Have operational creditors become non-operational? – An analysis of the status of operational creditors under the IBC

The article analyses how judicial pronouncements have weakened the position of the operational creditor under the IBC, by vitiating their chances of realization during the CIRP.

Insolvency and Bankruptcy Code

Introduction

The Insolvency and Bankruptcy Code, 2016 (IBC) in its nascent stages seemed to strengthen the position of suppliers and service providers by providing them the status of a creditor (operational creditor) under law. However, with the passage of time and development of judicial pronouncements, the IBC has weakened the position of the operational creditor, by vitiating their chances of realization during the Corporate Insolvency Resolution Process (CIRP).

Though various committee reports, legislative amendments and judicial pronouncements appeared to place operational creditors on an equal pedestal as that of a financial creditor, the Supreme Court in Swiss Ribbons held that operational creditors are seldom interested in the financial health of the company and consequently, cannot be allowed to determine the fate of a company.

In the background, we seek to examine the status and step-motherly treatment meted out to the operational creditors - especially in the current economic scenario where lot of focus and efforts are being made to save the operational creditors from being pushed into liquidation.

Significant bargaining power to NIL bargaining power – An analysis of the committee reports

The Bankruptcy Law Reforms Committee Report, 2015 (“BLRC”) observed that the resolution plan must necessarily provide for the protection of operational creditors, and must ensure that the operational creditor receives its fair share of dues. The BLRC placed importance on the operational creditor being able to recover its legitimate dues on the rationale that without the resolution of the debts of the operational creditor, there would be no effective resolution of the corporate debtor. However, this position of the operational creditor has since been watered down in the Insolvency Committee Report, 2018.

The Insolvency Committee Report, 2018 acknowledged that very often, payment made to operational creditors under a Resolution Plan is negligible since they fall under the residual category under Section 53 of the IBC. Consequently, such operational creditors will have no incentive to continue supplying to the corporate debtor. However, it dismisses the problem as trivial on the basis that there is “no empirical evidence” to suggest that operational creditors are given negligible amounts! This observation by the Committee has certainly influenced the Hon’ble Supreme Court to uphold a resolution plan that provides for NIL amounts to the operational creditor.

Interestingly, it is crucial to point out that the recent Report of the Insolvency Committee Report, 2020 has recommended that operational creditors be conferred with voting rights in the future. It specifically notes that based on the institutional factors and depending on whether the operational creditor is able to take key decisions to resolve insolvency, they may be bestowed with voting rights. It remains to be seen when and how this may become possible.

Quite contradictory to the recent amendments made to the IBC, the Insolvency Committee Report, 2020 notes that the IBC had made debt enforcement “more credible” for operational creditors, which in turn gave them further power to reach out of court settlements with corporate debtors. However, with the recent amendment which came effect from 24.03.2020[1], the bargaining power of the operational creditors is jeopardized. The recently introduced amendment increases the default threshold for initiation of insolvency to Rs. 1 crore and above. By virtue of this amendment, operational creditors with debts less than one crore are left remediless under the IBC. Unlike the financial creditors, who can prefer a joint application under Section 7(1) to initiate CIRP, even if individually their debts are less than one lakh (threshold for default prior to the amendment), operational creditors cannot initiate such joint petitions. Therefore, their bargaining power to reach out of court settlements as envisaged in the Insolvency Committee Report, 2020 is now debilitated.

Swiss Ribbons to Essar – The Committee of (financial) Creditors reigns supreme

Commencing from Swiss Ribbons v. Union of India, (“Swiss Ribbons”) till Committee of Creditors of Essar Steel India Limited through Authorized Signatory v. Satish Kumar Gupta, (“Essar Steel”), the Supreme Court has held that financial creditors are better equipped to decide the fate of a corporate debtor. Therefore, it is not only the fate of the corporate debtor that has been left to the “commercial wisdom” of the CoC (where the Financial Creditor controls the decisions), but also the fate of the operational creditor!

The Hon’ble Supreme Court of India in Essar Steel despite observing that payment of NIL amounts to operational creditors would “certainly not balance the interest of all stakeholders or maximise the assets of the Corporate Debtor”, upheld a resolution plan which provided for NIL amounts to a certain class of operational creditors. The Supreme Court’s rationale is premised on the fact that judicial review of an approved resolution plan is not warranted if, in the commercial wisdom of the CoC, it is in the interests of all the stakeholders and upholds the objective of the IBC (maximization of the value of the corporate debtor).

