Rain on the Insolvency Law Parade: The Rainbow Paper Case

Introduction

Even though lawmakers attempt to write legislation as clearly as possible, there is always the chance that it will be read differently and carry a different meaning for different people. A situation like this is frequently addressed by the judiciary, which resolves legal concerns as they come up in the course of events. There is, nevertheless, a chance that the courts themselves could offer varying interpretations of the same case. Undoubtedly, this would lead to uncertainty and turmoil. Such is the case in State Tax Officer v. Rainbow Papers Limited.

In the instant case, the status of statutory creditors like state tax authorities during CIRP under the Insolvency and Bankruptcy Code, 2016. It was decided by the National Company Law Appellate Tribunal, that the government could not assert the first charge over the corporate debtor’s (CD) assets. It further concluded that Section 53 of the IBC cannot take precedence over Section 48 of the Gujarat Value Added Tax (GVAT), 2003, which provides for first charges on a dealer’s property in respect of any amounts owed by him for tax, interest and penalties.

State Tax Officer appealed before the Supreme Court, asking, “Whether the provisions of the IBC and, in particular, Section 53 overrides Section 48 of the GVAT Act?”

The decision by the Supreme Court

The Honorable Supreme Court noted that pursuant to Section 48 of the GVAT Act, the Tax Department’s claim directly correlates to the definition of “Security Interest” found in Section 3(31) of the IBC, and as a result, they must be regarded as “secured creditors” for the purposes of Section 3(30) of the Code.

The court further held that the Adjudicating Authority must reject Resolution Plans that entirely disregard the statutory obligations to the government or legal authority. The court decided that NCLAT’s position that Section 53 of the IBC pre-empts Section 48 of the GVAT Act is factually incorrect as there is no conflict at all between the two provisions. Furthermore, it was also held that the Committee of Creditors, which may include financial institutions and other financial creditors, is not allowed to secure its obligations at the expense of the government’s statutory responsibilities.

As a result, the appeal was authorised, and the resolution plan and contested orders were likely to be overturned.

Analysis

Deviation from established jurisprudence

The court has, time and again, upheld the priority of security creditor dues over different kinds of tax dues in its previous judgment. Interestingly, none of these judgements was referred to by the court in the Rainbow Papers case.

For instance, in PR Commissioner of Income Tax v. Monnet Ispat & Energy Ltd, the Apex court held that secured creditors would take precedence over the income-tax (IT) dues. For this, the court referred toDena Bank v. Bhikabhai Prabhudas Parekh & Co., wherein the SC has unequivocally held that “the common law doctrine of priority of crown debts would not extend to providing preference to crown debts over secured private debts”. Similarly, in a recent case of Sundaresh Bhatt v. Central Board of Indirect Taxes & Customs, the court held that even though the Customs Act creates a statutory charge in favour of authorities, in case of any conflict between the Customs Act and IBC, the latter overrides the former.

Furthermore, in Jalgaon Janta Sahakari v. Joint Commissioner of Sales, the Bombay High Court refused to give priority to tax dues under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (SARFAESI Act) and the Recovery of Debts Due to Banks and Financial Institutions Act 1993 over secured creditors’ dues. Similarly, the High Court of Andhra Pradesh, in Leo Edibles & Fats Ltd v. the Tax Recovery Officer, held that Income Tax authorities cannot be secured creditors under IBC and cannot claim priority.

Can statutory charges create a security interest?

Statutory debts, as provided under Section 5(21) of IBC, are operational debt and hence, unsecured. But they can be “secured” by creating a “security interest”. As per the Rainbow Papers, since the state’s tax department is granted the charge over the assets of the CD under Section 48 of GVAT, they must be considered “secured creditors” as defined in Section 3(30). It’s because such a statutory charge creates a “security interest” by the “operation of law”.

However, by reading the definitions of “secured creditors” and “security interest” as assigned under section 3(30) and section 3(31), respectively, two things can be concluded.

For a party to be secured creditor, creation of security interest is must.
Security interest is a right or title created through a “transaction” which secures payment or performance of a duty.

