Navigating The Rapids: Understanding 'Waterfall Mechanism' In Section 53 Of Insolvency And Bankruptcy Code, 2016

By Advocate Srijan Tiwari 

The Insolvency and Bankruptcy Code 2016 represents a pivotal advancement in India's legal framework aimed at enhancing the nation's ease of conducting business. Enacted with the President's assent on 28th May 2016, this legislation has effectively streamlined and codified the previously fragmented and intricate landscape of bankruptcy laws in India. There is a "Waterfall Mechanism" present in Section 53 of IBC, 2016 which is explained here.

Among its numerous commendable provisions, Section 53 stands out prominently for its delineation of the methodology governing the allocation of proceeds derived from the liquidation assets of a corporate debtor. Given the diverse array of stakeholders involved, comprehending Section 53 necessitates a nuanced interpretation to grasp its underlying jurisprudential principles. The waterfall mechanism established therein serves as a litmus test for the preamble of the code, which underscores the imperative to harmonize the interests of all parties affected by insolvency proceedings.

This discourse aims to elucidate the intricacies of the waterfall arrangement prescribed by the Insolvency and Bankruptcy Code (IBC), thereby unveiling the distinctive features that define its essence. In essence, by delving into the mechanics of Section 53 and the broader framework it embodies, we endeavor to illuminate the foundational principles that imbue the Insolvency and Bankruptcy Code with its significance, underscoring its role in fostering a balanced and conducive environment for business operations in India.

In most instances, the amount received by lenders is often significantly less than what the successful resolution applicant pays to acquire the assets of a company through the corporate insolvency resolution process (CIRP). Nonetheless, the Insolvency and Bankruptcy Code establishes a structured framework for expeditiously resolving insolvency and bankruptcy cases, offering opportunities for the revival of distressed companies. The payment made by the successful bidder serves to settle the debts of the bankrupt company, with funds allocated according to a specified order known as the Waterfall Mechanism under the IBC. The Waterfall Mechanism dictates the sequence in which proceeds from the sale of a corporate debtor's assets are distributed among stakeholders. This distribution occurs in a hierarchical fashion, prioritizing the claims of certain stakeholders over others.

Section 53 of the Insolvency and Bankruptcy Code outlines a Waterfall Mechanism that specifies the sequence and priority for distributing proceeds from the sale of liquidation assets among the stakeholders of a corporate entity. The "non-obstante clause" at the beginning of Section 53 confers overriding authority upon the Waterfall Mechanism established under the IBC, superseding any conflicting provisions of statutes enacted by central or state governments.

First, the Insolvency Resolution Process Costs and the liquidation costs must be paid in full. Next in line are the workmen's dues for the 24 months preceding the liquidation commencement date, and debts owed to secured creditors who have relinquished their security, both of which are ranked pari passu. Following these are employee dues for the 12 months preceding the liquidation commencement date, unsecured financial creditors, operational creditors, government and statutory dues, and finally, equity shareholders and partners, if any.

It is important to note that Section 53 clearly outlines the hierarchy of claims during liquidation. This hierarchy must also be followed during the payment distribution under the resolution plan, as mandated by Sections 30(2)(b) and 30(4) of the Insolvency and Bankruptcy Code, introduced through recent amendments. This highlights the essential role of the waterfall mechanism not only in the liquidation phase but also in the revival process through a resolution plan.

Various judicial pronouncements have elucidated the significance of the waterfall mechanism, notably in the matter of Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta & Ors. In this case, it was adjudicated that the National Company Law Tribunal (NCLT) does not possess residual jurisdiction to reject a resolution plan solely on the basis of its perceived unfairness or injustice to a particular class of creditors. Provided that the interests of each class of creditors have been duly considered and addressed in accordance with the waterfall mechanism delineated in Section 53 of the Insolvency and Bankruptcy Code, along with the valuation of security interests of each creditor, the NCLT is compelled to sanction the resolution plan.

There has been disagreement between judicial interpretation and the statutory framework as a result of courts and tribunals departing from Section 53 of the IBC in certain cases. In the ruling in State Tax Officer V. Rainbow Paper Mills Limited, the court considered the state government to be a secured creditor and equated it with the obligation of workmen to repay debts during the settlement process. The distinction between government dues secured by operation of law and those secured through contractual transactions was essentially eliminated as a result. This decision delayed the resolution process by requiring tribunals to first define the status of claims.The explicit inclusion of "government dues" under Section 53(1)(e)(i) of the Insolvency and Bankruptcy Code (IBC) was overlooked in this case, which is noteworthy. This clause places the payment of government obligations below other obligations, stating that they must be paid after wages, workmen's compensation, debts to secured creditors, and unsecured loans, among other obligations. This highlights the difficulty in arriving at a correct textual interpretation of the law and adds another layer of complexity to figuring out the precise priority status of secured government dues under the Code.

However, in the case of Paschimanchal Vidyut Vitran Nigam Ltd V. Raman Ispat Private Limited, the Apex Courtupheld the legality of the security interest established in the appellant's favor and clarified that, depending on the specifics of the transaction with the corporate debtor, payments owed to statutory corporations such as the appellant, rather than to the federal or state governments, should be categorized as either operational or financial debt. Nevertheless, according to Section 53(1)(e)(i) of the Code, these obligations do not fall under the category of obligations owed to the federal government or any state government.Due to the corporate debtor in Rainbow Papers undergoing bankruptcy resolution procedures instead of liquidation, there existed a factual distinction between that case and the present instance. Additionally, the Court classified the state government as a "secured creditor" in Rainbow Papers because the case did not consider the waterfall mechanism outlined in Section 53 of the Code. The Court underscored that "government dues" are explicitly covered under Section 53 of the Code, highlighting Parliament's intent to differentiate government debt from obligations owed to other secured creditors.

A crucial element of the waterfall mechanism is the full payment of Insolvency Resolution Process costs before any distributions are made to other stakeholders. This ensures that interim finance providers, who take substantial risks by lending to distressed companies, receive their due payments, including any interest, promptly. Failure to honour these obligations could undermine confidence in the insolvency framework. The waterfall system encompasses eight stakeholder tiers arranged in descending order of distribution priority. It is designed to prioritize the interests of vulnerable operational creditors, placing them on equal footing with secured financial creditors. Despite the need for precise definition in certain sections to ensure a comprehensive framework under the Insolvency and Bankruptcy Code, the law's commitment to equitable treatment has effectively simplified business operations for all parties involved.

(Advocate Srijan Tiwari, with over a decade of experience, regularly practices Insolvency and Bankruptcy Code (IBC) matters before the National Company Law Tribunal (NCLT) and the Delhi High Court. The views expressed are of solely of the author.)