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Application of ‘Pari Passu’ Principle in IBC
The literal meaning of the term Pari Passu, means on an equal footing. This legal maxim refers to “equal footing” (or ‘Pari Passu’ means “with equal steps, equally, without preference”). In the case of International Coach Builders Ltd. v. Karnataka State Financial Corporation, REED 2003 SC 03501, the term ‘Pari Passu’ has been described a situation where two or more assets, securities, creditors, or obligations are equally managed without preference. This situation occurs during bankruptcy proceedings. When the court reaches a verdict, the court regards all creditors equally, and the trustee will repay them the same fractional amount as other creditors at the same time. The lexical meaning of the Latin word pari passu is – at an equal rate or pace, with simultaneous progress, proportionately etc. In the case of N.D. Jayal and Another v. Union of India, REED 2003 SC 09001, the term is generally used in the context of creditors who, in marshalling assets, are entitled to receive out of some fund without any precedence over each other.
The Insolvency and Bankruptcy Code, 2016 IBC is the most important law, dealing with the issues of insolvencies and corporate reorganisation in India. The abovementioned law is in force, w.e.f., 1st December 2016. The preamble of the Insolvency and Bankruptcy Code, 2016 (‘Code’/ ‘IBC’) also upholds the principles of equitable distribution – thus balancing interests of all stakeholders under the insolvency framework. Judicial developments have also had a significant role in holding such equity upright. However, in the recent order of the Hon’ble National Company Law Appellate Tribunal, in Technology Development Board v. Anil Goel, REED 2021 NCLAT Del, the Hon’ble NCLAT has refused to acknowledge the validity of inter-se rights of secured creditors once such security interest in relinquished in terms of section 52 of the Code.
This law provides a unique way for dealing with the whole-process of insolvencies as it provides a two-fold process to deal with the insolvency of a corporate person. The first stage functions in a "time-bound manner" and in case, if there is a failure the whole process of resolution reaches the second stage of insolvencies which is for the mandatory liquidation. For illustration, if the corporate debtor undergoes a corporate insolvency resolution project and the creditors of the debtor resolves the insolvency of the corporate in a time-bound manner. To resolve insolvency, "resolution plans" are made by eligible persons for the debtor and thereafter approved by the committee of creditors, if all this corporate insolvency resolution fails, the corporate debtor has to mandatorily go for the liquidation. Other than IBC, there are Banking Regulation laws, The Companies Act, 2013 and notifications of RBI may regulate the insolvency proceedings.
Under section 53 of the IBC, the section deals with the waterfall mechanism where the first priority is given to the costs which are identified with the liquidation process and dues of the workmen of the corporate debtor. The dues of the workingmen include every form of salaries, provident, pension, retirement and gratuity fund or any other fund which is kept for the support of the workers whereas, there exists, a separate priority given to creditors, this challenge and goes in connection to the leading principle in the law of insolvency i.e., "the Pari Passu" Principle.
Insolvency laws, globally, have propagated the principle of equitable distribution as the very essence of liquidation/ bankruptcy processes; and while, “equitable distribution” is often colloquially read as “equal distribution” the two terms hold significantly different connotations, more so in liquidation processes – an ‘equitable distribution’ simply means applying similar principles of distribution for similarly placed creditors.
THE ‘PARI PASSU' PRINCIPLE
The schematics of the Code categorise secured creditors in two types – (i) those who desire to go before the Company Court; and (ii) those who like to stand outside the winding up. The principle of ‘Pari Passu’ is timeless and far entrenched in the jurisdiction. This standard has been perceived so generally that for any creditor who claims a preferred position, it is mandatory to demonstrate that deviation from the equitable pari passu principle is warranted. There have been some five categories being made which are being considered as the true exceptions by the English Statutes:
I. "Rights of Insolvency Set - off", this applies whenever there have been mutual debits, mutual credits or any other mutual dealings, in advance of the liquidation.
II. "Creditors whose claims arise after the winding-up order has been handed down are given a privileged position", the reason they are treated as of pre- preferential status is making them rank ahead of preferential creditors as they are part of the expenses cost in the liquidation process. Moreover, utility suppliers can make it a prerequisite of the giving of the supply that the liquidator personally guarantees the expense of any charges with respect to supply.
III. "Creditors whose continued cooperation is desired by the liquidator may be able to extract payments in respect of pre-insolvency debts", they can oblige payment by virtue of their capacity to perpetrate some harm on the insolvent estate.
