What is the meaning of “Charge” and “Inter se Priority”?

Section 3(4) of the Code defines the term “charge” as an interest or lien created on the property or assets of any person or any of its undertakings or both, as the case may be, as security and includes a mortgage.

Several charges can be created in respect of a particular asset. This can be done by way of creating a pari passu charge over the asset where all the charge holders are placed on an equal footing or by way of the creation of a first charge and a subservient charge wherein the first charge holder can satisfy its debts in entirety prior to the subservient charge holders. This principle is embodied in Section 48 of the Transfer of Property Act, 1882. However, under Section 52 of the Code, a secured creditor has two options to realise its debts from secured assets held by it relating to a corporate debtor in liquidation:

Although the Code does not specifically indicate the validity of inter-se-priority of charges at the time of distribution in accordance with the waterfall mechanism provided under Section 53, the issue has been deliberated and decided upon by the Hon’ble NCLTs, Hon’ble NCLAT and Hon’ble Supreme Court of India in recent times, through judicial interpretation.

Pre-IBC Regime: Legal Position under the Companies Act, 1956

Under the earlier Companies Act, 1956, Sections 529 and 529A governed the ranking of creditors’ claims and the distribution of sale proceeds by the Official Liquidator in respect of a corporate debtor in liquidation.

The legal position vis-à-vis inter-se-priority of charges in the pre-IBC regime was discussed at length by the Hon’ble Supreme Court of India in the case of ICICI Bank vs Sidco Leathers Ltd. [Appeal (Civil) 2332 of 2006, decided on April 28, 2006]. In the said case, the Hon’ble Apex Court, while interpreting Sections 529 and 529A of the Companies Act, 1956, observed that even though workmen’s dues and secured creditors’ debts are treated pari passu, this does not negate inter se priorities between secured creditors. The Hon’ble Court stated that since the Companies Act of 1956 is a special statute which contains no provisions regarding inter se priority among secured creditors, the specific provisions set forth in the Transfer of Property Act, 1882 shall prevail. The Hon’ble Court further held that if Parliament, while amending the provisions of the Companies Act, 1956, intended to take away secured creditors’ entitlement to property, it would have stated so expressly. The Hon’ble Court, while deciding the issue, observed the following:

“Section 529A of the Companies Act does not ex facie contain a provision (on the aspect of priority) amongst the secured creditors and, hence, it would not be proper to read therein to things, which the Parliament did not comprehend. The subject of mortgage, apart from having been dealt with under the common law, is governed by the provisions of the Transfer of Property Act. It is also governed by the terms of the contract.”

“Merely because section 529 does not specifically provide for the rights of priorities over the mortgaged assets, that, in our opinion, would not mean that the provisions of section 48 of the Transfer of Property Act in relation to a company, which has undergone liquidation, shall stand obliterated.”

From the aforesaid, it is evident that the Hon’ble Apex Court upheld the validity of the Transfer of Property Act, 1882, which is a general law, over the provisions of the Companies Act, 1956, which is a special law and which did not recognise the concept of inter-se priority of charges.

Post-IBC Regime: Legal Position under the Code and the Report of the Insolvency Law Committee 2018

Report of the Insolvency Law Committee dated March 26, 2018

In the Report of the Insolvency Law Committee (ILC) dated March 26, 2018, it was noted that inter-creditor agreements should be respected. The ILC relied on the judgement of the Hon’ble Supreme Court in the case of ICICI Bank vs. Sidco Leathers Ltd. and came to the conclusion that the principles that emerged from the said case are also applicable to the issue under section 53 of the Code. The ILC in its report stated that Section 53(1)(b) of the Code only kept the workmen and secured creditors, on an equal pedestal and no observations were made on the inter-se priority agreements between the secured creditors and the same would therefore remain valid. The Report further clarified that the provision of Section 53(2) would come into effect only in cases where any contractual arrangement interferes with the pari passu arrangement between the workmen and secured creditors which means that contracts entered into between secured creditors would continue to remain valid.

