Symbolic Stake of Operational Creditors in the IBC
Falak Doshi
Final-year LL.B Government Law College, Mumbai
Before the Insolvency and Bankruptcy Code, 2016 (“the Code”) came into effect, there were multiple overlapping laws and adjudicating forums that dealt with the financial failure of artificial persons (companies) and real persons (individuals). Resolving these failures often took years, leaving creditors in a limbo and putting undue pressure on the credit system. Consider the example of a large manufacturing company (company A) that has defaulted on the payments of a smaller supplier (company B). Hypothetically, company B derives a majority of its business by supplying Metal sheets to company A. If Company A defaults on the payment for the said metal sheets, cash flow to Company B shall be disrupted which in turn may affect the day-to-day operations of Company B. While Company B struggles to survive, company A may continue with their regular operations, with little urgency to clear their dues. This creates a cycle of uncertainty and financial strain for creditors, particularly the operational creditors. The Code was thus introduced with an objective of preventing such a situation thereby providing a unified, time-bound mechanism to handle insolvency and debt recovery while focusing on reviving the businesses.
At its core, the IBC’s Corporate Insolvency Resolution Process (“CIRP”) aims to give financially distressed companies a second chance. If a corporate debtor defaults on payments of Rs. 1,00,00,000/-[1] or more, the creditors—or the debtor itself—can approach the Adjudicating Authority to initiate the CIRP. The priority under the Code is to revive the business of the corporate debtor, but if revival is not possible, liquidation becomes the next step.
Kinds of creditors
The Code divides creditors into two broad categories viz. financial creditors, such as banks and institutional lenders, and operational creditors, which include suppliers, vendors, and employees.
A financial creditor can, independently or jointly with other financial creditors, initiate the Insolvency Resolution Process by filing an application before the Adjudicating Authority when a default in the payment of debt occurs. Operational creditors, however, face additional steps. When a default occurs, the operational creditor is first required to issue a demand notice for the payment of the outstanding debt to the corporate debtor. Upon receipt of this demand, the debtor has 10 days to dispute the debt or make the payment thereof. If no payment or response is received, the operational creditor may file an application to initiate CIRP. However, the presence of a dispute can delay or bar such an application.
Evaluation of section 7 and section 9 under the Code
The Code provides distinct mechanisms for financial and operational creditors to initiate the CIRP, as outlined in section 7 and section 9 respectively.
Under section 7, a financial creditor has the right to file an application for the initiation of CIRP against a corporate debtor. This application can be filed either –
- Independently by a single financial creditor, or
- Jointly by multiple financial creditors acting together.
This provision acknowledges the collective nature of financial transactions and the interconnected claims of multiple financial creditors in cases of default. The flexibility to file individually or jointly allows the process to accommodate both singular claims as well as collective creditor actions.
Additionally, section 7 does not impose any requirement for prior communication with the debtor before initiating CIRP. This reflects the legislative intent to streamline the resolution process for financial creditors who often operate on the basis of documented loan agreements, reducing the need for additional procedural safeguards.
On the other hand, section 9 governs the initiation of CIRP by operational creditors. Moreover, before filing an application under this section, an operational creditor must adhere to the prerequisites established in section 8 – namely, sending a demand notice or invoice to the corporate debtor. Only if the notice period (10 days) lapses and the creditor does not receive payment or any notice of dispute from the corporate debtor, operational creditor can file an application for the initiation of CIRP.
Evidently, this requirement places an additional procedural burden on operational creditors, while trying to ensure that any pre-existing genuine disputes between the parties are addressed before CIRP is invoked.
Key observations and comparisons
One noticeable difference between the two types of creditors is that the financial creditors have an option to file CIRP applications both independently and jointly with other financial creditors, whereas the operational creditors are restricted to filing the applications solely in an independent capacity. The Code does not permit operational creditors to file a joint application by aggregating their claims, even if multiple operational creditors have claims against the same corporate debtor.
Moreover, the operational creditors must issue a demand notice before initiating a CIRP. While this requirement acts as a safeguard against frivolous claims by operational creditors, the financial creditors are exempt from such notice requirements primarily due to the well-documented and formalized nature of transactions.
Financial Creditors v. Operational Creditors: The uneven playing field
Despite the Code’s aims to provide a balanced resolution process, significant disparities between financial and operational creditors remain. As evident in the Code, financial creditors enjoy significant power in the resolution process[2]. They form a significant part of the Committee of Creditors (“CoC”), which has been empowered with key decision-making such as the approval of resolution plans. Operational creditors, however, have no seat at this table. Their role in the entire process is very limited, leaving them with little influence over outcomes that directly affect their dues. In fact, if a corporate debtor owes both a financial debt and an operational debt to the same creditor, the creditor’s inclusion in the CoC is limited to the proportion of only the financial debt[3].
