Financial and Operational Creditors under the Insolvency and Bankruptcy Code, 2016 (IBC)

 

Introduction

The Insolvency and Bankruptcy Code, 2016 represents a watershed moment in Indian commercial legislation, fundamentally transforming how insolvency and bankruptcy proceedings are conducted across the country. Before this Code came into effect, India’s insolvency framework was fragmented across multiple legislations including the Companies Act 2013, the Sick Industrial Companies (Special Provisions) Act 1985, and the Recovery of Debts due to Banks and Financial Institutions Act 1993. This fragmentation created significant delays in debt recovery, with India ranking poorly on international indices for ease of doing business. The Code consolidates these disparate laws into a unified framework designed to facilitate time-bound resolution of insolvency cases.

One of the most distinctive features of the IBC is its novel classification of creditors into two primary categories: financial creditors and operational creditors. This distinction between financial creditors and operational creditors, which is relatively uncommon in insolvency legislation worldwide, serves as the backbone of the entire insolvency resolution framework under the IBC. The classification determines not only how creditors can initiate insolvency proceedings but also their rights during the resolution process and their priority in the distribution of assets. Understanding this distinction is essential for anyone navigating the Indian insolvency landscape, whether as a creditor seeking to recover dues or as a corporate debtor facing financial distress.

Defining Financial Creditors under the IBC

The Insolvency and Bankruptcy Code provides a precise definition of who qualifies as a financial creditor. Under Section 5(7) of the Code, a financial creditor is defined as “any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred.” This definition, while appearing straightforward, carries significant implications for the nature of the relationship between the creditor and the corporate debtor.

The essence of being a financial creditor lies not merely in lending money but in the specific nature of the transaction. Section 5(8) of the Code defines financial debt as “a debt along with interest, if any, which is disbursed against the consideration for the time value of money.” This crucial element distinguishes financial debt from other forms of debt. The time value of money refers to the economic principle that money available today is worth more than the same amount in the future due to its potential earning capacity. When a financial creditor extends credit, they are essentially providing funds with the expectation of receiving not just the principal amount but also compensation for the time their money remains with the debtor [1].

Financial creditors typically include banks, financial institutions, debenture holders, and entities that have extended loans or credit facilities to corporate debtors. The relationship between a financial creditor and a corporate debtor is purely contractual and financial in nature. Unlike operational creditors who provide goods or services, financial creditors provide capital that enables the corporate debtor to conduct its business operations. This fundamental difference in the nature of the relationship has been recognized by courts and forms the basis for the differential treatment accorded to these two classes of creditors under the Code.

The inclusion of assignees and transferees within the definition of financial creditor recognizes the reality of modern financial markets where debts are frequently traded. Banks and financial institutions often sell or assign their debt portfolios to asset reconstruction companies or other entities. The Code ensures that such assignees retain the same rights as the original financial creditor, thereby maintaining continuity in the resolution process.

Understanding Operational Creditors

Operational creditors represent the second major category of creditors under the Insolvency and Bankruptcy Code. Section 5(20) of the Code defines an operational creditor as “a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred.” The definition of operational debt, provided in Section 5(21), encompasses “a claim in respect of the provision of goods or services including employment or a debt in respect of the 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 reveals that operational creditors fall into distinct subcategories. The first category comprises suppliers of goods and providers of services who have extended credit to the corporate debtor in the course of ordinary business operations. These could include raw material suppliers, service contractors, consultants, and various other vendors who have delivered goods or rendered services but remain unpaid [2].

The second category encompasses employees who have provided their labor and services to the corporate debtor. Unpaid salaries, wages, and other employment-related dues fall within the ambit of operational debt, making employees operational creditors with specific rights under the Code. The third category includes government entities, both central and state governments, as well as local authorities, to whom statutory dues such as taxes, levies, and fees are owed. These statutory obligations, though not arising from a commercial transaction in goods or services, are classified as operational debts under the Code [3].

