Priority Of Stakeholders In Liquidation Under Insolvency And Bankruptcy Code
Author: LawSphereX
Category: Corporate & Insolvency
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PRIORITY OF STAKEHOLDERS IN LIQUIDATION UNDER
INSOLVENCY AND BANKRUPTCY CODE
Divyam Kumar, BBA LLB, University of Mumbai Law Academy
ABSTRACT
The Insolvency and Bankruptcy Code, 2016 (IBC) has significantly reformed India’s insolvency framework, ensuring a time-bound resolution process while balancing the interests of various stakeholders. This paper delves into the evolution of insolvency laws in India, tracing the shift from fragmented legislations to a unified code. It examines the key stakeholders in corporate insolvency and their hierarchy during the liquidation process, with a specific focus on Section 53 of the IBC, which lays down the distribution waterfall for asset realization. A comparative analysis of financial and operational creditors is conducted to highlight their distinct roles, rights, and priorities under the Code. This paper critically examines the status of operational creditors and workmen, addressing concerns regarding their treatment in the liquidation process.
It further discusses key judicial pronouncements that have provided clarity on the interpretation and application of Section 53. Additionally, the study contrasts India’s liquidation framework with that of developed economies, shedding light on best practices and potential areas for reform. Finally, the paper proposes a way forward, suggesting policy and legislative improvements to enhance fairness and efficiency in asset distribution under IBC. By dissecting Section 53 in detail, this research aims to contribute to the ongoing discourse on strengthening India’s insolvency regime.
Introduction
As the economy grows, new companies and corporations emerge, often capturing the market share of established businesses. This can lead to significant losses for existing companies, ultimately forcing some to shut down. However, closing a company is a complex process involving numerous stakeholders. Any capitalist system must have bankruptcy rules. They serve as the foundation for the orderly dissolution or reorganisation of a variety of company structures, including limited liability companies, partnerships, and proprietorships. Therefore, from an economic standpoint, bankruptcy laws make it easier to efficiently reallocate funds that have been locked up in a failed company.
There are clear distributional ramifications in any bankruptcy procedure since bankruptcy laws require juggling the conflicting interests of numerous stakeholders, including banks, suppliers, employees, operational creditors, bondholders, and the government. Because of this, bankruptcy rules are subject to both economic and political pressures. 1 A corporate is an amalgam of various stakeholders. It is expected to maximise the value of its assets and consequently the interests of all its stakeholders. However, it may not always have the motivation to maximize the value of a corporate and/or promote the interests of all stakeholders simultaneously or equitably.
Therefore, the law prescribes governance norms to ensure that a corporate maximizes the value of its assets, today and tomorrow, and balances the interests of all the stakeholders, and assigns the responsibility for compliance with those norms primarily to a professional, the Company Secretary, and a custodian, the Board of Directors (Balancing the Interest of the Stakeholders, IBBI). Evolution of Insolvency Law in India Before the Insolvency and Bankruptcy law got enacted there were several events which took place. The balance of payment crisis of 1993, and the recommendation of broad-based financial sector reforms by Narasimham Committee-I (1991). Furthermore, these efforts can be grouped into two sets: those made by the Government of India and those made by the Reserve Bank of India (RBI). 1https://ibbi. gov.
in/uploads/resources/Article%20Balancing%20the%20Interests%20of%20Stakeholders%20in %20IBBI%20Newsletter%20July-September%202017. pdf The government legislated the Recovery of Debts Due to Banks and Financial Institutions Act,
1993 (RDDBFI) to speed up the recovery process. Under this Act, Debts Recovery Tribunals
(DRTs) were formed. Initially, the system functioned well. However, soon DRTs were to be overburdened with a large number of pending cases. Within a decade, the government introduced another legislation, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act, 2002) to safeguard the interest of secured creditors. The SARFAESI Act provided for the creation of asset reconstruction companies (ARCs) in India. India’s experiment with ARC in 2002 without any established bankruptcy laws or developed financial market, notably corporate bonds market, is quite puzzling. Particularly, the factors that led to the emergence of ARCs in the 1990s in the United States were completely absent in the case of India.
