Diluting Security: Part of the IBC’s Wise Design to Break Contracts
Introduction
The most crucial aspect in insolvency resolution is to forge a collective compromise to ensure that the company can erase its debts and revive itself financially. This sets in motion a process which aims to find an allocation where each creditor’s debt is satisfied to a practical degree.
The Insolvency and Bankruptcy Code, 2016 (‘IBC’) has a simple procedure to execute this. When a company is declared insolvent, its financial creditors form a committee to vote on a proposed resolution plan. If the majority approve the plan, it becomes binding on all creditors, including those who vote against it. These are referred to as ‘dissenting financial creditors’ (‘DFCs’).
The crux of this entire exercise pertains to calculating each creditor’s ‘relative’ portion. Amidst the calculation of relative shares, the law introduces an absolute minimum for some. This subset is composed of DFCs to whom the insolvent company had given collateral to take credit. To complicate matters, it does so without specifying how to calculate it.
To be precise, the law ambiguously gives two supposed means of calculating this amount. The first is to let the secured DFC retain the secured asset despite a corporate insolvency resolution process (‘CIRP’), allow her to sell it and fetch its market value. Essentially, this method allows the parties to adhere to the originally agreed terms of a surety agreement. The other means is to let the secured asset merge with the CD’s estate to be used for resolution, and then calculate a share in a distributive manner for all the creditors.
This piece favours the second method, since it is better aligned with the IBC’s intent. Namely, it is to dilute contractual terms between two individual parties in favour of the collective good.
The Source Of Confusion
To protect creditors who took security before extending credit to the CD and are in the minority, the IBC provides for Section 30(2)(b)(ii). This provision creates a statutory floor on what they must be paid under a resolution plan. It states:
“(2) The resolution professional shall examine each resolution plan received by him to confirm that each resolution plan-
[…]
[…] provides for the payment of debts of financial creditors, who do not vote in favour of the resolution plan, in such manner as may be specified by the Board, which shall not be less than the amount to be paid to such creditors in accordance with sub-section (7) of section 53 in the event of a liquidation of the corporate debtor.”
Viewed cursorily, the text appears to have a simple implication: even when financial creditors dissent, they must be paid at least what they would have received if the company were liquidated. However, this is precisely where the confusion arises: it is unclear how that amount is to be calculated. This, in turn, depends on how one interprets the liquidation provisions in Sections 52 and 53.
As evident, Section 30(2)(b)(ii) says that DFCs must be paid at least as much as they would receive under Section 53(1) if the company were liquidated. This provision sets down the order of priority in which different classes of creditors will be paid during liquidation.
In parallel, Section 53(1)(ii) also says that these rules apply only after taking into account the rights of secured creditors under Section 52. Section 52 allows secured creditors to decide what to do with their asset during liquidation. The first option is to hand over the asset to the liquidator. In this case, the asset becomes part of the pool of assets to be shared with other creditors, and the order of priority in Section 53(1) kicks in. Under the second option, the creditor may keep the asset and sell it directly. Needless to state, by this route, the asset does not enter the common pool, and the ‘order of payment’ in Section 53(1) does not apply.
The issue is then whether Section 30(2)(b)(ii) requires a combined reading of Section 52 and Section 53, or whether it should be taken to refer to Section 53 exclusively.
To clearly grasp the implications, consider an example. Let us say a company has two secured creditors:
- Two banks, A and B, had extended a loan of Rs. 100 crores to the CD, each.
- Bank A has security over a factory worth ₹80 crore.
- Bank B has security over a warehouse worth ₹20 crore.
Now, suppose the CD goes through liquidation:
- (Option 1) Section 52: Both keep their secured assets (factory/warehouse) and sell it themselves.
- They each get whatever their respective asset fetches in the market.
- Bank A gets ₹80 crore (value of the factory),
- Bank B gets ₹20 crore (value of the warehouse).
- (Option 2) Section 53: They surrender their secured assets to the liquidator, and get a share of the sale proceeds.
- They stand in a queue with other creditors in the same category and are paid proportionally.
- Suppose the liquidator has Rs. 100 crores to spare for each A and B.
- Each bank gets ₹50 crore (since both are owed the same: pari passu principle)
These provisions do not pose a problem if liquidation plays out and secured creditors take one route or the other. They neatly lay out an ‘if this, then that’ formula. However, they become a problem under resolution. Herein, Section 30(2)(b)(ii) is working on a hypothetical where liquidation plays out, but does not state how. None of the options has been chosen yet. The participants are in the dark about which value must be taken: the one under Section 52, or that under Section 53. This choice affects how much the creditor would receive in liquidation.
