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Position of secured creditors in liquidation proceedings

IBC Liquidation Secured creditor

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Inhouse credit: Editor: Amoolya Jain
Last updated: 21/10/2021

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Synopsis: There is a confusion regarding the priority of secured creditors in case of a liquidation proceeding under the Insolvency and Bankruptcy Code, 2016. This article aims to clarify the same with the help of interpretations of Section 53 of the IBC, the Companies Act and Transfer of Property Act, along with judgments on the same.

 

Since the inception of the Insolvency and Bankruptcy Code, 2016 (‘the Code’) there seems to be an uncertainty with respect to several matters, and the Judiciary has consistently tried to fill in the gaps by referring to the Sections contained in the Companies Act, 2013 (‘Companies Act’). One such legal issue pertains to the rights of secured creditors.

On the commencement of liquidation, a secured creditor has two options -

  • To realize his security interest outside the liquidation proceedings (Section 52 of the Code)
  • To claim the proceeds from the liquidation proceedings after relinquishment of the security interest (Section 53 of the Code).

It is often wrongly construed that once a secured creditor has not realized his security, under Section 52 of the Code, and has relinquished the security to the liquidation estate, there remains no classification inter se, i.e. by joining liquidation proceedings, all the secured creditors rank equal (pari passu), irrespective of the fact that they had first or second charge. This article analyses if such understanding holds good.

To begin with, it is important to understand what a first charge and second charge is. The first charge holder has a security interest on the asset of a company; the second charge holder has a subsequent charge over the remainder of the asset of the same company, which is remaining after settling the claims of the first charge holder. In that sense, the charges are sequential and not proportional. It is a settled position that when a charge is created on a property already subject to encumbrance, it is no good to say that the existing charge holder ought to have objected to the creation of the second charge. In fact, if the charge is existing and registered, the charge is deemed to be a public notice, and anyone acquiring any interest in the same property is presumed to have notice of the charge.

To understand the interplay of charges, one needs to understand Section 53(2) of the Code which provides that “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.” On interpretation of the aforesaid provision, the stress is clearly on the words ‘with equal ranking’. If there are security interests of equal ranking, and parties have entered into a contract to the effect that one party will be paid in priority to the other, such a contract will be disregarded in liquidation.

The whole stance in liquidation proceedings is to ensure parity and proportionality. However, the idea of proportionality is only as far as claims of similar ranking are concerned. A security interest determines the recovery rate of a defaulted loan; hence, the ranking of security interest directly determines the value of the defaulted loan. If, contractually, parties had put Mr. A on first priority, and Mr. B on second priority, there will be no parity whatsoever in the law pushing back Mr. A to the same status as Mr. B, as that would substantially erode the recovery rate for Mr. A.

  

Incorporation of the “pari passu” rights

The concept of distribution waterfall existed both in the Companies Act, 1956 and 2013, and not a concept unique to the Code. In fact, Companies Act is the parent Act, based on which the Code was formulated, and it is important to refer to Section 529A which was introduced in the Companies Act, 1956 by virtue of Companies (Amendment) Act, 1985, to provide a protection to the workmen. The intent of the said Section was deliberated upon by the Bombay High Court in the case of Sicom Limited v. State of Maharashtra, III (2006) BC 304. The relevant extracts of the judgment are reproduced hereunder -

 “35. In terms of Section 529 of the Companies Act, as it stood prior to its amendment, the dues of the workmen were not treated pari passu with the secured creditors as a result whereof innumerable instances came to the notice of the Court that the workers may not get anything after discharging the debts of the secured creditors. It is only with a view to bring the workmen’s dues pari passu with the secured creditors, that Section 529-A was enacted.

36. ** Only because the dues of the workmen and the debts due to the secured creditors are treated pari passu with each other, the same by itself, in our considered view, would not lead to the conclusion that the concept of inter se priorities amongst the secured creditors had thereby been intended to be given a total go-by. 