2 In contrast, the RBI implemented the Corporate Debt Restructuring (CDR) mechanism in August 2001, which allowed debt restructuring without requiring a reduction in asset quality if the restructuring plan satisfied specific requirements. The fundamental justification for CDR was that since the nation lacked an efficient bankruptcy law, restructuring plans were necessary. In essence, the schemes established a structure for a settlement that ought to typically take place within the auspices of bankruptcy and insolvency laws. At first, the CDR process functioned effectively. Later on, it was employed less for the successful settlement of stressed assets and more as a means of evading the identification of non-performance. As a result, the RBI removed the asset categorisation forbearance in May
2013 with effect from April 1, 2015. However, the RBI permitted asset classification benefits
for specific restructuring plans in response to the growing amount of non-performing assets (NPAs). These included the Scheme for Sustainable Structuring of Stressed Assets, flexible project credit structuring, and strategic debt restructuring. In 2014, the Bankruptcy Legislative Reforms Committee, led by T. K. Viswanathan, proposed the Insolvency and Bankruptcy Code (IBC). The objective of IBC was to consolidate and amend the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms, and individuals in a time-bound manner for the maximization of value of
2 https://journals.sagepub.com/doi/full/10.1177/0256090920953988
assets of such persons, to promote entrepreneurship, availability of credit, and balance the interests of all the stakeholders including alteration in the priority of payment of government dues. 3 IBC, 2016 was finally enacted and notified in the Gazette of India in May 2016. The law aims at insolvency resolution in a time-bound manner (initially 180 days, extendable by another 90 days under certain circumstances but now extended to 330 days) undertaken by insolvency professionals. The law ensures the separation of judicial and commercial aspects of the resolution process, thereby correcting the mistakes of past legislations. Furthermore, under IBC, the adjudicating body will be the National Company Law Tribunal (NCLT) and not the DRTs.
The Insolvency and Bankruptcy Code, 2016 (Code), however, envisages that if the corporate fail to service the debt, the corporate in default undergoes corporate insolvency resolution process (CIRP). An Insolvency Professional (IP) carries on the business operations of the corporate as a going concern until the Committee of Creditors (CoC) draws up a resolution plan that would keep the business of the corporate going on for ever. The Code, as stated in the long title, requires a CIRP to (a) maximise value of assets of the corporate, and (b) while doing so, balance the interests of all the stakeholders, and assigns this responsibility primarily to the IP, and the CoC comprising non-related financial creditors.
Under IBC, where insolvency is considered as the short term inability to pay off the due liabilities, bankruptcy is a longer-term view when company has reached at the brink of financial inability to discharge its liabilities using its assets (EY, 2017) The Insolvency Professional tries to resolve the corporate to the extent it is profitable for the stakeholders and economy of the country. But many times it is not possible to resolve a company therefore it goes for liquidation. The liquidation is a very complex process so the first preference is always resolution but if it is not possible at all then the IRP generally goes for liquidation. Balancing interests under CIRP assumes significance as every corporate may not have enough resources at the commencement of CIRP to satisfy the claims of all stakeholders fully, while 3 2 Vishwanathan, N. S. (2018, April 18).
It is not business as usual for lenders and borrowers [Speech by Deputy Governor, RBI]. NIBM. resolution provides an opportunity to the CoC to consider and balance their interests. In fact, the Code prescribes several balances in resolution process: repayment of at least liquidation value to operational creditors; repayment of interim finance in priority; approval of resolution plan by 75% voting power; etc. There are total 21604 companies under liquidation as per the Insolvency and Bankruptcy Board of India. This shows that the Insolvency and Bankruptcy Code, 2016 has been a success as it has successfully been able to ensure that the creditors do loose all their money. The table below shows some of the companies going through the liquidation. 4https://ibbi. gov. in/en/claims/claimprocess?
