Designing a Framework for Ensuring Labor Democracy during Insolvent Restructuring

–Urmil Shah†

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The workmen and employees usually finds themselves at the receiving end during the instances of restructuring or insolvency of a corporation on account of their relative bargaining position and asymmetrical power relationship with insolvent employer. An insolvent company may owe debtsto both external as well as internal creditors with the company’s workmen and employees forming part of the latter. Their debts can be in nature of unpaid wages, salaries, bonus, remuneration, gratuity, pension, annuity, superannuation, leave encashment, workmen compensation, provident fund etc. The claims relating to terms of employment are classified as service claims whereas those in nature of societal considerations are classified as welfare claims, both of which forms part of insolvency claims. The Indian law on insolvent restructuring is governed by the Insolvency and Bankruptcy Code, 2016 (IBC) which distinguishes between financial creditors and operational creditors on the basis of the nature of debt owed.

The workmen and employees are deemed to be operational creditors for the want of borrowing from them in commercial nature and a resolution plan for restructuring of the insolvent employer must provide certain safeguards for them for expeditious settlement of dues and discharge of employment. Section 53 of the IBC envisages the waterfall mechanism under which the dues of workmen for 24 months preceding the liquidation are prioritized over wages and unpaid dues of employees for past 12 months. Except Section 53, the IBC is largely silent on employee rights during insolvent restructuring including those relating to claims amounting to old age and social security benefits, representation capacity of employee unions to initiate the collective proceedings or continuation of discharge of employees under the resolution plan, resulting in excessive litigation. While the framework for worker wage claims in foreign jurisdictions is adequately comprehensive, it is the object of this research to understand different implementing models and proposing solution for the lacunas within the IBC. The models have been based upon the respective social security framework of difference countries where the preferential system treats the employees as privileged creditors for making payment of salary dues whereas the wage guarantee schemes doesn’t stereotype insolvency and allows gradual payment of premium during solvency of the employer. The hybrid system on the other hand combines the benefits of preferential treatment and wage guarantee schemes provisioning for flexibility for both the employer and employees. The miscellaneous systems evaluates the domestic peculiarities of foreign jurisdiction with respect to employment security scheme andformal insolvency framework.

Implementing Models for Worker Claims during Insolvency

Although the procedural frameworks for insolvent restructuring differs from country-to-country, the object of most systems globally is to preserve the assets of the insolvent employer from value erosion and to implement an arrangement which results in equitable distribution of such assets among all stakeholders, including the workers. The different frameworks envisaged internationally by foreign jurisdictions to facilitate smooth realization and settlement for employee wage and related compensation claims during insolvency includes:

Model I Preferential Treatment System: Article 11 of the ILO Protection of Wages Convention No. 95, 1949 states that in instances of judicial liquidation of an undertaking, the workers employed are to be treated as privileged creditors with respect to services rendered during their employment. Such privileged creditors are paid their dues out of the assets of the insolvent employer before making payment to other non-employee creditors in the waterfall mechanism including suppliers, secured and unsecured creditors and shareholders. The underlying rationale of the system is that the workers are considered to be vulnerable creditors, offering more than mere credit and according priority of claims can result in limiting their losses. The Japanese Bankruptcy Act, 2004 treats the employee’s wage and retirement payment claims for the preceding 90 days as preferential claims and in instances of super-priority claims where the retirement dues are less than wage related dues, then they have to be paid independently of the formal insolvency proceedings. The Colombian Civil Code, on the other hand, doesn’t apply any limitation on the realization of the preferential wage claims in nature of the maximum amount of dues or days preceding the liquidation. The system is considered as an incentivizing mechanism for the employees and workmen of the insolvent employer to continue the operational activities of the undertaking diligently without any fear of non-payment of wage and compensation related dues.

