Secured Financial Creditors Be Treated ‘Equally’ in case of relinquishment of Security Interest in Liquidation Process under the IBC

Protection from discrimination and inequality is guaranteed under the Constitution. Article 14 of the Indian Constitution mandates that ‘the State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India’. Unlike other fundamental rights, the right to equality extends to any person, including corporations. A corollary of equality is that unequals shall not be treated equally. Classification of unequals differently falls within the realm of ‘intelligible differentia’, a permitted exception to the rule of equality. It is this classification and/or sub-classification, the reasonability of which is often put to test before various courts/tribunals.

The regime under Insolvency and Bankruptcy Code, 2016 (“Code”) imbibes the rule of equality insofar as it treats creditors with distinct rights differently. Once an insolvency resolution process is initiated against a corporate debtor, its board stands divested of its powers and the same is entrusted upon a resolution professional who acts at the behest of a Committee of Creditors (“CoC”). The CoC comprises of all Financial Creditors (secured as well as unsecured) of the Corporate Debtor, seemingly, persons well equipped with deciding the fate of the Corporate Debtor, i.e. whether the Corporate Debtor (on account of its default) shall be put into liquidation or it shall undergo a restructuring.

Section 53 of the Code contemplates a waterfall mechanism for distribution of the proceeds realised from sale of the Corporate Debtor’s assets, among various categories of claimants. At the top of this pyramid are insolvency/liquidation costs which are accounted for the first out of the liquidation proceeds, followed by two sub-categories ranking equally, (i) workmen dues for period of twenty-four months preceding the liquidation commencement date and (ii) the debts owed to a Secured Creditor who relinquished its security interest. Secured Creditors who do not relinquish their security interest, to such limited extent of the amount that remains unpaid after enforcing the security interest, are fifth in line along with an equal share for Government dues for the preceding two years. ¹

An interesting question arose recently before the National Company Law Appellate Tribunal (“NCLAT”), whether in case of liquidation the secured creditors who have relinquished their security interest, can be treated equally regardless of the priority of its charge over the security interest.² Overturning the decision of National Company Law Tribunal (“NCLT”), Ahmedabad Bench, the NCLAT ruled that priority of charge i.e. first charge or second charge loses its significance on relinquishment of the security interest and therefore all such secured creditors who have relinquished their security interest, would be treated equally.

It further noted that the two sets of secured creditors, one relinquishing the security interest and the other realising its security interest are treated differently under the Code. In the event a secured creditor elects to realise its security interest and there is a shortfall, the claims for such shortfalls rank lower in priority. Per contra, secured creditors who have relinquished their security interest to the liquidation estate, in the waterfall mechanism are second only to the insolvency resolution process costs and the liquidation costs.

Customarily, there exists a sub-classification inter-se secured creditors basis the priority of charge, i.e. creditor having a first charge over a security enjoy a priority to recover its dues fully, before a subservient charge is apportioned from the proceeds of such secured asset. This classification is also well recognised under the Transfer of Property Act, 1882 which governs the law relating to creation of security interest. The NCLT while deciding this issue had ruled that inter-se priorities amongst secured creditors will remain valid and prevail in distribution of assets in liquidation.

The NCLAT in the instant case had permitted a subservient charge holding secured financial creditor to be treated at par with the creditors holding first charge. In support of its decision NCLAT held that the first charge holders would have gotten priority in the event they had not relinquished their rights, but having relinquished their rights, Section 53 mandating equal ranking among secured creditors would come into play. Moreover, the non-obstanate clause contained in the very opening words of Section 53 leaves no room for doubt that the distribution mechanism provided thereunder applies regardless of any other laws.

It is interesting to note the divulging classification within the Code itself in case of insolvency resolution vis-a-vis liquidation, which though interlinked but treats secured creditors distinctly. In the landmark Essar Case ³ the Supreme Court has held that distribution of proceeds among secured creditors, can be based on the value and quality of the security and that classification amongst secured financial creditors is permissible based on the wisdom of CoC. In fact, the provisions relating to insolvency resolution in the context of providing for a minimum payment to operational creditors, do rely on Section 53 of the Code. However, the Essar Case was not a case of liquidation, but that of a successful insolvency resolution.

A bare reading of Section 52 and 53 of the Code indicates that, once the secured financial creditors of a corporate debtor, holding first or second charge in different assets of a corporate debtor, relinquish the security interest in the assets charged in their favour, they would be treated equally at the time of distribution of proceeds from the liquidation of such assets, irrespective of their debt amount and valuation of the security interest relinquished. The NCLAT ruling follows the mandate of Section 53 of the Code and puts all the secured financial creditors, irrespective of the nature of their security interest in the asset at par, at the time of distribution of proceeds from the liquidation of assets as per section 53 of the Code. However, with this ruling the financial creditors holding first charge on the asset of a corporate debtor may be dissuaded from relinquishing their security interest in the liquidation process under the Code and they may rather opt to realise their security interest in the asset outside the liquidation.