Impact on Secured Financial Lenders
The Insolvency & Bankruptcy Code, 2016 (“IBC”) has been one of the most talked about debated, evolving legislations of recent times. It has brought with itself, a sea change in the manner that debt is resolved in India. From its very advent in late 2016, IBC has been embroiled in long fought interpretational tussles which have resulted in various gaps being filled in by the Supreme Court of India. In fact, the legislation itself has undergone several and frequent amendments.
While the initial controversies surrounding IBC were debtor centric, with time, as resolution processes have seen their full lifecycle and many companies have even undergone liquidation, a myriad of issues from the latter part of IBC have emerged. One such issue that this write up focuses on is the catch 22 situation of a secured creditor with statutory lien on the property of the debtor under liquidation. This write-up further attempts to juxtapose this conundrum against legal rights of other secured financial lenders.
How debts are typically secured and what is a “statutory lien”
Security interest can be created in two ways, (i) By contract, which means that a lender and debtor enter into a contract for creating a security interest to secure repayment of a debt; and (ii) By operation of law, which means that a security interest is created automatically by virtue of a statute.
A typical financial lending transaction by a bank or financial institution, is usually backed by security of the first category above and a security package often comprises of charge on immoveable assets of the debtor (by way of mortgage), charge on moveable assets (by hypothecation), pledge of shares & guarantees etc. As it is the banks or financial institutions that many a times finance the company’s day to day working by way of working capital facilities or term loan facilities, the security documents executed in favour of financial lenders often, create a “first” charge on assets or a pari passu charge in cases of consortium lending or secondary charge in some cases. Thus, the intent and purport of financial lending is that in cases of default or liquidation, the lenders would be first in line to collect by virtue of their security interest.
As a company undertakes its operations with other third parties, several statutes come into play which govern inter se rights and obligations. Such statutes at times, also provide for creation of a “lien” on certain conditions being fulfilled. Simply put, a lien means “a right at common law in one man to retain that which is rightfully and continuously in his possession belonging to another until the present and accrued claims are satisfied.” When a lien is created through statute, it is called a “statutory lien”, some common examples being, an unpaid seller’s lien under the Sale of Goods Act, 1930 or a lien under the Transfer of Property Act, 1882. Lien is expressly recognized as a form of security interest under the IBC.
The Process in a nutshell
Under the IBC, the process for security realization / relinquishment during liquidation is fairly straight forward and seemingly innocent: At the time a creditor files its claims, it needs to notify to the Liquidator, the security held against the debt and whether the creditor intends to realize this security interest outside the liquidation process or relinquish it to the liquidation estate.
At the other end of the table, the Liquidator is required to ascertain whether the security interest exists and if a request for realization outside liquidation is made, the Liquidator must verify the security interest and ascertain whether it is capable of being realized.5 The last part is where things get murky for a statutory lien holder, as the IBC provides that for a security interest to be realizable, it must be capable of being verified either from the records of an Information Utility (“IU”) or charge registered with the Registrar of Companies (“ROC”) or the Central Registry of Securitization, Asset Reconstruction and Security Interest of India (“CERSAI”).
Some of the key highlights of the realization process under the IBC are:
– IBC makes no distinction between secured creditors. Bluntly put, this would mean that in liquidation, a bank whose debt is secured by a mortgage for instance, is no different than an unpaid seller having a lien over goods.
– IBC also makes no distinction between secured creditors in terms of the priority of charges. This means that holding a first charge on assets has little to no meaning in the context of liquidation.
– A liquidator can permit realization only if a security interest is capable of being realized and the parameters for that are registration of charge with ROC or CERSAI or an IU record.
Realization of Statutory Lien and practical problems of verification
By virtue of the nature of debts, creditors holding statutory lien are mostly operational creditors, some examples being an unpaid seller of goods under the Sale of Goods Act, 1930, an unpaid seller of immoveable property under the Transfer of Property Act, 1882 or a port authority having lien under the Major Port Trust Act, 1963. On a plain reading of the IBC, all such lien holders would rank equally with other secured creditors (who are most usually secured financial lenders). Given that the ranking and rights are equivalent, such lien holders in theory, will also have the right to realize their security interest outside the liquidation estate.
