Preferential Payments in Winding Up: Section 327

Preferential payments in winding up are the debts that get paid before ordinary creditors see anything. The Companies Act, 2013 sets them in two sections that have to be read in order: section 326 for overriding preferential payments, then section 327 for preferential payments proper, which is expressly subject to section 326. A third rule, inserted in 2016, decides when either applies at all.

Which preferential payments in winding up rank first?

The ones in section 326, because section 327(1) opens subject to the provisions of section 326. Section 326 was substituted by Act 31 of 2016, section 255 and the Eleventh Schedule, with effect from 15 November 2016, and its sub-section (1) states that In the winding up of a company under this Act, the following debts shall be paid in priority to all other debts:

• (a) workmen's dues; and
• (b) where a secured creditor has realised a secured asset, so much of the debts due to such secured creditor as could not be realised by him or the amount of the workmen's portion in his security (if payable under the law), whichever is less, pari passu with the workmen's dues.

Clause (b) is a shortfall rule with a ceiling. The secured creditor's unrealised balance shares with the workmen, but only up to the workmen's portion in that security, whichever is less.

The proviso then pulls two of the four kinds of workmen's dues in front of everything, secured creditors included: the sums in sub-clauses (i) and (ii) of clause (b) of the Explanation, which are wages or salary and accrued holiday remuneration, which are payable for a period of two years preceding the winding up order or such other period as may be prescribed, shall be paid in priority to all other debts (including debts due to secured creditors), within a period of thirty days of sale of assets and are subject to such charge over the security of secured creditors as may be prescribed. Section 326(2) confirms the order: those proviso debts shall be paid in full before any payment is made to secured creditors, and the rest abate in equal proportions if the assets fall short.

How is the workmen's portion calculated?

By a ratio the section states and then works through. Explanation (c) defines workmen's portion, in relation to the security of any secured creditor, as the amount which bears to the value of the security the same proportion as the amount of the workmen's dues bears to the aggregate of the amount of workmen's dues and the amount of the debts due to the secured creditors.

The section carries its own illustration, and it works the ratio through with numbers. The value of the security is Rs. 1,00,000. Total workmen's dues are Rs. 1,00,000. Debts due to secured creditors are Rs.3,00,000. The aggregate of workmen's dues and secured debts is Rs. 4,00,000. The workmen's portion of the security is, therefore, one-fourth of the value of the security, that is Rs. 25,000.

Explanation (b) lists what counts as workmen's dues, and there are four items: wages or salary including wages payable for time or piece work and commission earned; all accrued holiday remuneration becoming payable on termination of employment before or by the effect of the winding up order or resolution; compensation under the workmen's compensation legislation, subject to a carve out where the company holds transferable insurance rights; and all sums due to any workman from the provident fund, the pension fund, the gratuity fund or any other fund for the welfare of the workmen, maintained by the company. Explanation (a) borrows the definition of workmen from clause (s) of section 2 of the Industrial Disputes Act, 1947 (14 of 1947).

One discrepancy is worth naming rather than smoothing over, because it sits in two adjacent sections of the same consolidation. Explanation (b)(iii) to section 326 cites the Workmen's Compensation Act, 1923 (19 of 1923), while section 327(1)(e) cites the Workmen's Compensation Act, 1923 (8 of 1923). The Act is the same one in both places; the bracketed number differs. Anyone quoting either clause should quote it as printed and note the mismatch.

What is on the section 327 list?

Seven heads, lettered (a) to (g), all of them paid in priority to all other debts but behind section 326.

Clause (g) is the one that connects this section to another part of the Act entirely. The cost of an investigation into the company's affairs under section 213, and of an investigation of ownership under section 216, becomes a preferential debt in the winding up to the extent the company is liable for it.

Note the drafting difference between section 326 and section 327 on who is covered. Explanation (b) to section 327 states that the expression "employee" does not include a workman. Workmen are dealt with by section 326 and employees by section 327, save that clause (b) of section 327(1) caps its own head against any workman: the amount payable under that clause to any workman shall not exceed such amount as may be notified.

How do the preferential debts rank against each other and against a floating charge?

Section 327(3) settles both. Clause (a): the debts enumerated in the section shall rank equally among themselves and be paid in full, unless the assets are insufficient to meet them, in which case they shall abate in equal proportions. Clause (b): so far as the assets of the company available for payment to general creditors are insufficient to meet them, they have priority over the claims of holders of debentures under any floating charge created by the company, and be paid accordingly out of any property comprised in or subject to that charge.

A floating charge, in other words, does not outrank the section 327 list. Whether a particular charge survives at all is a separate question under section 332, which invalidates a floating charge created within the twelve months immediately preceding the commencement of the winding up unless the company was solvent immediately after creating it. Charges registered against a company are recorded in its register of charges under section 85.

Three further sub-sections round it out. Section 327(4) requires the debts to be discharged forthwith so far as the assets are sufficient, subject to retention of sums for the costs and expenses of the winding up, and dispenses with formal proof for the clause (d) contributions except as prescribed. Section 327(5) gives the preferential debts a first charge on goods distrained by a landlord within three months immediately before the date of a winding up order, with the landlord subrogated to the priority of whoever is paid out of it. Section 327(6) deems holiday pay and pay during absence on medical grounds through sickness or other good cause to be wages for services rendered in that period.

Section 327(2) covers the person who funded a payroll. Where wages, salary or accrued holiday remuneration have been paid to an employee out of money advanced by some person for that purpose, that person shall, in a winding up, have a right of priority in respect of the money so advanced and paid-up to the amount by which the employee's own priority has been reduced by the payment. The lender steps into the priority the payment extinguished.

When do these sections not apply at all?

In an insolvency under the Insolvency and Bankruptcy Code. Section 327(7), inserted by Act 31 of 2016, section 255 and the Eleventh Schedule, with effect from 15 November 2016, reads: Sections 326 and 327 shall not be applicable in the event of liquidation under the Insolvency and Bankruptcy Code, 2016 (31 of 2016).

That single sentence is the first thing to check before applying either section. Sections 326 and 327 govern a winding up under the Companies Act, which since 15 November 2016 means a winding up by the Tribunal on the grounds in section 271, and not a liquidation under the Code.

The relevant date that clauses (a), (b) and (d) are measured from is defined by Explanation (c), substituted by Act 31 of 2016, section 255 and the Eleventh Schedule, with effect from 15 November 2016: in the case of a company being wound up by the Tribunal, the date of appointment or first appointment of a provisional liquidator, or if no such appointment was made, the date of the winding up order, unless the company had commenced to be wound up voluntarily before that date under the Code. So a provisional liquidator appointed early moves the relevant date earlier, and with it the twelve month look-back on taxes and contributions.

Applying preferential payments in winding up therefore runs in four steps: confirm the proceeding is a Companies Act winding up and not a liquidation under the Code; settle the relevant date under Explanation (c); pay the section 326 overriding claims, proviso items first; then pay the seven section 327 heads, which rank equally and abate together. Only after that does the Company Liquidator's general distribution power under section 290(1)(g) reach ordinary creditors, and only once the affairs are completely wound up does section 302 dissolution follow.

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