The Insolvency and Bankruptcy Code, 2016 (IBC), has revolutionized the approach to resolving insolvency in India. Among the fundamental aspects of the IBC are the distinctions between financial and operational creditors, classifications that determine the hierarchy and treatment of claims in insolvency proceedings. Understanding the distinctions between these types of creditors is crucial for interpreting the application of the IBC in corporate insolvency cases. This article explores the definitions, rights, procedural roles, and practical implications of financial and operational creditors within the framework of the IBC.
Definitions
Financial Creditors: A financial creditor is defined under Section 5(7) of the IBC as a person or institution to whom a financial debt is owed. Financial debt refers to debt along with interest, if any, which has been disbursed against the consideration for the time value of money, as defined under Section 5(8) of the IBC. This often includes loans, debentures, bonds, or other credit facilities typically provided by banks, financial institutions, and lenders.
Examples: Banks, bondholders, financial institutions, or any entity providing loans.
Operational Creditors: An operational creditor, defined under Section 5(20) of the IBC, is a person or entity owed an operational debt. Operational debt pertains to claims arising from providing goods and services, employment, or any other debt incidental to the company’s operations.
Examples: Suppliers, vendors, employees, and government authorities for unpaid taxes.
The categorization of creditors into these two categories impacts their legal rights and priorities during insolvency proceedings, as detailed below.
Role in Initiating Insolvency Proceedings
Financial Creditors
Financial creditors have the right to initiate corporate insolvency resolution proceedings (CIRP) under Section 7 of the IBC if there is a default in the repayment of the financial debt. The application must include evidence of default and is subject to verification by the adjudicating authority (National Company Law Tribunal or NCLT).
- Threshold for Filing: Financial creditors can file for insolvency upon a default of INR 1 crore or more. Joint applications by multiple financial creditors are permitted to reach this threshold.
Operational Creditors
Operational creditors can initiate insolvency proceedings under Section 9 of the IBC, but the process involves additional steps:
- They must first issue a demand notice to the corporate debtor, allowing the debtor a ten-day window to either repay or dispute the claim.
- If no payment or satisfactory dispute arises, the operational creditor may then apply to the NCLT to initiate CIRP.
This procedural difference imposes an additional burden on operational creditors, requiring them to establish that their claim is undisputed before they can move forward with an insolvency application.
Participation and Voting Rights in the Committee of Creditors (CoC)
Financial Creditors
Financial creditors form the Committee of Creditors (CoC), which plays a pivotal role in the insolvency resolution process. They hold voting rights proportionate to their share of the financial debt owed by the corporate debtor. The CoC is responsible for approving or rejecting the resolution plan, appointing or replacing the resolution professional, and making critical decisions regarding the debtor’s restructuring or liquidation.
- Voting Power: Financial creditors hold exclusive voting rights in the CoC, with major decisions requiring a minimum vote of 66% for approval.
Operational Creditors
Operational creditors, however, do not have voting rights in the CoC. They can attend CoC meetings if their claim is significant, but they cannot participate in decision-making.
- Representation Rights: Operational creditors with claims exceeding 10% of the total debt may attend CoC meetings but remain non-voting members.
This lack of voting rights highlights a disparity between financial and operational creditors, as it limits operational creditors’ influence over the outcome of the resolution process.
Priority of Claims in Distribution of Resolution Proceeds
The priority of claims in the distribution of proceeds from either the resolution plan or liquidation is a significant area of differentiation between financial and operational creditors.
Financial Creditors
In insolvency resolution, financial creditors have priority over operational creditors in the distribution of proceeds. Under the IBC, secured financial creditors are placed at a higher rank than unsecured creditors, including most operational creditors.
Operational Creditors
Operational creditors receive lower priority in the hierarchy of repayment. However, the IBC mandates that operational creditors should receive at least the amount they would have received in a liquidation scenario under the resolution plan, which ensures that operational creditors receive some protection, albeit limited, during insolvency proceedings.
- Impact of Supreme Court Rulings: The Supreme Court’s decision in the Essar Steel case (2019) upheld the IBC’s distribution hierarchy, emphasizing that operational creditors cannot demand equality in repayment with financial creditors in the resolution plan but must receive at least liquidation value.
Rights in Case of Liquidation
In the event of liquidation, financial creditors and operational creditors are ranked differently in the waterfall mechanism outlined in Section 53 of the IBC, which determines the order of repayment to creditors.
Financial Creditors
Secured financial creditors are given top priority in the liquidation process. They can choose to enforce their security interest outside the liquidation proceedings or relinquish it to participate in the distribution process under Section 53.
- Unsecured Financial Creditors: Although they have a lower ranking than secured creditors, unsecured financial creditors still receive priority over operational creditors.
Operational Creditors
Operational creditors fall below both secured and unsecured financial creditors in the liquidation hierarchy, placing them at a disadvantage in terms of recovery. They are typically paid only after secured and unsecured financial creditors have received their dues, and often recover minimal or no amounts in liquidation.
This waterfall structure illustrates the statutory prioritization favoring financial creditors, which has led to debates about fair treatment for operational creditors.
Implications for Resolution Plan Approval
Financial Creditors
The approval of a resolution plan requires a minimum vote of 66% from the CoC, composed solely of financial creditors. This grants financial creditors exclusive control over the approval or rejection of the resolution plan. They can thus negotiate better terms within the resolution plan or choose to proceed with liquidation if the plan is unsatisfactory.
Operational Creditors
Operational creditors lack the ability to influence the approval of the resolution plan directly. They rely on the CoC’s decision and have limited recourse unless they believe the plan violates IBC provisions regarding their entitlement to liquidation value.
- Right to Approach NCLT: Operational creditors may approach the NCLT if they feel their rights under the IBC are unfairly compromised, particularly regarding liquidation value entitlement.
Judicial Interpretations and Landmark Cases
Several judicial interpretations have clarified the rights of financial and operational creditors, with notable rulings as follows:
- Innoventive Industries Ltd. v. ICICI Bank (2017): The Supreme Court upheld the right of financial creditors to initiate CIRP based on proof of default, distinguishing financial creditors’ rights from operational creditors.
- Swiss Ribbons Pvt. Ltd. v. Union of India (2019): This case reinforced the rationale behind distinguishing financial creditors from operational creditors, emphasizing that financial creditors are better positioned to assess and manage credit risks.
- Essar Steel India Ltd. v. Satish Kumar Gupta (2019): The Supreme Court held that operational creditors are entitled to receive at least liquidation value and highlighted that CoC members, comprising only financial creditors, must balance the interests of all stakeholders, including operational creditors.
Conclusion
The classification of creditors into financial and operational categories under the IBC significantly impacts their roles, rights, and priorities in insolvency proceedings. Financial creditors enjoy substantial decision-making powers and priority in repayment, given their critical role in financing and evaluating corporate creditworthiness. In contrast, operational creditors, despite being essential to the company’s daily functioning, have limited control and lower priority in the IBC’s framework.
While these distinctions aim to streamline insolvency resolution and protect broader economic interests, they have sparked debates on fairness and the need to better address the interests of operational creditors. Ongoing judicial interpretations and potential legislative reforms may continue to shape and refine these distinctions, balancing the interests of all stakeholders within India’s evolving insolvency landscape.