Judicial Interpretation in recent times

Section 53 of the Code lays down the waterfall mechanism with respect to payment of debts to the creditors of the corporate debtor. The workmen’s dues and the debts of secured creditors rank pari passu under Section 53. However, the Code does not expressly provide for the preservation of inter-se-priorities between secured creditors at the time of distribution of sale proceeds realised by the liquidator by the sale of assets. The issue is to be understood and interpreted in the light of recent judicial decisions. Some of the recent judgments which have dealt with the issue are:

Technology Development Board vs Mr. Anil Goel & Ors. [I.A No. 514 of 2019 in CP(IB) No. 04 of 2017 decided on 27^th February, 2020 by the Hon’ble NCLT, Ahmedabad]

In the instant case, the liquidator had distributed proceeds from the sale of assets to the first charge holders, in priority to the applicant who was a second charge holder without considering the claim of the applicant as a secured creditor that such distribution ought to have been made prorate among all secured creditors. It is pertinent to mention here that all the secured creditors had relinquished their security interests in the common pool of the liquidation estate. The Applicant was one of the secured financial creditors of the Corporate Debtor having a 14.54% voting share in the CoC of the Corporate Debtor.

Aggrieved by such distribution which recognised inter-se-priority among secured creditors, the Applicant moved the Hon’ble NCLT, Ahmedabad Bench.

The issue to be determined:

The primary issue that was to be decided by the Hon’ble NCLT was that once a secured creditor has not realised his security under Section 52 of the Code, and has relinquished the security to the liquidation estate, whether there remains no classification inter se i.e., by joining liquidation, all the secured creditors are ranked equal (pari passu), irrespective of the fact that they have inter-se-priority in security charge.

Observations of the Hon’ble NCLT

The Hon’ble NCLT while deciding the aforesaid issue held:

• It is a settled position that when a charge is created on a property in respect of which there is already a charge, it cannot be said that the creation of the second charge on the property should have been objected to by the first charge holder as an existing and registered charge is deemed to be a public notice.

• Emphasis was placed on Section 53(2) of the Code, which provides that any contractual arrangements between recipients under sub-section(1) with equal ranking, shall be disregarded by the liquidator if it disrupts the order of priority under that sub-section. In other words, if there are security interests of equal ranking, and the parties have entered into a contract in which one is supposed to be paid in priority to the other, such a contract will not be honoured in liquidation.

• The whole stance in liquidation proceedings is to ensure parity and proportionality. However, the idea of proportionality is only as far as claims of similar ranking are concerned.

Decision:

The Hon’ble NCLT, relying on the judgement of the Hon’ble Supreme Court of India passed in ICICI Bank vs. Sidco Leathers Ltd., held that inter se priorities among creditors remain valid and prevail in the distribution of assets in liquidation.

Technology Development Board vs Mr. Anil Goel & Ors. [Company Appeal (AT) (Insolvency) No.731 of 2020 decided on 5^th April, 2021 by the Hon’ble NCLAT, Principal Bench, New Delhi]

The issue to be determined:

Aggrieved by the aforesaid order dated 27^th February 2020 passed by the Hon’ble NCLT, Ahmedabad, an appeal was preferred by the Applicant before the Hon’ble NCLAT wherein the issue raised for consideration was whether there could be no sub-classification among the secured creditors in the distribution mechanism adopted in a Resolution Plan of the Corporate Debtor as according to priority to the first charge holder would leave nothing to satisfy the claim of the Appellant who too is a secured creditor.

Observations of the Hon’ble NCLAT

The Hon’ble NCLT while deciding the issue took note of Sections 52 and 53 of the Code and held:

• Section 52(2) of the Code stipulates that a secured creditor, in the event it chooses to realise its security interest, shall inform the liquidator of such security interest and identify the asset subject to such security interest to be realised. The liquidator’s duty is to verify such security interest and permit the secured creditor to realise only such security interest, the existence of which is proved in the prescribed manner. It is abundantly clear that there is a direct link between the realisation of a security interest and the asset subject to such security interest to be realised.

