Introduction
The Insolvency and Bankruptcy Code (IBC), enacted in 2016, introduced a structured and time-bound resolution framework for distressed entities in India. A key aspect of the liquidation process under the IBC is the Waterfall Mechanism, enshrined in Section 53, which outlines the priority order for distributing the proceeds from the corporate debtor’s assets. By establishing a clear hierarchy for claims, the IBC aims to balance the interests of various stakeholders while maximizing asset realization.
Understanding the Waterfall Mechanism
The Waterfall Mechanism is a structured approach to distributing funds during liquidation, ensuring that payments are made in a predefined order of priority. This system ensures that certain creditors receive payments before others, based on their level of protection under the law. The provisions of the IBC define this hierarchy, granting preferential treatment to specific claims over others.
Hierarchy of Payments under the Waterfall Mechanism
Section 53 of the IBC establishes the following order for distributing liquidation proceeds:
1. Insolvency Resolution Process Costs and Liquidation Costs
* The first priority is given to covering insolvency resolution and liquidation costs, ensuring that professionals, legal advisors, and other service providers involved in the resolution process are adequately compensated.
* These costs include fees for insolvency professionals, legal expenses, expenses related to preserving the corporate debtor’s assets, and costs incurred to keep the company operational during the resolution period.
Secured Creditors and Workmen’s Dues
* Secured creditors who waive their security interest and workmen’s dues for the last 24 months before liquidation commencement are given second priority.
* This prioritization reflects the IBC’s focus on protecting the rights of workmen, recognizing them as vulnerable stakeholders.
2. Employee Dues (Other than Workmen)
* The third priority is given to unpaid salaries, wages, and benefits owed to employees (excluding workmen) for the preceding 12 months before liquidation commencement.
3. Unsecured Financial Creditors
* These creditors, who have extended loans without collateral, are next in line after secured creditors and employees. Since they assume greater risk, they receive payments before government dues and other unsecured obligations.
4. Government Dues and Remaining Secured Creditors
* Dues owed to the Central and State Governments for the past two years come after unsecured financial creditors.
* Secured creditors who could not fully recover their dues in previous stages also receive payments at this stage.
5. Other Debts and Dues
* This category includes remaining operational and unsecured creditors whose claims do not fall within the previous categories.
* Shareholders and equity partners also fall into this category, ranking the lowest in terms of payment priority.
6. Equity Shareholders and Partners
* Finally, if any funds remain after settling all debts and obligations, they are distributed among equity shareholders and partners based on their ownership stakes.
Key Features and Legal Principles of the Waterfall Mechanism
* Mandatory Compliance: The IBC mandates strict adherence to the Waterfall Mechanism to ensure fair and transparent distribution of liquidation proceeds. Courts have consistently upheld this order, preventing deviations that could lead to unfair treatment of stakeholders.
* Priority to Workmen: The mechanism prioritizes workmen’s dues, reaffirming the IBC’s commitment to protecting labour rights in insolvency situations.
* Balanced Approach: It balances the interests of secured creditors, operational creditors, and statutory dues, while ensuring that employees and insolvency costs receive top priority.
* Final Distribution Stage: By following this structured approach, the IBC ensures that liquidation proceeds are allocated in a manner that upholds fairness and stability in the insolvency process.
Significance of the Waterfall Mechanism
The Waterfall Mechanism plays a crucial role in enhancing transparency, equity, and efficiency in the insolvency process. Some of its key benefits include:
* Maximizing Asset Value: Ensuring that insolvency resolution professionals and legal experts are adequately compensated encourages efficient management and value preservation of assets.
* Employee Protection: The prioritization of workmen’s and employees’ dues safeguards the interests of vulnerable workers.
* Strengthening Creditor Confidence: By ensuring a structured and predictable claim settlement process, the mechanism fosters trust among investors and creditors, encouraging greater participation in insolvency proceedings.
Judicial Interpretation and Case Laws
The Waterfall Mechanism has been upheld in several landmark judgments:
1. Swiss Ribbons Pvt. Ltd. vs. Union of India (2019)
* The Supreme Court upheld the constitutional validity of the IBC, affirming that the classification between financial and operational creditors does not violate Article 14 of the Constitution.
2. Committee of Creditors of Essar Steel India Ltd. vs. Satish Kumar Gupta (2019)
* The Court ruled that the National Company Law Tribunal (NCLT) cannot reject a resolution plan solely on the grounds of being unfavorable to a particular class of creditors.
* If the plan aligns with the Waterfall Mechanism under Section 53, it must be approved, reinforcing the importance of the structured payment hierarchy.
Conclusion
The Waterfall Mechanism under the Insolvency and Bankruptcy Code, 2016, provides a clear and structured framework for the distribution of liquidation proceeds. By ensuring fairness and transparency, it protects stakeholder interests, enhances economic stability, and strengthens investor confidence. As insolvency laws continue to evolve, the Waterfall Mechanism remains a fundamental pillar of India’s insolvency resolution process, ensuring efficiency, consistency, and equitable treatment of creditors and employees.
