An unexpected danger is quietly snaking up over India’s credit market which has the potential to destabilise the economy and dry up all credit for future growth. These are the two recent pronouncements by the National Company Law Tribunal in the IL&FS case and by the appellate tribunal the NCLAT in the Essar Steel case.
In the IL&FS case, the NCLT has indicated that provident funds, even if they are not secured or senior creditors, should be given their dues at par with or even over secured creditors because the beneficiaries of these funds are more vulnerable due to their age.
Essar Steel case, the NCLAT set aside the distribution that the committee of creditors (the CoC) put forth. The CoC, in keeping with clause 30 (2b) of the Insolvency Code, gave 10 percent to the operational creditors and kept 90 percent for themselves, i.e the secured creditors. The NCLAT cancelled this plan and ordered the CoC to give 40 percent to the operational creditors on the ground that the CoC and the NCLAT are bound by a higher law of fairness.
The Clause 30 (2)(b) of the IBC says that operational creditors need to be given liquidation value, and once the CoC gives a plan that satisfies this clause the NCLT, under Section 31 “shall” accept the CoC’s plan.
Let us cut through the legalese, to where the two cases meet. The IBC and commercial law, in general, are predicated on the premise that those creditors, who have given loans in exchange for a collateral or security, should be paid before those who have given unsecured loans. The difference is reflected in the interest rates. World over, secured loans attract lower interest rates while unsecured loans bear a higher interest. This is because low risk in secured credit gets a low return, while unsecured loans are high risk and hence get a higher return. This fundamental principle of commercial law has gotten dislodged in the above two cases.
In the IL&FS case, the tribunal is moved by sentiment towards one group of lenders. But such a judgement can hurt the entire economy and cause untold misery to the entire country. If the fund manager of the provident fund has been reckless and subscribed to debentures that are substandard, while bankers have been smart enough to “secure” their credit, the mere fact that the PFs beneficiaries are more vulnerable cannot be used to override the rights of secured creditors.
If this became law (as all precedents do), then the concept of secured credit will be undermined and all banks will give only unsecured credit and charge high rates to make up for the risk. Bankers may go a step further and even demand that if a project needs their loans, the borrower must promise never to take loans from provident funds.
This will be a terribly retrogressive development since, in many countries, it is the large pools of provident and pension funds that invest in infrastructure projects since they are by definition long-term patient money. Also, global sovereign funds and stressed asset funds, which we hope will invest in Indian stressed debt, will flee the country. Even now, FPIs or foreign portfolio investors have only bought government debt in India and have not been attracted much to corporate debt. With such judgments, foreign funds may simply dump what little corporate debt they are holding.
Let us revert to the Essar Steel case. Here, the NCLAT has done two things which may upset the economic applecart.
1) The IBC has given more powers to the CoC to draw up a resolution plan since they are the biggest lenders and their help is needed for the future survival of the company. The CoC is directed by the IBC to follow a prescribed waterfall: first the legal dues to employees, then secured creditors after 10 percent liquidation value to operational creditors. The NCLT was intended to ensure the process has been followed, not substitute its commercial judgement in place of the CoC’s. By setting aside the position of the CoC, the Essar judgement can destroy the entire edifice of the IBC, since creditors and the resolution applicant will be willing to go ahead with a plan to rescue a company only if it makes commercial sense to them. In principle, therefore, the NCLT and the NCLAT must abide by the commercial judgement of the CoC. Else, no stressed asset will be sold and the IBCs purpose will not be served.
Separately, the Parliament , by the due process of law, has given the CoC this status and an NCLAT elbowing out the CoC amounts to serious judicial activism and challenging the just rights of Parliament.
2) The Essar Steel judgement of the NCLAT also in a way gives almost as much importance to the operational creditors as to secured creditors. Like in the IL&FS case, this can jeopardise the entire credit system in the country, with all creditors preferring to give unsecured loans at high interest rates, thus grinding all economic activity to a halt.
The law gives operational creditors liquidation value with a reason. An operational creditor is only exposed to one production cycle and, if not paid, the creditor stops supplying. The secured financial creditors, viz the bankers have taken a risk on the company for many years, betting its plant will be set up and bear profit over time. Commercial law, everywhere, gives such creditors more powers. Else, no one will fund expansion plans or greenfield projects.
Some experts have argued that in many small companies operational creditors bear the entire risk in the form of suppliers credit and hence they need to be given a fair share when the stressed company is sold. They have a point which perhaps needs to be addressed. However, while addressing operational creditors, the law needs to note that in many cases operational creditors are related parties: In Essar Steels case, over 20 operational creditors are group companies. If the NCLATs order becomes law, then all promoters, who see their companies in danger of going into IBC, may quickly create bogus operational credits with group companies. The NCLAT's judgement can thus lead to perverse developments that hurt the larger good.
It is no one’s case that operational creditors have to be ignored, but the law has to look at first principles and at the greater good. Commerce and industry can progress only if those who secure their credit are given their just rights over and before unsecured creditors.The IBC needs to be quickly amended to maybe give a fixed, say 10 percent or 15 percent share to operational creditors so that the entire issue is not left to the CoC’s or the NCLATs whims and cases get dragged on endlessly and case law goes all over the place. Any such amendment must also prioritise the rights of secured creditors.