Dilution of Secured Creditor Rights under the Indian Insolvency Regime

The position of secured creditors under India’s nascent Insolvency and Bankruptcy Code (2016) (‘IBC’) has been weakened due a recent order of the Supreme Court of India – India Resurgent ARC Private Limited v Amit Metaliks (2021) (‘Supreme Court Order’). Under the IBC, on initiation of insolvency proceedings, a committee of creditors (‘CoC’) is formed, comprised solely of financial creditors (ie banks and bondholders). A successful resolution plan must obtain at least a 66% positive vote of the CoC as per lenders’ debt exposure regardless of whether they are secured or not. However, if the company is not successfully resolved and goes into liquidation, the liquidation ‘waterfall’ (ie the rules governing priority in the distribution of the proceeds of a realisation) takes into account the secured status of a creditor and accords them higher priority in the pecking order.

Before India’s bankruptcy court—the National Company Law Tribunal (‘NCLT’) —approves a resolution plan, it must ensure that dissenting financial creditors (ie creditors in the 34% bucket which vote against a successful resolution plan) are paid at least the amount they would have received in case of a liquidation. The resolution professional must commission two independent valuation reports of the company to ascertain the worth of the company in a hypothetical liquidation to peg the minimum pay-out to dissenting financial creditors. The controversy in the Supreme Court Order pertains to the determination of the minimum pay-out to be paid to dissenting financial creditors.

A hypothetical

The treatment of financial creditors under a resolution plan as per the IBC is as follows:

• For assenting financial creditors, section 30(4) of the IBC provides that, while approving a resolution plan, the CoC shall consider the manner of distribution of the resolution proceeds and may take into account the value and priority of security for creditors under section 53(1) of the IBC (which contains the liquidation waterfall).
• For dissenting financial creditors, section 30(2) of the IBC provides that they must receive an amount which is not less than the amount payable to such creditors under section 53(1) of the IBC in the event of liquidation of the company.

Consider these principles in the context of the hypothetical set out in the tables below:

Table A

As per the above hypothetical, if Banks A and B vote in favour of the resolution plan, the plan will succeed since it has garnered 70% of the votes by value. The economically efficient distribution of the resolution amount of 50 would be as follows:

Table C

Note that the distribution of resolution proceeds amongst assenters may take into account the order of priority set out under the liquidation waterfall. Therefore, theoretically, Bank B with a liquidation value of 5 may get a pay-out of 4 with Bank A retaining 16. Even if irrational for B, this distribution is not unfair since B has voted in favour of this distribution mechanism. However, the pay-out to C of 30 must be sacrosanct since it has voted against the resolution plan as it would be better off in liquidation due to its superior collateral value.

There is some scope for doubt on the minimum value assured to dissenters under section 53(1) of the IBC and two views are prevalent. One interpretation is that this section provides priority to secured creditors on the assumption that they have relinquished their specific security interests to the liquidator and have become pari passu amongst each other regardless of the exclusivity or priority of their original security interests. The other view is that, since section 52 of the IBC also entitles secured creditors to enforce their security interest themselves outside the formal liquidation process, their exclusivity and priority cannot be diluted. The latter view is more plausible since the idea of paying dissenters a threshold amount under a resolution plan is to mirror an actual liquidation pay-out where the dissenter has the right to retain the value of their specific security interest.

The Supreme Court Order

In this case, one of the creditors, ‘IRA’, had a distinct security interest over certain assets of the company the liquidation value of which was much higher compared to the liquidation value of the security interests held by other secured creditors. IRA had signalled that it would only vote in favour of the plan if it were promised the liquidation value of its specific security. IRA’s position was not acceptable to the other secured CoC members which wanted the resolution proceeds to be distributed to all CoC members purely in the ratio of the aggregate liquidation value to the aggregate financial debt—with no reference to the unique security interests held by individual secured creditors. Such a distribution would have been detrimental to IRA as it would receive a lower pay-out compared to the liquidation value of its collateral. Further, it would have been advantageous to the other CoC members as they would gain a larger proportion of the resolution proceeds than they would if the pay-out was linked to their collateral which had inferior value. As a result, IRA voted against the resolution plan with the expectation that, as a dissenter, it would be assured of at least the liquidation value of its specific security interest.

The narrow question before the Supreme Court was whether an assenter can insist that it be paid liquidation value under a resolution plan. As discussed above, section 30(4) provides that it is not mandatory for the CoC to provide each assenter with its liquidation value. If the creditor is not satisfied with the proposed pay-out, it is free to vote against the plan with the expectation of receiving the full liquidation value of its security as a dissenter. The Supreme Court Order correctly notes that respecting the nature and priority of security interest of assenters is not mandatory. However, the Supreme Court went a step further and ruled that IRA was not entitled to the value of its specific security interest even as a dissenter and held that it must share the resolution proceeds in the same ratio as other secured creditors. The Supreme Court’s reasoning may have set a more dangerous precedent—that the assenters can not only elect to decide the manner of distribution amongst each other, but that they can also bind the dissenter into receiving an amount lower than its liquidation value. On the facts, it was clear that the secured creditors were not similarly situated as they had distinct sets of security interests over assets of the company. In effect, the Supreme Court permitted co-mingling of distinct collaterals and treated all secured creditors similarly.

