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Liquidation under the IBC – Order of priority signals shift in economic rationale

Previously in this series, we learnt about the corporate resolution insolvency process (“CIRP”) under the Insolvency and Bankruptcy Code, 2016 (“IBC”). We can now turn our attention to what happens if the CIRP is unsuccessful and the corporate debtor needs to be liquidated.

Liquidation

Unlike the CIRP which aims to sell a composite business, the liquidation of a corporate debtor involves the selling of its assets piecemeal and the distribution of the sale proceeds among its various creditors. The National Company Law Tribunal (“NCLT”) can order a liquidation under Section 33 of the IBC if no resolution plan has been submitted to it before the expiry of the CIRP period, or if it rejects a plan because it does not comply with the provisions of the IBC.

The NCLT can also order a liquidation after a resolution plan is approved. Under Section 33(4), any person (other than the corporate debtor) whose interests are prejudicially affected by a contravention of the resolution plan, can make an application to the NCLT. Judicial decisions have not yet provided colour to when interests can be considered prejudicially affected and it remains to be seen whether the courts establish some threshold principles to avoid liquidation being ordered for minor contraventions or frivolous litigation.

The resolution professional will be appointed as the liquidator unless the Insolvency and Bankruptcy Board of India (IBBI) recommends otherwise, or if the resolution professional submits a plan that is rejected for failing to meet the requirements under Section 30(2) of the IBC.

The liquidator is ordinarily required to sell the assets of the company through an auction process, as this is generally considered to be the best, and most transparent, price discovery mechanism. However, in certain circumstances, such as if the asset is perishable or likely to deteriorate in value if it is not sold quickly, a private sale can be conducted. Regulation 44 (1) of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 require a liquidator to liquidate the corporate debtor within a period of two years.

Priority in Liquidation

Section 53 of the IBC sets out the priority in which the proceeds of a liquidation will be distributed. The priority is:

  • the insolvency resolution process costs and the liquidation costs;
  • the following debts which rank equally: (i) workmen’s dues for the period of twenty-four months preceding the liquidation commencement date; and (ii) debts owed to a secured creditor in the event such secured creditor has relinquished its security to the liquidation estate;
  • wages and any unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date;
  • financial debts owed to unsecured creditors;
  • ranking equally, (i) any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date; (ii) debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;
  • any remaining debts and dues;
  • preference shareholders, if any; and
  • equity shareholders or partners, as the case may be.

The order of priority under the IBC is similar to the order for distribution under a winding up under the Companies Act, but with a couple of significant differences. Unsecured financial creditors have greater primacy under the IBC, and now take ahead of both crown debts, that is, debts owed to government, and other unsecured creditors.

While these changes are consistent with the general theme of the IBC, which seeks to provide greater protection to financial creditors, the considerations for this particular preference are not easily apparent. To begin with, it is unclear what class of financial creditors this order is trying to protect. Institutional lenders, which provide most of the debt financing in the economy, typically take security over a debtor’s assets and are protected as secured creditors. Thus, the broader justification for providing a more effective recovery mechanism for banks does not seem to apply here. It is possible the framers envisaged protection of individual bond and debenture holders, but this seems contrary to the thinking in other legislative attempts, such as the Companies Act, 2013, which seek to protect them by mandating the creation of security for such creditors.

Regardless of the rationale, prioritising unsecured financial creditors over crown debts clearly signals a shift in economic rationale. Crown debts, which are essentially public debt, are less important than unsecured financial creditors. As discussed above however, it is unclear how big this class of unsecured financial creditors is likely to be, and so perhaps the impact of this change may not be significant.

Uday Khare is a Partner at Cyril Amarchand Mangaldas.

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