corporate_debtor=&ip_name=&under_process=Liquidation&page=9 Stakeholders in a corporate There are various stakeholders involved in a corporate. It includes – • Shareholders • Employees • Management
Financial Creditors • Operational Creditors • Regulators • Investors And several others depending upon the type of business the Corporate is involved in. These stakeholders are equally involved in running a corporate but the money is distributed unequally divided among the stakeholders during the liquidation. As per section 31 of the
INSOLVENCY AND BANKRUPTCY BOARD OF INDIA (LIQUIDATION PROCESS) REGULATIONS, 20165 at the time of liquidation the liquidator is suppose to make a list of stakeholders. Section 31- (1) The liquidator shall prepare a list of stakeholders, category-wise, on the basis of proofs of claims submitted and accepted under these Regulations, with- (a) the amounts of claim admitted, if applicable, (b) the extent to which the debts or dues are secured or unsecured, if applicable, (c) the details of the stakeholders, and (d) the proofs admitted or rejected in part, and the proofs wholly rejected. 6 Hierarchy of Stakeholders in the Corporate during the liquidation In the matter of Prowess International Pvt. Ltd. Vs. Parker Hannifin India Pvt. Ltd. , the NCLAT reiterated: “It is made clear that Insolvency Resolution Process is not a recovery proceeding to recover the dues of the creditors.
” Further, the Code enables a financial creditor to trigger CIRP even when the corporate has defaulted to another creditor and thereby prevents any preferential treatment to a creditor over others. In the matter of Parker Hannifin India 5 1Vide Notification No. IBBI/2016-17/GN/REG005, dated 15th December 2016, published in the Gazette of India, Extraordinary, Part III, Sec. 4, dated 15th December, 2016 (w. e. f. 15. 12. 2016).
6 https://ibbi.gov.in/uploads/legalframwork/b37ac2f0201e2e3c41cfa3d989f58f4d.pdf
Pvt. Ltd. Vs. Prowess International Pvt. Ltd., the NCLT observed: “The nature of insolvency petition changes to representative suit and the list does not remain only between a creditor and the corporate debtor.” The hierarchy of stakeholders can be understood by section 31A7 of the INSOLVENCY AND BANKRUPTCY BOARD OF INDIA (LIQUIDATION PROCESS) REGULATIONS, 20168.
This section deals with the formation of the consultation committee based on the list of stakeholders under Section 31 of the INSOLVENCY AND BANKRUPTCY BOARD OF INDIA (LIQUIDATION PROCESS) REGULATIONS, 2016. The formation of the consultation committee is based on the table given below- Table Class of Stakeholders Description Number of Representatives (1) (2) (3) Secured financial creditors , who have Where claims of such creditors admitted during the liquidation Number of creditors in the category, subject to a relinquished their security interests under process is less than 50% of maximum of 2 liquidation value section 52.
Where claims of such creditors admitted during the liquidation Number of creditors in the category, subject to a process is at least 25% of maximum of 2 liquidation value Workmen and employees Governments Operational creditors other than Workmen, Where claims of such creditors admitted during the liquidation Number of creditors in the category, subject to a employees and process is less than 25% of maximum of 1 Governments. liquidation value. Where claims of such creditors admitted during the liquidation Number of creditors in the category, subject to a process is at least 25% of maximum of 2 liquidation value Shareholders or partners, if any Based on the analysis of the above table it can be understood that the Secured creditors are paid first, followed by unsecured creditors, and finally, shareholders, with preferred shareholders usually receiving priority over common shareholders.
The hierarchy of creditors under Section 53 of IBC The section 53 states that – (1) Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of the liquidation assets shall be distributed in the following order of priority and within such period and in such manner as may be specified, namely :— (a) the insolvency resolution process costs and the liquidation costs paid in full; (b) the following debts which shall rank equally between and among the following :— (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 security in the manner set out in section 52; (c) wages and any unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date; (d) financial debts owed to unsecured creditors; (e) the following dues shall rank equally between and among the following:— (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; (f) any remaining debts and dues; (g) preference shareholders, if any; and (h) equity shareholders or partners, as the case may be.
(2) Any contractual arrangements between recipients under sub-section (1) with equal ranking, if disrupting the order of priority under that sub-section shall be disregarded by the liquidator. (3) The fees payable to the liquidator shall be deducted proportionately from the proceeds payable to each class of recipients under sub-section (1), and the proceeds to the relevant recipient shall be distributed after such deduction.