The Two Lines Of Thought
The Supreme Court (‘the Court’) has given two opposite views on the issue.
In India Resurgence ARC Private Limited v. Amit Metaliks Limited & Another (‘Amit Metaliks’), it said that secured DFCs should be treated as if they exclusively opt for Section 53. That is, it must be assumed that they surrendered their security and received payment along with other creditors. This meant their entitlement was based not on the value of the asset they held. Instead, it was based on a proportionate share of the total pool available to all creditors. Distilled to its essence, the reasoning was that resolution is a collective process. As such, allowing individual asset-based claims would impede collective deliberation. In any case, Section 30(2)(b)(ii) was seen to have deliberately avoided citing Section 52.
In DBS Bank v. Ruchi Soya Industries (‘Ruchi Soya’), the Court contradicted the above decision. It stated that a secured DFC should be treated as if it sold its asset under Section 52, and that it is this value which must guide its minimum payout in resolution. Three elements in the IBC’s text led the Court to hold this: firstly, the explanation to Section 30 requires a ‘fair and equitable’ distribution; secondly, the intent of Section 30(2)(b)(ii) appears to ensure security for dissenting creditors; and lastly, Section 53(1)(ii) is subject to the outcome under Section 52. This indicated to the Court that the option which helps the creditor retain her control over her secured asset, as opposed to losing that security, is to be preferred.
Since both judgments came from coordinate benches and contradict each other, Ruchi Soya has referred the matter to a larger bench.
However, it is submitted that the holding of Amit Metaliks is better aligned with the IBC’s design and intent. Logically extended, it must be assumed that secured DFCs submit their security to the collective pool when a resolution kicks in, and this is how the ‘minimum’ under Section 30(2)(b)(ii) must be calculated. To do so, it is necessary to understand that a security for a creditor is a creature of contract. Allowing the creditor to deal with the secured asset as she deems fit would be to allow the original contract to stand. This contradicts the IBC, which is designed to break contractual obligations in favour of an ordered compromise.
Why The IBC Must Attack Contractual Relationships
Contracts demand complete satisfaction of specific obligations. However, the law on insolvency does not intend full realisation of claims, but aims for sub-optimal outcomes for all. The IBC realises the insufficiency of the CD’s value and is a workaround for this problem. The very existence of such a law in any jurisdiction denotes that under some circumstances, complete recovery is an impossibility. These circumstances instead require salvaging whatever can be salvaged and reducing the damage to all the involved creditors. The IBC not only aims to mitigate the damage to all stakeholders but does so by constantly monitoring and reviving the CD’s finances.
If all creditors could be paid in full, CIRP would be unnecessary. If the legislative intent was to help each creditor get her payout in full, it would have simply allowed all individual claims to be pursued in courts of law. This may result in a chaotic resolution of disputes. For instance, one contractual dispute may result in success that reduces available assets for another claimant.
Thus, it is proposed that the IBC’s intent is to compromise contractual rights for a fairer outcome for all involved. The difference in the respective natures of contract law and insolvency law explains why this is the case. Contract law creates obligations which are forward-looking. It is designed to shape future outcomes with certainty. In contrast, insolvency law is backward-looking in the sense that it reacts to a failed state of affairs which has already occurred. In this context, continuing to honour contracts misapplies the forward-looking logic of contracts to circumstances where no future performance is possible.
Another way to view IBC is to recognise that it is an exercise in debt restructuring. Debts with which the IBC is concerned arise out of contracts. Thus, ‘debt restructuring’ is essentially the legally permissible means to tinker with contractual obligations.
For these reasons, once CIRP begins, a CD is simply treated as a pool of assets for the benefit of all its creditors, instead of a bundle of bilateral obligations. For instance, when a creditor files a petition requesting CIRP, courts check whether the intention of the creditor is simply individual debt-recovery or a larger reorganisation of the CD. This shows that the process favours collectivisation and disregards exclusive bilateral rights.
There exist many indications of how the IBC deconstructs contractual relationships. This piece relies on three relevant design elements in the law that indicate this.
Assault on contracts at the very inception of CIRP
The moratorium under Section 14 captures how the IBC interferes with contract law from the very inception of a CIRP. Simply put, the moratorium protects the debtor from any past, present, or future liabilities until the insolvency proceeding concludes. Arguably, its role is not confined to postponing enforcement of legal claims against the CD, but to disrupt contractual frameworks altogether.
At the outset, this intent is evident from how widely phrased the text of Section 14 is. It bars both institution and continuation of legal proceedings against the CD. It extends protection from legal action to ‘all’ assets and rights of the CD. When a moratorium is in place, claims under various laws including contract law have no legal recognition.
