Section 2(16) of the Companies Act, 2013 and Section 3(4) of the Insolvency and Bankruptcy Code, 2016 (“IBC“) define ‘charge’ as an interest or a lien created on the property or assets of a company, or any of its undertakings or both as security. A charge created by a company can either be an exclusive charge, a pari-passu charge or a priority/ subordinate charge. The last one is more commonly recognized as first charge and second charge.
As per Section 48 of the Transfer of Property Act, 1882, in the event a person purports to create by transfer at different times, rights in or over the same immoveable property, and such rights cannot all exist or be exercised to their full extent together, each later created right shall, in the absence of a special contract or reservation binding the earlier transferees, be subject to the rights previously created. In other words, in the absence of an inter-creditor agreement to the contrary, the first charge holder shall have a right to sell the security to realize its debt prior to the other creditors. The claim of the first charge holder shall prevail over the claim of the second charge holder and in cases where the debts are due to both, the first charge holder will have to be repaid first .
The entire financial services industry banks on the enforceability of their security interests; and in particular the agreements executed amongst various holders of security interest over the same set of assets and properties. In the past, the Reserve Bank of India has conferred legal recognition to inter-creditor agreements executed amongst creditors to define their rights in relation to the stressed assets of a corporate debtor. However, there exists ambiguity with respect to the recognition of first charge holders and second charge holders under IBC.
RIGHTS OF FIRST CHARGE HOLDERS DURING CORPORATE INSOLVENCY RESOLUTION PROCESS
The IBC creates a distinction between secured creditors and unsecured creditors but does not create any distinction between different classes of secured creditors. Accordingly, first charge holders and second charge holders are conferred the same treatment under IBC and their claims are usually settled proportionately.
While IBC and the jurisprudence available on this subject provides for the principle of equitable treatment viz. creditors with similar legal rights should be treated fairly, receiving a proportional distribution on their claim in accordance with their relative ranking and interests, it does not mean that all creditors need to be treated identically. The courts have held that if an ‘equality for all’ approach is adopted, secured financial creditors will, in some cases, be incentivized to vote for liquidation rather than resolution, as they would have better rights if the corporate debtor was to be liquidated . Further, the courts have held that the equality principle cannot be stretched to treating unequals equally as it will destroy the very objective of IBC, which is to ensure revival and continuation of the corporate debtor by protecting the corporate debtor from corporate death by liquidation.
Despite the IBC not providing for differential treatment of first charge holders and second charge holder, the resolution plan submitted by a resolution applicant may provide for a differential treatment of such creditors. If the committee of creditors (“CoC“) approve such a resolution plan by a vote of not less than 66% (sixty six percent) of the total voting share of the financial creditors, the resolution plan may be submitted to the National Company Law Tribunal (“NCLT“) for its approval.
On receipt of such resolution plan, NCLT must ensure that the plan fulfils the requirements under Section 30(2) of IBC. If the resolution plan fulfils the requirements under Section 30(2), it must be approved by NCLT. However, if NCLT finds any shortcomings in the resolution plan approved by the CoC, it must send the resolution plan back to the CoC for resubmission and must not interfere with the commercial aspects of such resolution plan .
It is pertinent to note that the voting share of a creditor in the CoC is proportional to the financial exposure of such creditor to the corporate debtor. In order to approve a resolution plan, financial creditor holding not less than 66% (sixty six percent) of the total voting share must vote in favour of such resolution plan. However, if a second charge holder is conferred a higher voting share based on its exposure to the corporate debtor as against the first charge holder, the second charge holder may, in some cases, not approve a resolution plan that creates a distinction between the first charge holders and the second charge holders.
RIGHTS OF FIRST CHARGE HOLDERS DURING LIQUIDATION
On failure of the corporate insolvency resolution process to resolve the financial stress of the corporate debtor, IBC envisages liquidation of the corporate debtor, albeit, as a last resort . Section 53 of IBC deals with distribution of proceeds from the sale of the liquidation assets, in the order of priority prescribed therein. As per Section 53 of IBC, ‘secured creditors’ that have relinquished their security interest to the liquidation estate are ranked higher than the ‘unsecured creditors’. However, it is pertinent to note that Section 53 of IBC does not create any further sub-division/ classification of secured creditors based on inter-creditor agreements or subordinate agreements, thereby raising concerns relating to the validity of differential rights of the creditors.
