Are small creditors losing out in insolvency cases?
Table of Contents
In the insolvency framework “small creditors” are primary operational creditors, Micro, Small, or Medium Enterprises (MSMEs), individual suppliers, employees, etc. Unlike financial creditors under the Insolvency and Bankruptcy Code, 2016 (IBC) whose debt is based on the “time value of money” and is often secured, operational creditors are owed money for the goods and services they provide to a company during its regular operations. The objective of this article is to analyse whether small creditors losing out in insolvency framework. By examining legal precedents and the provisions of the IBC, this article will determine if the framework is delivering fair and equitable outcomes for all stakeholders.
Who Are Small Creditors Under the IBC?
Small creditors refer to operational creditors or MSMEs with lower claim amounts, such as suppliers of goods and services, utility providers, and employees owed dues. These creditors, contrasting to financial creditors, lack representation in the Committee of Creditors (CoC) and have no rights within it, unless their claims exceed 10% of the total. Their voting power is effectively negligible, as the CoC is composed solely of financial creditors, and decisions are made based on the proportion of financial debt owed, which often marginalizes smaller claims. Examples include local vendors supplying raw materials, freelance service providers, and employees awaiting unpaid wages or benefits.
Read more : Financial creditor can initiate CIRP against both Principal Borrower and Corporate Guarantor
Rights and Position of Small Creditors in the Insolvency Process
The IBC categorises creditors into financial creditors, who provide loans or financial assistance, and operational creditors, who supply goods, services, or are owed dues from unemployment or government levies. Operational creditors can trigger the insolvency process under section 9 of the IBC by first serving a demand notice for unpaid operational debt, if the corporate debtor does not respond or settle within 10 days, and the creditor may file an application with the National Company Law Tribunal (NCLT). After the insolvency process is initiated, operational creditors have a limited role – they can participate in proceedings and submit claims but are excluded from the CoC, which is composed solely of financial creditors and holds exclusive voting rights on resolution plans and liquidation decisions. The CoC decides the debtor’s fate, and while small creditors losing out in insolvency may have claims, they are excluded from decision-making unless their aggregate dues meet a significant threshold, typically 10% of total debt, to qualify for inclusion in the CoC.
Priority of Payment Under the Waterfall Mechanism
Proceeds from liquidation are distributed in a strict priority order under section 53 of the IBC, starting with insolvency and liquidation costs, followed by workmen dues and secured creditors who relinquished their security, then employee dues, unsecured financial creditors, government dues, other debts, preference shareholders, and finally equity shareholders. small creditors losing out in insolvency, such as unsecured financial creditors and trade creditors, rank below secured creditors, placing them in a vulnerable position where recovery is often partial or non-existent. For example, in the case in the Kingfisher Airlines liquidation, unsecured creditors recovered only about 1.5% of their dues, illustrating the low recovery rates common for small and unsecured creditors in real world insolvencies.
Case Studies: How Have Small Creditors Fared So Far?
The insolvency case of Essar Steel starkly highlighted the unequal treatment between financial and operational creditors. In this case, under the initial resolution plan proposed by ArcelorMittal, operational creditors with claims of less than Rs. 1 crore were to be paid in full, while those with claims above Rs. 1 crore were offered nothing. This was later modified to provide some recovery for the larger operational creditors. Financial creditors ultimately recovered about 85% of their admitted debt. In contrast, operational creditors with admitted claims of Rs. 4,976 crore received only Rs. 214 crore, representing a recovery of approximately 4.3%. In the Bhushan Steel case, the Supreme Court recalled its earlier order and dismissed the appeals by operational creditors and promoters. It upheld the commercial wisdom of the Committee of Creditors and the finality of the resolution plan, reaffirming the disparity between financial and operational creditor’s recoveries. These cases, along with significant judicial pronouncement, reveal a systematic pattern under the IBC where small (operational) creditors have received a disproportionately low share of recovered assets. The recovery statistics confirm that this legal structure, while promoting resolution, often does so at the expense of operational creditors, undermining the position of small businesses and suppliers in the economic ecosystem.
Challenges Faced by Small Creditors
Small creditors face multiple challenges, such as:
- Lack of representation in CoC.
- Long delays in payment or low recovery percentages.
- Legal and procedural costs are too high for small claims.
- Lack of awareness or access to professional help.
Judicial and Legislative Efforts to Protect Small Creditors
- Indian judicial efforts, exemplified by the Essar Steel case, have upheld the “commercial wisdom” of the CoC, limiting judicial interference in distribution. While the Swiss Ribbons ruling affirmed the constitutional validity of differentiating financial and operational creditors, it has led to unequal outcomes for smaller creditors.
- Government initiatives, such as the MSME-friendly pre-pack insolvency process (PPIRP), offer a quicker, less disruptive resolution process that keeps management with the corporate debtor.
- Ongoing IBC amendments aim to address these disparities and expedite resolutions, reinforcing the protection for all stakeholders.
Suggestions for Strengthening the Position of Small Creditors
There is a need to introduce reforms for:
- Greater representation or consultation rights in the CoC.
- Mandatory minimum payout thresholds.
- Simplified recovery mechanisms for small claims.
Further, information utilities and digital filing could significantly ease the process.
Conclusion : small creditors losing out in insolvency
While IBC has enhanced recovery mechanisms overall, small creditors often recover significantly less than financial creditors, particularly in large insolvencies where their claims are minor. This disparity arises from the dominance of financial credits in the CoC, who may prioritize their own recovery, leading to sub-optimal outcomes for smaller trade creditors. To ensure fairness and equitable treatment, policy reforms or stricter procedural safeguards are needed to prevent the disenfranchisement of vulnerable stakeholders. An insolvency framework is only as strong as its weakest creditor’s protection.
FAQs
Q1. Why do small creditors get less recovery under IBC?
Small creditors receive less recovery under the IBC because they are lower in the priority hierarchy, often unsecured, and the resolution process frequently results in minimal or zero distributions to them.
Q2. Can small creditors participate in the Committee of Creditors?
Yes, ssmall creditors losing out in insolvency can participate in the CoC, either directly as financial creditor, or if there are no financial creditors, with their representation facilitated by a representative if the number exceeds one thousand.
Q3. What are the legal remedies available to small creditors if they are unpaid after insolvency?
small creditors losing out in insolvency can participate in the process, have the right to representation in the CoC if their dues exceed 10% of the total debt, may submit a resolution plan, appeal the resolution plan or claim valuation, and are entitled to receive proceeds from liquidation in a specified priority order.
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