All About Waterfall Mechanism Under IBC

The insolvency law in India was transformed with the enactment of the  Insolvency and Bankruptcy Code, 2016. Among the many changes, the waterfall mechanism Under IBC was introduced as a systematic manner is distributing the proceeds. This ensures that the distribution is done fairly, according to the principle of equitable treatment, and maintains a structured manner for such distribution. It is called the “waterfall” mechanism because of its descending manner of distribution, where the one first mentioned must be satisfied before the next is met. This helps in balancing the interests of the classes of creditors and stakeholders.

Legal Framework of the Waterfall Mechanism

The Waterfall Mechanism Under IBC is governed by the Insolvency and Bankrtupcy Code, 2016 (hereon forward know as the “IBC”) and the Insolvency and Bankrtupcy Board of India (Liquidation Process) Regulations, 2016 (hereon forward known as “the Regulations, 2016”). The distribution process under section 53 of IBC and as per the Regulations, 2016 ensures that the distribution process is conducted as per the principles of fairness, transparency, and maximization of asset value. 

Order of Distribution Priority

As per section 53, the priority order for the distribution of proceeds from the sale of the liquidation assets of the corporate debtor is as follows:

1. The insolvency resolution process costs and the liquidation costs are paid in full.
2. Workmen’s dues for 24 months preceding the liquidation commencement date (LCD) and the debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner as per section 52.
3. Wages and unpaid dues owed to employees 12 months preceding the LCD
4. Financial debts owed to unsecured creditors
5. Any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State, if any, in respect of the whole or any part of the period of 2 years preceding the LCD and debts owed to a secured creditor for any amount unpaid following the enforcement of security interest
6. Any remaining debts and dues
7. Preference shareholders
8. Equity shareholders or partners

Key Stakeholders in the Waterfall Process

There are several stakeholders in the waterfall process that have an important role in deciding the amount of the proceeds to be distributed. Upon reading the IBC provisions, key stakeholders include the liquidator, the Committee of Creditors (CoC), secured creditors, unsecured creditors, workmen and employees, the Government, and shareholders:

1. Liquidator: The resolution appointed by the National Company Law Tribunal (NCLT) during the corporate insolvency resolution process (CIRP) is appointed as the liquidator during the liquidation process as per section 34(1) of the IBC. The liquidator has the role of overlooking the liquidation proceedings, which include verifying the claims of the creditors, taking custody or controlling the assets, property, effects, and actionable claims of the debtor, to taking measures to protect and preserve the assets of the debtor, etc. As per section 53(1)(a) the liquidator has the highest priority to be paid from the proceeds of the liquidation assets.
2. Committee of Creditors: The CoC is comprised of  the financial creditors of the corporate debtor and is constituted by the interim resolution professional. The CoC has a major role during the CIRP. Upon the decision of the CoC, the NCLT will pass an order rejecting the resolution plan, and the corporate debtor should be liquidated. Hence, the CoC decision impacts the liquidation process,  making the CoC decision have an indirect inclusion in the waterfall mechanism.
3. Secured and Unsecured Creditors: Secured creditors have a security interest in the corporate debtor’s assets, such as a mortgage on the property and unsecured creditors have no security interest. Unsecured creditors rank lower than secured creditors on the priority list under section 53 of the IBC. 
4. Workmen and employees: Workmen are higher on the priority list than employees and are overall the second priority. Therefore, there is a high chance that the wages and unpaid dues owed to employees may not be returned once the company is liquidated. Workmen may be paid for their dues for the period 24 months before the LCD.
5. Government: The Government is fifth on the priority list because it receives several dues and taxes and has a right to the proceeds from the debtor’s assets.
6. Shareholders: Last on the list, are shareholders, such as preference shareholders and equity shareholders. 

Implementation Steps and Challenges

The steps under the IBC and the Regulations, 2016  for the distribution of the proceeds from the liquidation asset is as under:

• Asset Valuation: The assets must be valued accurately and up-to-date according to the current financial position of the corporate debtor and the market status. This is important to determine the proceeds that are available for distribution.
  Verification of Claims: The liquidator has the duty under section 35 of the IBC  to verify all the claims and examine them to ensure which claims may or may not be admitted.
• Distribution Planning: The liquidator has the main role of overseeing the liquidation process, which includes making a distribution plan. This plan will be based on the value of the corporate debtor’s assets and the verification of claims. 
• Actual Distribution: Upon the distribution plan, the liquidator must distribute the proceeds among the stakeholders as per section 53.

However, several challenges may arise during the distribution process due to the difficulty in balancing the interests of the stakeholders. An issue may result in disputed claims, the value of assets during liquidation may be insufficient to fulfill all the claims, meaning that those low priority under section 53 funds may not be repaid. Handling large companies, and multinational companies, there may be difficulty in applying the waterfall mechanism under IBC due to international laws and regulations. There are also strict timelines under the IBC, which may make it difficult to meet the demands of complex cases. 

Case Studies and Precedents

Committee of Creditors of Essar Steel India Limited Vs. Satish Kumar Gupta upheld the power of the CoC in approving the resolution plans in insolvency proceedings under the IBC. The Supreme Court held that the CoC is not required to ensure equal treatment of all stakeholders and can approve the resolution plan with discriminatory distributions in certain circumstances. The National Company Law Tribunal in the Binani Cement Case focused on extracting maximum value from the resolution of the stressed assets and ensuring that the interests of operational creditors, who are not part of the CoC are also served. This case is important as it ensures that there is equitable treatment and maximising asset value.

Impact on Creditors and Debtors

The Waterfall Mechanism Under IBC has a significant impact on creditors and the corporate debtor. This mechanism provides creditors with an idea of the recovery of their debts, which helps them in making informed decisions during the insolvency process. Secured creditors are higher on the priority list and may receive proceeds from the sale of the assets. On the other hand, unsecured creditors may not receive any proceeds because of insufficient value of the corporate debtor’s assets. The corporate debtors may opt for a resolution process earlier when they face financial distress to maximise value for their stakeholders if they understand the future steps that they might have to take. The Waterfall Mechanism Under IBC may affect the debtor’s ability to access credit in the future upon the treatment of classes of creditors during CIRP.

Recent Amendments and Future Developments

In the National Company Law Appellate Tribunal in IDBI Bank Ltd. v. Jaypee Infratech Ltd. classified homebuyers as financial creditors, making it a significant step towards the equitable treatment in the Waterfall Mechanism Under IBC. The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021 introduced a pre-packaged insolvency resolution process for micro, small, and medium enterprises under section 54C of the IBC. This can influence how the Waterfall Mechanism Under IBC affects MSMEs. The COVID-19 pandemic also introduced measures for a particular duration and has had implications for the CIRP and any extensions under the Waterfall Mechanism Under IBC. There is a requirement that there be an inclusion of cross-border insolvencies in the priority list in section 53 of the IBC. 

Conclusion : Waterfall Mechanism Under IBC

The Waterfall Mechanism Under IBC under section 53 of the IBC establishes a priority system for distributing the proceeds after the sale of the assets. There have been challenges in balancing the interests of the stakeholders, but this mechanism has had more success than loss. As insolvency law progresses and developments are made, the waterfall mechanism will also go through changes. This means that the challenges will be addressed, judicial precedents may encourage amendments, and align with global best practices. The implementation of the waterfall mechanism has an important role in shaping the future of insolvency laws and the development of the economy, Therefore, this mechanism represents the principles of equity, and predictability, and maximises the corporate debtor’s asset value.