Contributed by Dhaval Bothra and Rajdeep Bhattacharjee

Introduction

Security interest/charge is defined under Section 3(4) of the Insolvency and Bankruptcy Code 2016 (“IBC”) as a lien created on a company’s property or assets, or any of its undertakings, or both. It can be an exclusive, pari-passu, or priority/subordinate in nature. Although the IBC distinguishes between secured and unsecured creditors, it makes no distinctions between various classes of secured creditors. As a result, under the IBC, first charge holders and second charge holders are given equal treatment, and their claims are typically resolved proportionately. This is due to the principle of equitable treatment.

The principle of equitable treatment under IBC means creditors within their class should be treated fairly, receive distribution based on their claims, and not be discriminated against. Therefore, pursuant to this principle, the conundrum that lies is whether exclusive interest/ first charge holders shall be given preferential treatment when the conflict is regarding the distribution of assets under Section 53 amongst all the secured creditors. 

This conundrum will be settled via the following three sections in this article by addressing the position in India, a cross-border analysis and the position in other foreign jurisdictions and end with a congruent suggestive model to reconcile this conundrum. 

Position in India

The principle of equitable treatment, states that creditors with similar legal rights should be treated fairly and receive a proportionate distribution of their claim in accordance with their relative ranking and interests. This is provided by the IBC and the jurisprudence on this topic, but this does not imply that all creditors must be treated equally. 

The Supreme Court in the case of Committee Of Creditors Of Essar v. Satish Kumar Gupta has opined that if an “equality for all” approach is used, secured financial creditors may occasionally be persuaded to vote in favour of liquidation over resolution because they would have better rights if the corporate debtor was to be liquidated. Additionally, the court laid down that the equality principle cannot be extended to treat disparate classes equally because such shall jeopardise the legislative intent of the IBC.

However, in the absence of differential treatment provisions of exclusive security holders under the IBC, reliance has to be placed for the same on the resolution plan submitted by the Committee of Creditors (“CoC”). Such a resolution plan needs to be in compliance with the requirements laid down under Section 30(2) of the IBC.  In the case of Jaypee Kensington Boulevard Apartments Welfare Association & Ors. v. NBCC (India) Limited & Ors., it was held that the commercial wisdom of distribution of assets cannot be meddled with by the court and the only intervention is subject to the contravention of the requirements laid down under Section 30(2).

The NCLAT, in the case of J.M. Financial Asset Reconstruction Company Limited. v. Finquest Financial Solutions Private Limited and Ors. (“JM Financial”) held exclusive charge can only be realised by a creditor who owns the right to it under Section 52 of the IBC and only one secured creditor will be able to enforce their rights under the said provision after the first secured creditor does so. This is because the excess amount received as a result of the first enforcement is deposited in the liquidator’s account, meaning that no other secured creditor may later seek to obtain the amount from the same secured asset

The moot point of the conundrum lies due to the mechanisms established under Section 52 of the IBC. Post the J.M Financial judgement, the contention was ameliorated to a certain extent. However, there still exist contradicting judgements on the same.  For example, in the case of Asset Reconstruction Company India (P.) (Ltd.) v Venkatramanrao Nagrajan, the NCLT asked the corporate debtor (CD) to identify the assets over which the creditor had exclusive rights and give the possession of the same to them and property that belonged to the “Liquidation Estate” and over which the applicant had a “second charge” or “pari passu” charge was to be held in the possession of the liquidator. However, in the case of ICICI Bank Limited v. Pratim Bayal and Another, the NCLT Kolkata bench held that just because a creditor enjoys exclusive security interest, it cannot be treated higher than other creditors who have financed the CD.

Cross-Border Analysis

In the United States of America, secured creditors have priority over unsecured creditors in the distribution of assets, with the ranking based on the perfection and priority of the security interest. This means that first lienholders or exclusive interest/first charge holders generally have a higher priority in recovering their debts compared to junior lienholders or other secured creditors. Similarly, in the United Kingdom, the priority of secured creditors is determined by the ranking and priority of their security interests. First-ranking security holders typically have a higher priority in the distribution of assets, providing an advantage to exclusive interest/first charge holders compared to other secured creditors.

In Canada, the treatment of exclusive interest/first charge holders and the resolution of conflicts among secured creditors are determined by provincial or territorial laws. The priority of secured creditors is generally established based on the date of registration or perfection of their security interests. This approach ensures that first-to-register or first-to-perfect secured creditors have priority in the distribution of assets over subsequent secured creditors, including exclusive interest/first charge holders. Australia follows a similar approach, where the priority of secured creditors is determined by the Personal Property Securities Act. First perfected security holders, including exclusive interest/first charge holders, have priority in the distribution of assets over subordinate or subsequent security holders.

Congruent Suggestive Model

To address the conundrum in India within the framework of the IBC, one practical solution could be to introduce amendments to Section 53 that incorporate the concept of priority based on the perfection and ranking of security interests. This would require implementing a comprehensive registration or perfection system for secured creditors to establish their priority. Under such a system, exclusive interest/first charge holders who have registered or perfected their security interest first would be accorded priority in the distribution of assets over subsequent secured creditors. This approach aligns with the principles followed in jurisdictions like the United States, the United Kingdom, Canada, and Australia.

To implement this solution, the Indian government could consider establishing a central registry where secured creditors are required to register their security interests promptly upon creation. The registry would maintain a chronological record of registrations, enabling a first-to-register or first-to-perfect rule. This would provide transparency and clarity regarding the priority of secured creditors, including exclusive interest/first charge holders, in the distribution of assets. Adopting such a priority regime would ensure a fair and consistent mechanism for resolving conflicts among secured creditors and promote predictability in the treatment of exclusive interest/first charge holders. It would also enhance the efficiency of the insolvency resolution process by streamlining the determination of priorities among secured creditors, thereby facilitating a more orderly distribution of assets under Section 53 of the IBC.

Conclusion

The Insolvency Law Committee (“ILC”) previously debated the issues surrounding the classification of claims based on the position of the security holders and determined to disregard inter-creditor agreement clauses that provide distinctive entitlements in light under Section 53 of the IBC. However, in its report, the committee rejected such a claim and made it clear that a straightforward interpretation of Section 53 was sufficient to establish that valid inter-creditor and subordination provisions must be respected in the liquidation waterfall. 

Such a stance was justified by the argument that if such differentiating rights and agreements were disregarded, secured creditors would be disincentivized from extending credit, which would have a negative effect on the credit market.