It is a well established principle that where conflicting, but equal interests have been created in favour of multiple persons, it should be determined based on the maxim qui prior est tempore potior est jure, i.e., he who is earlier in time is stronger in law.
This principle has been incorporated under the Transfer of Properties Act, 1882, as Section 48, which provides that where a person purports to create by transfer at different times, rights in or over the same immovable property, each later created right, in the absence of any agreement to the contrary, shall be subject to the rights previously created. This Doctrine of Priority has been one of the Cardinal principles that govern the mortgage based lending. The Lenders who are holding the first charge over an immovable property were always having a clear advantage against such other lenders who were having only a subservient charge, during the enforcement of security interest for recovery.
But whether this doctrine stand obliterated when it comes to the liquidation process under the Insolvency and Bankruptcy Code, 2016 ('Code") is a debatable aspect. During the deliberations at the Insolvency Law Committee, the possibility of ignoring the doctrine of Priority by interpreting the language used in Section 53 of the Code to treat all the debts inter se secured creditors at par was brought to the attention of the Committee. It was pointed out that such an interpretation would imply that priority of charges agreed upon between creditors in inter-creditor or subordination agreements would lose meaning once a creditor relinquished its security and came within the liquidation waterfall in section 53. However the Committee had pointed out that merely because the relevant section did not specifically provide for the rights of priorities over mortgaged assets, it would not mean that the provisions of section 48 of the Transfer of Properties Act shall stand obliterated in relation to a company that has undergone liquidation. Noting that it may not be prudent to take away a valuable property right vested with creditor, the Committee had concluded that this may negatively impact the credit market as the lenders shall have no protection in case the corporate debtor becomes insolvent.
However the reality seems to be quite different from the interpretation given under the Law Committee Report. For a better understanding of this proposition it is necessary to understand the relevant legal framework under the Code in detail. When it comes to the question of determining the rights of the Secured Creditors of a Corporate Debtor who is at the doorstep of Liquidation, the guiding provision is Section 52. It lays down the options that are available to the Secured Lenders of a Corporate Debtor in Liquidation. The Code offers two paths that the Secured Creditors may follow. They may elect either to:
- Relinquish the security interests created by the Corporate Debtor in their favour to the liquidation estate and receive proceeds from the sale proceeds during the liquidation process; or
- Enforce the secured assets in accordance with such law as applicable to the security interests and apply the proceeds to recover the debts due to it.
Where a secured Creditor opts to realise its security interest by themselves without participating in the liquidation proceedings, they shall inform the liquidator of same and identify the asset subject to such security interest to be realised. The IRP Costs, due from such secured creditors shall be deducted from the proceeds of any realisation by such secured creditors, and they shall transfer such amounts to the liquidator to be included in the liquidation estate. If, during such enforcement of security interest, any amount is received in excess of the debts due to the secured creditor, such surplus amounts shall be handed over to the Liquidator.
The sole disadvantage for such secured creditors who elects to realise its security interest by themselves is that in an event where the realised amounts are not adequate to repay the debts owed to the secured creditor, the unpaid debts of such secured creditor, loses priority under the Waterfall mechanism for distribution of the sale proceeds of the Liquidation assets, where they will be placed even below the unsecured creditors.
Section 53 of the Code provides for a hierarchical distribution mechanism for the sale proceeds of the liquidation assets. This Waterfall mechanism gives the apex priority to the IRP costs and the liquidation costs followed by the debts owed to the secured creditors who had relinquished their security interest to the liquidation estate.
The proposition that calls our attention in this context is as to relevance of the Doctrine of Priority in the distribution mechanism laid down under Section 53. This Distribution matrix under Section 53, is identifying only the following three classes of Creditors:
- Secured Creditors who had relinquished their individual security interests to the common pool of Liquidation Estate;
- Secured Creditors who had not relinquished their security interests, but had opted to enforce their security interests on their own and
- Unsecured Creditors
This provision is not prima facile differentiating the secured creditors on the basis of their inter se priority of the creation of security interests and recommends for a paripassu distribution of sale proceeds among the same class of creditors.
