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Operational Creditors: Benefits and Disadvantages Under IBC, 2016

Corporate Insolvency Resolution Process

Operational Creditors: Benefits and Disadvantages Under IBC, 2016

The Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as “The Code”) made the status of creditors of a corporate debtor clear from the beginning. The Code provides for two broad classifications of creditors; financial creditors and operational creditors. The classification serves several purposes. The primary purpose is to differentiate between the scope of involvement of the creditors with the corporate debtor.

Definition of Financial Creditors and Operational creditors

The Code defines a financial creditor as a person or entity to whom the corporate debtor owes a debt. It also expressly defines the scope of debt and which transaction would fall under this umbrella. The Code also defines operational creditors. An operational creditor is a person or entity to whom the corporate debtor owes an operational debt. This essentially means, in laymen terms, that an operational creditor is someone who has provided services or supplies to the corporate debtor in exchange of payment.

There is only one element established between a financial creditor and operational creditor in terms of insolvency and bankruptcy. The common element is that both classes of creditors have a right to apply before an adjudicating authority against a default in payment by the corporate debtor. Other than this, the consequences and repercussions of the insolvency proceeding are different for the two classes.

It can be argued to say that an operational creditor has lesser benefits and more losses under the Code.

Benefits for an Operational Creditor under IBC

Even though operational creditors are not the most fortunate in terms of recovery of payments from an insolvent corporate debtor, the Code lays upon them certain benefits;

Corporate Insolvency Resolution Process (CIRP)

The Code explicitly allows an operational creditor to make an application for insolvency against the corporate debtor before an adjudicating authority. This puts them in the position of power. The Code establishes a fixed procedure for an operational creditor to bring forward an application for insolvency. The process takes place in two stages;

  1. When the corporate debtor defaults in making payments, the operational creditor first sends a demand notice u/s 8 of the Code. Demand notice acts as a legal notice which demands clarification for the defaulted payment and fulfil the payment if not already made.
  2. If the corporate debtor still fails to make the payment to the operational creditor, then the creditor can move an application to the court. Section 9 of the Code empowers the operational creditor to apply.

The process of CIRP remains the same for financial creditors and operational creditors after the adjudicating authority admits the application.

Protection under Resolution Plan

The Bankruptcy Law Reforms Committee Report, 2015, lays downs that an operational creditor must receive protection when is resolution plan is devised. The committee states that the operational creditor must receive the dues it is owed. It also states that the resolution plan must ensure that the operational creditor is protected.

The same concern for operational creditors was upheld by the Insolvency Committee Report, 2018. It suggested the if the operational creditors are not repaid their dues, then they could lose motivation to supply services to the corporate debtor. However, the committee did not pay heed to this contention due to lack of evidence of non-payment.

However, the Insolvency Committee Report, 2020 has suggested to bring forward a motion to provide voting rights to operational creditor. Although an active debate and consideration is not ongoing regarding this contention, it strives to work in favour of operational creditors.

Right to Appeal against approved Resolution Plan

Another benefit that operational creditors have under the Code is a right to appeal against a resolution plan that was approved by the adjudicating authority. The Insolvency Committee Report, 2018 upholds the notion of The Bankruptcy Law Reforms Committee Report, 2015 to protect operational creditors under the Code. However, it does not mandate the Committee of Creditors to protect them since operational creditors fall way down the priority list under the waterfall mechanism.

The adjudicating authority receives the resolution plan to made a decision. If the adjudicating authority approves a plan without due payments of the operational creditors, then the operational creditors can appeal against this order in the appellate tribunal. Section 31 of the Code lays down this provision for the operational creditors.

Disadvantages for an Operational Creditor under IBC

The pointers listed above describe the benefits that the operational creditors hold under the Code. The following will now elaborate upon the disadvantages;

No Voting Rights

The fate of an insolvency proceeding depends largely on the Committee of Creditors (COC). The COC holds a lot of power during CIRP. They are the ones who nominate a Resolution Professional for the process and approve a resolution plan submitted by bidders.

The Committee of Creditors comprises only of the financial creditors and not operational creditors. This feature of the Code and the process has garnered a lot of criticisms from professionals and stakeholders. Since the operational creditors do not hold a position in the COC, they do not possess any voting rights. There are speculations that the COC can get biased and put operational creditors at disadvantage.

However, in the recent Insolvency Committee Report, 2020, the committee has discussed the possibility and viability of providing voting rights to operational creditors. At this point, this discussion is at a nascent stage and has no consequence to it.

Least in Priority in the Waterfall Mechanism

The Waterfall Mechanism is the list of priority in a liquidation proceeding where the distribution of assets is concerned. The Code lays down a list of distribution of assets in liquidation defining list of priority. The list goes something like this;

  1. Cost of liquidation;
  2. Secured creditors and workmen payments;
  3. Pending wages of employees;
  4. Unsecured creditors;
  5. Dues to the government and unpaid amount to secured creditors;
  6. Operational creditors and unpaid amount to unsecured creditors;
  7. Preference shareholder; and
  8. Equity Shareholders or Partners.

It is clear from this mechanism that in the list of priority for payments of creditors. Operational creditors stand at the back of the line. This diminishes the value of the asset of the corporate debtor by the time it reaches the stage of operational creditors. It is due to this mechanism; the operational creditors have a right to appeal.

Changes in the minimum threshold of the Code

The Ministry of Corporate Affairs, via a notification, changed the minimum threshold of applying for insolvency in March 2020. The Code states that if the default amount is equal to or over INR 1 lakh, then the petitioners can approach the adjudicating authority. However, the notification changed the minimum threshold to INR 1 Cr.

The biggest challenge with this change is that a corporate debtor seldom reaches the default threshold of INR 1 Cr. towards an operational creditor. Operational creditors, at an individual capacity, reach a small amount of default payment. Under the new regime, if the corporate debtor does not owe INR 1 Cr. to the operational creditor, then the operational creditor cannot apply for insolvency. This is a huge disadvantage for the operational creditors in contemporary times considering the business sector is already suffering.

Operational creditors’ status is a subject of discussion in several case laws and insolvency reports. These forums discuss the same point, among others, as discussed in this article. It is safe to state that operational creditors do stand at a disadvantage in terms of repayment of debts. But the Code still proves them with a remedy of appealing to the higher tribunal.