The paradox is glaring. The judicial pronouncements recognize and reiterate that the objective of the IBC is to keep the corporate debtor as a going concern. However, by upholding provision of NIL amounts to an operational creditor under a resolution plan, neither the primary objective of the IBC, being “maximization of the value of the assets” is achieved, nor is the objective of “balancing the interests of all of the stakeholders” attained. The fate of the operational creditors is clearly left in the hands of their competing creditors.

The above paradox has only been fortified in the recent decision of the Supreme Court in Maharashtra Seamless Limited v. Padmanabhan Venkatesh, wherein utmost primacy was given to the decision of the CoC and the Supreme Court held that the resolution plan need not match up to the liquidation value, as long as the CoC approves the same. The primacy given to the financial creditors can only result in disastrous consequences for competing creditors and the corporate debtor itself, as maximization of the value of the financial creditors will naturally be their only concern.

In this regard, the observations of the Hon’ble NCLAT in Binani Industries v. State Bank of India (“Binani”), is noteworthy. The NCLAT while interpreting Section 30(2)(b) of the IBC, had remarked that providing only liquidation value to operational creditors based on a misreading of Section 30(2)(b) would discourage the creditors to continue supplying goods and services to the corporate debtor. This would push the creditors supplying goods and services to insist on advance payments, which would run contrary to the basic principle of I&B Code.

It is also necessary to point out the decision of the Hon’ble NCLAT in Hammond Power Solutions Private Limited v. Sanjit Kumar and Ors, wherein the NCLAT, following the decision of the Supreme Court in Essar Steel, held that it was crucial for the resolution applicant to provide an explanation as to how the interests of all stakeholders are taken care of. This direction provides a glimmer of hope since, the resolution applicant may find it difficult to justify provision of NIL payment to operational creditors.

In rem poses a problem

Considering the predicament of the operational creditors under the IBC, one might wonder whether these problems will be resolved if the operational creditors prefer to enforce their rights before a civil court and avoid the IBC altogether. This again is not possible for reasons mentioned below:

Under the IBC, even if an operational creditor chooses not to initiate proceedings under the IBC, they will be automatically included in the resolution process, in the event another creditor initiates the process against corporate debtor. Therefore, in most cases there is no respite to the operational creditor, as the operational creditor cannot choose to stay out of the process.

Furthermore, the Essar Steel judgement has unequivocally observed that no creditor has the option of staying out of the resolution proceedings, as there can be no “hydra head popping up” after the conclusion of the resolution proceedings and when the new management takes over. The following is the relevant extract:

“A successful resolution applicant cannot suddenly be faced with “undecided” claims after the resolution plan submitted by him has been accepted as this would amount to a hydra head popping up which would throw into uncertainty amounts payable by a prospective resolution applicant who successfully take over the business of the corporate debtor. All claims must be submitted to and decided by the resolution professional so that a prospective resolution applicant knows exactly what has to be paid in order that it may then take over and run the business of the corporate debtor.”

Therefore, even if the operational creditor has approached an arbitral tribunal or a civil court for enforcement of its rights, it becomes futile when the resolution process commences against the corporate debtor.

Way forward

The above discussion would show that the interests of the operational creditors is a last priority during CIRP, virtually making payment of their dues impossible. Further, the predicament of the small operational creditors is further accentuated by the recent amendment which raised the threshold value for default to Rs. 1 crore.

With abysmally low debt realization, operational creditors may become more financially adept and cautious than the financial creditors themselves! The natural consequence of this, as observed by the Hon’ble NCLAT in Binani, would be that the operational creditors are now more likely to start demanding payments in advance and not extend credit.

This could lead to savy and astute contract drafting of contracts to prevent bad debts from mounting; work orders and contracts with the customers may have to be reviewed periodically. Going forward, one primary change in the contract that is likely to be incorporated would be insistence of advance amounts to be collected.

Another option that can be explored by operational creditors is factoring of receivables. This will provide them the option of recovering the amounts immediately and bearing significantly lower risk, albeit after accepting a discount.

The Insolvency Committee Report, 2020 seems to be providing a glimmer of hope by recommending the operational creditors be conferred with voting rights subject to fulfilment of certain criteria. Therefore, in the near future, we also foresee operational creditors conducting due diligence on the assets of the company, the number of existing creditors and the general credit worthiness of the company. After all, protection and prevention are the need of the hour.