Secured Creditors in ‘Liquidation’: Companies Act 2013 vs. IBC vs. SARFAESI
Table of Contents
During liquidation under the Insolvency and Bankruptcy Code, 2016 (IBC), secured creditors have the right to either relinquish their security interest to the liquidation estate or realize it independently, with the proceeds applied first to their debt, and any surplus paid to the liquidator. The objective of protecting creditor rights is to ensure fair and efficient recovery, with the IBC prioritizing secured creditors after insolvency costs. On the other hand, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 allows for direct enforcement without court intervention, and the Companies Act, 2013 govern priority among multiple secured creditors based on the principle of “first in time, first in right”.
Who are Secured Creditors?
According to Section 3(30) of the IBC, “secured creditor” means a creditor in favour of whom security interest is created. Similarly under the Companies Act, it is a creditor in whose favour a security interest is created over the property of a corporate debtor, such as through a mortgage, charge, or lien. This gives them a legal right to reclaim specific assets used as collateral if the debtor defaults on their right obligations. This security interest, defined under section 3(31) of the IBC, encompasses rights like mortgage, charge, hypothecation, pledge, assignment, and any other agreement securing payment or performance of an obligation. The key difference from an unsecured creditor is that a secured creditor has a legal claim over specific assets of the corporate debtor, providing a higher priority for repayment compared to unsecured creditors, who have no such collateral.
Read more Section 34 of Arbitration Act
Secured Creditors under the Companies Act, 2013
Under the Companies Act, secured creditors have certain rights, such as:
- Liquidation Process under Companies Act: Secured creditors have the right to realise their security interest by enforcing their charge on specific assets, either by taking possession of the asset or selling it, and are entitled to the proceeds from the sale of the asset they have secured against. They may also choose to relinquish their security and participate in the liquidation process, in which case they rank pari passu with workmen’s dues for the preceding 24 months, placing them second in the payment hierarchy after the costs of the liquidation process.
- Priority of Secured Creditors: The priority of secured creditors is determined by the nature of their charge; a first charge holder has priority over a second charge holder based on the principle “qui prior est tempore potior est jure” as established under the Transfer of Property Act, 1881.
Secured Creditors under the IBC
Secured creditors play crucial roles in the IBC, which is reflected through several provisions:
- Role during CIRP and Liquidation: During the corporate insolvency resolution process (CIRP), secured creditors are prohibited from enforcing their security interest due to the moratorium under section 14 of the IBC. Upon commencement of liquidation, they have two options – relinquish their security interest to the liquidation estate, thereby becoming a claimant in the priority waterfall under section 53; or realize their security interest independently outside the liquidation estate in compliance with section 53 and applicable laws.
- Distribution Waterfall under Section 53 IBC: Under section 53, secured creditors who have relinquished their security interest rank equally with workmen’s dues and are paid before unsecured creditors, but the order of priority among secured creditors themselves, particularly those with different charges, remains ambiguous and is a subject of legal debate. Dissenting secured creditors are entitled to receive a minimum amount equivalent to what they would receive in liquidation.
- Judicial Pronouncements: Secured creditors who relinquish their security interest under section 52 of the IBC are treated equally and ranked as one class for distribution under section 53(1)(b), with no priority based on the value of their security interest, as affirmed by the National Company Law Tribunal (NCLT) and National Company Law Appellate Tribunal (NCLAT). The Suprmee Court has staued the NCLAT’s order in the Technology Development Board case and referred the conflicting interpretations of section 53 of the IBC, particularly regarding the inter-se priority among secured creditors, to a large bench for a definitive determination.
Secured Creditors under SARFAESI Act, 2002
- Enforcement of Security Interest: Under section 13(2) of the SARFAESI Act, secured creditors, such as banks or financial institutions, can initiate enforcement of security interests by issuing a 60 day notice to a borrower who has defaulted on repayment and whose account is classified as a non-performing asset (NPA), or in the case of debt securities, even if not classified as an NPA. If the borrower fails to discharge the liability within this period, section 13(4) empowers the secured creditor to take possession of the secured assets, take over the management of the borrower’s business, appoint a manager, or require payments from third parties who owe money to the borrower, thereby enabling the recovery of dues without court intervention.
- Interplay with IBC: As established by section 238 of the IBC, the IBC prevails over the SARFAESI Act in case of conflict. Once the CIRP commences, a moratorium under section 14 of the IBC prohibits any action to foreclose, recover, or enforce any security interest created by the corporate debtor, including proceedings initiated under the SARFAESI Act.
