Balancing Creditors Right: The Waterfall Mechanism and Clean Slate Theory UnderThe IBC

Introduction

The Insolvency and Bankruptcy Code, 2016 (IBC) has brought a paradigm shift in the Indian insolvency regime, by laying down a defined and time-bound resolution procedure that is directed towards the revival of a business and maximization of recovery for creditors. Two key principles are at the heart of the framework, namely the Waterfall Mechanism under Section 53 which determines claim priority during liquidation and secondly the Clean Slate Theory which ensures that upon sanction of a resolution plan, all previous claims against the corporate debtor are extinguished. But a big criticism of IBC is its discrimination against Financial Creditors (FCs) and Operational Creditors (OCs) leaving the OCs with little or no recovery at all. Over time, judicial interventions tried to balance the scales, carving out exceptions to safeguard operational creditors from total erasure, so in this article we will delve into the case laws where exceptions through which grey area has been created towards operational creditor in realm of judgements of Supreme courts.

The Waterfall Mechanism Under Section 53

Liquidation is governed by the precedence of claims outlined in Section 53 of the IBC — the Waterfall Mechanism. The first step in the process is the settlement of costs and expenses of IRP and liquidation which is paid in full before any other claims are settled. After this, dues to workmen for 24 months prior to liquidation, and secured creditors if they surrender their security, are prioritized. Employee dues for 12 months prior to liquidation are next, followed by unsecured financial creditors. They are placed lower in priority along with government and statutory dues like taxes, electricity charges, they get little to no recovery. Peering all the way down the hierarchy used to reveal virtually no bond holders and only a small proportion of individuals who had lent money while at the same time leaving equity shareholders and partners at the bottom end, sweeping only the trash and evidence of them going home with nothing.

The Supreme Court has maintained that the Waterfall Mechanism is valid and that the powers of adjudicating authorities in varying the priorities of creditors are limited. In Essar Steel Case (2019)[1] Court reinforced that the commercial wisdom of Committee of Creditors (CoC) is final and that NCLT cannot interfere as long as mechanism has been followed. Likewise, in the case of Swiss Ribbons (2019)[2], while upholding the constitutionality of Section 53, the Supreme Court ruled that there is a rational basis for the differential treatment of financial and operational creditors. Nonetheless operational creditors and government dues occupying a low order of priority remain controversial given that they often end up providing poor recoveries to such claimants.

The Clean Slate Theory and Its Implications

Clean Slate Theory, which in itself is an inherent part of the IBC, provides that on approval of resolution plan (RP) by CoC & NCLT, allows the SRA (Successful Resolution Applicant) to take over the business as ”new” without any historical liabilities. This principle is derived through definitive judicial pronouncements. There are various judgements in this regard, for instance 2021, in verdict of Ghanashyam Mishra Case[3], the supreme court stated that statutory liabilities like taxes or electricity dues were extinguished after the approval of the resolution plan, protecting the SRA from being saddled with historical liabilities. In the Essar Steel Case (2019), it was reiterated that claims that existed before the approval of a resolution plan are extinguished, and the corporate debtor receives a clean slate post-approval.

Outliers to the Clean Slate Theory

While the Clean Slate Theory is generally regarded as absolute, courts have identified exceptions to this rule, which has introduced ambiguity into the interpretation of the Clean Slate Theory. In 2022, the Supreme Court introduced an exception to this general rule in its judgment on the Rainbow Papers Case[4], where it ruled that if statutory dues like Goods and Services Tax (GST) are not part of the resolution plan, the resolution plan may be rejected itself. This left uncertainties and apparently conflicted with the decision in Ghanashyam Mishra, wherein it was already held that statutory dues get extinguished after the RP’s approval. It was also similarly observed in the TANGEDCO Case[5] decided by Madras High Court in 2023 that neither the corporate debtor nor the interim resolution professional will be allowed to take a clean slate and if there was intention to mislead of any dues from either body like electricity due etc. then the Clean Slate Theory as above will not apply and the disclosure can be made even after approval of the resolution plan.

