the waterfall mechanism under Section 53. While Section 53(1)(b) holds that the debts of the workmen and the secured creditors must be similarly placed, the Code is silent when it comes to the priority between the secured creditors themselves.

The Technology Development Case

The liquidator allocated the proceeds from the sale of the assets to only the first charge-holders and the claim of the second charge-holder, Technology Development Board, was disregarded. The entire exercise was carried out under Section 53 of the Code. The NCLT had upheld the liquidator’s action and validated the inter-se priority amongst the secured creditors, but the decision was appealed further.

Ruling in favour of the appellant, the NCLAT remarked that once the secured creditors had decided to relinquish their security interest to the liquidation estate and participate in the liquidation waterfall under Section 53, they would be treated equally, regardless of the priority of charge they held prior to it. Only when they would choose to stay out of the liquidation proceedings and realise their security interest as per Section 52, would their inter-se priority matter. The NCLAT noted that the non-obstante clause in Section 53 overrides the other legislations. As such, the subordination agreements recognised under Section 48 of the TOPA would hold no value, when liquidation occurs under Section 53 of the Code.

Precedential Analysis

In the case of ICICI Bank Ltd. v. Sidco Leathers Limited (Sidco),the matter concerned Sections 529 and 529-A of the Companies Act 1956 (1956 Act), which provided the mechanism for liquidation, before the Code was enacted. The apex court remarked that although the debts due to the workmen and the secured creditors were to be treated in a manner, pari passu with each other, it did not imply that the inter-se priority amongst the secured creditors was eliminated. The court opined that since the provisions of the special statute, the 1956 Act, did not specifically mention, or reject the priority between secured creditors, the general rule covered by Section 48 of the TOPA would apply. It was further noted that if the legislature intended to deprive the first charge-holders of their precious right enshrined not just under the TOPA but also the common law, it would have expressed so explicitly in the statute. In the Technology Development case, the aforesaid judgement was relied upon by the respondent, but not accepted. The NCLAT had observed that the Sidco case was decided prior to the enactment of the Code. Consequently, the non-obstante clause in Section 53 of the Code would override the provisions of the other legislations.

In State of Bihar v. Bihar Rajya MSESKK Mahasingh (Bihar Rajya), the Supreme Court had observed as a general principle, that a non-obstante clause is usually attached to a provision with the intention to give the enacting part of the same, in case of a conflict, an overriding effect over the other provisions or statutes mentioned therein. It is of relevance to note that as part of the written submissions in the case of Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta (Essar Steel), the line of reasoning that the TOPA was not in conflict with the Code, had been advanced in favour of protecting the inter-se priority amongst the secured creditors.

In the said case, the Supreme Court had opined that the Code envisages an equitable treatment for similarly situated creditors such that the equality principle cannot be stretched in order to treat unequal as equals. The observations of the court in this regard, were limited to a differential treatment of creditors based upon the classifications of secured, unsecured, financial or operational. On the aspect of inter se priority amongst the secured creditors specifically, the Supreme Court noted that it is the commercial wisdom of the Committee of Creditors that must prevail in each case. As such, the Committee of Creditors has the discretion to approve a distribution arrangement whereby the inter se priority amongst the secured financial creditors is respected but the same cannot be mandated by the Adjudicating Authority. Although the Essar Steel case briefly touched upon the aspect of subordination agreements, it failed to address the arguments concerning the non-obstante clause in Section 53 of the IBC.

Upon a perusal of Section 529 of the 1956 Act and Section 53 of the Code, the two seem to convey the same rule. While the Sidco case was decided in the pre-Code era, its ratio decidendi can still be utilised in the present circumstances. The NCLAT in the Technology Development case was then erroneous in holding that the non-obstante clause of Section 53 would override the subordination agreements. Although Section 53 of the Code contains a non-obstante clause, in view of the principle laid down in Bihar Rajya, it should trigger only in times of a conflict. On examining the Code, it can be noticed there exists no provision which nullifies the inter se priority amongst the secured creditors. One can contend that Section 48 of the TOPA, which is not in disagreement with the Code, would continue to operate when a corporate debtor enters liquidation. Even in the current regime then, the general rule under Section 45 of the TOPA should prevail and the priority between the secured creditors ought to be upheld under Section 53 of the Code.

Report by the Insolvency Law Committee

As per Section 53(1)(b) of the Code, the debts of the workmen and the secured creditors have been put at the same pedestal. If any contract upsets such an equal ranking specified by Section 53(1)(b), it must be disregarded under Section 53(2). On this note, the Insolvency Law Committee in one of its reports had stated that Section 53(1)(b) only kept the workmen and the secured creditors at an equal footing. The provision did not comment upon the priority inter-se secured creditors. As such, the subordination agreements between the secured creditors would remain valid within the liquidation waterfall under Section 53. Further, the committee noted that Section 53(2) would operate only when the contract disturbs the pari passu arrangement between the workmen and secured creditors under Section 53(1)(b). Consequently, contracts pertaining to the inter-se priority amongst the secured creditors would not be disrupting their equal ranking. In the Technology Development case, the NCLAT failed to factor in such clarification offered by the Insolvency Law Committee as well.

Conclusion

The NCLAT’s decision in the Technology Development case stands against the Code’s primary objective, which is to establish an insolvency regime that caters to the requirements of all the stakeholders. The Supreme Court in the Essar Steel case, had opined that while the Code envisages an equitable treatment of creditors, the same did not suggest that every creditor must be treated equally. The UNCITRAL Legislative Guide on Insolvency Law also remarks that the creditors must receive a share from the proceeds generated, as per their ranking and interest. Moreover, the Report of the Expert Committee on Company Law observed that the priorities and rights of the creditors created before the insolvency and under the commercial laws must be respected to “preserve the legitimate expectations of creditors and encourage greater predictability in commercial relationship.”

Thus, recognising the inter-se priority amongst the secured creditors is of utmost importance during liquidation. The NCLAT’s judgement rejecting the same under Section 53, presents a challenge for the financial sector, as secured creditors would become hesitant to create multiple charges over the same asset. The lack of inter-se priority could encourage them to stay out of the liquidation proceedings and take the recourse under Section 52, which would hurt the efficiency and recovery under the Code. Through an interim order dated 29 June 2021, the Supreme Court in Kotak Mahindra Bank Limited v. Technology Development Board had stayed the NCLAT’s decision. It is imperative now that the impugned judgement be set aside, and the validity of the subordination agreements under Section 53 of the Code be upheld.