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Distinction between Operational and Financial Creditors and Position of the Former in view of the Swiss Ribbons Judgment

June 25, 2019

[Swati Singh is an advocate practicing law in Delhi since 2016. Her areas of interest are insolvency law and dispute resolution law.]

 

While dealing with the case of Swiss Ribbons Pvt. Ltd. and Ors. v. Union of India and Ors. (Swiss Ribbons), the division bench of the Supreme Court of India (Court) decided the constitutional validity of several provisions of the Insolvency and Bankruptcy Code 2016 (Code). The Court had to decide on provisions which formed the crux and essence of the Code. The said analysis on part of the Court holds immense significance due to the fact that if the said provisions were deemed to be held unconstitutional, the same would have a drastic effect on the Code itself. One such aspect which was decided in the judgment was the distinction between operational and financial creditors, as envisaged under the Code.

 

Point of Law

 

The distinction between the operational and the financial creditors underwent a microscopic analysis considering that there is no apparent intelligible differentia between operational and financial creditors under the Code.  Therefore, the distinction was contended as being violative of Article 14 of Constitution of India. The basis of the aforesaid challenge was the possible unjust and unfair treatment of the operational creditor under the corporate insolvency resolution process (CIRP). Operational creditors have been given no rights or say in the CIRP and the same lie at the mercy of the committee of creditors (COC) comprising of only financial creditors and of the National Company Law Tribunal (NCLT), the latter being the adjudicating authority to approve or reject a resolution plan. Therefore, the question to be decided by the Court was whether the operational creditors shall be granted the same rights as financial creditors as per the provisions of the Code.

 

Decision

 

In order to establish intelligible differentia as discussed above, the Court explored the rational relationship between the creditors so differentiated and the object sought to be achieved by the legislation. To achieve the said goal, the Court referred to a 52-page analysis, followed by a dissection of the various sections of the Code, the workings contained in regulations, the commentaries from the Bankruptcy Law Reform Committee Report (BLRC Report), the Insolvency Law Committee Report and the Joint Parliamentary Committee Report, which even included a counterpoint extracted from the UNCITRAL Legislative Guide on Insolvency Law.

 

Pursuant to providing a complete analysis and observations therefrom, the Court while deciding the appeal observed that “since equality is only among equals, no discrimination results if the Court can be shown that there is an intelligible differentia which separates two kinds of creditors”. It was thereby held that there exist many significant differences between financial and operational creditors. However, the most significant distinction, which as per the Court justifies the exclusion of operational creditors from the Committee of Creditors is involvement of financial creditors in assessing the viability of the corporate debtor. It was stated that financial creditors can and do engage in the restructuring of the loan as well as the reorganization of the corporate debtor's business when there is financial stress, which is beyond the powers of the operational creditors. The Court while establishing the intelligible differentia stated that the preservation of the corporate debtor as a going concern while ensuring maximum recovery for all creditors is the sole objective of the Code. In view of the said object, financial creditors can easily be distinguished from operational creditors. The Court accordingly concluded that the distinction is "neither discriminatory, nor arbitrary, and therefore non-violative of Article 14.”

 

Analysis

 

Through Swiss Ribbons, the Court has examined the position of operational creditors under the CIRP and has made an effort to crystallize the position on the basis of intelligible differentia between the creditors so that there is level playing field for all kind of creditors. Interestingly, as per Section 24 of the Code, the operational creditor is not a party to the COC unless at least 10% of the total debt due to corporate debtor belongs to the operational creditor. It is also pertinent to mention herein that operational creditors do not have a right to see or receive a copy of the resolution plan for not being a "participant" of the COC.[1] Therefore, it can be said that the operational creditors are at the mercy of COC, and since the NCLT is the final authority to approve or reject the resolution plan, the same cannot be finalized until the NCLT is satisfied that there is no unjust discrimination against any class of creditors and that the same balances the interests of every stakeholder. 

 

The NCLT may deny the confirmation of the resolution plan if it is found to be unjust to operational creditors. There are several resolution plans being rejected by the NCLTs across the nation on the basis of unjust treatment of operational creditors, one of them being the Binani Industries insolvency case,[2] wherein the resolution plan submitted by the Rajputana Properties Private Limited was rejected on account of being discriminatory towards the different class of financial creditors as well as operational creditors.

 

Another argument made before the Court was related to the repayment schedule as per Section 53 of the Code, which ranks operational creditors below all other creditors, including other unsecured creditors who happen to be financial creditors. The Court while dealing with the aforementioned argument held that Section 53 lays down the hierarchy of claims and the priority in the distribution of assets (or the so-called waterfall) in liquidation. The Court clarified the said position by observing that the claims of workmen are given preference over even the financial creditors and hence it cannot be said that unsecured creditors of all kinds including workmen and employees are treated in the same manner and are given lowest priority. The Court further reiterated that a resolution plan cannot pass under Section 30(2)(b) read with Section 31 unless a minimum payment is made to operational creditors, such amount not being less than the liquidation value. 

 

In this regard, attention may also be drawn towards Regulation 38 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations 2016, which further strengthens the position of operational creditors by stating that the amount due to the operational creditors under a resolution plan shall be given priority in payment over financial creditors.

 

Additionally, the BLRC Report, upon which IBC is largely based, also suggested that financial creditors can modify the terms of existing liabilities, while other creditors cannot take the risk of postponing payment for a better future prospectus. Therefore, financial creditor can take a haircut (a small portion of the claim) and can take the remaining dues in future, while operational creditors need to be paid immediately. The same is reiterated by NCLAT in Binani Industries case (supra).

 

Conclusion

 

Therefore, in the light of aforesaid circumstances, operational creditors may appear to be on the fragile footing; however, the legislature and the judiciary are trying their best to ensure that all key stakeholders are collectively participating and that the liabilities of all creditors who are not part of the negotiation process are also met in any negotiated solutions as per equity, justice and fair play. It is important to note that no business can survive without financial and/or operational credit and any discriminatory treatment towards either of them will only shrink the distinguished credit, and the same would be contrary to the legislative intent of the IBC.

 

 

[1]Vijay Kumar Jain v. Standard Charted Bank Ltd., [2019] SCC Online SC 103.

[2]Binani Industries Limited and Ors v. Bank of Baroda, [2018] 147 CLA 3201.

 

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