Financial Creditors and Operational Creditors

Authors: Tejas Chhura, NLSIU

Samriddhi Jha, JLU

Sumreet Kaur, GGSIPU

Soma Singh, Sharda University

Editor: Tejas Chhura, NLSIU



Introduction

The Insolvency and Bankruptcy Code was introduced in 2016 to bring the insolvency law in India under a single unified umbrella, to speed up the insolvency process and to ensure revival and continuation of the corporate debtor. At the core of the Insolvency and Bankruptcy Code, is the classification of creditors with the classification of people into one or the other category swinging entire cases. Hence, it becomes crucial to analyze these roles and how they are defined. In this article, the researchers aim to draw the distinction between these two types of creditors and look at the challenges that have been posed to it. The article also seeks to perform a comparative analysis between the powers given to creditors in the United Kingdom and India to see if the powers given to creditors in India are disproportionate or apt for the Indian context.

Financial Creditors

Section 5(7) of the Code, defines a financial creditor as “a person to whom a financial debt is owed and includes a person to whom such debt has been legally transferred”.[1] As the name suggests, financial creditors are those creditors that borrow money for a short period of time, usually in cash or cash equivalents. Their relationship with the entity is a pure financial contract. This Section is generally read along with Section 5(8)[2] which provides an exhaustive list of what types of debt can fall under the ambit of financial debt.

Operational creditors

The term operational creditor has been defined under Section 5(20) of the IBC, 2016 which states “Any person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred”.[3] To legally decide whether a person would fall under Operational Creditor, the debt owed by him must fall under the definition of operational debt as prescribed by section 5(21).[4]

Difference between a financial and Operational Creditor

As mentioned above the major difference between a Financial and Operational Creditor is the powers granted to them. The first significant difference between the two is rooted in the voting rights of both parties. While a financial creditor is given the right to vote based on their proportion of the final debt owed,[5] operational creditors do not have any form of voting rights whatsoever.[6] In addition to this, Financial Creditors are given the right to directly file an application for corporate insolvency on the occurrence of a default,[7] while an operational creditor is obligated to deliver a demand notice and only if the company does not respond, can they file an application to initiate insolvency.[8] Finally and most importantly, while constituting the committee of creditors, only financial creditors are allowed to be members of the committee and operational creditors may never form any part of the committee.[9] However, since the financial creditors have been given greater powers, there are increased obligations on them such as making it obligatory for them to submit financial information regarding assets in relation to any security interest, while this filing is optional for an operational creditor.[10]

Hence, there is a clear demarcation between the different types of creditors with increased obligations and power being bestowed upon the financial creditor. However, this was initially challenged as violating of Article 14 of the Indian Constitution in Swiss Ribbon Private Limited vs Union of India.

SWISS RIBBON PRIVATE LIMITED V. UNION OF INDIA

There were several matters up for contention in Swiss Ribbon Private Limited v Union of India, the most prevalent of which was the constitutional validity of the distinction between a financial and operational creditor.[11]

The petitioners brought to light the distinction between the types of creditors and challenged the requirement of a demand notice to the operational debtor by the operational creditor before initiating the process under the Code, which is absent in case of financial debt. The Court delved into the meaning of the terms ‘claim’, ‘debt’ and ‘dispute’ to establish that a claim gives rise to a debt, and a dispute occurs only when such debt becomes due and payable but is not paid by the debtor. As the Code requires the financial creditor to prove a ‘default’, whilst the operational debtor is merely required to prove a ‘claim’, the distinction becomes reasonable. This policy was identified as a move away from the concept of ‘inability to pay debts’ to ‘determination of defaults’ to enable the financial creditor to timely effectuate reconstruction based on the documentary evidences.

Hence, the Court upheld the provision recognizing that in a committee intended to keep the entity as a going concern, only those persons should be part of it who have the capability to assess the viability and willing to modify the existing terms of liabilities, which is generally restricted to financial creditors. Alongside this, the Court considered a four-fold institutional mechanism to establish that no prejudice is maintained against the operational creditors. Hence, although the constitutionality of the two types of creditors was challenged in this case, the Courts acknowledged the increased obligations of financial creditors and hence upheld the existing position of law.

