Should homebuyers be given liquidation preference under IBC?

Bar & Bench August 28 2018

Sakal Bhushan

The Insolvency and Bankruptcy Code (Amendment Ordinance), 2018 was promulgated by the President of India on June 6, 2018. Its preamble mentions its object “to balance the interests of various stakeholders in the Code, especially interests of homebuyers” and “promoting resolution over liquidation”.

It has now been replaced by the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018 notified on August 17, 2018.

Accordingly, the Parliament has now recognised the homebuyers as financial creditors by making a suitable amendment in Section 5(8)(f) of the Code. Consequently, the homebuyers will now find themselves in the Committee of Creditors (CoC).

Considering the practical difficulty in accommodating a large number of homebuyers in the CoC, an amendment has been effected in Section 21 of the Code by inserting sub-section 6A therein providing for the appointment of an authorised representative of the class in the CoC.

Corresponding amendments have been made in the Regulations by the Insolvency and Bankruptcy Board of India w.e.f. July 4, 2018.

Most significant Regulation is 16A(7) which provides as under:

“The voting share of a creditor in a class shall be in proportion to the financial debt which includes an interest at the rate of eight percent per annum unless a different rate has been agreed to between the parties.”

It is implied in law that interest will be simple unless otherwise provided. So it is 8% simple interest unless otherwise agreed. And banks charge a contractual rate of interest which is always higher. Assuming the usual rate of interest as 12% pa though banks charge even more at times, and then compounding the same monthly as a standard contract practice in bank loans, the effective average rate of interest comes to 17.27% pa for a 10-year-sample period. It is equivalent to charging 17.27% pa simple interest on a sum. And this average rate of interest is bound to increase with the addition of more years to the sample. Hence when we take 8% pa simple interest in case of homebuyers and 12% pa interest compounded monthly in case of banks, we are in fact comparing 8% pa simple interest with 17.27% pa simple interest for a 10-year-sample period. As such the banks’ debt will always grow faster as compared to that of the homebuyers. And this will always act to the prejudice of the homebuyers in the CoC despite their being declared as financial creditors. This imbalance cannot be ever cured.

Moreover, the banks are the secured financial creditors, unlike the homebuyers who are unsecured financial creditors. The homebuyers cannot be secured financial creditors. Banks know that in case of the failure of resolution in CoC and the consequent liquidation under Section 33 of the Code, they stand on a much higher pedestal than the homebuyers in the waterfall envisaged under Section 53 of the Code. Hence, their attitude in CoC is guided by their superior status and placement and so comparatively lesser stakes/risk in liquidation. Experience is also showing lesser co-operation from the banks in CoC for resolution.

Amendments are made in law after experiencing the practical difficulties in functioning. A straitjacket law for all sectors irrespective of its composition cannot prove to be effective as there cannot be a single cure for all diseases. It is very much obvious that the problems of the homebuyers were not conceived at the time of drafting and enacting the Code in 2016. That is why it was drastically amended recently by incorporating the homebuyers separately in the class of the financial creditors.

Now that the homebuyers have already been recognised as a separate class within the financial creditors in the latest Amendment, their interests cannot be jeopardised by putting them at the lower hierarchy of preference in case of liquidation considering their large numbers and the fact that they are the real strength behind the real estate sector.

It cannot be lost sight of the fact that the institutional and other financial creditors like banks extend financial credit to such projects being fully aware to the fact (as detailed projects reports are made and vetted by them before approving and disbursing credit) that the buyers will also invest substantially in the construction of the Units. Therefore, these banks should not be put in the hierarchy above the buyers based upon whom such projects are evaluated and financed by them.

So it is high time that this class of the financial creditors called "Homebuyers", already recognised as a separate class by the Parliament now, is placed over and above the banks/NBFC's in case of real estate projects financing where a lot of money comes from the homebuyers only and the banks earn commercial interest on their strength alone.

Once the banks know that in case of liquidation the homebuyers will get priority over their dues, they will be more resolution-oriented which is one of the most solemn objectives of enacting the Insolvency law in India.

Moreover, the banks will become more vigilant in the future before lending to the real estate projects, and it will weed out the unscrupulous elements from the real estate industry. It will further complement the objective of enacting RERA.

This single step of putting the homebuyers over and above the banks/NBFC's in Section 53 of the Code will tremendously restore their shattered confidence which will prove to be a big boon for the real estate industry, thus paving the way for an increased FDI in this sector which is the need of the hour.

In fact, such a timely step beside protecting the small investors will prove to be beneficial to the banks themselves in the longer run, as the real estate industry creates a lot of demand for the various related sectors giving an overall fillip to the economic activity and employment-generation in the country.

Considering the emergent need, a suitable Ordinance may be promulgated in the interim before it is replaced by an amending Act. The whole world is watching as a lot of homebuyers are NRI’s. So the urgency to move fast.

Sakal Bhushan is an Advocate practising in Delhi.