In the event of the proceeds from the sale of the liquidation assets are not sufficient assets are not sufficient to meet the outstanding payments to be made to each of the recipients under sec 53(1), the debt of each of the recipients that rank equally shall be paid in equal proportion within the same class of recipients. Section 53 of the IBC provides the order of priority in which the proceeds from the sale of liquidation assets of the Corporate Debtor shall be distributed amongst its stakeholders. The creditors are thus ranked in a hierarchical structure, giving this provision the name of “Waterfall Mechanism”. 9 During liquidation under the Insolvency and Bankruptcy Code (IBC), 2016, the hierarchy of stakeholders is determined by the waterfall mechanism outlined in Section 53 of the Code. This mechanism prioritizes the distribution of liquidation proceeds based on a specific order.
At the top of the hierarchy are the insolvency resolution process costs and liquidation costs, which must be paid in full before any other distribution. Following this, secured creditors and workmen’s dues for the preceding 24 months are prioritized equally. Next in line are the employee dues for the preceding 12 months, followed by unsecured creditors. Once these claims are satisfied, any remaining funds are distributed to government dues (such as taxes) and remaining secured creditors for unpaid amounts. After settling these statutory dues, the next priority is given to shareholders and equity holders based on their shareholding or agreements. Finally, if any funds remain, they are distributed to the corporate debtor or its contributors.
Dissecting Section 53 of the IBC This structured hierarchy ensures an equitable and transparent resolution, safeguarding the interests of various stakeholders during the liquidation process. But the question arises that whether inter-creditor or subordination agreements between creditors will be respected in the payment waterfall of Section 53 of the IBC when a secured creditor relinquishes its security. Typically, holders of the first charge have a higher priority in asset distribution, while second charge holders, with subordinate claims, are paid only after the claims of the first charge holders are fully satisfied.
9 https://www.indialaw.in/blog/insolvency-bankruptcy/sc-cbic-dues-to-follow-waterfall-mechanism/
The rights of secured creditors over the assets of a Corporate Debtor are governed by the Transfer of Property Act, 1881 (TP Act) and the Companies Act, 2013. Under Section
100 of the TP Act, when immovable property is offered as security for payment without
creating a mortgage, the beneficiary of such security holds a charge on the property. Additionally, Section 48 of the TP Act stipulates that if rights over the same immovable property are created at different times, earlier rights take precedence over latter ones unless a specific contract provides otherwise. Section 2(16) of the Companies Act, 2013, defines a "charge" as an interest or lien on a company’s property or assets, including a mortgage. This legal framework establishes that the first charge holder’s claim takes precedence over that of the second charge holder, consistent with Section 48 of the TP Act. In practical terms, this means that during liquidation, the proceeds from the sale of assets must first be applied to satisfy the debt owed to the first charge holder.
Only after the first charge holder’s claims are fully settled can any remaining amount be allocated to the second charge holder. While Section 53 of the IBC provides the general framework for prioritizing the distribution of liquidation proceeds, the specific rights and priorities of secured creditors—particularly in cases involving inter-creditor or subordination agreements—are also shaped by the principles outlined in the TP Act and the Companies Act. This intersection of laws highlights the complexities of resolving inter-creditor disputes and underscores the importance of clear legal interpretation to ensure equitable treatment of all creditors. The revised liquidation Waterfall is one of the features of the code that shows a significant shift in objectives of the insolvency process in relation to corporate debtors.
Most notably, the debts of unsecured creditors of the corporate debtors of the corporate debtors have now been giving priority over crown debts such as payments owed to government authorities and towards taxes and cess. Section 53 of the Code has also simplified the distribution of benefits to workmen and employees of the corporate debtor. By incorporating the language “Wages and any unpaid dues owed to the employees”, the Code has been simplified the existing arrangement under Section
529 of the Companies Act, 1956, as also under sec 327 of the Companies Act, 2013 which
specifically creates an exclusive rung of benefits to workmen in relation to benefits other than wages such as accrued holiday remuneration, Employees State Insurance and Provident Fund. On a close interpretation of Section 53 of the IBC on a real time basis in the case of most of the Corporate Debtors under Liquidation, it is predominantly the Secured Financial Creditors who stand to gain something from the realizations while all other creditors following them are left high and dry. Even here it is to be noted that Secured Financial Creditors (SFCs) gain only 'something', which clearly indicates towards the fact that even the SFCs are not able to recover their dues to the full extent, the reason being the asset value of the Corporate Debtor being abysmally low as compared to the dues owed by it, thereby resulting in insufficient realizations.