However, the judiciary has interpreted the provision even more expansively: the power to pause legal actions has evolved into a power to reshape obligations. Courts have adopted an ‘implication-based’ test to apply the moratorium. That is, the moratorium stops short of halting legal events which would help preserve or restore the debtor’s assets. This implies that the CD may pursue its contractual remedies. Hence, the usual bilateral right of securing performance is reshaped into a unilateral right in favour of the CD.
Closer to the issue at hand, this reasoning has also been applied to contracts involving secured interests. These not only create contractual rights but also enable statutory rights under recovery/foreclosure laws. Proceedings under these laws are stayed if directed against the CD. However, the CD remains free to invoke its rights under these laws.1
In parallel, courts have gone beyond interfering in legal proceedings and have used Section 14 to pause contractual provisions for the CD’s benefit. When a party tried to legally terminate its contract with the CD during the moratorium, it was stopped by the National Company Law Tribunal, since it would hit the financial viability of the CD. While the law does not expressly prohibit termination of contracts, courts have, so as not to undermine resolution. Hence, the invasion of Section 14 in the realm of contractual relations is both quick and deep.
The asymmetry in favour of the CD seems intentional. A contract operates on the assumption of normal commercial functioning and solvency. However, insolvency is initiated when those assumptions cease to exist. The legal actions of individual creditors can harm value available to all the creditors at large, whereas the CD’s legal actions may restore it. Hence, these contractual rights are paused by the law’s text immediately so that value can be preserved or maximised for all stakeholders. The pause has been judicially enhanced to benefit the CD’s viability: IBC can shut down, prolong or reorient contractual obligations if need be for planning a resolution.
Interestingly, the Code only preserves contractual rights at such an interim stage of the CIRP in one instance: Section 18. Here, the assets held by the CD under a contractual arrangement are exempt from being used for resolution. With the appearance of an exception to the larger, unspoken rule, this confirms the intent of the IBC: to immediately disrupt contractual obligations as soon as it is invoked.
Ruchi Soya neglects the above-revealed inclination towards asset-retention in favour of the CD. In making an interpretive choice, it prioritised Section 52, which clashes with that tilt. Moratorium dilutes contracts to preserve or expand CD’s asset-pool during CIRP. Its application cannot be suddenly abandoned towards CIRP’s conclusion.
Conclusion of resolution, end of contracts
The stark contrast between a resolution plan and a contract further symbolises the intent of the IBC and the argument advanced herein.
The very nature of a resolution plan is antithetical to the basis of contracts: consent. As captured by Section 30, the existence of, and cramdown on, dissenters make this the case. Approved resolution plans may restructure or extinguish existing claims, including operational or secured financial creditors, disregarding their consent.
The logic for repeatedly distinguishing a plan from a contract is clearly enunciated by the Court. SBI v. V. Ramakrishnan has stated that the outcome of a CIRP is a ‘necessary legal occurrence,’ suggesting lawful compulsion. It contrasted it with a contractual development, which is a party-driven and voluntary event. Contract law deals with private autonomy where parties decide for themselves. However, a resolution plan involves parties deciding for all others. While IBC technically belongs to the realm of private law, scholars argue that it injects public law values, like collective welfare and accountability to the public, into what was formerly a purely private bargain. IBC removes debt resolution from the realm of private autonomy, and instead situates it under public economic management.
Essential to this management is a quick resolution for all stakeholders, and this comes from finality. Approval of a resolution plan under Section 31 has been read to mean that the CD acquires a ‘clean slate.’ That is, all the CD’s liabilities factored in during CIRP end conclusively with the coming of the plan and cannot be revived in any form. This finality is the value the IBC privileges. The law willingly sacrifices the structural integrity of contractual relations to ensure that resolution is clean, definitive, and insulated from later claims.
The finality also exists in the sense that judicial review of the plan’s specifics is not permissible. The Court has clearly stated that a resolution plan is a creature born out of the ‘commercial wisdom’ of the assenting financial creditors. This was interpreted by how limited the judicial review by courts is under Sections 31, 32, and 61 of the IBC. To respect their commercial expertise, all distortions in prior obligations by way of debt restructuring are taken as the final word by courts.
Hence, the non-contractual nature of the plan becomes the legal basis for denying parties their original contractual rights. That is, these plans bind all stakeholders, regardless of what their contracts say. This is to enforce a legal fiction that the CD emerges free from all past liabilities. This reinforces the Code’s design that pertains to contractual discontinuity, in place of contract enforcement.