In the hypothetical scenario set out in the tables above, each creditor has a distinct security interest and Bank C, the dissenter is fully collateralised with the debt and the collateral value being the same—at $30. The economically efficient distribution model is set out in Table C above. However as per the Supreme Court order, the resolution proceeds ($50) must be shared in the ratio of the aggregate liquidation value of all secured creditors to the aggregate claims ie in the ratio of 45/100. As per this formulation, Bank C will not recover 100% of the value of its exclusive security (ie $30) but only 45% of it (ie $13.5), with the remaining amount (ie $16.5) unjustly enriching Banks A and B.

Critique of the Supreme Court Order

The Supreme Court Order prejudices the position of secured creditors. This is particularly problematic in the Indian financial sector where secured credit plays a critical function in the lending landscape—most of bank lending is secured and the vast majority of credit is advanced by state owned banks. Security creation reduces the credit risk of the lender as it can look to the hard assets it has collateralised in the event of default. Further, secured credit carries a lower interest rate due to the comparatively lower value of loss in the event of default. Under the norms prescribed by the Reserve Bank of India, provisioning for defaulted secured loans is lower than that for unsecured loans. Moreover, secured lending is even relevant to the risk weighting of capital for capital adequacy purposes.

The Supreme Court Order is also contrary to established international best practices. Under chapter 11 of the US Bankruptcy Code, a secured creditor cannot be bound to a plan unless the creditor is given the right to retain its security interest or proceeds from its security interest. Similarly, section 901G of the UK Companies Act 2006 deals with the treatment for dissenting classes of creditors during the sanction of a restructuring plan. This section provides that a dissenting class of creditors can be bound by a plan sanctioned by the requisite majority provided the court is satisfied that if the compromise or arrangement were to be sanctioned, none of the members of the dissenting class would be worse off than they would be in the event of the ‘relevant alternative’—where the relevant alternative is defined to be whatever the court considers would be most likely to occur in relation to the company if the compromise or arrangement were not sanctioned. The UNCITRAL Legislative Guide recommends that dissenting creditors are not bound to a restructuring plan unless they will receive at least as much under it as they would have received in liquidation proceedings. The World Bank’s 2015 Report on the Principles for Effective Insolvency and Creditor/Debtor Regimes states that the priority of secured creditors in their collateral should be upheld and absent the secured creditor’s consent its interest in the collateral should not be subordinated.

In principle, cramming down dissenting secured creditors is desirable if it leads to the rescue of the company and to a higher enterprise value than a fire sale during liquidation would yield. However, under the IBC such treatment of dissenting secured creditors is premised on ensuring a minimum standard of protection for them which respects the value, priority and exclusivity of the collateral of each secured creditor which may dissent. The Supreme Court Order fails to uphold this premise by treating dissimilarly placed secured creditors in a similar manner. This order effectively deprives lenders of the commercial bargain they had struck in a pre-insolvency situation. It also divests them of their property rights in the collateral which is mandatorily registered with the official companies’ registry and which serves as public notice of the encumbrance.

The Supreme Court Order has created consternation amongst banks and distressed asset funds which have bought secured debt in the recent past. There is uncertainty over the minimum entitlement due to secured creditors in an insolvency situation which is hindering decision making. Anecdotal evidence suggests that lenders with relatively small debt exposure to distressed companies are now hesitant to file insolvency applications for fear of being unfairly crammed down under a resolution plan even if they have exclusive security. Further, dissenters will now be incentivised to jeopardise the resolution process so as to cause an actual liquidation where the priority and exclusivity of their security interest would be respected. In the long run it remains to be seen if the Supreme Court Order will cause any increase in the cost of debt offered by secured lenders.

Conclusion

Forceful dilution of rights of secured creditors contravenes the scheme of the IBC, is contrary to internationally recognised principles and leaves lenders to the tyranny of the majority in a creditors’ committee. Since the Supreme Court Order has been passed by India’s highest court, overturning it will require reconsideration by a larger bench—which is infrequent in commercial matters. Therefore, it would be advisable for the government to amend the IBC to make it amply clear that, under any resolution plan, dissenters are entitled to the pay-out directly linked to the liquidation value of their security interest considering the value, exclusivity and priority of such security.

Suharsh Sinha is a Partner in Restructuring and Insolvency at AZB & Partners, Mumbai, India.