The nature of operational debt differs fundamentally from financial debt. While financial debt involves the extension of capital with an expectation of returns based on the time value of money, operational debt arises from the provision of goods, services, or labor in the ordinary course of business. Operational creditors do not typically assess the long-term viability of the corporate debtor’s business model or engage in restructuring exercises. Their primary concern is the recovery of dues for goods supplied or services rendered.

Initiating Insolvency Proceedings: Divergent Pathways

The Insolvency and Bankruptcy Code (IBC) establishes distinct procedures for financial and operational creditors to initiate corporate insolvency resolution proceedings. These procedural differences reflect the different nature of their relationships with corporate debtors and the varying levels of information and documentation typically available to each class of creditor.

Financial creditors can initiate proceedings under Section 7 of the Code. When a default occurs, a financial creditor may file an application before the National Company Law Tribunal seeking initiation of the Corporate Insolvency Resolution Process. The application must be filed in the prescribed format and accompanied by documents establishing the existence of financial debt and the occurrence of default. Critically, Section 7 requires the financial creditor to propose an interim resolution professional who will manage the insolvency resolution process if the application is admitted. The Adjudicating Authority must decide on the application within fourteen days of its receipt.

One of the notable features of Section 7 is the relatively straightforward admission process. The financial creditor must demonstrate the existence of debt and default. Unlike operational creditors, financial creditors are not required to serve a demand notice before approaching the Tribunal. This is because financial debts are typically well-documented through loan agreements, disbursement records, and repayment schedules. The corporate debtor is fully aware of the loan structure and any defaults that have occurred. The Supreme Court has recognized that the use of the word “may” in Section 7(5)(a) grants the Adjudicating Authority some discretion in admitting applications from financial creditors, allowing consideration of the overall financial health and viability of the corporate debtor [4].

Operational creditors follow a different pathway under Section 9 of the Code. Before filing an application with the Tribunal, an operational creditor must first deliver a demand notice to the corporate debtor demanding payment of the unpaid operational debt. This notice must be in the prescribed form and clearly state the amount due. The corporate debtor then has ten days from receipt of the notice to either make payment or bring to the operational creditor’s notice the existence of any dispute regarding the debt or the pendency of any suit or arbitration proceedings related to such dispute.

If the operational creditor receives neither payment nor notice of dispute within this ten-day period, they may file an application before the Adjudicating Authority. The application must be accompanied by copies of the demand notice, invoice, and a certificate from financial institutions confirming non-payment by the corporate debtor. The operational creditor may, but is not required to, propose an interim resolution professional. The Adjudicating Authority must admit the application within fourteen days if it is satisfied about the existence of default and the absence of a pre-existing dispute [5].

The requirement of a demand notice and the defense of pre-existing dispute create additional hurdles for operational creditors compared to financial creditors. This difference stems from the recognition that operational debts are more prone to genuine disputes about the quality of goods supplied or services rendered. A corporate debtor might legitimately dispute an operational creditor’s claim on grounds that goods were substandard or services were inadequately performed. In contrast, financial debts involve clearly documented monetary obligations with less room for such disputes.

The Committee of Creditors: Power and Exclusion

The composition and powers of the Committee of Creditors represent perhaps the most significant manifestation of the differential treatment between financial and operational creditors under the IBC. Section 21 of the Code provides for the constitution of a Committee of Creditors once an insolvency resolution process is initiated. However, Section 21(2) explicitly states that the Committee of Creditors shall comprise all financial creditors of the corporate debtor. Operational creditors, regardless of the quantum of their claims, are excluded from membership in this crucial decision-making body.

The Committee of Creditors exercises extensive powers during the insolvency resolution process. It has the authority to approve or reject resolution plans submitted by prospective resolution applicants. The committee assesses the viability and feasibility of proposed plans and determines whether they adequately address the interests of creditors. A resolution plan must be approved by not less than sixty-six percent of the voting share of financial creditors to be accepted. Once approved by the Committee and subsequently by the Adjudicating Authority, the resolution plan becomes binding on the corporate debtor and all its stakeholders.