The Economics of Creditors: One Generous Credit is Worth Another

One of the most compelling features of the IBC has been the treatment of operational creditors, who are, burnt by the process, left with little or no recovery. Unlike financial creditors, operational creditors would not form part of the Committee of Creditors under Section 21, IBC and have no right to vote on the resolution plan. Operational creditors, however, are ranked lower than the financial creditors in the Waterfall Mechanism which implies that they are supposed to receive not less than liquidation value, as per Section 30(2)(b) of the IBC, the same being non-fulfilment of their minimum dues resulting in cases where these dues are deemed to be hurtling towards a very small number. Moreover, as per Clause 24(3)(c), operational creditors shall only be allowed to attend any CoC meetings, only if their dues are more than 10% of the total debt; meaning that although Operational creditors are invited to the table, they don’t have a vote — just increasing the marginalization of their voice in the resolution process.

Protective Interventions by the Judiciary in favour executives of Operational Creditors

Notwithstanding these limitations under the statute, judicial interventions are attempting to relief operational creditors.  For instance, In the M.K. Rajagopalan Case, 2023[6] the Supreme Court ruled that the CoC is required to ensure exceptional treatment of Operational creditors under Section 30(2)(b), it necessarily implied that Operational creditors cannot be completely left out of the resolution process. In a similar vein, in the TANGEDCO Case, 2023[7] the Madras High Court held that the resolution plan could be challenged if it intentionally excludes operational creditors, providing a certain protection to these creditors who would otherwise be left empty-handed.

Judicial Exceptions for Operational Creditors for Recovering Dues

The judiciary has also carved out specific circumstances in which operational creditors can still raise claims for dues even after a resolution plan has been approved. The TANGEDCO Case reflects the right of Operational Creditors to challenge the plan if the IRP or RP fails to adequately verify the claims and disclosure requirements. Another circumstance recognized as a ground for fatal to the applicability of Clean Slate Theory was fraudulent concealment of liabilities by corporate debtor. Incidentally, Section 30(2)(b) itself has been read down to make a Resolution plan on behalf of the Corporate Debtor null and void if it contravenes the same with respect to the Operational Creditors receiving at least the liquidation value, as has been held in the Essar Steel Case. Moreover, statutory dues being treated as operational debt has also been a subject of litigation wherein the Supreme Court in Rainbow Papers Case[8] held that GST dues should be in the resolution plan and in the absence of the same the plan might be void. It upheld the position that undisclosed electricity arrears will nonetheless not be extinguished on the confirmation of resolution.

Final Thoughts: Finding Balance

The IBC Waterfall Mechanism and Clean Slate Theory support the timely and effective resolution of distressed entities while favouring revitalization of business activity. But, due to the intrinsic bias in favour of financial creditors, operational creditors have often ended up with paltry recoveries. Though the commercial wisdom of the CoC still reigns supreme, judicial disquisitions have been mostly responsible for ushering in greater transparency in verifying the claims, suggested minimum crippling payouts to the operation creditor, and prevented frauds that suppress liabilities. The decisions in TANGEDCO, Rainbow Papers and Ghanashyam Mishra thus reflect the evolving nature of judicial interpretations in balancing creditor rights while maintaining the overarching objectives of the IBC. In times to come, tighter scrutiny of the resolution plans and better protection of the operational creditors will be critical for shaping a conducive insolvency resolution architecture.

Author:– RISHI PANDEY,  in case of any queries please contact/write back to us at support@ipandlegalfilings.com or   IP & Legal Filing.

References: –

• https://www.taxmann.com/research/ibc/top-story/105010000000021077/operational-creditors-under-insolvency-and-bankruptcy-code2016-experts-opinion
• https://www.snrlaw.in/renewed-challenges-to-the-ibc-distribution-waterfall/
• https://www.jsalaw.com/newsletters-and-updates/jsa-prism-insolvency-august-2024-3/#:~:text=Clean%20slate%20theory%20cannot%20be,Ltd%20vs
• https://ibclaw.in/distinction-in-treatment-of-financial-creditors-vs-operational-creditors-by-vidushi-puri/
• https://ibclaw.in/waterfall-mechanism-basic-structure-of-the-insolvency-and-bankruptcy-code-2016-by-harshit-gupta/
• https://www.snrlaw.in/renewed-challenges-to-the-ibc-distribution-waterfall/

[1] [2019] 16 S.C.R. 275

[2] [2019] 3 S.C.R. 535

[3] [2021] 13 S.C.R. 737

[4] State Tax Officer v. Rainbow Papers Ltd., (2023) 9 SCC 545

[5] Infosys Ltd. v. Superintending Engineer, 2024 SCC OnLine Mad 1365

[6] M.K. Rajagopalan v. Periasamy Palani Gounder, (2024) 1 SCC 42

[7] Ibid 5

[8] Ibid 4