Securing Unsecured Creditors' Right!
Statutory dues, secured creditors, then unsecured creditors and finally if anything’s left – shareholders! That’s the traditional credit hierarchy – and it gives unsecured creditors little or no say in a recovery process. Not any more. Over the last one year, unsecured creditors, especially bondholders have forced companies to sit up and listen. 3 cases come to mind immediately – Wockhardt, Zenith and the Tayal Group. This month a trade creditor, also a type of unsecured creditor, challenged this credit hierarchy and won. Payaswini Upadhyay finds out if will set a precedent for all unsecured creditors!
In October last year, Wockhardt’s FCCB holders filed a winding up petition and blocked an asset sale; obtaining a court order for repayment of dues worth Rs 417 crores
In February this year, Zenith Infotech’s bondholders filed a liquidation petition in the Bombay High Court after failing to recover dues worth Rs 495 crores. The court restrained the company from selling any of its assets.
And just this month, a winding up plea in the Bombay High Court forced Tayal group firm KSL to settle with its bondholders out of court.
But it’s not just bondholders breaking new ground- this month for the first time a trade creditor asserted its rights and won!
Continental Carbon India, a supplier to the now sick Modi Rubber approached the Delhi High Court asking for the right to decline participation in the scheme to rehabilitate Modi Rubber
Founding Partner, Juris Corp
“If you go back in time, we had a judgment in relation to Wockhardt which also dealt with the rights of unsecured creditors- there is a difference between the Wockhardt judgment and Modi Continental judgment for a simple reason that Wockhardt was in the context of winding up and we were dealing with a company not declared as a Sick Industrial company i.e. not before the BIFR. The Delhi HC judgment is in the context of a sick industrial company and the powers of the BIFR to have a scheme of revival put in place. So while the Wockhardt judgment could have had persuasive value, now we have definitive judgment even in the context of the BIFR.”
The Delhi High Court granted Continetal Carbon its wish! The order says an unsecured creditor has an option to decline the scaled down value of its dues and wait to recover them till the rehabilitation scheme has worked itself out.
“It would certainly be a deviation from the practice so far because historically, schemes have involved write down of the amounts due to unsecured creditors and that’s how they’ve operated. Now for the first time it is held that a creditor can choose not to take the write off of the amount due to him unless it specifically consents to and should it choose to do so, it can seek the enforcement of the full amount at the end of the rehabilitation process.”
“Fundamentally, to exercise this right is not necessarily an attractive position to be in because it comes with an inherent negative as well. So either you accept the scheme which is what has been happening in practice most of the time and then your choice is to say that no, I don’t want to accept the scheme but then you’re taking the risk of company’s performance in the scheme because you have a up to 7 year wait period before you can enforce your claim and a lot can happen in those 7 years. In those 7 years, the company might revive itself which is what the unsecured creditor has to bet on or the company might go under and the scheme might be declared a failure in which case the unsecured creditor’s portion has become much worse than it was.”
Continental Carbon was willing to take that bet and in the process led to a new interpretation of Section 18 of the Sick Industrial Companies Act or SICA. SICA deals with the preparation and sanction of company revival schemes.
SICA requires a mandatory consent of person’s providing financial assistance to the sick company. But it makes no mention of unsecured creditors.
To date, that has been interpreted to mean unsecured creditors have no say. But the Delhi High Court took a different view – saying that just because the law is silent on unsecured creditors it doesn’t mean their rights can be ignored.
Besides that, the High Court also pointed to Section 22 of SICA that deals with the suspension of legal proceedings and contracts to rule that provisions of SICA cannot override a contract between two parties if the creditor is willing to wait for the company to rehabilitate i.e. enforcement of remedy can be suspended but not done away with.
Founding Partner, Juris Corp
“What the Delhi HC, and we think rightly so, has recognized that if the law is silent, it cannot be implied to mean that you can take away someone's property. And they've also taken into account that this very law does provide for a mechanism in which the secured creditors can be made to take a haircut. But what weighed in the mind of the court is that the Parliament could have very well provided something similar for unsecured creditors and while not explicitly referred to in the judgment, there is another provision of the same law which allows the BIFR to even wipe shareholders- even reduce their holding from 100% to 2%- and allow the incoming person who is reviving the company to become the majority shareholder. The law- where it explicitly wanted to overrule the rights of a class of stakeholders- it has said so explicitly and so the court was unwilling to infer that even if it doesn't say so in any manner for unsecured creditors, we can still deal with them as the scheme may provide.”
“I probably wouldn’t agree with this interpretation because I think it puts an extremely narrow scope in which the BIFR were to operate if you interpret it to mean that it cannot have a write down of debt in rehabilitating the company. Also, if I was to extend that logic of the Delhi HC, effectively in order to impose such a write down, it is requiring the consent of an unsecured creditor which is not that the Statute contemplates and where it does contemplate such a consent from certain classes of creditors, it has specifically provided for it- for eg, in Section 19 which are the banks and public financial institutions etc. So the contra way to look at it is that it imposes the requirement of a consent when none is specifically contemplated in the SICA.”
“They’ve distinguished this from a situation under 391-394 of the Companies Act which is how companies are amalgamated, demerged etc. Now, in the context of the Companies Act, there is a clear mechanism for all concerned stakeholders to provide their views and in that case, when certain majorities have approved of items, then those items are binding on the disapproving minority as well but there is a clear scheme that makes this very clear. The SICA doesn’t have that and under the circumstances that SICA doesn’t have it, that’s the situation where the court has said that unsecured creditors can’t be forced to part with property or make sacrifices without consent.”
At the Appellate Authority level, Modi Rubber, the sick company in question, argued that granting a creditor the right to stay out of the scheme can put the company’s revival in jeopardy. The Appellate Authority agreed; the Delhi High Court did not.
“Going forward, if we were to operate in the regime that Delhi HC has set out, it certainly puts a far greater onus on the Board or the operating agency to ensure that it tries and gets the consent of as many stakeholders as possible which is not something that it was doing to that length prior to this order. And the other risk is that you can have a situation where the rehabilitation of the company itself is made that much more difficult – today there is one creditor in this case, tomorrow it could be a class of 5 or 10 creditors or a much more significant proportion of creditors who choose to stay out of the scheme; potentially jeopardizing the success of the scheme itself.”
“I think it’s an important order; not just in terms of recognizing rights of unsecured creditors but recognizing rights of parties in the context of statute overall. Fundamentally what the order says is that if an unsecured creditor is required to make any sacrifices or provide financial assistance to a borrower, then in order for them to be bound by the terms of the scheme that require them to make such sacrifices or provide financial assistance, there must be a process followed for taking their consent and fundamentally, an unsecured creditor cannot be, under statute, be forced to part with property or give up something unless the statute has an express mechanism for allowing that to happen.”
Commercially not many unsecured creditors may jump onto the ‘let’s wait it out’ bandwagon; after all who knows whether a sick company will ever revive.
But that may not be the best way to measure the impact of this judgment – whether more unsecured creditors follow suit or not; their inferiority in creditor hierarchy just got a leg up. That’s a principle alteration made for the first time!