Operational creditors, while excluded from the Committee, are granted limited participatory rights. An operational creditor or operational creditors representing at least ten percent of the aggregate operational debt may attend meetings of the Committee of Creditors and make representations. However, they have no voting rights. This means operational creditors cannot influence the decision to approve or reject a resolution plan, even when such plan directly affects their ability to recover their dues [6].

This exclusion has been the subject of considerable debate and legal challenge. Critics argue that denying operational creditors voting rights violates principles of equality and natural justice. Proponents of the exclusion point to the rationale provided by the Bankruptcy Law Reforms Committee, which observed that members of the Committee of Creditors must have both the capability to assess viability and the willingness to modify terms of existing liabilities in negotiations. The Committee concluded that operational creditors typically lack the ability to assess business viability and are primarily concerned with recovering the amounts owed to them rather than with the long-term prospects of the corporate debtor.

Constitutional Validity: The Swiss Ribbons Judgment

The constitutional validity of the differential treatment between financial and operational creditors was comprehensively examined by the Supreme Court in Swiss Ribbons Pvt. Ltd. v. Union of India, decided on January 25, 2019. Multiple writ petitions challenged various provisions of the IBC, including the exclusion of operational creditors from the Committee of Creditors, arguing that such discrimination violated Article 14 of the Constitution, which guarantees equality before law [7].

The Supreme Court rejected these constitutional challenges and upheld the validity of the Code’s provisions. The Court examined the rationale behind the distinction between financial and operational creditors as articulated in the report of the IBC Law Reforms Committee. The Committee had explained that financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or debt security. Financial creditors typically have the expertise and information necessary to assess the viability of the corporate debtor’s business. They are engaged in evaluating financial risks and are capable of making informed decisions about restructuring and reorganization.

In contrast, the Committee observed that operational creditors generally provide goods or services in the ordinary course of business. Their relationship with the corporate debtor is transactional rather than financial. Operational debts tend to be recurring in nature, and the possibility of genuine disputes is much higher compared to financial debts. A supplier might dispute the quantum or quality of goods, or a service provider might contest the adequacy of services rendered. Such disputes are matters to be proven in arbitration or courts of law. Financial debts made to banks and financial institutions, on the other hand, are well-documented and defaults are easily verifiable.

The Court found that the distinction between financial and operational creditors was based on an intelligible differentia and had a rational connection to the objectives of the IBC. It emphasized that the Code’s main goal is to ensure the expeditious resolution of corporate insolvency while maximizing the value of the debtor’s assets. Limiting the Committee of Creditors to financial creditors supports this goal by ensuring that restructuring decisions are made by those with the expertise and ability to assess financial viability and engage in meaningful negotiations. The Court concluded that this distinction is neither arbitrary nor discriminatory and does not violate Article 14 of the Constitution.

The Essar Steel Precedent: Defining Distribution Rights

The Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta, decided by the Supreme Court on November 15, 2019, represents another landmark judgment that clarified the rights of operational creditors and the extent of the Committee of Creditors’ powers. Essar Steel owed approximately forty-nine thousand crore rupees to its creditors and was one of the twelve accounts mandated by the Reserve Bank of India for resolution under the Code. The case involved appeals against orders of the National Company Law Appellate Tribunal that had modified the distribution pattern approved by the Committee of Creditors [8].

The resolution plan approved by the Committee of Creditors provided for differential treatment of various classes of creditors. Secured financial creditors were to recover a significantly higher percentage of their claims compared to operational creditors. The National Company Law Appellate Tribunal had taken the view that operational creditors stood on equal footing with financial creditors and modified the distribution to ensure parity. The Supreme Court reversed this approach, holding that equality cannot mean treating unequals equally.

The Supreme Court reaffirmed the primacy of the commercial wisdom of the Committee of Creditors. The Court held that the Committee has the authority to decide on all commercial aspects of a resolution plan, including the manner of distribution among different classes of creditors. While the Committee must consider the interests of all stakeholders, it is not required to treat all creditors identically. The principle of equality applies to similarly situated creditors, not to creditors belonging to different classes with fundamentally different relationships to the corporate debtor.