Comparative Analysis with the United Kingdom

As mentioned before, prior to the Insolvency and Bankruptcy Code, the bankruptcy framework in India was vague as it overlapped with many other laws and acts. There was a lack of a regulatory body to look over the matters regarding insolvency and bankruptcy in our country. Thus, to clear the air and to introduce a new regulatory body, the Indian Government introduced a body named Bankruptcy Law Reforms Committee. The Bankruptcy Law Reforms Committee adopted a successful regime of the UK to reform insolvency and bankruptcy laws in India. While the Insolvency and Bankruptcy Code, 2016 is quite similar to the laws regarding the same in the United Kingdom, there are certain modifications that have been made to ensure that it properly fits into the Indian context.

In India, during the process of insolvency, the insolvency professionals that are appointed should take the approval of creditors on the various masters of insolvency. Section 28 of IBC states that insolvency professional this appointed cannot take certain decisions without the approval of the committee of creditors[12] whereas, in the UK, the same approval is required only at the time of the appointment of an insolvency professional. Another key difference between the two laws is the voting rights given to the creditors. While in India, voting rights are limited only to financial creditors; in the UK, all creditors have the right to vote. There is also a distinction between the thresholds of votes required for the passing or resolution plans with India requiring at least 75% of financial creditors to be in favour as opposed to the simple majority required in the UK.[13]

In addition to this, there is also a difference regarding the time period within which the process of liquidation can get initiated should the resolution bill not be passed. The Insolvency and Bankruptcy Code of 2016 states that if the resolution plan is not passed within the given time limit or if not approved within a span of 180 days, the process of liquidation will automatically get initiated whereas in the UK there is no prescribed law which provides a time limit for the resolution plans. The resolution plan is valid for the entire period until the plan is approved if the plan gets rejected then only the liquidation process will start. Finally, in India, any and all remuneration paid to the liquidator is decided by the creditors only. However, in UK remuneration is fixed agreement of creditors and the appointed insolvency professional in default, the Court may interfere to fix the remuneration. Hence, while India may have borrowed some features from the UK laws, the Bankruptcy Law Reforms Committee, the Central Government has done a commendable job to alter it to fit into the Indian context.

Conclusion

The Insolvency and Bankruptcy Code was introduced with the intention to unify the laws regarding the same under one Code, and to that effect, it has been successful. Drawing the distinction between the types of creditors has been a vital part of the Code as seen in Swiss Ribbon Private Limited vs Union of India, and despite the different amounts of power and rights given to them, with financial creditors having increased rights and powers, it has been balanced by the increased obligation on financial creditors. Despite using the Bankruptcy laws of UK as a basis, the lawmakers have correctly identified the areas which needed to be changed to match the Indian context, and with the recent amendment done to the Code, one can safely say it will remain relevant and stand the test of time.

[1] Insolvency and Bankruptcy Code 2016, Section 5(7). [2] Insolvency and Bankruptcy Code 2016, Section 5(8). [3] Insolvency and Bankruptcy Code 2016, Section 5(20). [4] Insolvency and Bankruptcy Code 2016, Section 5(21). [5] Insolvency and Bankruptcy Code 2016, Section 5(8). [6] Insolvency and Bankruptcy Code 2016, Section 5(21). [7] Insolvency and Bankruptcy Code 2016, Section 7(1). [8] Insolvency and Bankruptcy Code 2016, Section 8(1). [9] Insolvency and Bankruptcy Code 2016, Section 21(2). [10] Insolvency and Bankruptcy Code 2016, Section 215. [11] Swiss Ribbons Pvt. Ltd. v. Union of India, Writ Petition (Civil) No. 99 of 2018. [12] Insolvency and Bankruptcy Code 2016, Section 28. [13] Khan Sana, Gursale Aarohee, “Financial Creditor and Operational Creditor under the Insolvency and Bankruptcy Code, 2016” (July 4, 2017) < http://vinodkothari.com/2016/05/difference-between-financial-creditor-and-operational-creditor/>.

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