While the IBC reads very innocuously in this regard, there effectively is a huge lacuna in terms of documentation that can assist a Liquidator in verifying such statutory liens and permitting realization. A lien holder and particularly a statutory lien holder, would typically not register its charge with ROC or CERSAI as these are charges created automatically by operation of law as opposed to those created by consent of the debtor or under a contract. This poses a huge practical challenge for a Liquidator as he / she would frequently find a situation where a statutory lien exists but is not capable of being verified for lack of an ROC or CERSAI registration or an IU record. A Liquidator in such cases would have no choice but to refuse a request for realization on account of lack of record to verify the lien. Whilst one can argue that a statutory lien is created by operation of law and hence, verifiable, the Liquidator would find himself / herself in a situation where he /she will have to also analyze the underlying transaction which led to creation of the lien and act beyond the mandate given to him for the purposes of verification of security interest.
Cases before Tribunals and view of the IBBI
There have been cases before the NCLT and NCLAT, where the issue of realization of a statutory lien has been discussed at length. One such NCLAT Order6 goes to say, albeit improperly, that a lien is not recognized as a security interest under IBC. Another Order of the NCLAT7 where the Tribunal was deciding the right of an unpaid seller to realize its lien as an unpaid seller of goods, leans heavily on the provisions of the SARFAESI Act to hold that only a lender who can get consent of 60 % of secured creditors (in value) in terms of the SARFAESI Act can be permitted to realize their security interest. There are also Orders of the NCLAT which speak of the mandatory requirement of registration of charge with ROC and such charge becoming void in liquidation if not registered8. An NCLAT Order even considers the issue of priority of charges and holds that the IBC provides for no such inter se classification9. Most of these Orders are subject to challenge before the Supreme Court and remain pending final adjudication.
In the meantime, a report10 by the Insolvency and Bankruptcy Board of India (“IBBI”) proposes an amendment to IBC to include the principal laid down by NCLAT in the case of Srikanth Dwarakanth vs. BHEL (supra) such that if the secured creditors having 60% of the value in the secured debt decide to relinquish or realize the security interest, such decision shall be binding on the other pari-passu charge holders. This, as per the IBBI, would balance interest of all stakeholders.
Impact on Secured Financial Lenders
The conundrum of whether a statutory lien holder can realise the security interest or not has not only impacted the lien holder’s rights, but also gravely impacted and in a way, prejudiced the rights of secured financial lenders with “legitimate” security interests backed by ROC and CERSAI registrations. In scenarios where a lien holder would choose to realise security interest outside of the liquidation estate, when permitted, financial lenders with mortgage or hypothecation who have relinquished their security interest would stand to be excluded while an operational creditor would take the cake. Further, as IBC makes no distinction between category of charge holders (in terms of priority), in a scenario where a financial lender as well as a lien holder chooses to realise their respective security interests, a financial lender holding a first charge would find himself on the same pedestal as an operational creditor with a lien. It is doubtful if this could be the intent of IBC as in all other aspects, the Code blatantly upholds and endorses the supremacy of financial creditors in all aspects of resolution and liquidation.
In conclusion, while the IBC is suggestive of the fact that a statutory lien holder has the right to realise security interest just like all other secured financial lenders, in most scenarios, such lien holder would not meet the test of ROC or CERSAI registration or IU record. Even if this hurdle is crossed, the more glaring issue is the one that arises thereafter: intervening interests of secured financial creditors including creditors having first charge over the assets. The controversy will resolve itself with either the Legislature stepping in and bringing about a much-needed amendment to IBC to balance interests of all stakeholders or until such amendment, the Supreme Court remains a guardian to this complex issue of law and can be expected to clarify all aspects in due course.
Basis our experience in and insight into insolvency laws and personal involvement in some of the above mentioned case, in our view, in line with the other provisions of the IBC, even cases of realisation of security interest, secured financial creditors ought to be treated with a sense of priority. Thus, secured financial creditors must have the right to realise their security interest over other secured operational creditors such as lien holders. A tested way to resolve the deadlock would be to import into IBC, the provisions of SARFAESI Act (as has been done in the case of Srikanth Dwarakanath and the IBBI Report (supra)) and require a 60% creditor in value vote to permit realisation. Perhaps another amendment ought to be carried out to categorise and rank secured operational creditors lower than secured financial creditors in the liquidation waterfall mechanism. Lastly and to cover all corners, IBC also requires much needed clarity on priority of charges in a realisation scenario. Until such time this clarity is brought about, it is more or less “to each his own” or a “case to case” kind of an interpretation which is being adopted by liquidators and there is no clear mandate of the law governing this. Given this issue can and does significantly impact commercial interests, especially those of banks and financial institutions, expeditious resolution of the conundrum is definitely a need of the hour.