• Section 53 deals with distribution of assets by providing that the proceeds from the sale of the liquidation assets shall be distributed in the order of priority laid down in the section. The provision engrafted in Section 53 has an overriding effect over all other laws in force.

• The essential difference between the two provisions i.e Sections 52 and 53, lies with regard to the realisation of interest. While Section 52 provides an option to the secured creditor to either relinquish its security interest or realise the same, Section 53 is confined to the mode of distribution of proceeds from the sale of the liquidation assets.

• Whether the secured creditor holds the first charge or the second charge is material only if the secured creditor elects to realise its security interest.

• A secured creditor who once relinquishes its security interest ranks higher in the waterfall mechanism provided under Section 53 as compared to a secured creditor who enforces its security interest but fails to realise its claim in full and ranks lower in Section 53 for the unpaid part of the claim.

• Section 52 incorporating the doctrine of election, read in juxtaposition with Section 53 providing for distribution of assets, treats a secured creditor relinquishing its security interest to the liquidation estate differently from a secured creditor who opts to realise its security interest, so far as any amount remains unpaid following enforcement of security interest to a secured creditor is concerned by relegating it to a position low in priority.

• The non-obstante clause contained in Section 53 makes it clear that the distribution mechanism provided thereunder applies in disregard of any provision to the contrary contained in any Central or State law in force.

• A first charge holder will have priority in realising its security interest provided it elects to realise and not relinquish the same. However, once a secured creditor opts to relinquish its security interest, the distribution would be in accordance with the Section 53(1)(b)(ii) wherein all secured creditors have relinquished their security interest.

Decision

It was held by the Hon’ble NCLAT that the view taken by the Adjudicating Authority on the basis of the judgement passed by the Hon’ble Apex Court in ICICI Bank vs. Sidco Leathers Ltd. and ignoring the mandate of Section 53, which has an overriding effect and was enacted subsequent to the aforesaid judgment, is erroneous and cannot be supported. The Hon’ble NCLAT therefore held that the order of the Adjudicating Authority holding that the inter-se priorities amongst the secured creditors will remain valid and prevail in the distribution of assets in liquidation cannot be sustained and the liquidator was directed to treat the secured creditors relinquishing the security interest as one class ranking equally for distribution of assets under Section 53(1)(b)(ii) of the Code and distribute the proceeds in accordance therewith.

Kotak Mahindra Bank Limited vs Technology Development Board & Ors. [Civil Appeal Diary No(s). 11060/2021]

The aforesaid order passed by the Hon’ble NCLAT has been further challenged before the Hon’ble Supreme Court of India. The appeal is currently pending adjudication, but the Apex Court has stayed the operation of the impugned order dated 5^th April passed by the Hon’ble NCLAT, by order dated 29th June, 2021 . The appeal has been last heard on April 29, 2022, wherein an order has been passed to list the matter after eight weeks. It would be interesting to see whether the Apex Court upholds the order of the Hon’ble NCLAT and disregards the inter se priority among creditors at the time of distribution of sale proceeds under Section 53 of the Code or upholds the validity of the same.

Oriental Bank of Commerce (now Punjab National Bank) vs Anil Anchalia & Anr. [Comp. App. (AT)(Ins) No. 547 of 2022 decided on 26^th May, 2022 by the Hon’ble NCLAT]

• In the instant case, the appellant, who was the first and exclusive charge holder with respect to the assets of the corporate debtor, had relinquished its security interest in the liquidation estate. The liquidator, however, distributed the sale proceeds on a pro rata basis under Section 53 of the Code. Being aggrieved by the said distribution, the Appellant filed an application [IA (IBC)/101(KB)2022] before the Hon’ble NCLT, Kolkata, which was rejected by an order dated March 4, 2022. Aggrieved by the same, the appellant preferred an appeal before the Hon’ble NCLAT.