Additionally, the Resolution Professional (“RP”) is only bound to give a notice to the operational creditor or its representatives if the amount of their total dues is more than 10% of the total debt due by corporate debtor[4]. Even if the operational creditor or their representatives do attend the CoC meetings, they have absolutely no voting rights and the absence of the operational creditor or their representative do not invalidate the meeting or the decisions taken therein[5]. This renders the participation of the operational creditors largely symbolic.
The disparity is most glaring when it comes to the distribution of funds. Under the Code’s waterfall mechanism[6], operational creditors often receive only a fraction of their claims when compared to financial creditors. In Damodar Valley Corporation v. Dimension Steel and Alloys Pvt. Ltd.[7], the financial creditors were able to realise 7.74% of the total admitted claims as against the operational creditors who were able to realise a meager 0.19% of their admitted claims.[8] This raises a valid concern about whether the system is designed to prioritise large institutions at the expense of smaller but essential stakeholders, like businesses that supply goods or services to the corporate debtor.
The Banking Law Reforms Committee’s report[9] justifies the disparity in rights between financial and operational creditors by emphasizing the legislators’ intent to safeguard the interests of all stakeholders. The Code prioritizes the revival and restructuring of a financially distressed corporate debtor over liquidation, ensuring that liquidation is only considered as a last resort when all revival attempts fail. This approach reflects a deliberate policy choice aimed at preserving economic value and jobs. It is further understood from the report that the financial creditors are typically long-term stakeholders in the corporate debtor’s business and are therefore more invested in its survival and recovery. In contrast, operational creditors, such as suppliers or service providers, are often only concerned with recovering their outstanding dues. Their focus is more transactional in nature, and they may not have the incentive to prioritize the debtor’s revival. This distinction underpins the Code’s decision to grant the financial creditors broader rights, while the operational creditors face additional procedural steps and limitations.
The minimum threshold mandate
A significant challenge that operational creditors face is to meet the minimum threshold requirement for filing an application for initiation of CIRP. The Code mandates that the creditors’ claim must be at least Rs. 1,00,00,000/- as a pecuniary precondition to file such an application[10]. The operational creditors, given the nature of their transactions – often small-scale contracts or fragmented dues – may struggle to reach this threshold individually. Unlike financial creditors, who typically deal in larger sums and formalized loans, operational creditors often have claims arising from smaller, short-term supply or service contracts.
The inability to aggregate claims with other operational creditors under section 9 further exacerbates the issue. The restriction on filing joint applications means that operational creditors with smaller individual claims are effectively excluded from initiating CIRP, even when their combined claims may help in surpassing the threshold. This limitation raises concerns about equitable access to insolvency proceedings for the operational creditors and the same could be perceived as disproportionately favouring the financial creditors.
Dynamic of the Operational Creditors
Once the CIRP is admitted by the Adjudicating Authority, a moratorium is declared[11]. It applies to – the institution and/or continuation of suits or proceedings against the corporate debtor, enforcement of security interests, recovery of property or assets in possession of the corporate debtor, and termination of essential contracts due to non-payment of dues.
The financial creditors essentially control the entire resolution process through the CoC and the operational creditors have no mechanism to influence the terms of the resolution plan. While the decisions of financial creditors shape the resolution plan, the interests of the operational creditors are represented only indirectly, typically through the RP or legal provisions. The operational creditors all over are given lower priority in the Code. They only receive a fraction of their outstanding dues, and often face severely high haircuts on their claims as compared to the financial creditors. Moreover, the approved plans are binding on all stakeholders, irrespective of their participation or deliberation in the process. The only power with the operational creditors during the entire process is stoppage of delivery of goods or services to the corporate debtor until their dues are cleared. However, this termination is subject to the approval of the RP, which practically leaves the operational creditors powerless in the entirety of the process and at every stage, starting right from the application stage up until resolution or liquidation.
As apparent, the Code tilts in favour of the financial creditors, given their central role in driving the CIRP and their higher priority in the waterfall mechanism. The operational creditors, despite being essential to a company’s operations, are sidelined and marginalized.
The Constitutional validity of the differential treatment of the creditors under the Code
In Swiss Ribbons Pvt. Ltd. & Ors. v. Union of India[12], the constitutional validity of the preferential treatment given to the financial creditors over operational creditors was questioned. However, the constitutionality was upheld and the distinction was deemed to be fair and reasonable.
While the constitutional validity of the classification has been affirmed, the practical reality for operational creditors remains challenging. They face significant financial strain and procedural obstacles that make it harder for them to recover their dues in full, highlighting the need for further reforms to ensure that the interests of operational creditors are more adequately protected during the CIRP.
The Appellate Authority (National Company Law Appellate Tribunal) in Binani Industries Ltd. v. Bank of Baroda & Anr.[13] correctly noted that the workforce and suppliers of operational creditors play a crucial role in a company’s long-term financial health and operational stability. Operational creditors are essential for the continued survival of a corporation.
