[Harshil is a student at Symbiosis Law School.]
In a recent decision of the National Company Law Appellate Tribunal (NCLAT) in Mr Srikanth Dwarakanath, Liquidator of Surana Power Limited v Bharat Heavy Electricals Limited, the tribunal applied provisions of Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act 2002 (SARFAESI Act) to resolve a deadlock within Section 52 of the Insolvency and Bankruptcy Code 2016 (IBC). Here, I shall argue that the commercial implications of this judgement can be far-reaching as the tribunal has not only missed out on considering pertinent legal provisions but also stretched certain sections beyond their scope.
Concept of ‘charge’ and ‘joint charge holders’
A charge means an interest or lien created on the property or assets of a company for securing the repayment of a debt. Charges are governed by private contracts between a lender and a borrower. Depending on the inter-creditor arrangement with the borrower, some contracts allow the creation of several charges on the same asset, while some do not. When several charges are created, the parties can either consent to creation of subsequent charges on the same asset or can consent to creation of pari-passu charges. Simply speaking, in the former situation, creditors hold charges of different ranking on the same asset, and in the latter, the creditors hold equivalent charges on the same asset.
The aspect of priority in charge holding becomes significant at the time of default as the priority in charge decides the waterfall distribution from the proceeds of an asset; the first charge holder is paid off first, then the second-ranking charge holder, and so on. Pari-passu charge holders are equally placed and thus receive the proceeds in proportion to their debt. Usually, the enforcement of security interest takes place through Section 13 of the SARFAESI Act, however, when the company is in liquidation, there exists a parallel security enforcement mechanism under Section 52 of the IBC, read with Regulation 37 of Liquidation Process Regulations 2016.
At the stage of liquidation, in accordance with Section 36 of the IBC, the liquidator forms a liquidation estate of all the assets of the corporate debtor. Since the secured creditors have an enforceable security interest on such assets, they have, under Section 52 of the IBC, a choice between relinquishing their security interest to the liquidation estate and realising their security interest. In the making of this choice, two kinds of situations arose, which required judicial intervention:
situation where all the secured creditors holding charges of different ranking on the same asset opted for treating the asset differently i.e. some creditors wanted to enforce their security interest independently standing out of the liquidation pool; whereas the rest wanted to relinquish their interest to the liquidation pool.
situation where all the secured creditors holding pari-passu charges on the same asset did not collectively opt for treating the asset similarly.
The tribunal addressed the first situation in JM Financial Asset Reconstruction Company Limited v Finquest Financial Solutions Private Limited, holding that only the first charge-holder i.e. the secured creditor being highest in the inter-creditor ranking, is entitled to enforce his right for the realization of its debt out of the secured asset and no other 'secured creditor' can enforce his right subsequently for the realization of the amount for the same secured asset. In case the proceeds from realization are higher than the debt owed to the highest creditor, the extra amount would be transferred to the liquidation pool.
It was the second situation which the tribunal was called to answer in the instant case.
Factual background
The respondent i.e. Bharat Heavy Electricals Limited, an operational creditor, had succeeded in an arbitration proceeding against the corporate debtor (Surana Power) and as part of the award, received a pari-passu charge i.e. a lien over the assets of the corporate debtor. The same assets were already hypothecated to ten other secured creditors.
Post the failure of the insolvency resolution process of the corporate debtor, the appellant was appointed as a liquidator. On commencement of the liquidation process, the respondent informed about its unwillingness to relinquish its security interest in the asset in question. On the other hand, the rest of the secured creditors had already relinquished their security interest into the liquidation estate of the corporate debtor.
Consequently, a deadlock had been created, wherein a part of the pari-passu charge holders had relinquished their interest and the other part wanted to enforce it. In these circumstances, the liquidator filed an application seeking permission from the adjudicating authority to sell the assets of the corporate debtor. The said application was rejected by the adjudicating authority, and against that order, this appeal was preferred.