Thus, in Liquidation, it is Section 53, which plays a pivotal role, since all the stakeholders being Financial Creditors, Operational Creditors, and other stakeholders who are entitled to distribution of proceeds under section 53 in the Company would be interested in knowing how much of their debts are capable of being saved from turning into bad debts. (Camouflage Key Player in the Revival Process) 10 There are several judgements of the NCLT which further gave further clarity on section 53 of the IBC. For instance in LML Limited Vs Office of Commissioner of Income Tax, Mumbai it was stated that the tax liability arising out of sale of assets by the liquidator shall be distributed in accordance with the provisions of the Section 53 of the Insolvency and Bankruptcy Code, 2016 and capital gain tax shall not be treated as the liquidation cost.
11 In the State Tax Officer (1) Vs Rainbow Papers limited (CIVIL APPEAL NO. 1661 OF created by operation of law. The definition of secured creditor in the IBC does not exclude any Government or Governmental Authority. Further the Supreme Court upholds waterfall mechanism under IBC; Division Bench overturns Rainbow ruling in Paschimanchal Vidyut Vitran Nigam Ltd V. Raman Ispat Private Limited for creditors the National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) had set aside attachment of a property of the debtor Raman Ispat to fulfill repayment of electricity dues to the PVVNL. The tribunals stated that the electricity distribution company could realize its dues through the liquidation process as per the IBC.
PVVNL’s appeal before the Supreme Court following the NCLAT ruling contended that the scheme of repayment of dues under IBC shall not be applicable here. PVVNL’s arguments stood on two legs. One being the generalia specialibus non derogant doctrine, which implies that the Electricity Act, 2003 being a special law shall override the general law laid down under IBC. Second, it placed reliance on the State Tax Officer (1) Vs Rainbow Papers limited’ ruling. The apex court affirmed that the IBC shall have primacy over the Electricity Act’s non-obstante clauses by virtue of Section 238 of IBC. The position of law as regards IBC’s overriding effect is identical with the position discussed in Sundaresh Bhatt, Liquidator of ABG Ship Yard v. Central Board of Indirect Taxes and Customs.
This means that IBC would prevail over the other statutes, to the extent that the authorities shall have limited jurisdiction to initiate recovery of dues by means of attachment of property, once moratorium is imposed. It was also observed that the State Tax Officer (1) Vs Rainbow Papers limited ruling did not appreciate the waterfall mechanism under Section 53. It is crucial to note that this ruling applies to the liquidation process specifically, while the Rainbow Papers case dealt with a resolution process case. Furthermore, the separate and distinct treatment of amounts payable to secured creditors on the one hand, and dues payable to the government on the other, clearly signifies Parliament’s intention to treat the latter differently.
Financial Creditors vs Operational Creditors Unlike operational creditors, who are excluded from the committee of creditors, financial creditors possess voting rights and are accorded higher priority. The statutory provisions are designed to safeguard the rights and interests of financial creditors. However, a key concern is the discriminatory treatment faced by certain categories of operational creditors. This is evident from the fact that when operational creditors file an application, their class is not granted the right to provide any input during the meetings of the committee of creditors.
The Code delineates several distinctions in the treatment accorded to them, including, but not limited to: (i) the right to approach the NCLT (extent of adjudication), (ii) the right to participate in the Committee of Creditors (CoC), (iii) the right to receive funds under the Resolution Plan, and (iv) the right to benefit from the liquidation proceeds of the Corporate Debtor. Under Section 7(1), a financial creditor may file an application with the Adjudicating Authority to initiate the corporate insolvency resolution process (CIRP) against a corporate debtor upon the occurrence of a default. In such cases, an operational creditor has the right to issue a demand notice to the corporate debtor for unpaid dues, along with copies of invoices seeking payment of the defaulted amount.
If the operational creditor does not receive payment or notification of a dispute under Section 8(2), they may file an application after a 10-day period from the date of delivery of the demand notice or invoice under Section 8(1). Section 7(3) mandates that a financial creditor must include in their application the name of the resolution professional proposed to act as the interim resolution professional. Similarly, Section 9(4) allows an operational creditor to nominate a resolution professional for this role. Section 21(2) specifies that the committee of creditors (CoC) must consist exclusively of financial creditors, including all financial creditors of the corporate debtor, while operational creditors are excluded from the CoC.
