Priority of Dues of Secured Creditor under the Insolvency and Bankruptcy Code, 2016

The Hon’ble Supreme Court of India clarifies the status of Government Dues under Section 53 of the Insolvency and Bankruptcy Code, 2016

The Insolvency and Bankruptcy Code, 2016 (the Code) was implemented in India in the year 2016 after a series of schemes of Reserve Bank of India including that of the Corporate Debt Restructuring System popularly known as CDR Scheme, failed to resolve the insolvency problem. An attempt to redress the issue by way of independent mechanisms under the Sick Companies (Special Provision) Act, 1985 (SICA) also failed to yield the desired results and the system of debtor in possession failed miserably to provide relief to creditors. Consequently, the Code tried to address the causes of failure of the previous regimes and put in place a comprehensive procedure to address the insolvency of corporates by putting in place a system of ‘creditor in control’ mechanism . This was a replacement tothe erstwhile system of ‘debtor in possession’ under the SICA.

Priority of secured creditor in the light of Preamble of the Code

The preamble to the Code very clearly spelled out its objective and aims by specifying the Code being “an Act to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto”.

From the preamble of the Code, three objectives were clearly discernible first being “reorganisation and insolvency resolution in a time bound manner”, Second “maximisation of value of assets of such persons” and the third being “alteration in the order of priority of payment of Government dues”. The legislative scheme under the Code was also designed and put in place to achieve the above three objectives. The Code laid down time limits within which the Tribunals were to admit or reject an application for initiation of the corporate insolvency resolution process (CIRP), also including  setting in motion a ‘Calm Period’ by way of a moratorium under Section 14 of the Code. It also put in place the mechanism of Committee of Creditors tasked with the responsibility of evaluating the viability of the enterprise and of the resolution plans.. The time bound process of CIRP and evaluation of viability of the enterprise and that of the resolution plans were directly aimed at ensuring maximization of value for all the stakeholders. The third objective of “alteration in the order of priority of payment of Government dues” as envisaged in the preamble to the Code was achieved by laying down a clear waterfall mechanism under Section 53 of the Code.

The Hon’ble Supreme Court in its very first landmark judgment under Code[1] emphasized on the timely conclusion of the CIRP and overriding effect of the Code by observing that:

“It can be seen that time is of essence in seeing whether the corporate body can be put back on its feet, so as to stave off liquidation.

There can be no doubt, therefore, that the Code is a Parliamentary law that is an exhaustive code on the subject matter of insolvency in relation to corporate entities, and is made under Entry 9, List III in the 7th Schedule which reads as under: “9. Bankruptcy and insolvency” ….. It is clear that the later non-obstante clause of the Parliamentary enactment will also prevail over the limited non-obstante clause contained in Section 4 of the Maharashtra Act.”

The timelines laid down under the Code for culmination of CIRP and liquidation process  were considered to be optimistic given the experience and pendency under the civil jurisdiction of the courts in India. However, considering the fact that commercial matters need to be considered on a different pedestal, BLRC[2] strongly advocated and recommended for a strict timeline under the Code as it considered it to be “critical for the Code to preserve the time value of the entity by ensuring that negotiations in the IRP are time bound”. Later on, based on experience in handling of cases under the Code the initial timeline under the Code was also extended[3]. But despite all efforts, a lot of work still needs to be done for timely completion of CIRP.

Rainbow Judgement of the Supreme Court

While the stakeholders especially banks and financial institutions were somehow getting used to delayed CIRP and liquidation processes, the judgement of the Hon’ble Supreme Court in the case of State Tax Officer Vs Rainbow Paper Mills Limited[4] came as a surprise and created ripples in already trouble eco-system under the Code, by holding that “the Committee of Creditors, which might include financial institutions and other financial creditors, cannot secure their own dues at the cost of statutory dues owed to any Government or Governmental Authority or for that matter” and declared the tax dues under the Gujarat VAT Act being secured claim. This judgment effectively put the Government dues in the same bracket as that of workmen and secured creditors.

This understanding of the law was somewhat in contrast to the recommendation of the BLRC which recommended that “there should be a separate declaratory provision that upholds the priority rights of secured creditors on their security interests notwithstanding anything to the contrary contained in any state or central law that imposes a tax or revenue payable to the Government by virtue of a specific statutory provision made as a first charge on the assets of the assessee; provided that such first charge may be allowed for claims that existed on the date when such security interest was created”. This  was also clearly captured in the preamble of the Code and also under the waterfall mechanism set out in Section 53 of the Code where the Governmental dues were placed at fifth position along with the claims of the secured creditors for their residual amount of claims. This priority of the secured creditors (priority built in under the state enactments) was implemented across all the Central enactments governing recovery process for the banks and financial institutions[5] to safeguard the financial sector which was faced with strong headwinds  of burgeoning non-performing accounts.

