Differentiating between Statutory vis-à-vis Contractual Charge Holders — Relevance During Liquidation — Initial Discussion

In liquidation, several issues have come up and have been promptly addressed by remarkable rulings. There are however issues such as on how the assets of the debtor are to be liquidated, or which person enjoys priority in the distributed process or which option could fetch the best possible returns for the assets liquidated; are issues that are in constant flux.

One such issue is on how to deal with the security interests of the secured creditors during the liquidation process. Numerous judgments dealing with the same have been rendered, but far-reaching effects that the obiter in BHEL v. Anil Goel¹ could carry, require some discussion. The same would form the central focus of the article, wherein the NCLAT agreed with the findings of adjudicating authority and held that if the benefit of lien or charge is to be taken, then the same should be a conscious creation between the corporate debtor and the creditor. In other words, statutorily created lien was held to be not a valid charge.

The present post deals with this subset of creditors, namely, secured creditors and how such a creditor could stake the claim of being a secured creditor during liquidation process and prove its security interest and avail the priority of claim over other creditors.

We will proceed with the analysis of this issue in the next column discussion.

A. Understanding the relevant provisions under the Insolvency and Bankruptcy Code

The IB Code under Section 53² crystallizes the distribution mechanism ranking the priority to be accorded to each claimant depending on their status. The waterfall mechanism seeks to do justice in relative terms. Therefore, a creditor enjoys a better standing to recover their dues than, say, an equity shareholder. A perusal of the same would show that while there is a differentiation of ranking of workmen dues, insolvency process costs, debts due towards the Government; there is an inter se varying of the ranking of creditors based on the security interest.

While (i) the debts owed to a secured creditor who relinquishes its security enjoys a higher rank than (ii) the creditor who is unsecured; but the least amongst is the rank accorded to (iii) a secured creditor who still has a debt to recover even after enforcing the security interest.

The IB Code defines a “secured creditor” as is a creditor under whose favour a security interest is created,³ whereas a “security interest”⁴ means a right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, “charge”, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person.

This brings us to the provision of Section 52 of the IB Code wherein a security interest of a creditor is relevant and such a creditor can choose if such security is to be relinquished or enforced. The same stipulates in the following terms:

52. Secured creditor in liquidation proceedings. —(1) A secured creditor in the liquidation proceedings may—

(a) relinquish its security interest to the liquidation estate and receive proceeds from the sale of assets by the liquidator in the manner specified in Section 53; or

(b) realise its security interest in the manner specified in this section.

(2) Where the secured creditor realises security interest under clause (b) of sub-section (1), he shall inform the liquidator of such security interest and identify the asset subject to such security interest to be realised.

(3) Before any security interest is realised by the secured creditor under this section, the liquidator shall verify such security interest and permit the secured creditor to realise only such security interest, the existence of which may be proved either—

(a) by the records of such security interest maintained by an information utility; or

(b) by such other means as may be specified by the Board.

(4) A secured creditor may enforce, realise, settle, compromise or deal with the secured assets in accordance with such law as applicable to the security interest being realised and to the secured creditor and apply the proceeds to recover the debts due to it.

(5)-(8) …

(9) Where the proceeds of the realisation of the secured assets are not adequate to repay debts owed to the secured creditor, the unpaid debts of such secured creditor shall be paid by the liquidator in the manner specified in clause (e) of sub-section (1) of Section 53.

Choice of secured creditors — Realise or relinquish

Section 52 allows the secured creditor two options: (a) to either give up its security interest and recover the amount from the sale of assets by the liquidator under Section 53; or (b) the secured creditor may try and seek to recover its dues by making its own efforts using that secured asset.

A “secured creditor” may enforce, realise, settle, compromise or deal with the secured assets in accordance with such law as applicable to the “security interest” being realised and apply the proceeds to recover the debts due to it.⁵ Prior to that, a “secured creditor” in order to realise its “security interest” under Section 52(1)(b) is mandated to inform the liquidator of such “security interest” and identify the asset subject to such “security interest” to be realised.⁶

Furthermore, before any such “security interest” is realised by a “secured creditor” under Section 52, on receipt of an application, the liquidator is required to verify such “security interest” and only after proof of the existence of such “security interest,” any permission may be granted to the “secured creditor” to realise the interest from such assets.⁷

Section 52(2) of the IB Code provides that in the event of the secured creditor choosing to realise the security interest, it shall inform the liquidator of such security interest and identify the asset subject to such security interest be realised. The liquidator must 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.⁸

The provision of Section 52 is also crucial because even before an adjudicating authority passes an order of liquidation and assigns the assets of the company to the liquidator for distribution in terms of Section 53 of the IB Code, the security interest of the secured creditors, if any, are to be decided in terms of Section 52.⁹

