The Supreme Court is currently re-examining the issue of whether debts owed to secured creditors (banks and financial institutions) prevail over dues owed to Central and state governments in the waterfall mechanism provided under the Insolvency & Bankruptcy Code, 2016 (IBC).

This is a rare instance where the Court has agreed to hear in open court review petitions against its earlier judgment in Sales Tax Officer v. Rainbow Papers. In our view, the judgment in Rainbow Papers is flawed and upsets the carefully designed waterfall mechanism under the IBC for distribution of proceeds from the liquidation of a corporate debtor. The ongoing review proceedings offer an excellent opportunity for the Court to undertake some much-needed course-correction.

Under English common law, government dues (denoted as crown debts) prevail over the dues/rights of an ordinary citizen. The principle evolved in England was that whenever the right of the Crown and the right of a subject with respect to payment of a debt of equal degree come into competition, the Crown’s right prevails. However, the precedence enjoyed by the Crown is only with respect to unsecured creditors. Secured debts stand on an entirely different footing and are not ‘equal in degree’ with government dues.

This legal principle has been followed in India as well, first by the High Courts (Bank of India v. John Bowman; Manickam Chetiar v. IT Officer, Madura) and then by a Constitution Bench of the Supreme Court in Builders Supply Corporation v. Union of India.

When Parliament enacted the Companies Act, 1956, the provisions for winding up of a company also ranked government dues below workmen’s dues and debts owed to secured creditors in order of priority (see Sections 529-A & 530 of the 1956 Act). In State of Maharashtra v. Sicom Ltd, the Supreme Court upheld a judgment passed by the Bombay High Court relating to winding up proceedings of a company under the 1956 Act. It was laid down that the sales tax dues owed to the State government under the Bombay Sales Tax Act, 1959 would rank below the dues owed to Sicom, which was a secured creditor. This order of priority in winding up proceedings was maintained even in the Companies Act, 2013 (see Sections 326 & 327 of the 2013 Act).

The Bankruptcy Law Reforms Committee (BLRC), which was tasked with giving its recommendations for designing an insolvency resolution regime in India, extensively deliberated upon the order of priority of payments to various stakeholders in the event of liquidation of a company. In Volume I of its final report dated November 4, 2015, the Committee recommended that government dues ought to rank lower than workmen’s dues and secured debts. The Committee reasoned that the government had deeper pockets than secured creditors, who were ordinarily banks and financial institutions. Maximising the recovery of debts for these creditors would ensure a stable and healthy financial system, encourage lending and promote entrepreneurship, which would contribute to the growth of the economy as a whole. This in turn would augment government revenues as well.

If the government’s dues were ranked higher than or even pari passu with the dues of secured creditors, it would limit the latter’s recovery of dues. This would adversely impact the balance sheets of the banks and raise the risks involved in extending credit to borrowers. This rise in risk would be passed on to the borrowers in the form of higher interest rates.

The recommendations of the BLRC were accepted by Parliament while enacting the IBC. Section 53 of the IBC contains the waterfall mechanism and prescribes the following order of priority for distribution of proceeds upon liquidation of a corporate debtor:

(i) Insolvency resolution process costs and liquidation costs;

(ii) Workmen’s dues and dues of secured creditors who have relinquished their security interest. Both these debts are to rank pari passu;

(iii) Unpaid dues of employees other than workmen;

(iv) Financial debts owed to unsecured creditors;

(v) Dues owed to Central and state governments and unpaid debts of those secured creditors who have enforced their security interest. Both these debts to rank pari passu;

(vi) Any remaining debts & dues;

(vii) Preference shareholders

(viii) Equity shareholders

It is clear from the provision that those secured creditors who have opted to relinquish their security interest and avail the distribution under the waterfall mechanism are ranked much higher in order of priority compared to the government. The IBC has in fact gone one step further by giving higher priority to even financial debts of unsecured creditors compared to the government, evidently to maximise debt-recovery and free up stressed assets.