IV. "Preferential claims", this includes various types of taxes like VAT, Car Tax etc.
V. "Debts that have been deferred by the Statute", these include debts owed by the insolvent to the director, who is charged for fraudulent or wrongful trading, and who is deferred by the court.
Earlier there was a question, particularly the question of whether the first/second ranking amongst secured creditors at all remains, or all secured creditors will be of the same ranking, has been discussed by the Hon’ble Supreme Court, in context of similar provisions under the Companies Act, 1956, in the case of ICICI Bank v. Sidco Leathers Limited, REED 2006 SC 04001. The Apex Court held that – “…. Section 529-A of the Companies Act does not ex facie contain a provision (on the aspect of priority) amongst the secured creditors and, hence, it would not be proper to read thereinto things, which the Parliament did not comprehend. The subject of mortgage, apart from having been dealt with under the common law, is governed by the provisions of the Transfer of Property Act. It is also governed by the terms of the contract.
…. Merely because Section 529 does not specifically provide for the rights of priorities over the mortgaged assets, that, in our opinion, would not mean that the provisions of Section 48 of the Transfer of Property Act in relation to a company, which has undergone liquidation, shall stand obliterated.”
In addition, in the case of ICICI Bank Limited v. Standard Chartered Bank and Others, Civil Appeal No. 5634-5635 of 2019 the Apex Court was pleased to hold that –
“72. Apart from the fact that there is no provision of the Code which abrogates security interest during insolvency resolution, the field continues to be occupied by settled law protecting sanctity and inter-se priority rights amongst creditors on the basis of security interest inter alia under the Transfer of Property Act, 1882. These principles and provisions, not being in conflict with the provisions of the Code, are not overridden on account of Section 238 of the Code – the latter coming into play only in the event of conflict.
73…… Respectfully, an insolvency law must protect and preserve the pre-insolvency rights and differential bargains entered into by the creditors” (Emphasis Supplied)
Going further back in time, it is important to note that the Hon’ble Supreme Court in Workmen of M/s. Firestone Tyre and Rubber Company of India (P.) Ltd. v. Management and Others, 1973 AIR 1227 : 1973 SCR (3) 587 identifying the valuable right of property of the first charge holder held that-
“Such a valuable right, having regard to the legal position as obtaining in common law as also under the provisions of the Transfer of Property Act, must be deemed to have been known to the Parliament. Thus, while enacting the Companies Act, the Parliament cannot be held to have intended to deprive the first charge holder of the said right. Such a valuable right, therefore, must be held to have been kept preserved.”
Not only during the pre-IBC regime, the Supreme Court in Standard Chartered Bank v. Satish Kumar Gupta, R.P. of Essar Steel Ltd. and Others, (2020) 8 SCC 531 has upheld differential treatment of a financial creditor which did not have any charge or security on the project assets but had advanced large sums on the basis of pledge over the shares of an offshore entity and a corporate guarantee extended by the corporate debtor. Further, even if the corporate guarantee were to be enforced, such creditor would at best stand as ‘secured creditor’ only to the extent of the value of shares of the offshore company as on the date of enforcement of the guarantee and an unsecured creditor with respect to rest of the loan advanced by it. The Supreme Court, in Essar, has deliberated extensively on global authorities, guides, and declared that “equitable” does not mean equal distribution; it means distribution which does justice to every stakeholder involved in the process.”
LIQUIDATION WATERFALL UNDER IBC
Under section 53 of the Insolvency Bankruptcy Code, there exists a mechanism given for the distribution of assets in the process of liquidation. This provision gives the direction to follow the order of priority and within such period and in a certain manner. The sections ask for cost and liquidation cost to be paid in full. This section categorised Workmen's dues and debts owed to the secured creditor are ranked equally i.e., pari passu then comes the unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date. Then, the unsecured creditors. Then comes due to the governments and debts owed to the secured creditor for the enforcement of security interest. Lastly comes, remaining debts after that preference share-holders and lastly, equity shareholders or partners.
