Financial and Operational Creditors Under the Insolvency and Bankruptcy Code 2016: Legal Framework, Distinctions, and Judicial Interpretations

Introduction

The Insolvency and Bankruptcy Code, 2016 [1] represents a watershed moment in India’s corporate restructuring and insolvency landscape. This landmark legislation consolidated and revolutionized the laws relating to reorganization and insolvency of corporate persons, partnership firms, and individuals. One of the most significant innovations of the Code lies in its clear delineation between two distinct categories of creditors – financial creditors and operational creditors – a classification that fundamentally shapes the entire insolvency resolution framework.

The Code defines a creditor broadly under Section 3(10) as “any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree holder” [2]. This definition encompasses various categories of creditors, but the distinction between financial and operational creditors has emerged as particularly crucial for determining rights, procedures, and priorities in corporate insolvency resolution processes.

Unlike the Companies Act, 2013, which merely introduced the term ‘creditor’ without any meaningful classification, the Insolvency and Bankruptcy Code has introduced nuanced definitions that carry significant legal and practical implications. The maintainability of applications for initiating corporate insolvency resolution processes now depends fundamentally on the applicant’s ability to establish their status as either a financial creditor or an operational creditor under the Code.

Legal Framework and Statutory Definitions

Financial Creditors: Definition and Scope

The Code defines a financial creditor under Section 5(7) as “a person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred” [3]. The essence of being a financial creditor lies in the nature of the underlying debt, which must qualify as a ‘financial debt’ under the Code.

Section 5(8) of the Code elaborately defines financial debt as “a debt along with interest, if any, which is disbursed against the consideration for the time value of money” [3]. This definition encompasses various forms of financial arrangements including money borrowed or raised through bonds, debentures, loans, deposits, advances, or any other form of indebtedness. The key distinguishing factor is that the money must be disbursed against consideration for the time value of money, which may include interest, discount, premium on redemption, or any other charge or fee.

The definition further includes obligations under financial derivatives, guarantees or suretyship for financial debt, repurchase agreements, forward sale agreements, and any other transaction creating monetary obligations. This broad definition ensures that modern financial instruments and arrangements are captured within the ambit of financial debt.

Operational Creditors: Definition and Characteristics

An operational creditor is defined under Section 5(20) of the Code as “any person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred” [4]. The classification depends on whether the debt qualifies as an ‘operational debt’ under Section 5(21) of the Code.

Operational debt encompasses four specific categories: claims relating to the provision of goods or services including employment, or a debt in respect of repayment of dues arising under any law for the time being in force and payable to the Central Government, any State Government, or any local authority. This definition captures trade creditors, service providers, employees, and governmental authorities who have transactional relationships with the corporate debtor arising from its business operations.

The Bankruptcy Law Reforms Committee, in paragraph 5.2.1 of its final report, clarified the distinction by noting that “Financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or debt security. Operational creditors are those whose liability from the entity comes from a transaction on operations” [5].

Procedural Differences in Insolvency Initiation

Financial Creditor Initiated Processes

Under Section 7 of the Code, financial creditors enjoy a relatively streamlined process for initiating corporate insolvency resolution proceedings. Upon occurrence of a default, a financial creditor may either by itself or jointly with other financial creditors file an application before the National Company Law Tribunal (NCLT). The application must be accompanied by evidence of debt and default, along with the name of a resolution professional proposed to act as interim resolution professional.

The threshold requirement for financial creditors is the existence of a financial debt of at least one lakh rupees, and the adjudicating authority must either admit or reject the application within fourteen days of its filing. Importantly, financial creditors need not provide prior notice to the corporate debtor, and the debtor cannot dispute the debt at the admission stage.

Operational Creditor Initiated Processes

The process for operational creditors under Section 9 is more elaborate and includes additional procedural safeguards. Before filing an application, an operational creditor must deliver a demand notice to the corporate debtor demanding payment of the amount involved in the default. This notice must be accompanied by a copy of an invoice or other evidence of the operational debt.