Post the Rainbow judgment, there were some judgments which, in light of specific provisions of the governing enactment under which the claims were preferred by the Governmental bodies, upheld the priority of the secured creditors dues[6]. However,  on account of the issues highlighted in the Rainbow Judgment, Government bodies by and large contested resolution plans claiming status of the secured creditor at par with secured financial creditors and workmen dues. Due to these practices, Tribunals are now forced to first determine status of their claims which adds to the uncertainty over the resolution process and also delays resolutions.

The Hon’ble Supreme Court now clarifies the status of Government Dues under section 53 of the Code

The recent judgment of the Supreme Court in the matter of Paschimanchal Vidhut Vtran Nigam Ltd Vs Raman Ispat Pvt Ltd[7] decided on July 17, 2023, has come as a welcome relief (pending review of the Rainbow Judgement) to the banking industry, which has been pressing for clarifications on the issue. The judgment has clarified two issues. First,  is   that dues payable to statutory corporations which do not fall within the description “amounts due to the central or state government” and whose dues do not constitute government dues payable or those payable into the respective Consolidated Funds stand on a different footing. Second,  it has clarified the legal position under section 53 of the Code by observing that the decision “Rainbow Papers did not notice the ‘waterfall mechanism’ under Section 53 – the provision had not been adverted to or extracted in the judgment. Furthermore, Rainbow Papers (supra) was in the context of a resolution process and not during liquidation. Section 53, as held earlier, enacts the waterfall mechanism providing for the hierarchy or priority of claims of various classes of creditors. The Apex Court has emphasized that the careful design of Section 53 locates amounts payable to secured creditors and workmen at the second place, after the costs and expenses of the liquidator payable during the liquidation proceedings. However, the dues payable to the government are placed much below those of secured creditors and even unsecured and operational creditors. This design was either not brought to the notice of the court in Rainbow Papers (supra) or was missed altogether. In any event, the judgment has not taken note of the provisions of the IBC which treat the dues payable to secured creditors at a higher footing than dues payable to Central or State Government”. 

The Hon’ble Court has further laid down that the separate and distinct treatment of amounts payable to secured creditor on the one hand, and dues payable to the government on the other clearly signifies Parliament’s intention to treat the latter differently – and in the present case, having lower priority. The Court further clarified that this intention is also evident from a reading of the preamble to the Act itself.

The Court placed reliance on its earlier judgments in the case of Sundaresh Bhatt, Liquidator of ABG Shipyard v. Central Board of Indirect Taxes and Customs and  Duncans Industries Ltd. v. AJ Agrochem, Innoventive Industries, CIT v. Monnet Ispat & Energy Ltd. , Ghanashyam Mishra & Sons (P) Ltd. v. Edelweiss Asset Reconstruction Co. Ltd. and Jagmohan Bajaj v. Shivam Fragrances Private Limited, to reiterate primacy of the Code under section 238 despite other enactment having specific provisions which open with non-obstante clause.

Pending final view of the Hon’ble Supreme Court in the review petition in the matter of Rainbow, this judgment should help in settling the law on the issue and pave way for faster approval of resolution plans.

We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.com  or write to our authors:

Mukesh Chand, Senior Counsel – Email – MukeshChand@elp-in.com

Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein.

 References:
[1] CIVIL APPEAL NOs. 8337-8338 OF 2017- M/s Innoventive Industries Limited Vs ICICI Bank
[2] The report of the Bankruptcy Law Reforms Committee Volume I: Rationale and Design
[3] Proviso inserted in section 12 of the Code 2  by Act No. 26 of 2019, sec. 4 (w.e.f. 16-8-2019) which provided for mandatorily completion of CIRP within a period of three hundred and thirty days from the insolvency commencement date.
[4] CIVIL APPEAL NO. 1661 OF 2020 decided on September 6, 2022
[5] Section 31B of Recovery of Debts and Bankruptcy Act, 1993 –was inserted by Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016, (w.e.f. 01.09.2016 vide N. No. S.O. 2831(E) dated 01.09.2016 and Section26B in the SARFAESI Act was inserted in the SARFAESI Act – by Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Act, 2016. (w.e.f. 24.01.2020 vide N. No. S.O. 4619(E) dated 26.12.2019) to provide for priority of secured creditor over the Government Dues.
[6] PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, decided by the Supreme Court, Bombay High Court very recently in the matter of M/s Edelweiss Asset Reconstruction v. M/s Tax Recovery Officer, dated July 28, 2021, Bombay High Court, in the case of Jalgaon Janta Sahakari v. Joint Commissioner of Sales, Axis Bank Limited vs State Of Maharashtra And Anr decided on 7 March, 2017, to quote a few.
[7] Civil Appeal CIVIL No 7976 OF 2019 decided on July 17 2023