THE ‘WATERFALL MECHANISM’ UNDER THE IBC CODE, 2016

 

The IBC Code is a legislation deals with economic matters and, in the larger sense, deals with the economy of the country as a whole. It was enacted with the objective of unifying the legal regime on commercial insolvency.  

The CIRP is initiated upon a corporate debtor’s default in repayment of a debt, and the value of the default crosses the statutory threshold (Section 4); Default is defined in Section 3(12) in wide terms as, “Non-payment of debt when whole or any part or instalment of the amount of debt has become due and payable and is not paid by the debtor or the corporate debtor, as the case may be”.

CIRP may be initiated by the corporate debtor itself or a financial creditor or operational creditor (Section 6). IBC makes a distinction between debts owed to both these classes of creditors. A financial creditor has been defined under Section 5(7) as, “A person to whom a financial debt is owed”. A “financial debt” is defined by Section 5(8) as a debt which is disbursed against consideration for the time value of money. On the other hand, an operational creditor is one to whom an operational debt is owed. “Operational debt” under Section 5(21) is “a claim in respect of provision of goods or services”. 

Sections 7 and 8 of the IBC controls the initiation of insolvency process by financial creditors and operational creditors respectively. The corporate debtor can contest a debt within a stipulated time period. The Adjudicating Authority has to determine the existence of a default from the records of the information utility or on the basis of evidence furnished by the creditors, and communicate the same to the corporate debtor – this initiates the resolution process, which must be completed within 180 days from the date of admission of the application (Section 12), and can be extended beyond 180 days for a further period of not exceeding 

After the the insolvency proceedings are decided against the corporate debtor’s default, and the said debtor undergoes liquidation. The distribution of assets to the line of financial and operational creditors shall be done as per the priority order envisaged under section 53 of the code.  As opined in  Swiss Ribbons Private Limited v. Union of India the distinction of the classification of creditors are not violative of Article 14 of the Constitution.

 

The Waterfall Mechanism

The Section 53 also referred to as the waterfall mechanism provides for the order of distribution of assets once the insolvent company’s plan is approved and is declared liquidation.

The SC in President Mahesh Chand Sharma v. Union of India & Ors., 2023 SCC OnLine SC 547.

“The waterfall mechanism is based on a structured mathematical formula, and the hierarchy is created in terms of payment of debts in order of priority with several qualifications, striking down any one of the provisions or rearranging the hierarchy in the waterfall mechanism may lead to several trips and disrupt the working of the equilibrium as a whole and stasis, resulting in instability. Every change in the waterfall mechanism is bound to lead to cascading effects on the balance of rights and interests of the secured creditors, operational creditors and even the Central and State Governments. Depending upon the facts, in some cases, the waterfall mechanism in the Code may be more beneficial than the hierarchy provided under Section 326 of the Companies Act, 2013 and vice-versa. Therefore, we hesitate and do not accept the arguments of the petitioners”

Section 53 of the IBC reads as under: -

“53. Distribution of assets.—(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 Writ Petition (C) No. 421 of 2019  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.

Explanation.—For the purpose of this section—

(i) it is hereby clarified that at each stage of the distribution of proceeds in respect of a class of recipients that rank equally, each of the debts will either be paid in full, or will be paid in equal proportion within the same class of recipients, if the proceeds are insufficient to meet the debts in full; and

(ii)  the term “workmen's dues” shall have the same meaning as assigned to it in Section 326 of the Companies Act, 2013 (18 of 2013).”

Priority of Claims

The priority of claims, indicated in the hierarchy of preferences, under the waterfall mechanism is therefore:

1. insolvency resolution process costs and the liquidation costs;

2. workmen’s dues for the period of 24 months preceding the liquidation commencement date and debts owed to a secured creditor in the event such secured creditor has relinquished security;

3. wages and any unpaid dues owed to employees other than workmen for the period of 12 months preceding the liquidation commencement date;

4. Financial debts owed to unsecured creditors;

5. any amount due to the central government and the state government and debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;

6. any remaining debts and dues;

7. preference shareholders; and

8. equity shareholders or partners. This hierarchy or order of priority thus accords government debts [clause (e)] and operational debts [clause (f)] lower priority than dues owed to unsecured financial creditors.

The Debts owed to a secured creditor, whenever such secured creditor “has relinquished security in the manner set out in section 52” receive a fairly high priority (immediately after insolvency resolution process costs), whereas in other cases, i.e., when the secured creditor does not relinquish security, the priority of claim is lower [Section 53 (1) (e) (ii)] in respect of “any amount unpaid following the enforcement of security interest”. Another feature is that amounts due to the government (i.e., payable into the Consolidated Fund of India or Consolidated Fund of a State) are ranked in the same manner as those of secured creditors who do not relinquish their security interest [Section 53 (1) (e) (ii)].

Precedents

There have been many major precedents laid down by the Supreme Court with respect to the distribution of assets under section 53 of the IBC.