The Court emphasized that financial creditors are capital providers who enable the corporate debtor to conduct business. Operational creditors, while important stakeholders, are in essence beneficiaries of the capital provided by financial creditors. The differential treatment reflects the different risks undertaken and the different relationships maintained with the corporate debtor. The Supreme Court clarified that while the Committee of Creditors has wide discretion in determining distribution, it must ensure that the resolution plan meets the requirements specified in Section 30(2) of the Code, including that operational creditors receive at least the amount they would have received in liquidation.

The Essar Steel judgment addressed concerns about potential conflicts of interest by imposing certain checks on the Committee of Creditors. The Court held that while the Committee enjoys commercial wisdom and its decisions deserve deference, such wisdom must be exercised keeping in mind the interests of all stakeholders. The Adjudicating Authority retains jurisdiction to ensure that the resolution plan complies with the statutory requirements and does not unfairly prejudice the interests of any class of creditors [9].

Priority in Liquidation: Section 53 Waterfall

When a corporate debtor’s assets are liquidated, the Insolvency and Bankruptcy Code establishes a specific priority or waterfall for the distribution of proceeds. Section 53 of the Code provides this distribution mechanism, which places different classes of creditors at different levels of priority. Understanding this waterfall is crucial for all creditors as it determines the likelihood and extent of recovery in the event that the insolvency resolution process fails and liquidation becomes necessary.

The waterfall begins with insolvency resolution process costs and liquidation costs, which receive first priority. These include the fees of the resolution professional and costs incurred in conducting the insolvency process. Following these process costs, workmen’s dues for the twenty-four months preceding the liquidation commencement date receive priority, along with debts owed to secured creditors to the extent of the value of security held by them.

Wages and unpaid dues owed to employees other than workmen for the twelve months preceding the liquidation commencement date come next. Financial debts owed to unsecured creditors fall into the subsequent category. Crown debts, being amounts due to the government, follow these unsecured financial debts. Operational creditors find their place in the waterfall after these categories, sharing priority with certain other specified debts.

This prioritization means that in liquidation scenarios, operational creditors typically recover significantly less than secured financial creditors and often less than unsecured financial creditors as well. The rationale for this ordering reflects policy choices about which obligations society considers most important to honor when a business fails. Employee dues receive high priority to protect workers who depend on their wages for livelihood. Secured creditors’ priority reflects the contractual bargain struck when security was granted. Operational creditors, while entitled to payment, rank lower in this hierarchy.

Regulatory Framework and Procedural Safeguards

The Insolvency and Bankruptcy Board of India, established under Section 196 of the Code, serves as the principal regulatory authority overseeing the insolvency resolution process. The Board regulates insolvency professionals, insolvency professional agencies, and information utilities. It issues regulations that provide detailed procedures for various aspects of the insolvency resolution process, ensuring uniformity and transparency in proceedings across different cases and tribunals.

The Board has issued the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016, which provide comprehensive procedures for conducting the Corporate Insolvency Resolution Process. These regulations specify the forms to be used for various applications, the manner of filing claims, the procedures for meetings of the Committee of Creditors, and the requirements for resolution plans. Both financial and operational creditors must comply with these regulations when participating in IBC proceedings.

Information utilities, as envisaged under the Code, play a crucial role in reducing information asymmetry and facilitating quicker resolution of insolvency cases. These entities collect, collate, authenticate, and disseminate financial information about debts and defaults. When creditors report financial information to information utilities, it creates a credible record that can expedite the admission of insolvency applications and reduce disputes about the existence or quantum of debt. While the full potential of information utilities has yet to be realized, their development represents an important aspect of the Code’s infrastructure.

Challenges and Criticisms

Despite the Code’s achievements in improving India’s insolvency resolution framework, the treatment of operational creditors remains a subject of ongoing debate and criticism. Operational creditors argue that they face systematic disadvantages that undermine their ability to recover legitimate dues. The exclusion from the Committee of Creditors means they have no say in determining their own fate during the resolution process. Resolution plans often provide minimal recovery to operational creditors, sometimes as low as five to ten percent of admitted claims, while financial creditors recover substantially higher percentages.

