Insolvency And Bankruptcy Code: Battle Between Operational And Financial Creditors.

For the purpose of proceedings under the Insolvency and Bankruptcy Code, 2016 (“the Code”) a distinction between the financial creditors and operational creditors has been created.

The principal argument is that there is no intelligible differentia having relation to the object intended to be achieved by the Code between financial and operational creditors and therefore, it is alleged to be discriminatory, arbitrary and violative of Article 14 of the Constitution of India.

Financial Creditor v. Operational Creditor

Under Section 5(7) of the Code, a Financial Creditor is defined as "a person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred".

Financial debt has been defined under Section 5(8) as "a debt along with interest, if any, which is disbursed against the consideration for time value of money".

The Operational Creditor is defined under Section 5(20) of the Code as "any person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred".

Operational Debt has been defined under Section 5(21) as "a claim in respect of the provisions of goods or services including employment or a debt in respect of the repayment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority".

Disparities between the creditors under the Code:

1. Requirement of Demand Notice

An operational creditor, as per Section 8 of the Code, is required to serve a demand notice upon the corporate debtor before filing an application before the National Company Law Tribunal. However, there is no such requirement for the financial creditor.

2. Disputed Debts

As per Section 9 of the Code the application of operational creditor shall be rejected if the debt is a disputed debt, however, there is no such rejection criteria for financial creditors.

3. Committee of Creditors

Section 21(2) of the Code states that the committee of creditors (“CoC”) shall consist only of financial creditors whereas operational creditors are not allowed to be a part of the CoC.

Each financial creditor shall vote in accordance with voting share assigned and the resolution plan can be implemented only if it has been approved by vote of 66% of voting shares of financial creditors.

However, section 24(3)(c) of the Code states that unless the operational creditors amount to 10% of the aggregate of the amount of debt owed, they will have no voice in the CoC.

Therefore, it is clear that an operational creditor is not allowed to be a member of the CoC. Also, the Code limits the right of an operational creditor to only attending the meeting of CoC subject to the abovementioned threshold.

The issue now appears to have been bedded down in finality:

The year 2018 saw many writ petitions assailing the constitutional validity of the Code. Various matters were brought into question and on January 25, 2019, a judgment was pronounced by the Supreme Court (the "SC") on this batch of petitions in Swiss Ribbons Private Limited & Anr. v. Union of India[1].

The SC concluded that the distinction is "neither discriminatory, nor arbitrary, nor violative of Article 14 of the Constitution of India". Insofar as the disparity between the creditors is concerned, this is because operational creditors are typically interested only in getting payment for supply of goods or services made by them, whereas financial creditors are typically involved in seeing that the entirety of their loan gets repaid, for which they are better equipped to go into the viability of corporate enterprises, both at the stage of grant of the loan and at the stage of default.

Section 53 was analysed separately. This section lays down the waterfall mechanism of claims and the priority in distribution of assets in liquidation. The Code accords preference to financial creditors secured claims and the operational creditors find themselves at the bottom of the hierarchy.

The SC went on record to state that they do not find that operational creditors are discriminated against or that Article 14 has been infracted on the ground of arbitrariness.

The rationale behind the difference between financial and operational creditor under the Code has also been explained in the Banking Law Reforms Committee as under:

"Members of the creditors committee have to be creditors both with the capability to assess viability, as well as to be willing to modify terms of existing liabilities in negotiations. Typically, operational creditors are neither able to decide on matters regarding the insolvency of the entity, nor willing to take the risk of postponing payments for better future prospects for the entity. The Committee concluded that, for the process to be rapid and efficient, the Code will provide that the creditors committee should be restricted to only the financial creditors."

In summary, the SC found sufficient intelligible differentia justifying the differential treatment accorded to financial and operational creditors and concluded: "it can be seen that unsecured debts are of various kinds, and so long as there is some legitimate interest sought to be protected, having relation to the object sought to be achieved by the statute in question, Article 14 does not get infracted. For these reasons, the challenge to Section 53 of the Code must also fail".