In Rainbow Papers, the Supreme Court was seized with a VAT demand by the Gujarat government against the corporate debtor, Rainbow Papers Ltd. The Court noticed Section 48 of the Gujarat Value Added Tax Act, which states that any tax liability would operate as first charge on the assets of the assessee. On the strength of this provision, it was held that the Gujarat government would be a secured creditor enjoying pari passu priority of payment alongwith other secured creditors and workmen. Resultantly, the Court set aside the resolution plan duly approved by the Committee of Creditors as well as the National Company Law Tribunal for the reason that it omitted to make provision for discharging the dues of the government.

The Court reasoned that the government, being an operational creditor under the resolution plan, was entitled to receive at least the liquidation value of the corporate debtor as per the waterfall mechanism under Section 53. This is because under Section 30(2) of the IBC, a resolution plan, in order to pass legal muster, must at least pay the operational creditors the amount they would have received under Section 53 if the company had been liquidated. Pertinently, the VAT or Sales Tax statutes of other states also contain similar provisions imposing first charge on the property of an assessee in default.

However, it is interesting to note that simultaneous to the enactment of the IBC in 2016, Parliament had also amended the Securitization & Reconstruction of Financial Assets & Enforcement of Security Interest Act, 2002 and the Recovery of Debts & Bankruptcy Act, 1993 to state that notwithstanding any other law creating any charge in favour of the government, the debts of secured creditors would be paid in priority over government taxes and dues. Similar amendments were made to the Central Excise Act and the Customs Act, explicitly stating that the dues of the government under those Acts would be subject to the rights of secured creditors.

These amendments were made specifically to overcome previous judgments passed by the Supreme Court, including Central Bank v. State of Kerala, wherein the Court had accorded priority to government dues arising out of state enactments since those enactments imposed first charge on the assets in favour of the government. Therefore, in 2016, when the IBC was enacted, the Parliamentary intent was clear- to accord priority to dues of secured creditors, notwithstanding the fact that the government may enjoy first charge over the assets of the assessee in default for recovering its taxes and dues.

Treating the government as a secured creditor as the Court did in Rainbow Papers (supra) would effectively mean that the government jumps from fifth place to second place in the waterfall mechanism under Section 53. With the government also having an equal share in the pie, the recoveries for workmen and secured creditors would inevitably suffer. This is clearly contrary to Parliamentary intent.

The Court’s reasoning also overlooks what it means to be a “secured creditor” under the IBC. Section 3(31) defines “secured creditor” as one in whose favour a security interest is created. “Security interest” is in turn defined as “right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person”.

“Transaction” too is defined as “an agreement or arrangement in writing for the transfer of assets, or funds, goods or services from or to the corporate debtor”.

Therefore, the sine qua non for creation of a “security interest” is the existence of a transaction, which is a voluntary act where the debtor and the creditor mutually agree to subject the debtor’s property to sale or transfer in the event of default in repayment of the debt. The IBC does not envision creation of “security interest” by operation of law. Therefore, merely because a statute grants first charge to the government over the properties of a person for recovering taxes or other dues does not convert the government into a “secured creditor” under the IBC.

Most pertinently, the Ministry of Corporate Affairs has issued a notice dated January 18, 2023 proposing amendments to the IBC in order to overcome the Court’s judgment in Rainbow Papers. It has been proposed to clarify that a security interest created by law in favour of the government would not entitle the government to claim alongside other secured creditors.

The Court’s anxiety for prioritizing government dues for the sake of public welfare is understandable. However, the IBC is an economic legislation framed by domain experts. The waterfall mechanism in Section 53 of the IBC is an outcome of well thought out policy choices made by Parliament. A judicial hands-off approach is warranted in such cases, otherwise the economic consequences could be devastating. In the pending review proceedings, all eyes would be on the Court to see whether it agrees to review its earlier decision.  

Dhruv Mehta is a Senior Advocate and Shyam Rajan Agarwal is an Advocate.