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Constitutionality Affirmed: Unmasking The Moser Baer Karamchari Union Case And The Paramount Of The Waterfall Mechanism

The recent tussle between Section 327(7) of the Companies Act,2013 and Section 53 of the Insolvency and Bankruptcy Code,both of which hold significant implications for stakeholders in the corporate and insolvency landscapes, came into light when the Supreme Court pronounced its judgment in the case of Moser Baer Karamchari Union v Union of India.

While Section 327(7) precludes the scope of application of Sections 326 and 327 to the liquidation process, Section 53 of the IBC, 2016 establishes an order of priority for the distribution of proceeds to creditors based on the liquidation value.The conflict develops when the priority created by Section 327(7) seems to be compromised by the implementation of Section 53.

This article delves into the conflict between Section 327(7) of the Companies Act and Section 53 of the Insolvency and Bankruptcy Code, exploring the potential challenges it poses for stakeholders. Additionally, it analyzes the recent ruling by the Supreme Court, which upheld the constitutionality of Section 327(7) of the Companies Act. Through an examination of the conflicting provisions and with the help of constitutional perspective, this article aims to shed light on the implications of this conflict and the Supreme Court's decision.

Understanding Section 327(7) of the Companies Act, 2013

Preferential payments are made in a winding up in accordance with the Act's provisions enumerated in Sections 326 and 327. These include the worker's dues, earnings, taxes, and cesses that the business owes to the union, a state, or a municipal government.However, according to the Insolvency and Bankruptcy Code, 2016, distribution must be done in accordance with Section 53 of the IBC in cases of liquidation under the IBC.

The Companies Act of 2013 was amended to provide that Sub-Section (7) of Section 327 and Sections 326 and 327 of the Act 2013 will not be applicable in the event of liquidation under the IBC in light of the ratification of the IBC and Section 53 of the IBC. The said amendment was brought in order to avoid any friction or inconsistency with the IBC.

Scope of Section 53 of the IBC and the Waterfall Mechanism

The order of priority for receiving the proceeds from the sale of liquidation assets is laid forth in Section 53 of the IBC, which has the effect of superseding all other provisions because it is a non-obstante clause. This gives priority to the costs of the bankruptcy resolution procedure and liquidation. Workman's wages and obligations owed to a secured creditor are paid after them, both equally.

The 'waterfall mechanism' refers to the precedence hierarchy.Secured financial creditors are given the greatest priority under the waterfall process. Following them are unsecured financial creditors, governmental obligations, and then operational creditors.Financial organisations such as banks are examples of secured creditors, whereas credit card companies, landlords, and others are examples of unsecured creditors. Operational creditors are people who have provided services to the company.

The Conflict between Section 53 and Section 327(7)

The conflict arises when we consider the contrasting treatment of worker's dues under Section 326 and 327 of the Companies Act and Section 53 of the Insolvency and Bankruptcy Code (IBC). The Companies Act provisions, namely Section 326 and 327, acknowledge the importance of safeguarding worker's interests by providing preferential treatment to their dues in the event of liquidation. This recognition is grounded in the understanding that workers often find themselves in vulnerable positions during insolvency proceedings and need protection.

However, the IBC takes a different approach by categorizing all dues, including worker's dues, under the umbrella of operational creditors. This means that in the context of liquidation under the IBC, worker's dues do not receive any preferential treatment compared to secured financial creditors. This categorization can create a conflict of interest between the provisions of the Companies Act and the IBC, potentially compromising the interests of workers.

The conflict of interest arises from the need to strike a balance between the rights of workers and the overarching objective of the insolvency proceedings, which is to ensure a fair and equitable distribution of assets among all stakeholders. While the IBC aims to streamline the insolvency process and provide a level playing field for all creditors, the preferential treatment accorded to worker's dues under the Companies Act recognizes their unique position and the need to protect their livelihoods.

Moser Baer Karamchari Union Case

The Supreme Court denied the plea to declare Section 327(7) of the Companies Act, 2013 arbitrary and in violation of Article 21 of the Constitution. The applications come on the heels of a Supreme Court decision last month ordering Moser Baer's dissolution.The National Company Law Tribunal (NCLT) held in 2019 that provident fund, pension, and gratuity dues do not form part of a corporate debtor's liquidation estate.

The Petitioners argued that Clause 19(a) of the Eleventh Schedule of the IBC be declared unreasonable and in violation of Article 14 of the Indian Constitution because Clause 19(a) of the Eleventh Schedule of the IBC inserts sub-section (7) in Section 327 of the Companies Act, 2013, which places an obligatory bar on the application of Sections 326 and 327 of the Companies Act, 2013, to liquidation proceedings under the IBC. They requested in court that Workers Dues be settled in accordance with the reasonable criteria outlined in Section 326, even in the case of liquidation under the IBC.

While upholding the validity of the provision, a bench of Justices M R Shah and Sanjiv Khanna stated, "We will not set aside the legislation solely on the ground that some or marginal sacrifice is to be made by the workers."

Certain sacrifices are required from all parties, especially the workers, for the revival and rehabilitation of the companies. "In the case of insolvent companies, everyone, including secured creditors and the central and state governments, must make sacrifices for the sake of survival and regeneration," the bench stated.

The bench further stated that the "waterfall mechanism is based on a structured mathematical formula, and the hierarchy is created in terms of payment of debts in order of priority with several qualifications, and striking down any of the provisions or rearranging the hierarchy in the waterfall mechanism may lead to several trips and disrupt the working of the equilibrium as a whole and stasis, resulting in instability".

The judgment of the Moser Baer Karamchari Union case, upholding the constitutionality of Section 327(7) of the Companies Act carries significant implications. It underscores the court's recognition of the organic evolution of law and the extensive consultative process involved in enacting the Insolvency and Bankruptcy Code (IBC). The judgment highlights the Code's objective of maximizing asset value and balancing stakeholder interests, bringing Indian practices in line with global standards.

In terms of corporate interests, the case emphasizes the importance of a comprehensive and time-bound framework for insolvency resolution. The court recognizes the need to protect the rights of both secured creditors and workmen, maintaining a delicate balance between the two. By upholding Section 327(7), the judgment reinforces the notion that the Code promotes transparency, efficiency, and economic growth by ensuring equitable compensation for workmen and enabling the revival of viable companies.

Additionally, the judgment acknowledges that economic legislations like the IBC require a practical and pragmatic approach, allowing for experimentation to address complex issues and serve the greater societal good. It signifies the court's willingness to consider the economic impact and overall objectives of such legislation, provided they are not manifestly arbitrary or unfair.

The case highlights the intricate interplay between corporate interests, stakeholder protection, and the broader objectives of insolvency resolution frameworks. It offers insights into the court's approach to constitutional challenges and the significance of balancing the rights of various stakeholders in promoting a robust and efficient corporate governance regime.

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