Statutory dues cannot override section 53: Supreme Court clarifies the applicability of Rainbow ruling

– Barsha Dikshit | resolution@vinodkothari.com

Introduction 

Section 53 of Insolvency and Bankruptcy Code, 2016 (‘IBC’) has created a waterfall citing priority of dues. Whether it is distribution in liquidation process or resolution plan – both processes would need to honour the priorities under Section 53 of IBC. However, in September, 2022, in State Tax Officer v. Rainbow Papers Ltd., the Hon’ble Supreme Court (SC) held that by virtue of the ‘security interest’ created in favour of the Government under GVAT, the State is a ‘secured creditor’ as per the definition in IBC. Hence, as workmen’s dues are treated pari passu with secured creditors’ dues, so should the debts owed to the State be put at the same pedestal  as the debts owed to workmen under the scheme of section 53(1)(b)(ii). [Read our detailed analysis on Rainbow Papers ruling here]. As such, this ruling led to anomalies in interpretation, as it shuffled the already well-settled view on priorities of tax dues vis-a-vis secured creditors. 

Interestingly, the recent ruling of SC in Paschimanchal Vidyut Vitran Nigam Ltd. Vs. Raman Ispat Private Limited & Ors. [Civil Appeal Nos. 7976 of 2019] has confined the applicability of Rainbow Papers to its own factual circumstances, thereby, providing relief to all stakeholders, especially IPs undertaking liquidation/resolution processes, who started receiving demands from tax authorities on the strength of Rainbow Papers.

The article below notes the important observations of SC, alongwith author’s insights. 

Issues under Consideration

In the present matter, Paschimanchal Vidyut Vitran Nigam Limited (‘Appellant’), that has attached property of Raman Ispat Pvt. Ltd. (CD) due to unpaid electricity dues, claimed to be treated at par with the first priority secured creditors by placing reliance on the decision of Hon’ble SC in State Tax Officer v. Rainbow Papers Ltd.

The 2 moot issues that arose for consideration before the Hon’ble SC were- 

1. Whether ‘security interest’ created by operation of law can be treated at par with the first priority secured creditor under IBC?
2. Whether the Electricity Act, 2003 overrides the provisions of IBC?

Analysis

 ‘Waterfall mechanism’ under IBC

Prioritisation of claim or waterfall mechanism is one of the most important aspects of the Insolvency laws, wherein, secured creditors hold the priority position over the operational creditors and government dues. The position has been upheld by the Hob’ble Supreme Court in various rulings. For instance, in PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, the Hon’ble SC held that the income tax dues, being in the nature of crown debt, do not take precedence over secured creditors, who are private persons. Similarly, in 

Moser Baer Karamchari Union thr. President Mahesh Chand Sharma v. Union of India & Ors, the Hon’ble SC had emphasized upon the priority payments under IBC and held that provisions of the IBC are carefully thought out. The same gives options to secured creditors, and balances their interests with those of other creditors in a liquidation proceeding. 

In similar vein, in the matter of Sundaresh Bhatt, Liquidator of ABG Shipyard v. Central Board of Indirect Taxes and Customs,, it was held that IBC has an overriding effect over proceedings under Customs Act, such that authorities cannot seek enforcement of taxes and levies due under Customs Act once the moratorium period has commenced.

However the position got shaken due to SC’s judgement in Rainbow Papers Ruling (supra), wherein, the Hon’ble SC, contrary to its earlier decisions, emphasised on non-obstante clause of GVAT Act and held that a ‘security interest’ under IBC can also be created by operation of law and a statute, and can accord the status of a ‘secured creditor’ to the government authorities. The Ruling created chaos in the IBC regime as it triggered the State tax departments to file their claim afresh in the ongoing liquidation proceedings and get treated at par with the first priority secured creditors. The concern was also raised by Ministry of Corporate Affairs (‘MCA’) vide discussion paper dated 18^th January, 2023, wherein, in order to bolster the frameworks under the Code, MCA proposed to provide clarity w.r.t. the treatment of security interests created by statutes in the Code itself.

While the proposal of MCA was pending to reach its finality, the SC’s judgement in the instant matter cleared the cloud created due to Rainbow Papers ruling (supra) on the position of secured debts, and once again upheld the overriding effect of IBC. 

Observation of Court and final verdict

The Hon’ble SC after explaining the ‘waterfall mechanism’ envisioned under the IBC and the judgement passed earlier, upheld the supremacy of IBC over other laws and came to the conclusion that section 53 of IBC provides the hierarchy or priority of claims of various classes of creditors. The secured creditors are given 2 options- First, to relinquish the security interest and receive the proceeds from the sale of assets by the liquidator in the manner specified in Section 53 of IBC. The second option is to realise the security interest in the manner specified u/s 52 of the IBC, and take the position of 5^th priority for the remaining dues, if any.

The Hon’ble SC also went on emphasising upon the inclusion of ‘government dues’ in the lower priority u/s Section 53 of the Code, highlighting the intention of the Parliament to treat debt owed to the government as distinct from debt owed to a secured creditors and observed that in Rainbow Papers, ‘waterfall mechanism’ under Section 53 was not noticed, consequently treating the State Government as a ‘secured creditor’. The relevant para of the judgement is as follows:

‘Rainbow Papers (supra) 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 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.”[Emphasis supplied]

Thus, it was clarified by the Hon’ble SC that the judgement in Rainbow Papers (supra) has to be confined to the facts of that case alone, and cannot be taken as precedent in matters relating to treatment of government dues. 

The decision also establishes that the IBC takes precedence over the Electricity Act, ensuring a structured recovery of debts and organised distribution of realised proceeds among creditors.

Conclusion

The author humbly supports the judgment of the Hon’ble Supreme Court which has rightfully observed that the attempt of Supreme Court in Rainbow Papers w.r.t. prioritising the debts of the State Government was made without looking at the other provisions of the IBC. Vide the instant judgement, the Hon’ble Supreme Court has reinstated the viability of the established principle of waterfall mechanism and the overriding effect of IBC over other laws by drawing conclusions with the aid of provisions of Code and previous judgments.