The Section 53 (1) (b) (ii) reads as follows:
"Notwithstanding anything to the contrary contained in any law enacted by the Parliament or any State Legislature for the time being in force, the proceeds from the sale of the liquidation assets shall be distributed in the following order of priority and within 58 such period as may be specified, namely:
(ii) debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;"
The Explanation (i) to Section 53 clarifies that at each stage of the distribution, the proceeds shall be paid in equal proportion within the same class of recipients.
The Sub Section (1) of Section 53 has put together all the Secured Creditors who had relinquished their individual security interests into one single class, standing second in the order of priority after the IRP and liquidation costs. This provision read together with the Explanation to the Section makes it clear that no differentiation is to be made among the secured creditors inter se while distributing the proceeds of the sale of the liquidation assets and does not leave any scope for any interpretation to the contrary. Further the Sub Section (2) to Section 53 is expressly directing the liquidator to disregard any contractual arrangements between equally ranked recipients under Section 53 (1) which disrupts the order of priority under the Sub Section (1).
Section 238 of the Code expressly stipulates that notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law, the provisions of IBC shall have effect. The Section 53 itself is beginning with a non obstante clause which overrides any other laws which is contrary to the distribution hierarchy as laid down under the provision. Thus the applicability of the Doctrine of priority amongst the secured lenders inter se shall therefore be construed as to be inconsistent with the order of priority under Section 53 (1) and hence will be overridden.
However it would not be correct to make a statement that the legislature has chosen to completely ignore the Doctrine of Priority when it comes to liquidation. The Doctrine of Election incorporated under Section 52 of the Code gives the option to a secured creditor to elect between the right to enforce the security interest based on the priority of charge over the security interest created in its favour and a right to claim from the entire liquidation estate of the corporate debtor. Whether a secured creditor holds first charge or second charge is material only if a secured creditor elects to realise its secured interest. It is pertinent to note that while the realisation of security interest can be exercised only qua the asset which is subject to such realisable security interest, by relinquishing the security interest to the liquidation estate, Secured Creditor becomes entitled to claim distribution in the proceeds from the sale of the entire liquidation assets. In the Technical Development Board Judgment, the NCLAT had observed that once a secured creditor elects to relinquish its security interest to the liquidation estate and becomes entitled to claim a proportionate share to the entire liquidation estate proceeds, it cannot further claim any inter se sub classification between the secured creditors based on the priority of charge.
However this legal position may, in the long run, fail to protect the interest of the stakeholders in a liquidation process. It is always a delicate decision for a secured lender to choose between relinquishment of its security interest and standing alone for enforcement of security interest created in its favour. The realisable value of the security interests in comparison to the debts due, marketability of the security interest, the underlying delays that may be involved in such enforcement on its own and such other factors influencing the balance of convenience shall all play their own role in moulding the decision of a secured creditor in this regard. There are many instances where a Corporate Debtor is not having any liquid assets and all of its immovable assets may be mortgaged with multiple lenders who might be holding differential rights based on the Doctrine of Priority. The present framework under the Code which divests the secured creditors of their advantageous position rising from doctrine of priority, during the liquidation process, may dissuade such lenders from pooling in such assets into the liquidation estate. If a secured lender or a lenders' consortium is divested of its priority of charge over the security interest merely because they had relinquished their security interests to the liquidation estate and is forced to share the sale proceeds on a pari passu basis to such other lenders who had only a second charge over such security interest, it shall tilt the balance of convenience towards the enforcement of security interests by such lenders outside the liquidation process. Such a circumstance shall lead only to the dissolution of the Corporate Debtor without leaving any meaningful recourse to the other stakeholders diminishing the underlying spirit of the Code.
Views are personal.