Supreme Court prioritizes Financial Creditors over Operational Creditors in Essar Steel-ArcelorMittal case

A bench of Justices R.F. Nariman, Surya Kant and V. Ramasubramanian ruled that in insolvency cases, financial creditors have to be prioritized over operational creditors.

ArcelorMittal won approval from the Supreme Court to complete its $5.8 billion purchase of the bankrupt steel mill – Essar Steel, clearing the way for tycoon Lakshmi Mittal to enter the world’s second-biggest market for the metal.

In this case, important questions as to the role of resolution applicants, resolution professionals, the Committee of Creditors (CoC) constituted under the Insolvency and Bankruptcy Code, 2016 (IBC), and the jurisdiction of the National Company Law Tribunal (NCLT/Adjudicating Authority) and the National Company Law Appellate Tribunal (NCLAT/Appellate Tribunal), qua resolution plans that have been approved by the Committee of Creditors have been raised. The constitutional validity of Sections 4 and 6 of the Insolvency and Bankruptcy Code (Amendment) Act, 2019 (Amending Act of 2019) have also been challenged.

Essar Steel India Limited (Essar Steel/corporate debtor) was auctioned to recover Rs. 54,547 crore of unpaid dues of financial creditors and operational creditors. The resolution plan of ArcelorMittal was accepted after several proceeding with the NCLT and NCLAT. The NCLT by its judgment dated 8th March 2019 disposed of the application to allow the resolution plan filed by ArcelorMittal.

On appeal before the NCLAT, the appellate authority held directed the Committee of Creditors (CoC) to take a decision. The NCLAT ruled that financial creditors and operational creditors deserve equal treatment under a resolution plan. The NCLAT had ordered that financial creditors will get 60.7 % of their admitted claims of Rs. 49,473 crore, which was roughly the same as that of operational creditors.

The NCLAT further held that the profits generated by the corporate debtor during the Corporate Insolvency Resolution Process (CIRP) would be distributed equally amongst the financial creditors and operational creditors of the corporate debtor. It also held that the CoC would not be empowered to decide the manner of distribution of the proceeds.

The CoC of Essar Steel appealed before the Supreme Court of India. It was argued that the provisions of the IBC provided for a broad classification of creditors as financial creditors and operational creditors on the basis of the nature of the transaction between creditors and a corporate debtor. The CoC relied upon the provisions of the IBC and submitted that financial creditors as a class have a superior status as against operational creditors, the same being the case with secured creditors vis-a-vis unsecured creditors.

The final resolution plan as approved in October 2018 was as Rs. 42,000 crores was to be paid to financial creditors. The resolution applicant agreed that the Committee of Creditors will decide the manner in which the financial package being offered by the resolution applicant to financial creditors will be distributed to secured financial creditors. The payment of INR 17.4 crore was to be made to unsecured financial creditors.

The CoC sought opinion of Justice B.N Srikrishna who said that “In my view, therefore, the Approved Resolution Plan would be fully justified in classifying between secured and unsecured financial creditor, and also according to the value of their securities and apportioning the amounts payable to them in the best manner which is considered reasonable.”

The Apex Court ruled that complete freedom and discretion has to be given to the Committee of Creditors to so classify creditors and to pay secured creditors amounts which can be based upon the value of their security, which they would otherwise be able to realize outside the process of the Code, thereby stymying the corporate resolution process itself. The Court also held that “the NCLAT judgment which substitutes its wisdom for the commercial wisdom of the CoC and which also directs the admission of a number of claims which was done by the resolution applicant, without prejudice to its right to appeal against the aforesaid judgment, must be set aside.”

The Court ruled that there is no doubt that even under the IBC that re-organization is a collective remedy designed to find an optimum solution for all parties connected with a business in the manner provided by the Code. Protecting creditors in general is an important objective - the observation that protecting creditors from each other is also important. Further the Apex Court held that Bankruptcy Code should not be read so as to imbue creditors with greater rights in a bankruptcy proceeding than they would enjoy under the general law, unless it is to serve some bankruptcy purpose.

The Court said “If an “equality for all” approach recognizing the rights of different classes of creditors as part of an insolvency resolution process is adopted, secured financial creditors will, in many cases, be incentivised to vote for liquidation rather than resolution, as they would have better rights if the corporate debtor was to be liquidated rather than a resolution plan being approved. This would defeat the entire objective of the IBC which is to first ensure that resolution of distressed assets takes place and only if the same is not possible should liquidation follow.”

The Court elaborated on the distinction between financial creditors and operational creditors stating that financial creditors are capital providers for companies, who in turn are able to purchase assets and provide a working capital to enable such companies to run their business operation, whereas operational creditors are beneficiaries of amounts lent by financial creditors which are then used as working capital, and often get paid for goods and services provided by them to the corporate debtor, out of such working capital.

According to the Apex Court, fair and equitable dealing of operational creditors’ rights under Regulation 38(1A) of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (Regulations) involves the resolution plan stating as to how it has dealt with the interests of operational creditors, which is not the same thing as saying that they must be paid the same amount of their debt proportionately. Also, the fact that the operational creditors are given priority in payment over all financial creditors does conclude that such payment must necessarily be the same recovery percentage as financial creditors. So long as the provisions of the IBC and the Regulations have been met, it is the commercial wisdom of the requisite majority of the Committee of Creditors which is to negotiate and accept a resolution plan, which may involve differential payment to different classes of creditors, together with negotiating with a prospective resolution applicant for better or different terms which may also involve differences in distribution of amounts between different classes of creditors.

The crucial take aways from this judgment are –

1) Ultimate decision on distribution is with CoC

2) Principle of equality is flawed

3) NCLT cannot interfere with commercial decision/wisdom of Banks

4) Distribution to take place as per plan of Arcelor Mittal India Private Limited (AMIL)

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