Article on ‘THE WATERFALL MECHANISM IN THE INSOLVENCY AND BANKRUPTCY CODE’ by CS Venkat R Venkitachalam, Chairman, Bizsolindia Services Pvt Ltd. (September 2025)

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Introduction:

Death is a certainty.  This profound truth is true for human beings and even for the corporate entities.  When this eventuality happens, the corporate warrior also should be able to meet it with equanimity.  When the fateful date arrives, the company should be fully prepared to discharge its obligations.  Being a corporate entity the distribution of residual assets on the date its death (we call it, the liquidation), after adjusting the liabilities that the companies owe to outsiders, however big or small, should be fair and justifiable.  A code of fair practices of the process of liquidation is thus critical when an insolvency occurs.  In order to bring in certainty to this process, countries enact appropriate legislations mandating how this process is done post liquidation, in the absence of this there would be utter chaos during the liquidation process.  When a company becomes insolvent and is sold off, the money recovered is distributed to various claimants according to a hierarchy known as the waterfall mechanism. This mechanism, outlined in Section 53 of India’s Insolvency and Bankruptcy Code (IBC) 2016, ensures a predictable and orderly distribution of assets preventing a chaotic free-for-all among creditors.  The core principle behind this mechanism is to establish a clear order of priority while ensuring that certain debts are paid off before others based on the law of the land and equity.  More often than not, the companies getting liquidated have more liabilities than assets.  This, then call for a calibrated approach to how the residual properties are distributed among the stakeholders, in the absence of which there would be utter chaos and uncertainty in winding up of corporate entities.  The principle adopted in the Insolvency and Bankruptcy Code is called the “Waterfall” mechanism. This metaphor conjures up images of water cascading down levels progressively – each tier receiving flow only after the one above it is full. In financial or legal contexts this expression is used to describe a tiered distribution system, where resources (usually money) are allocated in a predefined sequence of priority.  Under the Insolvency and Bankruptcy Code, 2016 (IBC) the “Waterfall Mechanism” refers to the statutory order of priority for distributing the proceeds from the liquidation of a Corporate Debtor’s assets. This is neatly codified in Section 53 of the IBC though the Section had not earlier provided for a structured framework for the preferential treatment of various categories of creditors during the winding up of insolvent companies.   Earlier, Section 529 had made certain insolvency provisions applicable to such proceedings, there was no explicit provision for preferential payments to various categories of creditors.   Today recognising the need to protect the worker’s interest one finds these provisions explicitly stated in Sections 326 and 327 of the Companies Act.  Moreover, according to Section 52, the proceeds from the liquidation estate are subject to deductions to defray the insolvency process costs and proportionate workmen’s dues in order to preserve the fairness of the liquidation framework.  With this objective Section 36 of the IBC defines the “liquidation estate” which explicitly excludes the employee welfare funds such as provident fund, gratuity and pension funds.  This safeguards the social security rights of employees balancing the creditor’s rights along with protections of vulnerable stakeholders.

Cardinal Principles Behind an Insolvency Code:

Having seen the broad contours of the intent and scheme of the Act, the next issue to be decided is how do we distribute the amounts recovered from those who owe money to the corporate debtor.  The very success of the insolvency legislation is dependent on the amount distributed which in turn is dependent on the amounts collected.  It is natural to assume that in all most all cases the amount recovered are likely to be less than the total amount recoverable by the corporate debtor as indicated above.  Therefore, there has to be a predetermined formula of distribution of sums collected that is both fair and equitable to all the parties. That is why the mechanism of distribution of assets assumes importance in insolvency law. The Act itself must provide an equitable method of distribution that should be fair and reasonable to all concerned. As per the provisions of IBC the distribution of residual assets must take place in the following order keeping in mind that it is fair and also seen to be fair.  The priority of payments is built into Sec 53 of IBC. Think of the proceeds from a liquidated company as a bucket of water at the top of a waterfall. The water fills the first pool completely before it spills over to the next, and so on, until the water runs out. Many at the bottom may receive nothing if the bucket is empty by the time the water reaches them.  This waterfall mechanism is not an arbitrary concept.  On the contrary, it is built on fundamental economic and social principles designed to balance the interests of all stakeholders and build confidence in the credit system.