Setting aside the impugned order, the NCLAT held that all the secured creditors including the respondent are on the same footing regardless of the mode of the creation of charge. Furthermore, for equally-footed charge holders, it held that as per Section 13(9) of the SARFAESI Act, any steps about the realization of assets by the secured creditors require confirmation from creditors holding at least 60% of the value of the total debt. Since the respondent held only 26.24% share (in value) of the total debt, it had no option but to relinquish its interest.
Critical analysis
In this part, I will contend that the tribunal’s reasoning to debar the respondent’s claim has two glaring errors – first, that it fails to consider Regulation 37 as a parallel security enforcement mechanism; and second, that the application of Section 13(9) to the respondent’s claim is erroneous.
Interest enforcement through Regulation 37
The tribunal reasoned that every enforcement of security interest takes place through Section 13 of the SARFAESI Act and because the respondent is a secured creditor, enforcement of its interest also had to take place through Section 13. The tribunal completely missed out on Regulation 37 of the Liquidation Process Regulations 2016, which gives the charge holders an option to enforce their interest through the code itself - without availing the SARFAESI Act. This choice was correctly highlighted by the NCLT, Mumbai in Edelweiss Asset Reconstruction Company Limited v Abhijeet MADC Nagpur Energy Private Limited, wherein it had held:
"For realisation of the security interest, law provides two provisions. First option is to deal with the security interest in accordance with the provisions of Section 13 of SARFAESI Act 2002.
Other option available to the secured creditor is provided under IBBBI (Liquidation Process) Regulations 2016, Regulation 37."
The tribunal failed to take note of a situation where a pari-passu charge holder, with any percentage of share in the security, can enforce its security interest through this regulation. There is nothing in the regulation which prevents any pari-passu charge holder from enforcing its interest through the code itself. While the right to enforce undoubtedly exists, such enforcement is not without its problems
One issue is, the regulation does not specifically provide for pari-passu charge holders. In the absence of any specific provisions, such as the 60% rule under Section 13, the regulation poses a pertinent question; that whether under the regulation an overriding power is granted to that secured pari-passu charge-holder who wants to enforce its security interest instead of relinquishing it to the liquidation pool? For instance, in the present case, if the respondent was allowed to enforce its security interest through the regulation, whether such enforcement can happen against the will of the other ten secured creditors holding pari-passu charges. Therefore, will they have to remain satisfied with whatever they receive (in proportion) from the sale of the asset? On the face of it, this is obviously an untenable proposition as it gives one stakeholder [holding minority share (in value)] the power to decide for others. It is to avoid this conclusion and subsequent litigation arising from it, that the tribunal should have applied its wisdom to this.
Therefore, the problem in the tribunal’s judgement is not that it disqualified the respondent’s claim based on a majority rule, but the problem lies in the fact that the tribunal did so without considering Regulation 37 as an alternate security enforcement mechanism.
Section 13(9) and secured operational creditors
Another problem with the tribunal’s reasoning is that it considers Section 13(9) of the SARFAESI Act to also apply to operational creditors - in addition to financial creditors. This, however, is incorrect as Section 13(9) is a bar on the enforcement rights granted under Section 13(4) and these enforcement rights are conferred only upon ‘secured creditors.’ ‘Secured creditors’ under the SARFAESI Act, include only banks, financial institutions, asset reconstruction companies, and debenture trustees (see Section 2(zd)), but do not include operational creditors. The respondent is an operational creditor and hence, the tribunal’s reasoning to restrict the respondent’s right based on Section 13(9) is erroneous.
Conclusion
It is this ambiguity around the two parallel security enforcement mechanism which demanded judicial intervention. The NCLT Mumbai (supra) had also highlighted this juxtaposition in its judgement (para a (iv)) but due to the facts therein, it did not feel the need to resolve this position. The NCLAT, in the present case, had an opportunity to provide some clarity on this issue, but unfortunately, instead of resolving anomalies, it has further muddled the position. This predicament of the joint-charge holders is, therefore, left hanging in the air with no clarity on what mechanism is to apply in a given situation.