As per Section 215(2), financial creditors are required to disclose financial information and details regarding any assets over which they hold a security interest. Section 215(3) permits operational creditors to submit financial information to the information utility. According to Section 5(28), a financial creditor’s voting rights are proportional to the amount owed to them.
Decisions of the CoC require approval by at least 75% of the voting shares. Operational creditors, however, have no voting rights in the meetings of the CoC. Once enacted, the Code’s constitutional validity was promptly challenged. One of the grounds was discrimination under Article 14 of the Constitution of India - the Code granted a separate status to operational and financial creditors. However, In Swiss Ribbons, it was held that the Code was an economic legislation and therefore, a certain amount of leeway would be given to the legislature12. Further, the Court also stated that intelligible differentia existed between operational and financial creditors. The Court took this principle further in Committee of Creditors of Essar Steel India Ltd. v. Satish Kumar Gupta.
13 In this case, the CoC had approved a resolution plan that allowed the financial creditors to recover the bulk of their debt while a much smaller amount to operational creditors. There was also a distinction drawn between secured and unsecured financial creditors, with the latter receiving only 5 percent of their dues. However, the Supreme Court held that the same was within the power of the CoC. In the matter of Swiss Ribbons Pvt. Ltd. and Ors. vs. Union of India [2019],14the Hon. Supreme Court of India was asked to rule on the differential treatment and preference given to “Financial creditors” over “Operational Creditors,” which was contested. In the case of Swiss Ribbons(supra), the Supreme Court specifically evaluated whether or not it violated Article 14 of the Constitution by not having organisational creditors represented on the CoC. (Protection from discrimination).
The Bankruptcy Law Reforms Committee’s (hereafter “BLRC”) report, the predecessor to the IBC, served as the foundation for the Supreme Court’s reasoning for the exclusion of operating creditors from the CoC. A resolution plan’s viability could be assessed by financial creditors since staff members were qualified to do so, according to the BLRC. Conversely, operational creditors are typically unable to assess a company’s profitability and viability; instead, they are simply concerned with collecting the money they are owed for their goods and services. Such a justification, though, appears tenuous. The BLRC posits that since
12 (2019) 4 SCC 17, para 23.
13 (2020) 8 SCC 531
https://digiscr. sci. gov. in/admin/judgement_file/judgement_pdf/2019/volume%203/Part%20I/2019_3_535- 662_1704378052. pdf financial creditors can assess a plan’s effectiveness and viability, they will do so and base their choice to approve or reject a plan primarily on those considerations. The NCLAT has always considered whether operational creditors are treated roughly the same as financial creditors when evaluating the viability and feasibility of resolution plans that are approved by the committee of creditors. If they are not, such plans are either rejected or modified so that the rights of operational creditors are protected. As can be observed, a resolution plan is ineligible for approval under Section 30(2)(b) read in conjunction with Section 31 unless a minimum payment is given to operational creditors that is not less than liquidation value.
Regulation 38 was also changed on October 5th, 2018. By putting the notion of fair and equitable treatment of operational creditors’ rights, as well as priority in payment over financial creditors, into statute, the aforementioned Regulation significantly strengthens operational creditors’ rights. Due to all of the aforementioned factors, the court does not believe that either the equal treatment of equals or the obvious arbitrariness provisions of Article 14 have been violated, nor does the court think that operational creditors are being discriminated against. In this case, the Supreme Court upheld Section 53 of the IBC’s constitutional validity and rejected the argument that there should be a distinction between Financial Creditors and Operational Creditors on the grounds that doing so would violate Article 14 of the Indian Constitution and undermine the intent behind the Code.
15 The rights of operational creditors and workmen Section 53 of the Insolvency and Bankruptcy Code (IBC), 2016, outlines the waterfall mechanism for the distribution of liquidation proceeds, establishing a hierarchy for creditors' claims. The rights of operational creditors and workmen are addressed within this framework, but their adequacy remains a subject of debate. Secured creditors and workmen share the second priority in the liquidation hierarchy, after the costs of insolvency resolution and liquidation. Workmen's dues for the preceding 24 months receive priority at par with secured creditors. 15 https://ibclaw. in/distinction-in-treatment-of-financial-creditors-vs-operational-creditors-by-vidushi-puri/ Operational creditors are ranked lower in the hierarchy, falling below financial creditors and workmen. They are positioned alongside unsecured creditors.
