Group insolvency: Allow ‘subordination of claims’ in limited cases, suggests UK Sinha-led committee

The UK Sinha-led working group on ‘group insolvency’ has made a case for allowing ‘subordination of claims’ of other companies in a group in exceptional situations. However, it has stipulated that ‘subordination of claims’ should be done only by the adjudicating authority (like NCLT) and, that, too, only in cases where there is any evidence of fraud and diversion of funds.

Simply put, the working group has rejected blanket ‘subordination of claims’ in a group for the proposed framework on ‘group insolvency’ that is under the contemplation of the government.

A ‘subordination’ means a claim though payable at par will be ranked lower in priority and will be paid after settlement of another claim. In the case of subordination, a creditor is placed in a lower priority for the collection of its debt from its debtor’s assets than the priority the creditor previously had. Although it is commonly said that the debt has been subordinated, it is actually the right of the creditor to collect the debt that has been, say experts.

In lay man terms, it will translate as a wrongful transaction and will not enable a group lender to get precedence over a bonafide creditor.

What the report says

In its report, submitted to the insolvency regulator IBBI recently, the working group noted that stakeholders consulted by it suggested that ordinarily the claims of other group members should not be ‘subordinated’, and that only in exceptional circumstances, when the adjudicating authority finds an intention to defraud the creditors of the debtor or to divert the funds of the debtor, should the claims of the group member be subordinated.

The working group is of the view that subordination of intra-group debts without evidence of wrongdoing is likely to have an adverse effect on the ability of individual group members to arrange for adequate finance, especially during a period of financial distress when external creditors may not be willing to provide additional finance to it.

The threat of subordination of claims may also deter the parent company from undertaking measures to rescue its subsidiaries by providing additional finance. However, the working group notes that it may be fit to statutorily empower the adjudicating authority to subordinate the claims of other companies in a group in exceptional circumstances, such as fraud and diversion of funds.

The working group noted that according to UNCITRAL guide, the claims of a related party should not be subordinated merely because it is related to the corporate debtor. Interestingly, the UNCITRAL guide does not recommend the subordination of any particular types of claims under the insolvency law, simply noting that subordinated claims would rank after claims of ordinary unsecured creditors.

Experts’ take

Charanya Lakshmikumaran, partner, Lakshmikumaran and Sridharan, a law firm, said the working group has recommended that subordination of claims should only be done by the adjudicating authority in case there is evidence of fraud and diversion of funds.

“Adding this layer of scrutiny by the adjudicating authority may prolong the Corporate Insolvency Resolution Process. But this will definitely go a long way in instilling confidence in other creditors and various stakeholders involved in the process,” she said.

Vidisha Krishan, partner, MV Kini and Co, a law firm, said subordination of claims in exceptional circumstances – if frauds and intentional diversion of funds happen – is recommended to avoid cases where related parties can come in as financial (other) creditors to the detriment of other bonafide creditors

COMMENT NOW