The defense of pre-existing dispute available to corporate debtors when operational creditors file applications under Section 9 creates an additional hurdle. Even frivolous disputes raised by corporate debtors can delay or prevent the admission of applications by operational creditors. This stands in contrast to the relatively smoother path available to financial creditors under Section 7. Critics argue that this differential treatment incentivizes corporate debtors to preferentially repay financial creditors while neglecting operational debts, knowing that operational creditors face greater obstacles in enforcing their claims.

Small and medium operational creditors, including suppliers and service providers, often lack the resources to pursue prolonged legal battles. When their claims are admitted but the resolution plan provides minimal recovery, they have limited recourse. The concentration of power in the Committee of Creditors, which comprises only financial creditors, can lead to plans that favor financial creditors at the expense of operational creditors. While the Adjudicating Authority theoretically reviews plans for fairness, the deference accorded to the commercial wisdom of the Committee of Creditors limits the scope of such review.

Conclusion

The Insolvency and Bankruptcy Code, 2016 has fundamentally transformed India’s approach to insolvency and bankruptcy, replacing a fragmented and inefficient system with a consolidated, time-bound framework. The distinction between financial and operational creditors lies at the heart of this framework, shaping how insolvency proceedings are initiated, conducted, and concluded. While this classification has been upheld as constitutionally valid and serves important policy objectives, it creates significant practical consequences for the different classes of creditors.

Financial creditors enjoy several advantages under the Code, including simpler procedures for initiating insolvency proceedings, exclusive membership in the Committee of Creditors, and higher priority in asset distribution. These advantages reflect the recognition that financial creditors provide the capital that enables businesses to function and possess the expertise to assess viability and engage in meaningful restructuring. Operational creditors, while accorded certain rights and protections, face procedural hurdles and have limited influence over the resolution process.

The tension between the rights of financial and operational creditors under the IBC continues to evolve through judicial pronouncements and legislative amendments. The Supreme Court’s decisions in Swiss Ribbons and Essar Steel have provided important clarifications while also imposing certain checks to ensure that the interests of operational creditors are not entirely disregarded. As the Code matures and more cases are resolved, the balance between efficiency in resolution and fairness to all stakeholders will continue to be refined.

Understanding the nuances of being a financial or operational creditor under the IBC is essential for anyone involved in commercial transactions in India. Creditors must be aware of their rights, the procedures they must follow, and the practical limitations they may face. Corporate debtors must recognize their obligations to different classes of creditors and the consequences of default. As India continues to develop its insolvency ecosystem, the experiences of creditors and debtors alike will shape the ongoing evolution of this critical area of commercial law.

References

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

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

[3] Insolvency and Bankruptcy Board of India, “Understanding the Insolvency and Bankruptcy Code, 2016,” https://www.ibbi.gov.in/uploads/publication/190609_UnderstandingtheIBC_Final.pdf 

[4] IBC Laws, “Section 7 of IBC – Initiation of Corporate Insolvency Resolution Process by Financial Creditor,” https://ibclaw.in/section-7-initiation-of-corporate-insolvency-resolution-process-by-financial-creditor-chapter-ii-corporate-insolvency-resolution-processcirp-part-ii-insolvency-resolution-and-liquidation-for-corpor/ 

[5] Enterslice, “Difference Between Financial Creditor and Operational Creditor Under IBC,” https://enterslice.com/learning/difference-between-financial-creditor-and-operational-creditor-under-ibc-2016/ 

[6] 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/ 

[7] Swiss Ribbons Pvt. Ltd. v. Union of India, Writ Petition (Civil) No. 99 of 2018, https://indiankanoon.org/doc/17372683/ 

[8] Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta, Civil Appeal No. 8766-67 of 2019, https://indiankanoon.org/doc/7427609/ 

[9] India Corporate Law, “Essar Steel India Limited: Supreme Court Reinforces Primacy of Creditors Committee,” https://corporate.cyrilamarchandblogs.com/2019/11/essar-steel-india-limited-supreme-court-reinforces-primacy-of-creditors-committee-insolvency-resolution/