Employees (excluding workmen) are given priority immediately after secured creditors and workmen, for wages due in the preceding 12 months. Any remaining proceeds after satisfying the claims of higherranking creditors are distributed to operational creditors, among others. Workmen's dues for the last 24 months are given high priority, ensuring their claims are considered before financial creditors’ unsecured debts. This demonstrates the Code's intent to protect workmen, recognizing their critical role in the functioning of a corporate debtor. The protection is limited to dues from the preceding 24 months, potentially leaving longer-term arrears unaddressed. The realization of dues is contingent upon sufficient liquidation proceeds, which may not always be available. Operational creditors are included in the distribution mechanism, ensuring their claims are acknowledged.
The IBC requires resolution plans to consider payments to operational creditors, offering some protection during the resolution process. However there are certain challenges to it. Their position in the hierarchy is significantly lower, leaving them vulnerable if proceeds are insufficient to satisfy higher-priority claims. Unlike financial creditors, operational creditors lack representation in the Committee of Creditors, limiting their influence over the resolution process. The Code prioritizes financial creditors to encourage lending and ensure economic stability, often at the expense of operational creditors.
Judicial pronouncements which has posed clarity on Section 53 of the IBC Committee of Creditors of Essar Steel India Limited Through Authorised Signatory vs Satish Kumar Gupta & Ors, the NCLAT held that the Section 53 of the Code cannot be applied during the corporate resolution process but will apply only at the stage of liquidation. In the same matter it was argued in the Supreme Court that Section 53 of the Code would apply only during liquidation and not at the stage of resolving insolvency as is clear from the fact that “secured creditor” as defined by Section 3(30) of the Code is used only in Section 53 of the Code which is contained in Chapter III entitled “Liquidation Process” and not at all in Chapter II of the Code which is entitled “Corporate Insolvency Resolution Process”. In Chapter II, only financial and operational creditors, as defined, are spoken about.
It was further argued that the provision is an arbitrary exercise of power which brings in Section 53, which is applicable only when the corporate debtor gets liquidated, into the Corporate Resolution Process, contrary to the original scheme of the Code. There were also certain public comments received by the Committee stated that, in practice, the liquidation value which is guaranteed to the operational creditors may be negligible as they fall under the residual category of creditors under section 53 of the Code. Particularly, in the case of unsecured operational creditors, it was argued that they will have no incentive to continue supplying goods or services to the corporate debtor for it to remain a ‘going concern’ given that their chances of recovery are abysmally low.
It was stated to the Committee that liquidation value has been provided as a floor and in practice, many operational creditors may get payments above this value. The Committee appreciated the need to protect interests of operational creditors and particularly Micro, Small and Medium Enterprises (“MSMEs”). In this regard, the Committee observed that in practice most of the operational creditors that are critical to the business of the corporate debtor are paid out as part of the resolution plan as they have the power to choke the corporate debtor by cutting off supplies. (Synergies- Dooray Automative Ltd). 16 It was further modified in the operational creditors were required to be paid prior in time, due to the quantum of debt and nature of the creditors. Similarly, the approved resolution plan in the case of Hotel Gaudavan Pvt. Ltd17.
provided for payment of all existing dues of the operational creditors without any write-off. The Committee felt that the interests of operational creditors must be protected, not by tinkering with what minimum must be guaranteed to them statutorily, but by improving the quality of resolution plans overall. This could be achieved by dedicated efforts of regulatory bodies including the IBBI and Indian Banks' Association. Proposed Changes There are certain amendments which are under consideration as per File No. 30/38/2021- Insolvency, Government of India, Ministry of Corporate Affairs. Further, more there are certain changes which is required for the smooth implementation of the liquidation process.
