Homebuyers As Financial Creditors: An Inelegant Solution?

The high profile insolvencies of several real estate and housing development companies have tested the mettle of the Insolvency and Bankruptcy Code, 2016. Thousands of homebuyers were left in the lurch as they remained bereft of recourse in insolvency proceedings against these companies in distress. Recent reforms have sought to address the concerns of homebuyers by treating them as ‘financial creditors’ for the purposes of the Code. While these efforts certainly provide the much-needed succour to homebuyers, their precise treatment as financial creditors raises more questions than it answers, thereby beckoning an alternative approach.

The essence of the homebuyers’ predicament is attributable to the binary nature of the treatment of creditors under the Code. Creditors are necessarily of two types: financial or operational. Financial creditors are those who have disbursed monies to the corporate debtor ‘against consideration for the time value of money’ and includes a range of parties, such as those who have lent money to the debtor against the payment of interest. On the other hand, operational creditors are those who have established certain types of relationship with the debtor company, such as the provision of goods or services, employment or for government dues. In several cases that arose before adjudicating authorities, homebuyers were meted out an orphaned treatment: they were considered to be neither financial creditors nor operational creditors. Although the Insolvency and Bankruptcy Board of India whipped up a temporary solution by creating a residual third class of creditors, it provides limited benefit to homebuyers.

Such a lacuna in the law attracted considerable backlash given that several home builders entered insolvency after having collected significant amounts of money from homebuyers who had to face inordinate delays in obtaining possession of the homes they had substantially paid for. Sufficient momentum was garnered to provide appropriate protection to this vulnerable constituency. Accordingly, the Insolvency Law Committee, in its report released in March 2018, recommended that homebuyers be treated as financial creditors so that they can take recourse to the protection conferred under the Code. The Government has taken on board this suggestion and the President has promulgated an Ordinance on June 6, 2018. Although the need to protect the interests of the homebuyers is welcome, the manner of implementation of this idea leaves much to be desired.

Viewed conceptually, homebuyers as consumers bear a closer resemblance to operational creditors than financial ones.

The only reason they were excluded as operational creditors is that the Code refers to the provision of “goods and services” and does not contemplate immoveable property. This can be more easily addressed by expanding the scope of the definition of “operational debt”. On the other hand, the concept of financial debt is more remote from the relationship that homebuyers bear with sellers. This is hardly a relationship of financial nature. It may be true, as the Insolvency Law Committee has unduly emphasised, that the money paid by the homebuyers ultimately go towards financing the business of the debtor companies. The utility of the funds is by itself insufficient to define the relationship between the parties. For that matter, a seller of goods or services may also utilise an advance received from a customer towards financing its business.

That ought not to change the nature of the ‘operational’ nature of the relationship.
Residential buildings stand under construction at project developed by Jaypee Infratech, in Noida, Uttar Pradesh. (Photographer: Prashanth Vishwanathan/Bloomberg)
Residential buildings stand under construction at project developed by Jaypee Infratech, in Noida, Uttar Pradesh. (Photographer: Prashanth Vishwanathan/Bloomberg)

More specifically, the bifurcation between financial and operational creditors is relevant for three broad purposes, against which one may juxtapose the position of homebuyers.

First, it is necessary to classify creditors to determine how they may trigger an insolvency. Since the process for establishing the default that constitutes the trigger is different for financial and operational creditors, the framers of the Code found it necessary to create such a distinction. For example, the liability for a financial debt may arise from a pure contract such as a loan, while that for an operational debt may arise from a transaction for sale or purchase or operations towards payment of wages or taxes. Hence, the documentation for triggering the Code would be different in either case. Homebuyers’ situation would be similar to that of operational creditors involving a transactional or operational relationship of purchases and sales rather than financial transactions.

Treating homebuyers as financial creditors side-steps this functional distinction altogether and may cause problems in implementing the insolvency trigger mechanisms.

Second, the Code has been structured on the basis that the committee of creditors taking decisions regarding the insolvency will be comprised only of financial creditors. This is on the assumption that financial creditors such as banks and financial institutions would be better placed in assessing the viability of an insolvency plan and determining modifications to the existing liabilities through negotiations. Moreover, homebuyers in most insolvencies are likely to comprise large numbers that prevent them from engaging in meaningful and informed decision-making. Such collective action problems may potentially be overcome by outsourcing the decision-making function to an agent to be appointed by the homebuyer or even by the adjudicating authority itself. However, such solutions are likely to be fraught with difficulties, especially because the voting power of the members of the committee of creditors is determined by the amount of debt owed to them.

The Code was explicitly designed to confer decision-making powers to financial creditors to overcome these inefficiencies, which will certainly creep in if homebuyers are treated as financial creditors.

Third, the distinction between financial and operational creditors would be relevant for distributions in accordance with a resolution plan. Here, the Code compensates operational creditors for their lack of participation in the decision-making process. Such creditors are entitled to receive no less than liquidation value, i.e. the same value they would have received had the company been liquidated. This mechanism ensures that homebuyers receive at least a minimal level of protection. Additionally, the Code provides protective measures towards all stakeholders (which would include homebuyers in these circumstances), whose interests are to be considered by the adjudicating authorities before approving a resolution plan.

To conclude, the efforts to rectify the prevalent anomaly that deprives homebuyers of benefits in insolvency are indeed beneficial. However, the proposed manner of addressing the concern simply by treating them as financial creditors is an inelegant solution. While it may help assuage the growing numbers of affected homebuyers, it is sure to inflict collateral damage on the philosophical framework of the Code.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.

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