The operational creditor can file an application only after the expiry of ten days from the date of delivery of the notice, and only if the corporate debtor fails to make payment or disputes the debt. If the corporate debtor disputes the debt by providing notice of dispute along with credible evidence, the operational creditor cannot proceed with the application unless it obtains a decree, order, or award from a competent court, tribunal, or arbitrator.

This additional layer of protection for corporate debtors in operational creditor cases reflects the legislature’s recognition that operational debts may be more susceptible to genuine disputes and require greater scrutiny before triggering the insolvency process.

Rights and Representation in Committee of Creditors

One of the most significant distinctions between financial and operational creditors lies in their participation rights in the Committee of Creditors (CoC), which serves as the primary decision-making body during the corporate insolvency resolution process.

Financial Creditors’ Dominant Role

Under Section 21(2) of the Code, the Committee of Creditors consists solely of financial creditors. All financial creditors of the corporate debtor are entitled to be members of the CoC, and their voting rights are proportionate to their financial debt. The approval of the committee requires a vote of not less than seventy-five percent of the voting shares, with each financial creditor’s voting share determined by the proportion of their financial debt to the total financial debt.

This structure gives financial creditors complete control over critical decisions including approval of resolution plans, appointment of resolution professionals, and other matters relating to the conduct of the corporate insolvency resolution process. The rationale behind this approach is that financial creditors typically have larger exposures and have provided funding that enabled the corporate debtor to establish and operate its business.

Limited Rights of Operational Creditors

Operational creditors have significantly limited participation rights in the insolvency resolution process. Under the original framework, operational creditors had no voting rights in the Committee of Creditors and could only attend meetings as observers. However, subsequent amendments have provided some relief to operational creditors.

Currently, operational creditors can be represented in the CoC if they collectively hold at least ten percent of the total debt or if they individually hold at least ten percent of the total operational debt. Even when represented, operational creditors cannot vote on substantial matters and their role remains largely advisory.

The operational creditors can authorize an insolvency professional to represent them in CoC meetings, but this representation does not translate to voting power on crucial decisions affecting the resolution process. This limited participation reflects the legislative intent to prioritize the interests of financial creditors who are perceived as having a greater stake in the revival of the corporate debtor.

Judicial Interpretations and Key Cases

The Col. Vinod Awasthy Case: Defining Operational Debt Boundaries

The National Company Law Tribunal, Principal Bench, New Delhi, in Col. Vinod Awasthy v. AMR Infrastructure Limited [6], provided important clarity on the scope of operational debt. The case involved a flat purchaser seeking to initiate insolvency proceedings against a real estate developer claiming status as an operational creditor.

The Tribunal held that the framers of the Code had not intended to include within the expression of operational debt any debt other than those specifically enumerated in Section 5(21). The Tribunal observed that operational debt is confined to four categories: goods, services, employment, and government dues. The debt owed to a flat purchaser, being associated with the possession of immovable property, did not fall within any of these categories.

The Tribunal emphasized that the petitioner had neither supplied goods nor rendered services to acquire the status of an operational creditor. This decision established important precedent regarding the limited scope of operational debt and clarified that not all commercial relationships automatically qualify parties as operational creditors under the Code.

Supreme Court’s Constitutional Validation in Swiss Ribbons

The distinction between financial and operational creditors faced constitutional challenge in Swiss Ribbons Pvt. Ltd. v. Union of India [7], where the Supreme Court was called upon to examine whether the differential treatment accorded to these creditor categories violated constitutional principles of equality and non-discrimination.

The Supreme Court comprehensively upheld the constitutional validity of the Code’s provisions relating to financial and operational creditors. The Court observed that financial creditors generally lend finance on term loans or for working capital that enables the corporate debtor to set up or operate its business, while contracts with operational creditors relate to supply of goods and services in business operations.