16 Company Appeal No. 123/2017, NCLT Hyderabad, Date of decision – 02 August, 2017
17 Company Appeal No. 37/2017, NCLT Principal Bench, Date of decision – 13 December, 2017
Proposed changes in the Insolvency and Bankruptcy Code (IBC) aim to further streamline the resolution process and enhance stakeholder protection. One significant proposal involves approving multiple resolution plans for a single corporate debtor, allowing for more flexible and tailored approaches to resolving insolvency cases. This would enable the Committee of Creditors (CoC) to consider individual or collective assets of the debtor for resolution, ensuring optimal outcomes for creditors and maximizing asset value. Additionally, there is a proposal to separate resolution plans from the distribution of proceeds received from successful resolution applicants. This segregation aims to provide greater clarity and transparency in the resolution process, ensuring that the distribution of proceeds aligns with the approved resolution plan.
By presenting resolution plans and proceeds distribution schemes separately to the adjudicating authority (AA) for approval, the proposed amendment seeks to enhance procedural efficiency and legal certainty. Furthermore, the proposed introduction of a separate waterfall mechanism for distributing proceeds received pursuant to a resolution plan represents a significant development. This mechanism would prioritize creditors' claims up to the corporate debtor's liquidation value in accordance with Section 53 of the IBC. Any surplus beyond the liquidation value would then be distributed proportionally among creditors based on their unsatisfied claims. Finally, remaining amounts or further surpluses would be allocated to equity shareholders or partners of the corporate debtor, as applicable.
This proposed framework aims to ensure equitable distribution of proceeds and optimize creditor recovery in insolvency cases. Overall, the proposed changes signal continued efforts to strengthen the IBC's effectiveness and provide clarity in insolvency resolution. These developments are crucial for enhancing confidence in the insolvency framework and facilitating smoother resolution outcomes for all stakeholders involved. Conclusion Section 53 of the Insolvency and Bankruptcy Code (IBC) reflects a creditor-centric approach, with a clear preference for financial creditors over operational creditors and other stakeholders. The waterfall mechanism ensures that secured financial creditors receive priority in the distribution of liquidation proceeds, reinforcing their superior position in insolvency resolution.
This preference is rooted in the rationale that financial creditors contribute significantly to the economy by providing capital and taking calculated risks, thereby warranting greater protection under the insolvency framework. Although this prioritisation improves investor confidence and loan availability, it has raised questions about fairness, especially from government agencies and operational creditors whose claims are lower in the hierarchy. This disparity has been consistently maintained by judicial rulings, which confirm that financial creditors have a greater interest in insolvency procedures. To guarantee fair treatment without jeopardising the IBC's fundamental goals, however, the continuous discussion about striking a balance between creditors' rights points to the necessity for further legislative development.
It can be observed that even a minor deviation from the waterfall mechanism prescribed under Section 53 of the Insolvency and Bankruptcy Code (IBC) can result in significant complexities, creating a disconnect between the legislative intent and the practical enforcement of the law. Such deviations often lead to protracted litigation, thereby consuming the limited and valuable time of courts and tribunals. The IBC was enacted with the primary objective of ensuring timebound resolution and maximizing the value of assets, and any divergence from its core principles risks undermining its efficacy. While it is important to safeguard the legitimate interests of all stakeholders, this objective should not come at the cost of delaying or diluting the insolvency resolution process.
The waterfall mechanism is a product of careful legislative design, structured to maintain fairness, predictability, and efficiency in the distribution of proceeds. Judicial or legislative interventions that alter this balance—however well-intentioned—must be exercised with caution. Unchecked or frequent interference may lead to inconsistent precedents, forum shopping, and erosion of creditor confidence in the process. Further, the incremental weakening of the waterfall mechanism under Section 53 not only threatens the sanctity of the statutory framework but also poses a risk to the overall stability of the insolvency ecosystem in India. It may deter potential investors and resolution applicants who rely on the certainty and enforceability of the law.
Therefore, any proposed modifications to the distribution priority must undergo thorough deliberation and empirical assessment to ensure they align with the foundational goals of the IBC: resolution over liquidation, creditor democracy, and timely closure of distressed assets.
In conclusion, preserving the integrity of Section 53 is not merely a procedural necessity but a critical factor in upholding the spirit and effectiveness of the IBC. Stakeholders, policymakers, and courts must collaborate to maintain this delicate balance, ensuring that reforms and interpretations continue to reinforce, rather than weaken, the trust in India's insolvency resolution framework.