After the categorical understanding in abovementioned paragraph. It can ne inferred from the explained mechanism that, the objective of IBC code has deviated itself from the equal footing i.e., pari passu of creditors but, recognises whenever there is importance like for example, workers are placed in a similar position of Secured creditors. In the case of Nico Corporation Limited, Company Appeal (AT) (Insolvency) No. 1347 of 2019, the issue was before the court was that whether workers are placed pari passu with the secured creditors and if so then whether they are on the same pedestal as secured creditors. The NCLT - Kolkata held that, if the workers are placed pari passu with the secured creditors, then they have an equal pedestal and section 35(2) of the IBC, 2016 empowers the liquidator an option to consult any of the stakeholders. The tribunal was also of the view that, in order to have an effective deliberation and to have a fair and just conclusion regarding the distribution of proceeds under section 53 of the Code, it appears to me that inclusion of the representatives of the Workmen enable the Liquidator to have a fair and just conclusion and therefore, the direction sought for inclusion of the representatives of the Workmen in the Monitoring Committee is perfectly maintainable under section 35(1) of the Code and accordingly, it is just and open to the Liquidator to include any number of the representatives of the Workmen at his choice so as to enable him to have an effective deliberation in the process of distribution of assets of the Company under liquidation.
The tribunal was very crystal clear with its view that, if the statute demands the Pari Passu treatment, then no compromise can be made with the treatment and said it is just and open for the liquidator to have a fair conclusion. But, a strict approach like this may create chaos in many situations.
CONCEPT OF REVERSE CIRP
The foremost objective of bringing the Insolvency and Bankruptcy Code, 2016was achieving structured and time-bound redressal for distressed companies. There are two routes for the process of a corporate resolution, one is liquidation and the other is corporate rescue which is an aspect of modern insolvency law. The IBC gives priority to the corporate rescue as its creditors can have better returns and the forum can have reconstruction rather than completely dissolution into the liquidation. As discussed earlier, the IBC provides a waterfall mechanism for the liquidation, but for the corporate rescue or corporate re-organisation, IBC does not mandate to follow the waterfall mechanism of Section 53.
In the case of Flat Buyers Association v. Umang Realtech (P) Limited, Company Appeal (AT) (Insolvency) No. 926 of 2019, the National Company Law Appellate Tribunal held that, in the case of real estate groups or companies, the corporate insolvency resolution process (CIRP) cannot be strictly followed and therefore, laid down the concept of 'Reverse CIRP'. Where an unsecured creditor can also have priority over secured creditors in case of corporate resolution of the real estate company.
Whether the concept of 'reverse CIRP' is violative of provisions of IBC.
To deal with this particular issue, the Hon'ble Supreme Court has explained in various cases like Committee of Creditors of Essar Steel India Ltd. v. Satish Kumar Gupta, Civil Appeal No. 8766-67 of 2019 has explained that why the priority of secured creditors should be more than the unsecured. But, under the concept of reverse CIRP, the unsecured gains more priority. Under such circumstances, the secured creditors have the right of confiscation and can sell it. Such privilege held by the secured creditors put them second on the priority list. However, IBC provides that the committee of creditors may consider the priority list, therefore the order might be different on a case-to-case basis.
Hence, the deviation from section 53 for the concept of 'reverse CIRP' cannot be held to be violative of the provisions of IBC. In normal circumstances, the complications may arise if the unsecured creditors are given priority over the secured ones like some of them have highlighted by the Supreme Court. They are,
(a) This will lead to dilution of the rights of the secured creditors and will pose an obstruction for the economy as a whole, as it may dissuade the secured creditors who generally comprise banks and other financial institutions from extending credit.
(b) The discontented creditors can hinder the advancement of the resolution process if they are unhappy with the settlement of the claim or the process followed for collecting, verifying and determining it.
(c) The secured creditors might also vote for liquidation instead of accepting the proposal of a corporate resolution, as they have been given priority under section 53(1), IBC in case of distribution of assets when a company goes into liquidation.
(d) Secured creditors will more likely be incentivized to get their security through legal proceedings rather than depending upon the framework of IBC wherein the resolution process of the corporate debtor will be carried out at the cost of their financial interests.
The "pari passu" principle is to govern the distribution of assets. The principle of having creditors on equal footing may lead to certain disparities. The Waterfall mechanism of IBC recognises minimum standards of the "Pari Passu" principle and also is broad and liberal for the committee of creditors in what way the liquidation or corporate reorganisation should take place. The 'concept of Reverse CIRP' even permits deviating from the long-established principle of "Priority of secured creditors". Corporate law today is different from that of the 16th century, today the "pari passu" principle is existed but in a very different spirit. The particular insolvency law cannot be held as a bad law only based on that; it is violative of the principle. Since, in today's corporate world where everyone demands their equity and fairness, the strict application of the 'Pari Passu' Principle is not possible and is impractical.