The advent of the Insolvency and Bankruptcy Code, 2016 (‘Code’) was a huge step by the Indian legislature towards providing a robust, market driven and time bound mechanism for the insolvency and bankruptcy process in India. Prior to the Code, the insolvency laws in India were scattered amongst various laws and judicial forums. However, the creditors did not greatly benefit from these laws. This led to the birth of the Code, enacted specifically to address the issues faced by the then prevailing laws as well as revolutionise the insolvency and bankruptcy regime in India.
The Code established a creditor-driven insolvency and bankruptcy regime with an aim to promote the availability of credit in the market. Under the Code, if a company is in default of dues owed by it, a creditor may first seek to initiate the Corporate Insolvency Resolution Process (‘CIRP’) where an attempt is made to revive the company by selling it to a willing purchaser (called a resolution applicant) and the creditors being paid off from the monies received from such sale. If the CIRP fails then the company is liquidated.
The Code today is the primary law for insolvency and bankruptcy in India and was also declared to prevail over the existing laws either by way of specific amendments to certain laws or by way of judicial pronouncements. In order to avoid any inconsistency or hurdles in implementing the Code and to maintain its supremacy, it has been provided an overriding effect over other laws in India. The Code has, in fact, been rather successful in achieving its objectives, but like any new law, it has faced challenges in implementation.
A significant aspect of the Code is section 53, which provides the ‘waterfall mechanism’, ie the priority for distribution of sale proceeds in the liquidation process. The waterfall mechanism is significant because the Code provides for the priorities laid down therein to be considered even during the CIRP. Under this provision the dues owed to secured creditors were accorded utmost priority in distribution along with employee and workmen dues (after deduction of the insolvency resolution process and liquidation costs). It was provided priority over all other debts including taxes, cess, and other dues payable to the central government or state government or any local authority. This was a step by the Indian legislature in promoting the development of credit markets in the country and showcased the legislatures intent to protect the rights of creditors by providing them supremacy under the insolvency and bankruptcy regime.
The waterfall mechanism, as mentioned above, specifically provides for distribution of sale proceeds firstly to the secured creditors and, thereafter, to the government, whose dues are fourth in rank for distribution. This order of priority under section 53 of the Code demonstrates the intent of the legislature by assigning priority to secured creditors over crown debts. The order of priority under the waterfall mechanism has been carefully designed by the Indian law makers who opined that while the recovery of dues by secured creditors is triggered with the initiation of insolvency proceedings against a corporate, the government has been given substantial power to recover its arrears prior to the initiation of insolvency proceedings.
Courts in India have repeatedly upheld the objective of the Code by barring government authorities from seeking any priority over the dues of secured creditors under the Code as well as other similar laws. However, a recent judgment passed by the Supreme Court of India in the case of State Tax Officer vs Rainbow Papers Ltd.1 (‘judgment’) took a completely contrary view – contrary to the specific provision of section 53 and contrary to prior judgments of the Apex Court. The Apex Court in this case held that the term ‘secured creditor’ under the Code also includes a charge created by operation of law and, consequently, any government or statutory authority having such a charge will qualify as a secured creditor under the Code.
This judgment completely disturbed the waterfall mechanism laid down under section 53 of the Code which was thoughtfully drafted by the Indian law makers, keeping in mind the aims and objectives of the Code. The judgment, in fact, defeated one of the main objectives of the Code ie, the alteration in the priority of government dues, which was intentionally placed much lower in rank to the secured creditors and other financial debts. The judgment failed to appreciate that the law in India, as laid down by judicial pronouncements, even prior to the enactment of the Code did not allow for the government or any statutory authority to be treated as a secured creditor merely on the basis of a charge created in their favour by operation of law.
The judgment has now set a precedent for government authorities to claim the same priority as a secured creditor, which runs contrary to the aim of the Code. Unfortunately, the importance and impact of this waterfall mechanism, drafted with a distinct objective and consciously kept impermeable, itself has now been watered down by the judgment.
Considering the impact of the judgment, the Indian law makers have taken cognizance of the same and a notice dated 18 January 2023 was issued by the Ministry of Corporate Affairs, Government of India, inviting public comments to the changes considered to the framework under the Code. One such change under consideration is to nullify the impact of the judgment by clarifying that only such security interest created by a transaction between a borrower and the government authority will grant them the status of a secured creditor. The Apex Court has in a subsequent judgment also attempted to reduce the impact of the judgment by seemingly limiting its applicability2 to only the CIRP stage.
In conclusion, the Code marked a significant milestone in India’s legal landscape. While its creditor driven approach has been largely successful, it is important that some of the challenges that it has faced by way of recent judgments is addressed by either well considered amendments or subsequent judicial pronouncements. This will be crucial to protect the original intent of the Code.
Notes
- 2022 (13) SCR 808
- Paschimanchal Vidyut Vitran Nigam Limited v Raman Ispat Private Limited and Others