Priorities of Financial and Operational Creditors during CIRP Proceedings

Introduction


The Corporate Insolvency Resolution Process (CIRP) under the Insolvency and Bankruptcy Code (IBC) of India is a critical framework designed to resolve corporate insolvency issues in an efficient and time-bound manner. One of the key aspects of the CIRP is the distribution of recoverable assets and proceeds, particularly the priorities between financial creditors and operational creditors. This article aims to explore these priorities and how they influence the outcomes for each type of creditor during insolvency proceedings.

 

 1. Classification of Creditors: Financial vs. Operational

 

Under the IBC, creditors are broadly classified into two categories:

 

- Financial Creditors: These include lenders and institutions that provide financial loans or credit to the corporate debtor. Banks, financial institutions, and bondholders are common examples of financial creditors. Their claims are typically based on debt instruments or loan agreements that are financial in nature.

 

- Operational Creditors: These creditors provide goods or services to the corporate debtor, including suppliers, vendors, employees, and government authorities (in the case of unpaid taxes). Their claims arise from operational transactions necessary for the day-to-day functioning of the corporate debtor.

 

 2. Constitution of the Committee of Creditors (CoC)

 

The Committee of Creditors (CoC) plays a pivotal role in the CIRP process. One of the most significant distinctions between financial and operational creditors is their involvement in the CoC:

 

- Financial creditors are entitled to form the CoC and have voting rights in decision-making during the resolution process.

- Operational creditors do not participate in the CoC, unless their claims constitute more than 10% of the total debt. Even in such cases, they do not have voting rights but may be invited to present their concerns.

 

This asymmetry in participation means financial creditors have greater control over key decisions, including approving or rejecting a resolution plan.

 

 3. Priority in Distribution: The Waterfall Mechanism

 

The Waterfall Mechanism under Section 53 of the IBC governs the distribution of assets during the liquidation of the corporate debtor. The proceeds from the liquidation of the debtor's assets are distributed in the following order:

 

1. Insolvency Resolution Process Costs and Liquidation Costs: These costs are given the highest priority and are paid in full before any other distributions.

2. Secured Financial Creditors and Workmen’s Dues: Secured financial creditors receive priority, along with dues owed to the workmen of the corporate debtor for the preceding 24 months.

3. Unsecured Financial Creditors: After secured creditors, unsecured financial creditors come next in the line of distribution.

4. Operational Creditors and Other Creditors: Operational creditors rank below financial creditors in the priority list. This often leads to lower recovery rates for operational creditors compared to financial creditors.

5. Government Dues and Remaining Secured Creditors: Dues owed to governmental authorities (e.g., unpaid taxes) are ranked after operational creditors.

 

 4. Impact of Priorities on Financial and Operational Creditors

 

The differing priorities have a substantial impact on the recovery prospects for each category of creditors during insolvency proceedings:

 

- Financial Creditors: Due to their control over the CoC and higher ranking in the distribution of assets, financial creditors tend to have a greater chance of recovering their claims. In most cases, they are better positioned to negotiate favorable terms in the resolution plan.

 

- Operational Creditors: Since operational creditors rank lower in the distribution waterfall and have limited involvement in the decision-making process, their recoveries are often less favorable. In many cases, operational creditors receive only a fraction of their claims or nothing at all if the corporate debtor’s assets are insufficient.

 

 5. Judicial Interpretations and Amendments

 

Several judicial rulings have addressed the concerns raised by operational creditors regarding their lower priority in the insolvency process. The Supreme Court of India, in landmark cases such as Swiss Ribbons Pvt. Ltd. v. Union of India, upheld the differential treatment of financial and operational creditors under the IBC, stating that financial creditors are better equipped to assess the viability of a resolution plan due to their role as institutional lenders.

 

In response to concerns from operational creditors, the IBC was amended to ensure that operational creditors receive at least the liquidation value of their claims under any resolution plan. While this amendment offers some protection to operational creditors, they still remain subordinate to financial creditors in most cases.

 

 6. Challenges and Criticisms

 

The unequal treatment of financial and operational creditors has been a subject of debate since the inception of the IBC. Some of the key challenges and criticisms include:

 

- Operational creditors' limited say in the resolution process: Since they do not have voting rights in the CoC, operational creditors often feel marginalized in the decision-making process. This can lead to dissatisfaction, especially when their recoveries are lower than expected.

 

- Lower recovery rates for operational creditors: The ranking of operational creditors in the waterfall mechanism means that they are often the last to receive payouts, which may significantly reduce their chances of recovering dues, especially in cases of liquidation.

 

 7. Conclusion

 

The priority framework under the IBC, which favors financial creditors over operational creditors, reflects the risk-bearing nature of institutional lending versus the operational credit extended by vendors and suppliers. While financial creditors have more control over the resolution process and enjoy higher priority in asset distribution, operational creditors face challenges in recovering their dues due to their lower ranking and limited involvement.

 

Although recent amendments have sought to improve the situation for operational creditors, significant disparities still exist. The evolving jurisprudence and potential further amendments to the IBC may continue to shape the rights and priorities of creditors in India’s insolvency regime. For now, financial creditors continue to hold the upper hand in CIRP proceedings, while operational creditors seek more equitable treatment within the insolvency framework.







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