Amit Metaliks works to prioritise the ‘public law’ element in CIRP over individual, consensual arrangements. Ruchi Soya is doubly faulty in this sense. It intends to hold on to consent of the past, when resolution plans are designed to dilute it. In parallel, it shows blithe disregard for the ‘public law element:’ it misunderstands Section 30’s text on ‘fairness in payouts’ in weighing its ‘intent to secure DFCs.’ Legislature cannot be expected to insert both elements to carry the same meaning. To avoid this redundancy and in light of the discussion above, ‘fairness’ must denote a limiting principle to protect the larger whole. Both combined, thus, must mean a safety net for DFCs which least reduces salvage value for other creditors. This is better served by the mechanism under Section 53.
Contractual rights cannot be exhumed
Another strong indicator of the IBC’s tendency to contradict contract law is its treatment of personal guarantors. When insolvency resolution starts, the debt framework created by the law of contract collapses. Creditors, debtors, and guarantors, lose contractual ties. Albeit the source for this design element is judicial and not directly textual, it falls in line with the framework made out in the preceding parts.
Under contract law, a guarantor who repays the borrower’s debt takes over the original creditor’s right to seek repayment from the borrower. This is known as subrogation, and is captured by Sections 140 and 141 of the Indian Contract Act, 1872. This ensures that the guarantor is not left without recourse if she plays her part.
Now, suppose a guarantor for an insolvent CD’s loans pays the creditor. Under the IBC, her right of subrogation is disabled if a resolution is initiated or the plan goes through. After a plan’s approval, the guarantor cannot revive a claim because it is deemed ‘already settled’ as against the CD. In the preceding stage, when the moratorium is in place, subrogation is equally barred since the ‘implication-based’ test pre-empts proceedings where the CD may have to pay.
Hence, contract law on subrogation is completely halted by the IBC. Judicial logic states that insolvency is not a recovery mechanism: instead, it is a procedure to salvage as far as is practicable for the claimants so that the company can start anew, without the burden of past claims. Allowing subrogation would reintroduce past claims, diluting the outcome of resolution. If such guarantors could reassert the same debt from the CD that it just fought off, the process would be reduced into a loop of recycled claims.
Viewed differently, this discussion reveals Ruchi Soya’s anomaly more sharply.
Courts deny subrogation even after resolution for a single reason: insolvency is about ending the debt-ecosystem through means other than individual recovery. This ecosystem involves a creditor, a debtor and a security. Subrogation continues the creditor–debtor relationship by transferring the right of action to one who acted as ‘security.’ Section 52 is similar in essence if slightly different in form. It continues the relationship by letting creditors enforce security in the form of assets. Whatever IBC intends to do to subrogation must, then, logically extend to invocation of Section 52.
As shown, the IBC mostly intends to impede contract law. Contract law wants a debt-ecosystem to play out fully. The IBC, however, ends and buries it in a consistent manner: moratorium pauses it, resolution plan kills it, subrogation cannot resurrect it. If Section 52 is read as permissible within resolution, it shatters this consistency: it keeps one debt-ecosystem alive when others are dismantled forever.
Conclusion
In conclusion, IBC embodies the principle that there is no injustice in undoing legal expectations when the circumstances that forged them no longer exist. It invades contractual rights when the resolution begins, and then conclusively settles them by the time it approves a resolution plan. Thereafter, other contract-law provisions such as those on subrogation are barred from interfering with the concluded process
Contract law is about ‘absolute restitution’. However, IBC works to provide collective relief, which involves finding the ‘relative share’ of each stakeholder. Viewed in this light, Amit Metaliks is more faithful to the IBC’s underlying intent.
The security held by secured DFCs cannot fall under their absolute control if a CIRP is taking place. Section 52 effectively reiterates the original arrangement of a contract, and does not factor in the insolvency of the original borrower. In this context, and befitting the larger design of the IBC, the secured asset must be pooled with the CD’s estate available for CIRP. Since Section 53 leans in favour of finding a relative share, it must be the method to calculate the ‘minimum amount’ to be reserved for secured DFCs.
Only this reading settles the conundrum and upholds the essence of insolvency law: after insolvency starts, individual rights, even if contractual, can be adjusted to protect the collective good.
*Yash Sinha (NLSIU ’19) is a Delhi-based lawyer and has previously worked as a Judicial Law Clerk (Supreme Court of India). He is interested in legal writing on commercial and constitutional law. Views are purely personal
- Thermax Limited v. Viswa Infrastructures Services Private Limited, (2019) SCC OnLine NCLAT 904, paras 9, 12.[↩]