Another important question has been discussed by the Supreme Court in ICICI Bank v. Sidco Leathers Ltd., (2006) 10 SCC 452 - If the secured creditors relinquish their security interest and make claim on the liquidation estate, will the first/second ranking remain, or all secured creditors will be of the same ranking. In this case, the Supreme Court discussed the legal position and, reversing the rulings of lower courts, maintained the ranking of the secured creditors. Further, in Jitendra Nath Singh v. Official Liquidator & Ors., (2013) 1 SCC 462, the Supreme Court held as follows -

 “The Court cannot overlook the reality that intention of the framers of law could not have been that the public funds, for instance, the money of secured creditor (like banks), should be completely ignored for the benefit of the creditors in general, despite there being a definite protection in law, more so, when the security may be sufficient for recovery of dues of such secured creditors to a limited extent, if not in entirety. The scheme of these provisions, thus, has to be understood to make it practicable and in consonance with the accepted commercial principles. It is precisely for these reasons that I am taking the view that the workmen’s charges, as well as that of the secured creditors, have to be paid in preference to all others, but with inter se pari passu charge on the amounts realized from the sale of the security or otherwise.

In this very judgment, the Court also stated that “only because the dues of the workmen and the debts due to the secured creditor are treated pari passu with each other, the same by itself, would not lead to the conclusion that the concept of inter se priorities amongst the secured creditors had thereby been intended to be given a total go by.” It has also been explained that that relinquishment has to be by virtue of a specific act and a conscious decision on behalf of the secured creditor and there cannot be any contrary presumption to the detriment of such creditor.

 

Transfer of Property Act and its applicability

The general notion has been that once the secured creditors relinquish their security interest and have made their claim on the liquidation estate, it is assumed that they lose their mutual ranking, and will all be taken at par. Pursuant to Section 53 of the Code, all secured creditors are treated equally and the debts are either paid in full or paid in equal proportion if the proceeds are insufficient to meet the debts in full. 

Here, it will be pertinent to mention that the Supreme Court in Sidco case, cited the case of Allahabad Bank v. Canara Bank, [2000] 2 SCR 1102, and held that while enacting the statute, i.e. Companies Act, 1956, the Parliament cannot be presumed to have taken away the right in the property, such right being a constitutional right. The relevant extract is reproduced below -

 “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. **

** If the Parliament while amending the provisions of the Companies Act intended to take away such a valuable right of the first charge holder, we see no reason why it could not have stated so explicitly.

Though Section 53 of the Code provides for the respective rights of the secured creditors vis-à-vis unsecured creditors, it does not envisage respective rights amongst the secured creditors, and for that purpose, we need to be guided by Transfer of Property Act, 1882, more particularly Section 48, which stipulates that the claim of the first charge holder shall prevail over the claim of the second charge holder.  

Section 48 of Transfer of Property Act, 1882 is based on the maxim qui prior est tempore potior est jure which means that one which is first in time is better in law. The transferor cannot prejudice the rights of the transferee by any subsequent dealing with the property, and the Code does not contain any provision to the effect of inapplicability of Section 48 of the Transfer of Property Act, 1882. Unless, expressly or by necessary implication, a provision contrary to or inconsistent therewith carrying a different intent can be found in the Code, Section 48 of the Transfer of Property Act, 1882 cannot be held to be inapplicable.

It has further been contended that Insolvency and Bankruptcy Code, 2016 is a complete code in itself and since there exists a non-obstante clause which will supercede all other laws. It is to be clarified that a non-obstante clause is usually used in a provision to indicate that the provision should prevail if anything contrary stated is mentioned in any other provision. However, it was stated in Parasuramaiah v. Lakshamma, AIR 1965 AP 220 when there is no question of inconsistency, such clauses have no relevance.

 

Conclusion

Considering the above, it is clear that once the share of secured creditors is determined, the same will be split sequentially to different categories of secured creditors, i.e. creditors having the first charge will have priority to those having second or subsequent charge. A second charge is a charge on the residual value which is left after paying off the first charge holder. This interpretation of the provisions relating to ranking of secured creditors seems to be lost in transit from Companies Act to the Code. Further, the fact that Judiciary has already deliberated upon this issue in numerous cases when dealing with matters under the Companies Act; such interpretation should be applied and upheld in the extant scenario.

 

DISCLAIMER: The information provided in this article is for educational purposes only. The same cannot be construed as legal advice





Richa Saraf

Legal Advisor
Vinod Kothari Consultants Pvt. Ltd.

Richa Saraf is a Legal Advisor at Vinod Kothari Consultants Pvt. Ltd., where she is involved in rendering opinions and advisory services in the area of corporate and banking laws, drafting and vetting of different agreements and making representations/appearances before the National Company Law Tribunal with respect to various matters including corporate insolvency resolution proceedings, liquidation and voluntary liquidation.

Ms. Saraf is also a keen writer who has authored several articles which are published in various law magazines and legal blogs.

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