The Court noted that financial contracts generally involve larger sums of money, whereas operational contracts typically involve smaller amounts. More importantly, the Court recognized that the differentiation was based on the fundamental difference in the nature of relationships – financial creditors have pure financial contracts while operational creditors have operational relationships arising from business transactions.

The Supreme Court’s decision in Swiss Ribbons not only validated the legislative classification but also provided important guidance on interpreting the distinction between financial and operational debts based on the intent of the parties and the nature of the underlying transaction.

Distribution Priorities and Recovery Rights

The Code establishes a clear hierarchy for distribution of assets during liquidation proceedings, with significant implications for both categories of creditors. Under Section 53 of the Code, the distribution waterfall places secured creditors at the top, followed by insolvency resolution process costs, workmen’s dues, and other specified categories.

Financial creditors rank higher than operational creditors in the distribution hierarchy. Unsecured financial debts are placed at clause (d) of Section 53(1), while operational debts fall under clause (f). This means that in liquidation scenarios, financial creditors recover their dues before operational creditors, even when both are unsecured.

This prioritization reflects the legislative understanding that financial creditors provide the capital foundation for business operations and should therefore receive preferential treatment in recovery proceedings. The Supreme Court has consistently upheld this priority structure, recognizing it as a rational classification based on the different roles played by financial and operational creditors in corporate financing.

Recent Developments and Amendments

The Code has undergone several amendments since its enactment, many of which have impacted the treatment of financial and operational creditors. One significant development was the treatment of homebuyers in real estate projects, who were initially caught in definitional ambiguity.

Following the Jaypee Infratech case and other similar situations, the legislature amended the Code to specifically include allottees under real estate projects within the definition of financial creditors. The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2018, inserted Explanation 1 to Section 5(8) clarifying that amounts raised from allottees under a real estate project constitute financial debt.

This amendment settled the controversy surrounding homebuyers’ status and provided them with the enhanced rights and protections available to financial creditors, including participation in the Committee of Creditors and priority in distribution of assets.

Regulatory Framework and Enforcement Mechanisms

The Insolvency and Bankruptcy Board of India (IBBI) serves as the regulatory authority overseeing the implementation of the Code. The IBBI has issued various regulations and circulars providing detailed guidance on the treatment of financial and operational creditors in insolvency proceedings.

These regulations cover aspects such as verification of claims, representation in Committee of Creditors, voting procedures, and distribution of assets. The IBBI’s regulatory framework ensures uniformity in the treatment of different creditor categories across various insolvency proceedings and provides clarity on procedural requirements.

The enforcement mechanisms under the Code include penalties for non-compliance, disciplinary action against insolvency professionals, and appellate procedures before the National Company Law Appellate Tribunal (NCLAT) and Supreme Court. These mechanisms ensure adherence to the statutory framework governing financial and operational creditors.

Challenges and Practical Considerations

Despite the detailed statutory framework, several practical challenges persist in the classification and treatment of financial and operational creditors. The determination of whether a particular debt qualifies as financial or operational often requires careful analysis of the underlying transaction and the intent of the parties.

Hybrid arrangements involving both financial and operational elements pose particular challenges. The Code addresses this by providing that a creditor can be considered a financial creditor to the extent of financial debt and an operational creditor to the extent of operational debt. However, practical implementation of this principle requires careful documentation and legal analysis.

The limited participation rights of operational creditors continue to be a source of concern, particularly for trade creditors and suppliers who may have significant exposures to corporate debtors. While the amendments have provided some relief, the fundamental structure continues to prioritize financial creditors’ interests.

International Comparisons and Best Practices

The Indian approach to distinguishing between financial and operational creditors finds parallels in several international insolvency regimes, though the specific mechanisms vary. The United States Bankruptcy Code, for instance, recognizes different classes of creditors with varying rights and priorities, though the classification criteria differ from the Indian framework.

The Indian system’s emphasis on financial creditors’ control reflects influences from the UK insolvency regime, where secured creditors and financial institutions traditionally exercise significant influence over insolvency proceedings. However, the specific procedural distinctions and representation rights in the Indian Code represent unique innovations tailored to Indian commercial realities.

