Types of creditors under the insolvency law – Are all of them protected?

Under the Insolvency and Bankruptcy Code, 2016 (“IBC”), different classes of creditors have different rights, privileges, and roles in the corporate insolvency resolution process (“CIRP”) and in the liquidation process. This classification of creditors is a key element in the process of resolution or liquidation of a corporate debtor.

Categories of debt and creditors

In the previous regime under the Companies Act, which only provided for winding up or liquidation, the main distinction among creditors, barring a couple of exceptional creditors like unpaid workmen and the government, was between secured and unsecured creditors. Secured creditors were at a higher priority to the extent of proceeds from the sale of their security. The reason for this was that where any creditor has provided debt on the condition that some asset of the company is secured, that condition should be respected when the debtor is being wound up. This remains the case in the liquidation process under the IBC.

The IBC introduces a new distinction between “financial debt” and “operational debt”. This distinction is important. Only financial creditors, as I’ve discussed previously, are members of the COC, the body with the power to approve or reject a resolution plan, and to make decisions regarding the corporate debtor during the CIRP. Operational creditors do have some statutory protection. Any resolution plan must, under Section 30 of the IBC, provide for payment to operational creditors of an amount they would have received had the corporate debtor been liquidated.

Further, only financial creditors, operational creditors, and the corporate debtor itself have the ability to initiate a CIRP, although, as I’ve discussed previously, there are different evidentiary thresholds for financial and operational creditors when seeking to initiate a CIRP. Let’s take a closer look at these distinctions, the reasons they have been put in place, and their implications.

Who is a creditor?

The Money Lender, a painting by Auguste Charpentier (1842)
A “creditor” is any person to whom a debt is owed. A “debt” is a liability or obligation in respect of a claim, due from any person. An essential part of the term “claim” is a right to payment, or a right to remedy for breach of contract, which gives rise to a right to payment. To be considered a creditor of the corporate debtor, therefore, a right to payment is essential. Someone seeking a remedy of specific performance, injunction, or any other remedy, which does not give rise to a payment, would not be considered a creditor.

Who is a financial creditor?

Financial debt has been defined in the IBC to mean a debt, which is disbursed against the consideration for the “time value of money”. The expression “time value of money” is an established concept in finance and is based on the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. Thus, for example, if Rs. 100 is deposited today into a fixed deposit or savings account, it would earn interest, and three years later, may increase to, say, Rs. 110. Similarly, when a lender lends to a borrower, it does so only because later in time, it will get back that amount together with interest or some other return. The lender’s earning by way of interest is the consideration for making the loan in the first place. The essential idea that the expression “time value of money” captures is that of a “borrower-lender relationship”, where a loan that has been provided, has to be returned with interest or return of some kind.

In ascertaining whether a transaction is financial debt, it is the underlying nature of the transaction, which needs to be looked at. In Nikhil Mehta v. AMR Infrastructure, the applicant creditor had paid the defendant real estate developer the full price of under-construction commercial premises, with the understanding that until possession of the completed premises were handed over to him, the defendant would pay him a fixed sum every month. Overturning the decision of the Delhi NCLT, the NCLAT looked at the underlying nature of the transaction and held that this was not simply a contract to buy and sell commercial premises, but was in effect a transaction whereby one party had advanced monies against the consideration of an assured return, thereby giving it the character of financial debt.

What is operational debt?

The Money Lender and His Wife, a painting by Quentin Metsy (1465)
“Operational debt” on the other hand, has been defined as “a debt in respect of the provision of goods and services”. The primary intent is to cover trade creditors of various descriptions, whom the corporate debtor contracts with as part of its business. A vendor who supplied tires to an automobile manufacturer, and has not yet been paid, would be a typical example. However, the expressions “goods” and “services” are not defined in the IBC, and the jurisprudence on this is yet to evolve. One of the significant early decisions in this regard is by the NCLAT in Pawan Dubey v. JBK Private Developers Limited, in which allottees of residential and commercial premises were held not to be operational creditors as the transaction did not involve “goods” or “services”.

Are there other categories of debt and creditors?

The case of Nikhil Mehta mentioned above involved a specific transaction and not a typical transaction between homeowners and developers. The overall effect of NCLAT judgments has been to classify homebuyers as neither operational nor financial creditors. It is not clear whether the framers of the IBC intended to exclude such transactions. One potential policy reason for this exclusion might be that the Real Estate (Regulation and Development) Act, 2016 (“RERA”), was enacted around the same time as the IBC as a specialised legislation to protect the interests of purchasers of real estate properties. This reason fails to take into account other specialised legislation (such as labour and consumer protection statutes), which are available to various creditors who are not excluded from the purview of “operational creditors”. Moreover, due to the operation of the moratorium during the CIRP process, action under RERA may not even be possible during the pendency of the CIRP.

The case of the homebuyers brings to light one of the key early issues under the IBC. The IBC has an additional definition of “debt”, which would imply that the framers did not consider financial and operational debt as comprising the entire universe of debt. This Insolvency and Bankruptcy Board of India (IBBI) has also released, as part of the regulations framed under the IBC, a new form for non-financial and non-operational creditors to make claims under a CIRP, thus lending weight to this interpretation.

However, it is unclear why there should be any categories of debt that should not get the protections and privileges afforded to financial creditors or operational creditors. A creditor who is classified as neither financial nor operational has no statutory protection under the CIRP, nor does it have the ability to initiate a CIRP. Given that the erstwhile provisions of the Companies Act on winding up have been repealed, such a creditor now also does not have the ability to initiate a liquidation which it had under the previous regime. This outcome therefore appears contrary to the intents and purposes of the IBC.

As things stand, the uncertain status of allottees of residential and commercial premises has resulted in confusion and concern. A petition by the allottees of Jaypee Infratech Limited, another real estate company admitted into CIRP, is pending before the Supreme Court. Hopefully the Supreme Court can bring some clarity to the situation.

Primacy of financial creditors

As highlighted previously, financial creditors have far greater power than operational creditors, including ultimately, the power to decide whether the corporate debtor is to be liquidated. The report of the Bankruptcy Law Reforms Committee, on whose recommendations the IBC is based, felt that financial creditors were better able to assess the overall viability of the company and be more willing to modify the terms of existing liabilities, due to which the process would be more efficient if only financial creditors were on the committee of creditors.

This is a bold but risky position. It is true that banks and financial institutions, who would typically be the financial creditors, are better equipped to assess the corporate debtor’s business viability – after all, they are in the business of making such assessments for the purposes of providing loans. The IBC however, does not impose on them a responsibility to take the interests of other stakeholders into account. Although, as mentioned above, the liquidation value due to operational creditors is statutorily protected under the IBC, it may not be sufficient in all cases. For example, the unpaid dues to workmen (who are operational creditors) will get primacy in both a resolution plan as well as a liquidation scenario, but as they are not members of the COC, the decision to liquidate the corporate debtor, over which they have no control, would have a significant impact on the future livelihood of those workmen.