Supreme Court upholds waterfall mechanism under IBC; Division Bench overturns Rainbow ruling

Setting the record straight, the Supreme Court of India has overturned the Rainbow ruling that altered the treatment of government dues in the repayment preference hierarchy.

The Indian bankruptcy regime puts in place a mechanism which decides repayment of dues according to the priority of claims under the hierarchy of preferences.

Section 53 of the Insolvency and Bankruptcy Code (IBC), 2016 – also dubbed the heart of the legislation - outlines the sums of stakeholders in a sequential manne,r designating the repayment priority. As a general rule, secured creditors are given a higher footing over government and statutory dues.

It is pertinent to note that the waterfall mechanism for distribution of assets in liquidation and repayment of dues in resolution places insolvency and liquidation costs at a top priority. This is followed by workmen dues and debts owed to unsecured creditors. Third on the priority list are the wages and dues owed to unpaid employees. Fourth are unsecured creditor debts followed by government dues and financial debts owed to secured creditors, and all remainder debts and dues. Lastly, all dues owed to equity shareholders and partners are to be paid off.

But this rule has been recently challenged in some judicial pronouncements, enabling government obligations owed by the debtor to be paid before any other outstanding debts. This ruling was deleterious for potential bidders on account of pending government and statutory dues.

The Supreme Court has now dismissed this stance, reaffirming the waterfall mechanism.

Paschimanchal Vidyut Vitran Nigam Ltd V. Raman Ispat Private Limited: Relief for creditors

In the aforementioned case, the National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) had set aside attachment of a property of the debtor Raman Ispat to fulfill repayment of electricity dues to the PVVNL. The tribunals stated that the electricity distribution company could realize its dues through the liquidation process as per the IBC. PVVNL’s appeal before the Supreme Court following the NCLAT ruling contended that the scheme of repayment of dues under IBC shall not be applicable here.

PVVNL’s arguments stood on two legs. One being the generalia specialibus non derogant doctrine, which implies that the Electricity Act, 2003 being a special law shall override the general law laid down under IBC. Second, it placed reliance on the Rainbow Paper Mills’ ruling.  

The apex court affirmed that the IBC shall have primacy over the Electricity Act’s non-obstante clauses by virtue of Section 238 of IBC. The position of law as regards IBC’s overriding effect is identical with the position discussed in Sundaresh Bhatt, Liquidator of ABG Shipyard v. Central Board of Indirect Taxes and Customs. This means that IBC would prevail over the other statutes, to the extent that the authorities shall have limited jurisdiction to initiate recovery of dues by means of attachment of property, once moratorium is imposed.

It also observed that the Rainbow ruling did not appreciate the waterfall mechanism under Section 53. It is crucial to note that this ruling applies to the liquidation process specifically, while the Rainbow Papers case dealt with a resolution process case. Furthermore, the separate and distinct treatment of amounts payable to secured creditors on the one hand, and dues payable to the government on the other, clearly signifies Parliament’s intention to treat the latter differently.

State Tax Officer V. Rainbow Paper Mills Limited: The fallout

The Court in the Rainbow pronouncement had deemed the state government as a secured creditor, at par with workmen dues for repayment of dues in the process of resolution. This essentially wiped out the distinction between government dues secured by operation of law and those secured through contractual transactions. This ruling had compelled the tribunals to first delineate the status of claims which delayed the resolution process.

This can be established from the NCLAT ruling in Principal Director of Income Tax v. Synergies Dooray Automotive Limited & Ors. It was held here that all statutory dues, including income tax and VAT, should be considered as operational debt, essentially placing them in the ‘operational creditor’ bracket. A similar pronouncement was given by the NCLT Chennai in the Assistant Commissioner of Customs v. Mathur Sabhapathy Vishwanathan ruling. It had also noted that the state ought to fall under the purview of ‘secured creditor’. The Supreme Court held that the Rainbow ruling is limited to the facts of the said matter.

Furthermore, it seemed that government dues were slowly creeping to a favoured position. Beginning with spectrum dues, the Rainbow ruling conferring a secured status to the state VAT. Most recently, a Ministry of Corporate Affairs (MCA) circular dated June 15, 2023 outlined that the provision of moratorium on royalties would not be applicable in case of Production Sharing Contracts, Revenue Sharing Contracts, Exploration Licenses and Mining Leases made under the Oilfields (Regulation and Development) Act, 1948.

Thus, the PVVNL pronouncement is a major relief for the creditors and financial institutions constantly pressing for clarity on the issue. This ruling clarifies the status of government dues under Section 53 of the IBC. After all, conferring preferential treatment to government dues could deter potential investors or buyers from participating in the resolution process, leading to reduced recovery for all stakeholders.

Trisha Shreyashi is an Advocate and columnist.

Gourav Choudhary is an Associate at Trilegal.