• One of the contentions raised by the Appellant in the instant case was that the order of the Hon’ble NCLAT in the case of Technology Development Board vs. Mr. Anil Goel & Ors. that secured creditors after having relinquished their security interest could not claim any amount realised from secured assets once they elected for relinquishment of security interest, and that they would be governed by the waterfall mechanism under Section 53 has been stayed by the Hon’ble Supreme Court of India and therefore the Appellant is entitled to receive the entire amount realised from its secured assets.

• The Hon’ble NCLAT rejected the aforesaid contention and observed that in the light of the judgement passed by the Hon’ble Supreme Court in “India Resurgence ARC Private Limited vs. Amit Metaliks Limited and Anr. [2021 SC OnLine SC 409] and “Indian Bank vs. Charu Desai, Erstwhile Resolution Professional & Chairman of Monitoring Committee of GB Global Ltd. & Anr.[CA(AT)No. 644 of 2021] the issue is no more res integra. In the aforesaid two cases, a similar contention was raised by the Appellants that the dissenting financial creditors are entitled to receive payment as per their secured interest, wherein it was decided that “when the extent of value received by the creditors under Section 53 is given which is in the same proportion and percentage as provided to the other Financial Creditors, the challenge is to be repelled”.

• Since the issue is no more res integra and has been decided in the case of India Resurgence ARC Private Limited vs. Amit Metaliks Limited and Anr. by the Hon’ble Apex Court by its judgment dated 13.05.2021, the instant appeal was also dismissed.

Conclusion

Section 52 of the Code gives each secured creditor the option of relinquishing their right to the liquidation estate or realising their security interest on its own, subject to the Code’s requirements.

It can be possibly interpreted that once the secured creditor has relinquished its security interest in the liquidation estate, such a secured creditor exercises its option in favour of losing its priority rights over assets charged to it and joins the liquidation pool wherein the secured creditor is paid from the proceeds of the liquidation estate in accordance with Section 53 of the Code. The Code has provided the option to a secured creditor to enforce its first and exclusive charge by taking recourse to Section 52, whereby in the event it is unable to realise its entire dues, it would be ranked lower under Section 53 for realisation of the balance amount. A secured creditor cannot enjoy the fruits of both the provisions under Sections 52 and 53 of the Code at the same time. Once the secured creditor relinquishes its security interest to the common pool of the liquidation estate, it will be treated at par with all other creditors.

It can also be argued that the NCLAT has ignored the legislative intent clarified in the Insolvency Law Committee Report which after considering the decision of the Hon’ble Supreme Court in ICICI Bank vs Sidco Leathers Ltd. applied its principles to the issue under Section 53 of the Code and recommended that inter-se-priority among creditors was not disturbed by Section 53. Section 53 does not deal with inter-se-rights amongst creditors. It merely deals with the distribution of proceeds arising from the sale of assets to various stakeholders. The non-obstante clause in Section 53 would apply to scenarios where the provisions of the section are contrary to any law. Section 53(1)(b) merely mandates that workmen’s dues and debts owed to a secured creditor, in the event such secured creditor has relinquished security in the manner set out in Section 52, shall rank equally and nothing more. The said section does not deal with mortgages or inter-se-priorities amongst creditors/mortgagees. Mortgages are governed by the provisions of the Transfer of Property Act, 1882 and as such inter-se-priorities between mortgagees have been dealt with in that Act. Therefore, there may not be any justification for excluding the applicability of the provisions of the Transfer of Property Act, 1882 relating to mortgages for payment of dues to creditors under Section 53. The absurd result of not providing inter-se-priority to creditors at the time of distribution of sale proceeds under Section 53 would be that every secured creditor holding the first charge on assets would encourage liquidation and realise its dues by selling assets itself by opting to not relinquish the assets to the liquidation pool under Section 52. The chance of selling the corporate debtor as a going concern would then absolutely be eradicated, which would be contrary to the object and spirit of the Code.

It is expected that the Supreme Court will finally rest the issue while deciding the appeal in the case of Kotak Mahindra Bank Limited vs Technology Development Board & Ors. [Civil Appeal Diary No(s). 11060/2021 which is scheduled to appear for a hearing later this month.