INTRODUCTION
The Insolvency and Bankruptcy Code of 2016 outlines the corporate insolvency process for companies that cannot pay their liabilities. In the Insolvency and Bankruptcy Code, two kinds of creditors are identified. Namely, financial creditors and operational creditors are identified. These creditors can initiate the Corporate Insolvency Resolution Process (CIRP) by applying to the NCLT against the corporate debtor upon default of the corporate debtor’s liabilities. However, initiating the CIRP is different for each of the creditors. For financial creditors, it is easier to begin the CIRP proceedings, but for operational creditors, it is more difficult to initiate. During the insolvency process, a Committee of Creditors is formed in which financial creditors have a place in that committee. Still, the operational creditors may or may not have a place in that committee. The important question is why there is such a differential treatment and whether it is fair or not.
INITIATION OF THE CIRP PROCESS
For the purposes of the IBC, financial creditor is defined under section 5(7) of the IBC, 2016, which states, “financial creditor means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred.”[1] Meanwhile, an operational creditor is defined under Section 5(20) of the IBC, which states, “operational creditor means a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred.”[2] The initiation of the CIRP process for financial creditors and operational creditors is different.
Section 7 of IBC speaks about initiating liquidation proceedings by a financial creditor. According to Section 7, financial creditors or creditors, upon default of a corporate debtor, can file a suit for corporate insolvency resolution process before the NCLT[3]. The process of initiation of liquidation proceedings by an operational creditor is stated in Section 9[4], which is very similar to the process laid down for the financial creditor, except for one significant difference, which is indicated in Section 8. Before the initiation of the liquidation proceeding, the operational creditor must first send a notice to demand notice of unpaid operational debtor copy of an invoice demanding payment of the amount involved in the default to the corporate debtor. Then, within ten days, the corporate debtor must pay the unpaid debt or bring to the notice of the operational debtor that there is an existence of a dispute or a pendency of a suit or arbitration proceedings. If the corporate debtors do not do such things within ten days, then only the operational debtor can initiate the liquidation proceedings mentioned[5] in Section 9. Hence, we can see that initiating liquidation proceedings is easier and quicker for financial creditors than operational creditors.
COMMITTEE OF CREDITORS AND PRIORITY OF PAYMENT
During the CIRP proceedings of a company, an interim resolution professional will be appointed who first collects all the claims against the corporate debtor and then forms a committee of creditors. The Committee of Creditors is mentioned in Section 21[6] of the act and the composition of the committee. The committee’s composition is mainly composed of financial creditors, and they have voting rights proportional to the debt owed to them by the company. The operational creditors are generally not part of the committee of creditors, as mentioned in Section 21(2)[7], and they are only part of a committee of creditors if there are no financial debtors. If its aggregate due is 10% of the debt owed by the corporate debtor, they have a right to attend the committee of creditor meeting but not vote according to section 24(3)(c)[8] but will not have a right to vote according to section 24(4)[9].
The act also puts a low priority on the distribution of liquidated assets to an operational debtor if the committee of creditors decides on the liquidation of the company. Section 53[10] of the code talks about the priority of distribution of liquidated assets of the company. We can see that Section 53[11] gives preference to financial creditors, both secured and unsecured, and it mentions nothing about the operational creditors; hence, it will come under Section 53(1)(f)[12], which mentions any remaining debts and dues that come after the priority given to financial creditors.
JUDICIAL DECISION
The landmark case that deals with the differential treatment of financial and operational debtors is Swiss Ribbons Pvt Limited and Anr v. Union of India and Ors[13]. In this case, many provisions of the IBC were challenged in the Hon’ble Supreme Court. One of the aspects of the law that was challenged was whether the differential treatment of financial creditors and operational creditors is violative of Article 14 of the Indian Constitution. The Supreme Court held that this differential treatment between financial creditors and operational creditors is because they have intelligible differentia between them; hence, it is not violative of Article 14. The reasoning that the Hon’ble Supreme Court gives for this differentiation was that:
- Financial creditors generally lend finance on a term loan or for working capital, enabling the corporate debtor to set up or operate its business. On the other hand, contracts with operational creditors are only related to the supply of goods and services in business operations. (Para 27 of the judgment)
- Financial contracts generally involve large sums of money, whereas Operational contracts do not involve large sums of money (Para 27 of the judgment)
- Financial Creditors have specific repayment schedules due to which if there is a default, they need to recover the debt in its totality, whereas operational creditors do not have such clauses and they might instead have arbitration clauses or have a dispute with the corporate debtor (Para 27 of the judgment)
- from the very beginning, financial creditors are involved in assessing the corporate debtor’s viability. They can, and therefore, engage in restructuring the loan and reorganizing the corporate debtor’s business when there is financial stress, which operational creditors do not and cannot do. (Para 28 of the judgment)
Hence, due to the above reasons, the Hon’ble Supreme Court held that there is intelligible differentia, and therefore, the differential treatment of the two types of creditors is valid.
CONCLUSION
Hence, from the above, we can conclude that operational and financial creditors are treated differently. Financial creditors are given preferential treatment within the ambit of this act in terms of initiation of the process, seat in the committee of creditors, and priority of payment compared to operational creditors. This differential treatment was challenged in the Hon’ble Supreme Court of India under Article 14 of the Indian constitution. However, the Hon’ble Supreme Court held that there was intelligible differentia; hence the differential treatment was valid.
I agree with the opinion that there is an intelligible difference between financial creditors and operational creditors. Still, I feel that too much preferential treatment is given to financial creditors. I understand the reasoning behind the easier initiation of the CIRP process because of the higher amount of money involved and the payment schedule plan that needs to be followed. Still, in the committee of creditors, the operational creditors need to have a place with full voting rights. According to the Hon’ble Supreme Court, the rationale behind the decision to consist of the committee of creditors consist of financial creditors because of the amount of money that is involved. They have specific repayment schedules due to which if there is a default, they need to recover the debt in its totality. Still, I feel at least twenty-five percent should be reserved for operational creditors with voting rights because though the quantum of money is less they are more vulnerable financially than the big financial institutions hence they should also get a say in the committee of creditors. Also, they should have some priority in getting the liquidated assets of the company.
Author(s) Name: Shatarup Banerjee (School of Law, Christ (Deemed-to-be-University) Bangalore)
References–
[1] The Insolvency and Bankruptcy Code 2016, s 5(7)
[2] The Insolvency and Bankruptcy Code 2016, s 5(20)
[3] The Insolvency and Bankruptcy Code 2016, s 7
[4] Insolvency and Bankruptcy Code 2016, s 9
[5] Insolvency and Bankruptcy Code 2016, s 8
[6] Insolvency and Bankruptcy Code 2016, s 21
[7] Insolvency and Bankruptcy Code 2016, s 21(2)
[8] Insolvency and Bankruptcy Code 2016, s 24(3)(c)
[9] Insolvency and Bankruptcy Code 2016, s 24(4)
[10] Insolvency and Bankruptcy Code 2016, s 53
[11] Ibid
[12] The Insolvency and Bankruptcy Code 2016, s 53(1)(f)
[13] Swiss Ribbons Pvt Limited and Anr v. Union of India and Ors (2019) 2019 (4) SCC 17
