When a corporate defaulter is brought under the resolution process (Corporate Insolvency Resolution Process or CIRP), there can be two types of creditors to whom the corporate should give back money – (1) the entities who gave loans or funds to the corporate and (2) the entities from whom the corporate bought inputs and other services. Here, the Insolvency and Bankruptcy Code (IBC) classifies these two creditors under the following categories:

1.  Financial Creditors – Section 5(7) and

2.  Operational Creditors – Section 5(20).

The financial creditors are basically entities (lenders like banks) that have provided funds to the corporate. Their relationship with the entity is a pure financial contract, such as a loan or debt security.

On the other hand, business and other entities that have provided inputs and other materials and services and to whom the defaulted corporate owes a debt are called as operational creditors. Both have claims on the defaulted corporate or the defaulted corporate owe payments to both these categories.

Rights for these categories under the resolution process are also different. The IBC gives a clear preference to the claims of the financial creditors over the operational creditors through several procedures. It is in this difference in the levels of rights given in the resolution process that difference between the two groups actually exists.

1. Who is a financial creditor?

The financial creditor in simple terms is the institution that provided money to the corporate entity in the form of loans, bonds etc.

Three important types of financial credit

1. Money borrowed against payment of interest

2. Any amount raised by acceptance under any acceptance credit facility, dematerialised form etc.

3. Any amount raised through the issue of bonds, notes, debentures, loan stock or any similar instrument.

The Supreme Court in a remarkable verdict clarified that in the case of housing projects, the homebuyers should be treated as financial creditors. The implication is that their obligation will be serviced out first when developers make default.

2. Who is an operational creditor?

          An operational creditor is the entity who has a claim (corporate has the debt) for providing any of the four categories to the defaulted corporate- goods, services, employment and Government dues (central govt, state or local bodies).

3. Rights of the two types of creditors

The IBC gives certain rights to the creditors both financial and operational; in the resolution process. From the submission of requests for resolution to liquidation, there are various steps and procedures for resolution. The IBC here gives rights and responsibilities to various creditors.

(a) Operational creditors and the right to initiate resolution process

Operational creditors have the right to submit a resolution application like the financial creditors. As per the IBC, in case of default of debt by the corporate debtor, any financial or operational creditor can make an application to the respective authority (i.e. National Company Law Tribunal or DRT) for commencing the Insolvency Resolution Programme. This means that the operational creditor can file a resolution application.

At the same time, when there is a dispute with the corporate debtor, the operational creditor can’t submit an application for resolution. Here, only a financial creditor can file a resolution application.

According to credit rating agency ICRA, out of the 1,858 corporate debtors referred to the NCLT upto March 31,2019, nearly 920 or 49 per cent cases have been referred by the operational creditors.

(b) Operational creditor’s right in the committee of creditors

The Committee of Creditors (CoC) is the decision-making body that decides the course of action on behalf of the debtors in the resolution process. Here, the IBC prescribes that the Committee of Creditors shall consist solely of financial creditors. The resolution plan can be implemented only if it has been approved by 66% of the creditors. Only operational creditors having aggregate dues of at least 10% of the total debt shall be given the notice of the meeting. But these operational creditors don’t have the voting power. So, the right of the operational creditor is to sit in the CoC if he has the threshold credit but don’t have the voting power.

(c) Operational creditors and the distribution of proceeds: who should bear a higher loss (means higher hair cut)?

After the IBC amendment of 2019, the financial creditors have a priority in the distribution of proceeds of a defaulted company. This amendment has provided the right to the Committee of Creditors after the verdict by the NCLT that both financial creditors and operational creditors have the same right.

 The NCLT verdict:

(a) Financial and operational creditors must be given similar treatment (which has been interpreted to mean the same percentage of haircut); and

(b) Discrimination amongst financial creditors on the basis of existing priorities or security interest is not permitted in a resolution plan.

The NCLT also ruled that the committee of creditors (CoC) has no role to play in determining the manner of distribution of proceeds of a resolution plan amongst the financial or operational creditors, since the financial creditors comprising the CoC are interested parties and there will be a conflict of interest if they are permitted to decide on the manner of distribution.

Government brings IBC Amendment 2019

After the third amendment of the IBC Act in 2019, the Committee of Creditors that includes the financial creditors has the explicit authority over the distribution of proceeds in the resolution process. Here, since the financial creditors are the only members of the CoC, they got hither rights implicitly compared to the operational creditors.

 (d) Rights of the operational creditor in asset distribution in the case of liquidation.

 When the committee of creditors fails to approve a resolution plan within the stipulated time period or demands liquidation, the adjudicating authority can pass an order for liquidation of the corporate debtor.

As per the liquidation process, the official liquidator appointed by the CoC is required to sell the assets of the corporate debtor. The procured money should be distributed among all the creditors. Here, the Unsecured Financial Creditors and Operational Creditors are treated equally but Secured Financial Creditors’ obligations have to be paid first.

IBC Amendment 2019: Priority and Value of Security to be considered by COC

The IBC Bill specifies that while approving the resolution plan, the CoC is can decide the manner of distribution of proceeds and can take into account the order of priority amongst creditors, including the priority and value of the security interest of a secured creditor. This means the when the proceeds or reimbursements from a corporate defaulter is taken, the priority can be set by the CoC in the distribution of such proceeds among various creditors.

Understandably, the CoC comprises only the financial creditors like banks. So, they now get a right to get the proceeds in a preferable way vis a vis the operational creditors. This is the most important implication of the amendment. This provision will settle the issue after the verdict of the NCLT that there is equal treatment for financial creditors and operational creditors in the distribution of the proceeds.

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