Policy recommendations
- Lowering the threshold for the operational creditors
More often than not, the operational creditors are MSMEs or sole-proprietorships. These entities often struggle to meet the current minimum threshold for initiating a CIRP application independently. Lowering this threshold specifically for the operational creditors would give them a fairer chance to participate in the insolvency process and secure the payment for their dues.
Reducing the minimum threshold for the operational creditors to a more accessible amount such as Rs. 25,00,000/- or Rs. 50,00,000/-, might ensure that smaller businesses are not excluded from initiating the CIRP. A lower threshold would allow the operational creditors to seek redressal sooner, ensuring that they aren’t left waiting indefinitely for payments that could put their business at risk. This could be crucial in maintaining liquidity for small businesses.
- Allowing merger of claims from multiple operational creditors against the same corporate debtor
Operational creditors, especially those with smaller individual claims, may face difficulties in reaching the minimum threshold to initiate a CIRP. Thus, allowing multiple operational creditors to merge their claims could help them collectively meet the threshold and pursue insolvency proceedings as a group.
Operational creditor, under the Code, is defined to mean “a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred”[14]. This definition allows for the possibility of assigning or transferring operational debts. If the scope of assignment of debt is expanded to allow the transfer of operational debts to a larger operational creditor or to financial creditors—either fully or partially—this could potentially lead to more favourable outcomes for smaller operational creditors. By consolidating their claims, operational creditors could reduce the extent of their haircuts in the resolution process, as larger, more influential creditors would advocate on their behalf and increase their bargaining power during the formulation of the resolution plan.
- Introducing representation mechanism for operational creditors
Operational creditors are often sidelined in the decision-making process during the CIRP. To address this, a formal mechanism for their representation in the CoC could be introduced, ensuring that their interests are directly considered when the resolution plan is being formulated.
A separate class or sub-committee within the CoC for the operational creditors may be established which may be chaired by the representative of the operational creditor to whom the highest debt is due and payable. Alternatively, a mechanism may be provided where operational creditors can collectively elect a representative by way of single-transferable vote under the supervision of the RP.
The current framework aims to prioritize the revival of distressed corporate debtors; however, it is important to recognize the challenges faced by operational creditors. While it may be argued that favouring financial creditors is justified given their significant financial exposure and long-term interest in the debtor’s survival, that does not negate the essential role that operational creditors, which may be particularly smaller businesses, play in the functioning of the debtor’s operations. Without fair treatment and an equitable voice in the insolvency process, said operational creditors may face severe financial duress, undermining the broader objective of the Code to preserve economic value and ensure equitable treatment for all creditors.
Conclusion
The Code has made significant strides in creating a structured insolvency resolution process; however, the unequal treatment of financial and operational creditors remains a critical issue. Financial creditors, with their larger claims and formalized nature of dealings, dominate the resolution process, while operational creditors—often smaller businesses—face additional procedural barriers that limit their ability to participate. This disparity is evident in their limited role in the Committee of Creditors and the preferential treatment that they receive in the distribution of funds.
Operational creditors are the lifeblood of a company’s operations. Without the supply of raw materials, services, or manpower, the debtor cannot sustain their operations in any form. When these creditors are unpaid, it disrupts the entire supply chain, leading to operational bottlenecks, financial strain, and sometimes the complete shutdown of business operations of the operational creditors. Therefore, by addressing the procedural hurdles for operational creditors, the Code could better protect the interests of all stakeholders. Reforms such as lowering the threshold for operational creditors to initiate proceedings, allowing the consolidation of claims from multiple creditors, and introducing a mechanism for better representation of operational creditors in decision-making bodies would not only promote fairness but also ensure that smaller creditors, who are often key to a business’s day-to-day operations, are not marginalized in the insolvency process. While the current framework has its rationale, further reforms are necessary to create a more balanced and inclusive system for all creditors.
References:
[1] The Insolvency and Bankruptcy Code, 2016, s.4
[2] The Insolvency and Bankruptcy Code, 2016, s.21
[3] Supra
[4] The Insolvency and Bankruptcy Code, 2016, s.24
[5] Supra
[6] The Insolvency and Bankruptcy Code, 2016, s.53
[7] Damodar Valley Corporation Vs. Dimension Steel and Alloys Pvt. Ltd. [2022] ibclaw.in 387 NCLAT
[8] Fair and Equitable Distribution Clauses in Resolution Plans – Is Section 30(2)(B) of Insolvency and Bankruptcy Code, 2016 Being Illusory for Operational Creditors? | SCC Times by Bhumika Indulia, (04 Jul. 2022)
[9] The report of the Bankruptcy Law Reforms Committee, Volume I: Rationale and Design, (04 Nov. 2015).
[10] Supra note 1
[11] The Insolvency and Bankruptcy Code, 2016, s.14
[12] Swiss Ribbons Pvt. Ltd. & Ors. v. Union of India [2019] ibclaw.in 03 SC
[13] Binani Industries Ltd. v. Bank of Baroda & Anr. [2018] ibclaw.in 06 NCLAT