The Supreme court in State Tax Officer (1) vs Rainbow Papers Limited while considering whether the Gujarat Value Added Tax came under the definition of secured creditor as it was challenged that the Government cannot claim first charge over the property of the ‘Corporate Debtor’. Section 48 of the GVAT Tax cannot prevail over Section 53 of the IBC. Therefore, the Appellant do not come within the meaning of ‘Secured Creditor’ as defined under Section 3(30) read with Section 3(31) of the I&B Code’. It observed that ““Secured Creditor” as defined under the IBC is comprehensive and wide enough to cover all types of security interests namely, the right, title, interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction, which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person. In view of the statutory charge in terms of Section 48 of the GVAT Act, the claim of the Tax Department of the State, squarely falls within the definition of “Security Interest” under Section 3(31) of the IBC and the State becomes a secured creditor under Section 3(30) of the Code.”

On the contrary, the Supreme court in  Paschim Anchal Vidyut Vitran Nigam Limited vs. Raman Ispat Private Limited and Others held that the precedent laid down in Rainbow papers(supra) should only be confined to its facts of the case as it fails to consider the water mechanism as a whole. It held that “ Rainbow Papers (supra) did not notice the ‘waterfall mechanism’ under Section 53 – the provision had not been adverted to or extracted in the judgment. Furthermore, Rainbow Papers (supra) was in the context of a resolution process and not during liquidation. Section 53, as held earlier, enacts the waterfall mechanism providing for the hierarchy or priority of claims of various classes of creditors. The careful design of Section 53 locates amounts payable to secured creditors and workmen at the second place, after the costs and expenses of the liquidator payable during the liquidation proceedings. However, the dues payable to the government are placed much below those of secured creditors and even unsecured and operational creditors. This design was either not brought to the notice of the court in Rainbow Papers (supra) or was missed altogether. In any event, the judgment has not taken note of the provisions of the IBC which treat the dues payable to secured creditors at a higher footing than dues payable to Central or State Government.”

It also further opined that the IBC code would prevail over the Customs Act. “The IBC would prevail over the Customs Act, to the extent that once moratorium is imposed in terms of Sections 14 or 33(5) of the IBC as the case may be, the respondent authority only has a limited jurisdiction to assess/determine the quantum of customs duty and other levies. The respondent authority does not have the power to initiate recovery of dues by means of sale/confiscation, as provided under the Customs Act.”

Section 52 and 53 of the code has to be read conjointly while deciding the dues of the secured creditor with respect to the dues of the workman and the Secured creditor.  The  SC in Moser Baer Karamchari Union vs Union Of India held that “the issue with respect to the workman and the secured creditor being kept at equal footing under Section 53 of the IBC is only in a case wherein the secured creditor has relinquished its security and the same is the part of the stage of the liquidation pool.he unpaid dues of the workmen are adequately and significantly protected in line with the objectives sought to be achieved by the Code and in terms of the waterfall mechanism prescribed by Section 53 of the Code. In either case of relinquishment or non-relinquishment of the security by the secured creditor, the interests of workmen are protected under the Code. In fact, the secured creditors are taking significant hair-cut and workmen are being compensated on an equitable basis in a just and proper manner as per Section 53 of the Code. The Code balances the rights of the secured creditors, who are financial institutions in which the general public has Writ Petition (C) No. 421 of 2019  invested money, and also ensures that the economic activity and revival of a viable company is not hindered because it has suffered or fallen into a financial crisis.”

It further observed that “the debts due in the form of workmen’s dues for a period of twenty four months preceding the liquidation commencement date and the debts owed to the secured creditor in the event such secured creditor has relinquished security in the manner set out in Section 52 of the Code shall rank equally between and amongst the workmen and the secured creditors.”

In PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, The SC held that Income tax dues cannot supersede the dues of the financial creditor.  It opined that “the Code will override anything inconsistent contained in any other enactment, including the Income-Tax Act.” Relying on Dena Bank vs. Bhikhabhai Prabhudas Parekh and Co. & Ors. (2000) 5 SCC 694, the court observed that “the income-tax dues, being in the nature of Crown debts, do not take precedence even over secured creditors, who are private persons.”

Conclusion

Thus, the significance of the water mechanism under the IBC is of great volume for proper implementation of the principles of the code. The code originates with the agenda to comply to comprehensive and time-bound framework to maximize the value of assets of all persons and balance the interest of the stakeholders. The guiding principle for the Code in setting the priority of payments in liquidation and to bring the practices in India in line with global practices.  the waterfall mechanism, after the costs of the insolvency resolution process and liquidation, secured creditors share the highest priority along with a defined period of dues of the workmen. The unpaid dues of the workmen are adequately and significantly protected in line with the objectives sought to be achieved by the Code and in terms of the waterfall mechanism prescribed by Section 53 of the Code.  The Ministry of Corporate Affairs in 2023 also sought comments for amendments from stake holders with respect to “all debts owed to any government or government authority, whether or not they involve a security interest created by operation of statute, to be treated equally with other unsecured creditors; only if the security interest is created pursuant to a transaction of the government or a government authority with the corporate debtor, should the relevant government or government authority be treated as a secured creditor in the order of priority.”

The interpretation with respect to the secured creditors have not been entirely examined by the Apex court and still has been left unclear with the legislative intent with respect to government dues to be regarded as unsecured creditors. Notwithstanding what the amendment may bring in the future “Some sacrifices have to be always made for the greater good”