  1. Predictability and Investor Confidence: For banks and financial institutions to lend money, they need to understand the risks involved. A concept like the “waterfall” provides this clarity. By knowing their exact position in the pecking order, financial creditors can price their loans suitably. This predictability is vital for a healthy credit market.
  2. Respect for Contractual Rights: Secured creditors (those who lend money against a specific asset, like a building or machinery) are given high priority. This respects the sanctity of their contracts and acknowledges the lower risk they took by securing their loan with collateral.
  3. Social Safety Net: The IBC places a high value on protecting the most vulnerable stakeholders. Dues owed to workmen (up to 24 months) are placed very high in the hierarchy, sharing priority with secured creditors. This ensures that the individuals who powered the company with their labour are not left empty-handed.
  4. Rebalancing the Role of the State: In a major departure from the previous regime, government dues (like taxes) are placed significantly lower in the waterfall. This signals a pro-business shift, ensuring that the operational and financial creditors who took commercial risks are prioritised over the sovereign, thereby encouraging enterprise and facilitates lending.

Waterfall Mechanism Under Sec 53 of IBC:

The following are the predetermined priorities in distribution of funds during liquidation:

  1. Insolvency Resolution and Liquidation Costs: The first priority is to pay the fees of the insolvency professionals and other costs incurred in running the liquidation process itself. This ensures the process can be completed seamlessly.
  2. Workmen’s Dues and Secured Creditors: This is a crucial tier where these two groups stand together.
  3. Unsecured Financial Creditors: Debts owed to financial lenders who did not have any collateral against their loans.
  4. Operational Creditors.
  5. Government Dues and Remaining Secured Debts: This tier includes dues owed to the Central and State Governments (for up to two years).
  6. Preference Shareholders
  7. Equity Shareholders: The owners of the company are the last in line. As they hold the highest risk, they receive a share only if all other claims have been fully satisfied, which is rare in liquidation.

This waterfall mechanism is the backbone of the IBC’s liquidation process. It provides a transparent, fair, though often harsh, framework for distributing the assets of a failed company. By prioritising secured lenders and workmen while re-evaluating the position of government dues, the mechanism aims to create a more robust and predictable credit environment, which is essential for fostering investment and economic growth in the country.

International Practices:

A discussion on the Waterfall mechanism cannot be complete without making a reality check on how other countries deal with this requirement which is both fair and ethical. Countries around the world employ several key mechanisms to safeguard the rights of vulnerable creditors such as employees, tort victims and sometimes small suppliers or individual consumers when a company enters the liquidation zone. The primary methods include:

  1. Priority of Claims: Many countries establish a clear hierarchy for creditors’ claims, granting vulnerable creditors such as employees and sometimes tort victims preferential or priority status over other unsecured creditors. For example, employee wage claims and certain employee benefits are typically paid ahead of unsecured creditors. In the UK, for instance, employees are granted preferential status for certain claims under the Insolvency Act, while recent reforms have elevated tax authorities’ priority as well.
  2. Best-Interest-of-Creditors and Fairness Tests: Some jurisdictions, influenced by international standards such as the EU Preventive Restructuring Directive and good practice guidelines from development banks, require that dissenting (often vulnerable) creditors receive at least as much in a reorganisation plan as they would under liquidation. Courts review restructuring plans for fairness, ensuring vulnerable creditors are not disadvantaged compared to what they would recover in liquidation.
  3. Creditors’ Committees and Representative Bodies: Legal frameworks often require or allow the formation of creditors’ committees. These bodies represent different classes of creditors including vulnerable ones and can participate in decisions regarding the conduct of the insolvency, asset sales, and distributions. This gives vulnerable creditors a voice in the process, oversight of asset management, and a line of communication with the liquidator.
  4. Public Policy and Cross-Border Safeguards: Under cross-border insolvency regimes (e.g., the UNCITRAL Model Law), countries may refuse to recognise foreign insolvency proceedings if vulnerable creditors’ protection in the originating country falls below local public policy standards. For example, if a foreign court subordinates employee rights below unsecured creditors, the host country might deny recognition of that process to avoid prejudicing vulnerable local claimants.
  5. Legal and Social Policy Provisions: The priority granted to vulnerable creditors reflects specific legal and social policy goals—such as protecting employees who lack bargaining power or tort victims who had no choice in dealing with the insolvent company.
  6. Transparent and Predictable Procedures: Sound insolvency systems emphasise collecting and safeguarding debtor assets, ensuring the process prevents individual creditors from seizing assets prematurely and distributing assets in accordance with law and priority.

Conclusion:

Globally, while practices may vary, there is a growing convergence in wanting to safeguard vulnerable creditors’ rights, often through statutory priority, representation and judicial oversight. In the end, legislations in the bankruptcy laws are still evolving, especially in light of international coordination needs in cross-border insolvencies.

Thank you.