After a “security interest” is enforced under Section 52(4), if an amount by way of proceeds is in excess of the debts due to the “secured creditor,” the “secured creditor” is required to deposit the same in the account of the liquidator.¹⁰ Therefore, after enforcement of a right under Section 52(4) by one of the “secured creditor,” no other secured creditor can enforce its right subsequently for the realisation of the amount for the same secured assets as the excess amount by way of proceeds pursuant to the first enforcement is to be deposited into the account of the liquidator.¹¹

The procedure of Sections 52(2), (3), (4) is mandatory before any assistance of the adjudicating authority is sought in terms of Section 52(5) read with 52(6) in seeking recovery of the secured assets. Otherwise, such an application under Section 52(6) is held to be not maintainable.¹²

B. Current position of law on secured creditor under the IB Code

Coming to the issue at hand, the term secured creditor becomes the focal point of discussion. The adjudicating authority in BHEL v. Anil Goel¹³ was confronted with the issue if the claimant before it was a secured creditor based on the lien and charge over the goods sold and lying in its possession and used in the erection of plant and machinery. Correspondingly, the issue also became if the provisions of the IB Code prevail over the provisions of Sections 45 to 48 of the Sale of Goods Act, 1930 and Section 55(4)(b) of the Transfer of Property Act, 1882. The claimant argued that since there is no conflict between any of the provisions of the IB Code with the aforementioned provisions of the Sale of Goods Act, 1930 and Transfer of Property Act, 1882; hence there is no cause for the invocation of the non obstante clause under Section 238 of the IB Code.

The adjudicating authority, in its analysis, went on lengths in explaining the provisions of “security interest” under the IB Code, 2016. The Tribunal referred to the definition of a “secured creditor” that defined it as a creditor in favour of whom security interest is created,¹⁴ and laid emphasis on the word “created”. Then it noted that the definition of security interest¹⁵ which covers the situation of creation as well as provision of a right, title or interest or a claim to a property in favour of a secured creditor to secure payment or performance of an obligation at the first instance. The adjudicating authority on comparing, observed that the scope of the mode and manner of creation of security interest has been widened in the definition of “security interest”, since as per the definition of the word “secured creditor” under Section 3(30) only the word “created” has been used, whereas in the definition of “security interest” not only the word “created” but the word “provided” has also been used. The NCLT opined that the crucial part, however, is the inclusion of creation or provision of interest through agreement or arrangement between the parties.¹⁶

In a composite interpretation of the terms “security interest”, “secured creditor”, “transfer”, “transaction”, and “property”, the NCLT held that the word “created” is of paramount importance as the IB Code provides a specific mechanism regarding what is the security interest and how such security interest is created and/or provided for by the parties.

The NCLT resultantly concluded that only those interests could be tantamount to a security interest, wherein the action or process of creation is done consciously or explicitly. As a corollary, the NCLT held that a security interest that arises due to the operation of law or due to any event other than a deliberate act of creation or provision by the parties would not be covered under the definition of “secured creditor” and “security interest” in terms of the IB Code.

In this case, the NCLT noted that there is no formal agreement between the parties and the terms of the notice inviting tender and the letter of award do not contain any clause wherein any security interest gets “created”. Therefore, the claim of the claimant for being a secured creditor was rejected. The NCLT also noted that the initial arrangement between the claimant and the corporate debtor had provided that the original payment would be secured by a letter of credit, however the same was waived off without any alternative arrangement. The same prompted the NCLT to peruse the terms of contract and observe that there is no clause in the same that could show any creation of a security interest.

In appeal, when the matter went to the NCLAT, the Appellate Tribunal in BHEL v. Anil Goel observed the following:

[a]lthough we do not hold that that provisions of Sale of Goods Act and Transfer of Property Act are inconsistent or contrary as such to IBC, we hold that considering the provisions (as discussed in detail by the adjudicating authority) as found in Section 3(30) which defines “secured creditor” and Sections 3(31) and (33) read with Section 238 of IBC, if benefit is to be taken under the provisions of IBC, it can be done if there was a contractual arrangement/transaction creating security interest in favour of the creditor. It has to be a security interest which is “created” as such. IBC is complete Code in itself. The appellant is claiming to be secured creditor on statutory basis. Admittedly, the appellant is not relying on any contractual provision, or transaction creating security interest to claim benefits of lien/charge.¹⁷

These observations formed the major crux of the issue. Whether a charge has to be necessarily shown through a contractual arrangement for the same to be considered a security interest in terms of the IB Code and cloth such creditor with the status of a secured creditor for the purposes of liquidation. The same carries crucial implications for several creditors who may stake claim during liquidation, thereby mandating deeper discussion and analysis.