Comparative Analysis: Companies Act vs. IBC vs. SARFAESI
| Aspect | Companies Act | The IBC | The SARFAESI Act |
| Priority of Claims | Secured creditors priority is governed by the nature of the charge, first charge takes precedence | Secured creditors rank second in the liquidation waterfall under section 53 | Secured creditors have the right to enforce their security interests with priority determined by the order of creation of the charge. |
| Recovery Mechanism | Recovery is primarily through winding up proceedings | The IBC provides a time-bound mechanism, CIRP, which aims for revival. If unsuccessful, liquidation follows with a defined “waterfall mechanism” | Allows banks to take possession of collateral and sell it without court intervention, enabling faster recovery. |
Creditor Empowerment vs. Debtor Protection |
Provides a framework for winding up but offers limited protection for the debtor, and creditor rights are paramount | Balances stakeholder interest, protects the debtor’s business through a resolution process while empowered creditor through the Committee of Creditors | Strongly empowers secured creditors to recover dues quickly, offering minimal protection to the debtor. |
Challenges and Practical Issues
- The conflict between SARFAESI and IBCarises primarily when a secured creditor seeks to enforce security interest under the SARFAESI Act after the initiation of CIRP under the IBC, leading to procedural clashes and uncertainty over asset control.
- Under evolving jurisprudence, secured creditors can enforce their security interest only after the CIRP fails and liquidation commences, and their rights are subject to the IBC’s liquidation process and the waterfall mechanism, with the moratorium under IBC preventing pre-liquidation enforcement.
- Delays occur due to the lack of coordination between enforcement mechanism, the need for multiple proceedings, and the potential for conflicting court orders, particularly when SARFAESI actions are initiated before or during CIRP, despite the IBC’s overriding effect.
The Way Forward
- Harmonizing the IBC, Companies Act, and SARFAESI through clear legislative coordination to ensure the IBC’s primacy under section 238 of the IBC while providing specific procedural frameworks for secured creditors to enforce their rights outside the insolvency process, thereby reducing overlaps and conflicts.
- Strengthening secured creditor rights while ensuring equitable distribution is required to recognise the IBC’s overriding effect and allowing secured creditors under section 52, provided they follow the prescribed procedures, thus, balancing their rights with broader objective of maximizing asset value for all stakeholders.
- Reducing overlaps and conflicts among statutes is necessary for the coherent interpretation of the IBC’s moratorium, which halts all actions to enforce security interests under SARFAESI Act, while also acknowledging the distinct purpose of each law and ensuring that the IBC’s framework for insolvency remains the primary mechanism for resolving defaults.
Conclusion
The IBC balances creditor rights with the goal of maximising asset value through resolution, whereas SARFAESI focuses on swift recovery, and the Companies Act provides foundational rules for inter-creditor ranking. Secured creditors enjoy varying levels of protection under these Acts, with the IBC now serving as the primary insolvency framework through section 238. The interplay between the IBC and SARFAESI Act continues, particularly concerning the treatment of assets sold under the SARFAESI Act before the moratorium. The Supreme Court has clarified that a sale completed by issuance of a sale certification is not subject to inclusion in the liquidation estate. Judicial consistency, as demonstrated in recent rulings, and further legislative clarity are essential for achieving smoother and more predictable liquidation outcomes.
FAQs
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Who is considered a secured creditor under the IBC?
A secured creditor under the IBC is a creditor in favour of whom security interest is created.
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Can secured creditors enforce security outside the IBC liquidation process?
Yes, secured creditors can enforce security outside the IBC liquidation process, provided they notify the liquidator of their intent.
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How does Section 53 of the IBC affect secured creditors?
Section 53 of the IBC establishes a priority order for distributing proceeds from a corporate debtor’s liquidation, placing secured creditors who relinquish their security interest second in line.
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Does SARFAESI override IBC in enforcement of security?
No, SARFAESI does not override the IBC in enforcement of security as the IBC takes precedence over the SARFAESI, and other laws, through section 238 of the IBC.
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What is the difference in treatment of secured creditors under Companies Act vs. IBC?
Under the Companies Act, secured creditors are paid after workmen’s dues during liquidation, while under the IBC, secured creditors are paid pari passu with workmen’s dues for the preceding 24 months, following the costs of the insolvency process.
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