An Introduction to the Waterfall Mechanism under IBC

What is the Waterfall Mechanism under IBC?

The Insolvency and Bankruptcy Code (IBC), 2016, marked a paradigm shift in India’s insolvency resolution framework. Among its crucial components is the “waterfall mechanism,” a systematic approach to distributing proceeds from the sale of liquidation assets. This mechanism ensures a fair and orderly distribution of funds among various stakeholders, reflecting the principle of equitable treatment while maintaining a clear priority structure.
The waterfall mechanism derives its name from the cascading nature of fund distribution, where each level must be fully satisfied before proceeds flow to the next. This approach brings clarity and predictability to the often complex process of resolving insolvency cases, balancing the interests of different classes of creditors and other stakeholders.

What is legal framework of the Waterfall Mechanism?

The waterfall mechanism is primarily governed by Section 53 of the IBC, which outlines the order of priority for distributing the proceeds from the sale of liquidation assets. This section is complemented by various regulations issued by the Insolvency and Bankruptcy Board of India (IBBI), particularly the IBBI (Liquidation Process) Regulations, 2016.
The legal framework ensures that the distribution process adheres to the principles of fairness, transparency, and maximization of asset value. It also provides a clear roadmap for liquidators and resolution professionals to follow during the insolvency resolution process.

What is the order of distribution priority under the Waterfall Mechanism?

The waterfall mechanism establishes a hierarchical order for the distribution of proceeds. The order of priority, as per Section 53 of the IBC, is as follows:
a) Insolvency resolution process costs and liquidation costs
b) Workmen’s dues for the period of 24 months preceding the liquidation commencement date and debts owed to secured creditors who have relinquished their security
c) Wages and unpaid dues of employees (other than workmen) for the period of 12 months preceding the liquidation commencement date
d) Financial debts owed to unsecured creditors
e) Government dues (including debts to secured creditors for any amount unpaid following the enforcement of security interest) and debts owed to secured creditors for any unpaid amounts following the enforcement of security interest
f) Any remaining debts and dues
g) Preference shareholders, if any
h) Equity shareholders or partners, as the case may be
This order ensures that the most critical stakeholders, such as employees and secured creditors, receive priority in the distribution process.

Who are the key stakeholders in the Waterfall Process?

Several stakeholders play crucial roles in the implementation of the waterfall mechanism:

a) Liquidator: Appointed by the National Company Law Tribunal (NCLT), the liquidator is responsible for overseeing the entire liquidation process, including the distribution of proceeds according to the waterfall mechanism.
b) Committee of Creditors (CoC): While primarily involved in the corporate insolvency resolution process, the CoC’s decisions can significantly impact the eventual liquidation process and the application of the waterfall mechanism.
c) Secured and Unsecured Creditors: These stakeholders have different priorities in the waterfall mechanism, reflecting their varying levels of risk and security.
d) Employees and Workmen: Given special consideration in the priority order to protect their interests.
e) Government: As a recipient of various dues and taxes, the government has a specific place in the waterfall mechanism.
f) Shareholders: Although last in the priority order, shareholders’ interests are still considered in the distribution process.

What are the steps of implementation and challenges faced in the process?

Implementing the waterfall mechanism involves several steps:

a) Asset Valuation: Accurate valuation of the debtor’s assets is crucial for determining the total proceeds available for distribution.
b) Claim Verification: The liquidator must meticulously verify and admit claims from various creditors and stakeholders.
c) Distribution Planning: Based on the verified claims and the priority order, the liquidator prepares a distribution plan.
d) Actual Distribution: The liquidator executes the distribution plan, ensuring compliance with the waterfall mechanism.
However, the implementation process often faces challenges:
a) Disputed Claims: Disagreements over the validity or amount of claims can delay the distribution process.
b) Inadequate Asset Value: In many cases, the liquidation value of assets is insufficient to satisfy all claims, leading to partial or no recovery for lower-priority stakeholders.
c) Complexity of Cross-Border Insolvencies: When dealing with multinational companies, the application of the waterfall mechanism can become complex due to varying international laws and regulations.
d) Time Constraints: The IBC stipulates timelines for the resolution process, which can be challenging to meet in complex cases.

Case Studies and Precedents

Several high-profile cases have shaped the interpretation and application of the waterfall mechanism:

a) Essar Steel Case: This landmark case led to clarifications on the treatment of operational creditors and the extent of the CoC’s discretion in fund allocation.
b) Jaypee Infratech Case: This case highlighted the complexities of balancing homebuyers’ interests (classified as financial creditors) with those of other stakeholders in the waterfall mechanism.
c) Binani Cement Case: This case underscored the importance of maximizing asset value and ensuring equitable treatment of similarly situated creditors.
These cases have contributed to a more nuanced understanding of the waterfall mechanism and its practical application in diverse scenarios.

What is the impact on Creditors and Debtors?

The waterfall mechanism has significant implications for both creditors and debtors:

For Creditors:

i. Secured creditors generally benefit from their high priority in the distribution order.
ii. Unsecured creditors, particularly operational creditors, may face challenges in recovering their dues, especially in cases of insufficient asset value.
iii. The mechanism provides clarity on recovery expectations, allowing creditors to make informed decisions about their involvement in insolvency proceedings.

For Debtors:

i. The clear priority order incentivizes debtors to seek early resolution of financial distress to maximize value for all stakeholders.
ii. The mechanism can impact a debtor’s ability to access credit in the future, based on how different classes of creditors are treated during insolvency.
What are certain recent amendments under the process?
The IBC and the waterfall mechanism have undergone several amendments since their inception:
a) Homebuyers as Financial Creditors: The classification of homebuyers as financial creditors has impacted their position in the waterfall mechanism.
b) Pre-packaged Insolvency Resolution: The introduction of pre-packaged insolvency for MSMEs may influence how the waterfall mechanism is applied in these cases.
c) COVID-19 Related Amendments: Temporary measures introduced during the pandemic have had implications for the insolvency process and, by extension, the waterfall mechanism.

Looking ahead, potential areas for development include:

• Further refinement of creditor classifications
• Enhanced mechanisms for dealing with cross-border insolvencies
• Improved integration of alternative dispute resolution mechanisms within the insolvency framework

Conclusion

The waterfall mechanism under India’s IBC represents a significant step towards a more structured and predictable insolvency resolution process. By establishing a clear priority order for the distribution of proceeds, it brings transparency and fairness to a complex area of corporate law.

While challenges remain in its implementation, particularly in balancing the interests of diverse stakeholders, the mechanism has largely succeeded in its objectives. It has contributed to improving India’s ease of doing business ranking and has instilled greater confidence among creditors and investors.

As the IBC continues to evolve, the waterfall mechanism is likely to undergo further refinements. These changes will aim to address emerging challenges, incorporate lessons from practical experiences, and align with global best practices. The ongoing development of this mechanism will play a crucial role in shaping India’s insolvency landscape and its broader economic environment.

In conclusion, the waterfall mechanism stands as a cornerstone of India’s insolvency regime, embodying the principles of equity, predictability, and value maximization. Its continued evolution will be essential in meeting the dynamic needs of India’s growing and increasingly complex economy.