The secured creditor is repaid from the proceeds of the liquidation estate under Section 53 of IBC, once the creditor has relinquished its security interest to such estate, in the manner set out under Section 52 of IBC. Section 52 of IBC confers each secured creditor with a choice to either relinquish its right to the liquidation estate or realize its security interest independently, subject to the provisions of IBC. The secured creditor may realize its security interest either by enforcement of security under Section 13 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 or enforcement of security under Regulation 37 of the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 .
The mechanisms laid down under Section 52 of IBC create ambiguity in relation to the course of action that may be undertaken in case creditors of different ranks have been secured by a charge on the same asset. In the case of J.M. Financial Asset Reconstruction Company Limited. v. Finquest Financial Solutions Private Limited and Ors. , the National Company Law Appellate Tribunal (“NCLAT“) has held that the right to realize security under Section 52 of IBC is restricted to a creditor that has an ‘exclusive charge’ or ‘sole first charge’. Further, NCLAT has also held that after enforcement of rights under Section 52 of IBC by 1 (one) of the ‘secured creditors’, no other ‘secured creditor’ can enforce its rights subsequently for realization of the amount from the same secured asset, as the excess amount by way of proceeds pursuant to the first enforcement is deposited in the account of the liquidator, and accordingly only 1 (one) secured creditor will be able to enforce its rights under Section 52 of IBC.
The Insolvency Law Committee (“ILC“) has previously discussed the issues relating to gradation of rights on the basis of ranking of the charge holders, wherein it was deliberated that the provisions of the inter-creditor agreements which afford differential rights be disregarded in view of Section 53 of IBC. However, ILC rejected this argument and clarified that a plain reading of Section 53 of IBC was sufficient to establish that valid inter-creditor and subordination provisions are required to be respected in the liquidation waterfall under Section 53 of IBC. The rationale for such a position was that in case such differential rights and arrangements were disregarded, secured creditors would be disincentivized from providing credit, which would negatively impact the credit market.
In the case of Technology Development Board v. Anil Goel , NCLAT discussed the validity of inter-creditor arrangements vis-à-vis the waterfall mechanism under Section 53 of IBC and held that while secured creditors had the option between relinquishing their right in favour of the liquidation estate and realizing their security interests independently, once they choose to relinquish interest, the repayment would take place strictly as per Section 53 of IBC, which does not recognize any distinction between different classes of ‘secured creditors’.
THE LONG ROAD AHEAD
The judicial uncertainty with respect to the validity of inter-creditor agreements under IBC requires clarification. Clarity on this issue will determine the manner in which secured creditors choose to participate in the corporate insolvency resolution process, as well as the option that provides them with the highest rate of recovery in case of liquidation of the corporate debtor. It is pertinent to note that this issue involves both legal and commercial considerations, which could significantly impact creditor behavior and the use of IBC as a mechanism to resolve financial stress.
Therefore, it is extremely important to achieve finality on this critical issue involving validity of inter-creditor agreements under IBC and consequently the rights of first charge holders under IBC. Given that IBC is an evolving legislation, there may be certain amendments down the road providing clarity on this issue with a view to uphold the rights of first charge holders.
 ICICI Bank Limited v. Sidco Leathers Limited & Ors., (2006) 10 SCC 452.
 Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta & Ors., (2020) 8 SCC 531.
 Jaypee Kensington Boulevard Apartments Welfare Association & Ors. v. NBCC (India) Limited & Ors., Civil Appeal No.3395/2020.
 Kridhan Infrastructure Private Limited v. Venkestesan Sankaranarayan & Ors., Civil Appeal No 3299/2020.
 Edelweiss Asset Reconstruction Company Limited v. Abhijeet MADC Nagpur Private Limited, Company Petition (IB) No. 1315(MB)/2017.
 J.M. Financial Asset Reconstruction Company Limited. v. Finquest Financial Solutions Private Limited and Ors., Company Appeal (AT) (Insolvency) No. 593/2019.
 Technology Development Board v. Anil Goel, Company Appeal (AT) (Insolvency) No. 731/2020
Hardeep Sachdeva, Senior Partner
Anurag Singh, Associate
Siddhant Bhasin, Associate