Future Outlook and Recommendations

The distinction between financial and operational creditors under the Insolvency and Bankruptcy Code represents a fundamental structural choice that continues to evolve through judicial interpretation and legislative amendments. As the Code matures and more cases are resolved through its mechanisms, the practical implications of this classification become clearer.

Future developments may include further refinement of the definitions to address emerging financial instruments and business models. The growth of alternative financing mechanisms, including peer-to-peer lending, supply chain financing, and crypto-currency based transactions, may require legislative clarification of their treatment under the Code.

The ongoing emphasis on maximizing value for all stakeholders while maintaining clear priority structures suggests that the current framework will continue to evolve in response to market needs and judicial interpretations. The success of the Code in achieving its objectives of timely resolution and value maximization will largely depend on the continued refinement of the balance between different creditor interests.

Conclusion

The Insolvency and Bankruptcy Code’s distinction between financial and operational creditors represents a sophisticated approach to corporate insolvency that recognizes the different roles and interests of various stakeholder groups. This classification system has withstood constitutional scrutiny and has been refined through judicial interpretation and legislative amendments.

The framework provides financial creditors with enhanced rights and control mechanisms while ensuring that operational creditors retain meaningful participation opportunities. The procedural distinctions reflect the different risk profiles and verification requirements associated with financial and operational debts.

As India continues to develop its insolvency ecosystem, the treatment of financial and operational creditors will remain a critical component of the framework. The balance between protecting different creditor interests while ensuring efficient resolution processes will continue to evolve through practice, judicial interpretation, and legislative refinement.

The success of this distinctive approach in achieving the Code’s objectives of value maximization and timely resolution will ultimately determine its continued relevance and potential influence on insolvency frameworks in other jurisdictions. The ongoing evolution of this framework reflects India’s commitment to developing a world-class insolvency and bankruptcy system that meets the needs of its dynamic economy.

References

[1] The Insolvency and Bankruptcy Code, 2016, https://www.indiacode.nic.in/bitstream/123456789/15479/1/the_insolvency_and_bankruptcy_code,_2016.pdf 

[2] Lawbhoomi, “Who is a Creditor under IBC?”, https://lawbhoomi.com/creditor-under-ibc/ 

[3] Taxmann, “Operational Creditors Under Insolvency and Bankruptcy Code, 2016”, https://www.taxmann.com/post/blog/operational-creditors-under-insolvency-and-bankruptcy-code-2016/ 

[4] KS&NK Legal, “Understanding the Key Differences Between Financial Creditor and Operational Creditor under IBC 2016”, https://ksandk.com/insolvency/key-differences-between-financial-and-operational-creditors-under-ibc-2016/ 

[5] IBC Laws, “Distinction in Treatment of Financial Creditors vs. Operational Creditors under IBC”, https://ibclaw.in/distinction-in-treatment-of-financial-creditors-vs-operational-creditors-by-vidushi-puri/ 

[6] Bar & Bench, “The Viewpoint: Financial Creditor and Operational Creditor”, https://www.barandbench.com/law-firms/view-point/financial-creditor-operational-creditor 

[7] Indian Kanoon, “Swiss Ribbons Pvt. Ltd. vs Union Of India on 25 January, 2019”, https://indiankanoon.org/doc/17372683/ 

[8] India Corporate Law, “Swiss Ribbons v. Union of India – The Foundation for Modern Bankruptcy Law”, https://corporate.cyrilamarchandblogs.com/2019/02/swiss-ribbons-v-union-india-foundation-modern-bankruptcy-law/ 

[9] iPleaders, “Swiss Ribbons Pvt. Ltd. and Anr. Vs. Union of India and Ors”, https://blog.ipleaders.in/swiss-ribbons-pvt-ltd-and-anr-v-union-of-india-and-ors-comprehending-the-underpinnings-of-the-insolvency-and-bankruptcy-code-2016/ 

Authorized by Dhrutika Barad