Model II Wage Guarantee Insurance Schemes: Article 11 of the ILO Convention No. 95 was amended by the Protection of Workers’ Claims (Employer’s Insolvency) Convention 173, 1992 which along with the preferential system added the wage guarantee insurance scheme. Under this scheme, the worker wage and compensation claims are realized not out of the liquidation estate of the insolvent employer but out of a special fund constituted from contributions from the employer during its solvency. Other than employer contribution, these funds can be financed through the State tax revenue or through private industry unions and bodies. The German Social Code provides for wage protection scheme funded out of employer contribution and employer associations, thereby ensuring sufficient capitalization. Under the Austrian Insolvency Remuneration Protection Act, 1977, employers are obligated to pay premiums on their annual unemployment insurance contribution for meeting the wage claim requirements in case of declaration of insolvency. These insurance schemes provides certainty and transparency to the workers claims realization process, resulting in less litigation costs for all the affected parties. They also do not affect the waterfall distribution arrangement under the formal process, thereby ensuing confidence amongst the external creditors over fair realization of assets.

Model III Hybrid System: While the preferential system for wage claims can be prejudicial towards external creditors, the wage insurance mechanism can unnecessarily burden the tax machinery or industry associations when the employers are recalcitrant. To avail the benefits and address the limitation arising out of both the models, States are moving towards a hybrid mechanism wherein in a parallel arrangement, priority treatment for workers and reduced burden upon the employers is provided. Under this model, where the insolvent employer has the required assets to satisfy adequately the claims of internal and creditors, then preferential treatment is accorded but when the assets are insufficient to be realized, then insurance system is available to the benefit of workers. During the solvency of the employer, premiums have to be paid towards the guarantee fund and when the assets are sufficient for realization of claims of creditors, the premium can form part of the liquidation estate. The French Civil Code provides for general preference for workers while also parallel requiring employers to contribute towards the Employee Wage Guarantee Scheme. The Korean Wage Claim Guarantee Act secures employee wages of the preceding 90 daysalong with accident compensation allowance over secured claims and under the Israeli National Insurance Law, the state-run National Insurance Institute is liable for wage payments approved by the company liquidator in instances of failure of repayment of workers dues. Such a beneficial arrangement can attain the interests of the employee, who is guaranteed the repayment of their dues, the employers, who will not have to accord additional personal liability as well as external creditors, who would have to undertake less haircuts.

Model IV Miscellaneous Systems: Without strict disregard to either of the above systems, some jurisdiction provides for more generalized social security claims realization mechanism to incorporate domestic peculiarities. The Dutch Employee Insurance Agency makes part payment of the insolvent employer’s dues of salaries, pensions and holiday allowances preceding 90 days. The South African Insolvency Act, 1936 allows terminated employees to make claims for repayment of pending dues from the liquidation estate of the insolvent employer. The Italian Marcora Law, 1985 allows employees to take over the insolvent business of the employer by participating through their accumulated unpaid unemployment benefits, creating opportunities for self-employment. The Canadian Business Corporations Act, 1985 imposes personal joint and several liability upon the officers and directors of the corporation for repayment of employee dues preceding 240 days of the insolvency admission, in accordance with the director and officer liability insurance (D&O Insurance). The Brazilian Unemployment Insurance Law No. 13,134 allows discharged employees as consequence of insolvency of the employer to avail social assistance in form of national wage from the Government for period of 150 days. Under the Chinese Enterprises Bankruptcy Law, 2006, cooling-off termination for period of 3 years is imposed upon the directors and supervisors of the corporations for violation of their fiduciary duty of repayment towards employees. All these different models in some form or another obligates the employers to repay the legitimate debts of employees and highlights the significance of their direct participation in formal insolvent restructuring proceedings.

Framework on Employee Wage & Compensation Claims: Revisiting the Dark Ages?

Neither the Joint Parliamentary Committee nor the Bankruptcy Law Reforms Committee in their reports on the IBC talk about different implementing models for worker claims during insolvency. Section 36(4) excludes provident, pension and gratuity fund from the liquidation estate of the insolvent employer, thereby implying incorporation of the preferential treatment system. However, explanation to Section 53 states that workmen dues shall have same meaning as assigned under Section 326 of the Companies Act, 2013 which includes wages, salaries, compensation holiday remuneration and sums due under provident, pension and gratuity funds. The existence of provident, pension and gratuity funds as part of exclusion u/s. 36(4) and inclusion u/s. 53 created a legislative discrepancy which was duly noticed by the NCLAT in Baer where the liquidator had denied providing preferential treatment of provident, gratuity and pension funds of employees of the Corporate Debtor upheld by the NCLT. The NCLAT on appeal by differentiating between distribution of assets and according preferential treatment held that by virtue of the non-obstante overriding effect clause u/s. 238,Section 36(4) read with 53 overrides Section 326; implying that employee debts would not form part of the waterfall mechanism While the Moser Bear had the effect of upholding the fundamental right to life of workers vis-à-vis proprietary rights of creditors, non-exclusion of wages and salaries from the liquidation estate u/s. 53, recalibrated the distrust amongst the latter.

Under the pre-IBC regime, the Sick Industrial Companies (Special Provisions) Act, 1985 governed corporate insolvency where the creditors had to await 50% erosion of the net worth or quantum of accumulates losses to exceed the total net worth of the corporate employer. While a perusal shows that the IBC implicitly incorporates the preferential treatment system; however, there are certain inherent shortcomings with the system which has the effect of nullification of multi-stakeholder welfare mechanism prejudicial towards external creditors. Such preferential treatment, without sufficient legislative certainty, towards workers not only results in value erosion of the corporation but also haircuts as high as 52% for financial creditors, resulting in distrust towards the system. A hybrid mechanism with gradual recourse to wage guarantee insurance schemes can not only benefit the creditors but also workers with assured repayments without resorting to the formal process and await the stage of liquidation. The wage insurance scheme as part of the hybrid mechanism can be easily implemented as the Employees’ State Insurance Act, 1948 and Employees’ Provident Funds and Miscellaneous Provisions Act, 1952 already provide for regular payment by employers of social security measures for employees. Further the mechanism can be effected through sector-wise industry led frameworks with the chamber of commerce acting as the supervising association with periodical contribution from employers and industry associations.

Unlike the UK Transfer of Undertaking (Protection of Employees) Regulations, 2006, the IBC doesn’t mandate the resolution applicant to retain all workers and employees of the insolvent employer and accordingly, when the resolution plan provides for termination of all or certain class of workers, the terminated workers are entitled to payment of benefit claims. However, when any restructuring takes place as going concern as provided under Regulation 32(c) of the IBBI (Liquidation Process) Regulations, 2017 retrenchment compensation u/s. 25FFF of the Industrial Disputes Act, 1947 is to be provided to terminated workers. The hiatus in this scenario arises from the fact that while employees and workmen have the right to opt-out from employment under the resolution plan, there is no compulsion upon the resolution applicant to continue the services of all or any of the former employees. Regulation 25(10) of the SEBI (Listing Obligations & Disclosures Requirement), 2015 mandating the top 500 listed entities by market capitalization to undertake D&O liability insurance for independent directors can act as catalyst for imposing fiduciary duty upon the employer to continue the services of the former employees. 


A matured insolvency regime is characteristic of economic welfare and maximization of stakeholder interests and the IBC in its present stage is far from being a neutral code balancing the interests of different categories of creditors. The resistance to incorporate wage insurance schemes and personal and several liability of the board of directors towards worker wage and compensation claims is evident of litigation fallacies arising out of improper interpretation of the legislation. The lack of discourse both by the legislation and the judicial interpretation on related unpaid compensation claims like holiday allowances, maternity benefit, medical termination of pregnancy benefits and layoff and retrenchment compensation deserves critical consideration. Moreover, the efficacy of the IBC remains to be seen where the threshold of default is set at Rs. 1 crore when the month. While the hybrid system has the effect of curing the conceptual inefficiencies surrounding balancing of rights of employers and employees, provisioning for seat for employees as deeming fiction on the Committee of Creditors, despite being operational creditors, can result in procedurally fair resolution for all categories of stakeholders. The Code at its present stage raises serious suspicion over annulment of beneficial nature of employment jurisprudence.

† Urmil Shah is a 4th-year law student from AURO University, India and researcher at the Indian Institute of Management, Ahmedabad, India.

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