The keyword in section 3(31) is the term “transaction”, which is defined as any written agreement or arrangement for the transfer of assets, funds, products, or services from or to the CD under section 3(33) of the IBC. It can be inferred that such a security can only be created through a bilateral contract or any such arrangements in which the CD is a party. The provision doesn’t take cognisance of a provision under any other law creating such security and hence, it can be interpreted that a security interest shall not be created merely because of a statutory charge. The definition doesn’t seem to include assessment of statutory dues by tax authorities as it involves forced and non-consensual acts like attachment of properties etc. The application of the concept of a security interest is closely linked to a mutual agreement or transaction between the parties (as used in debt recovery laws like the SARFAESI Act).

Furthermore, almost all of the tax statutes including the Central Goods and Services Tax, 2018 (Section 82) and Customs Act, 1962 (Section 142A) have the provisions for the tax dues to be secured on the assets of the debtor. If the legislature intended give the tax dues the status of a secured creditor, it could have specified it in the provision itself.

In fact, the Bombay High Court has very recently held in Jalgaon Janta Sahakari that “…there is no magic in the words’ first charge’. Even a ‘first charge’, by express statutory intendment, can be made subordinate or subservient to a paramount charge.” Hence, the tax authorities should not be equated with a “secured creditor” based on a charge created by a tax statute.

Ranking under Section 53 disregarded

Section 53 of the IBC specifies the distribution waterfall for the proceeds to be dispersed to stakeholders in the event of liquidation. The court, in this case, has observed that Section 48 of the GVAT is not in conflict with Section 53 of the IBC because the state is a secured creditor as per the GVAT, and the debts owed to them rank equally with other specified debts in Section 53(1)(b)(ii). However, if this reasoning doesn’t explain the separate ranking of government dues in the same provision [Section 53(1)(e)(i)]. If the tax authorities and secured creditors were to be ranked on the same pedestal, this discrimination in the provision doesn’t seem logical.

An argument can be raised that the tax dues and government dues are not the same but such n argument is absurd. Section 53(1)(e)(i) clearly specifies that it includes “any amount due to the Central Government and the State Government including the amount to be received on account of the Consolidated Fund of India and the Consolidated Fund of a State”. Since tax dues are an input to the Consolidated Fund of India or of States, they shall come within the section’s ambit. This was also observed by the High Court of Andhra Pradesh in Leo Edibles.

Overriding provisions of IBC

Starting with a non-obstante clause, Section 53 of the Code supersedes any other contrary provision of any law enacted by the central or state legislatures. Hence, any other legislation (like Section 48 of GVAT in this case) that has a non-obstante provision establishing a different priority for any sort of debt shall be impliedly in conflict with the IBC. The code, by virtue of Section 238, overrides any other conflicting law as has been reiterated in several judgments of the SC including Innoventive Industries Ltd v. ICICI Bank, Rajendra K Bhutta v. Maharashtra Housing and Area Development Authority and Sundaresh Bhatt v. Central Board of Indirect Taxes and Customs. Hence, IBC has become an island and the jurisdiction of all other laws stand excluded in that island. In any case, the GVAT, being a state legislation cannot prevail over a central legislation pursuant to the doctrine of repugnancy.

Disregard of key principles of IBC

The court has observed that a resolution plan is bound to be rejected if it doesn’t provide any payment to statutory creditors or other creditors. This observation ignores the fact that there is no mandate under IBC that all the creditors, regardless of their prioritisation must be paid under a resolution plan. The test to provide minimum amount to dissenting creditors has been put under Section 30(2) of the IBC and this amount can can even be zero. Decisions on payment of such amounts are trusted with the commercial wisdom of the Committee of Creditors without any mandate that it must be equal to that of secured creditors. Further, the provisions in the IBC make it clear that in case of a company’s insolvency, some creditors are not entitled to any proceeds if the company’s assets are not sufficient to pay their dues. Hence, it is not the jurisdiction of courts to mandate that all creditors be paid regardless of their entitlements or be paid in “uniformly proportionate manner”.

The court’s observation that the FCs cannot obtain their own dues at the expense of statutory dues, completely ignores the legal design and policy intent behind the IBC. As is clear from the objectives of the IBC that its aim is to abolish the preference of crown debts or government dues. The intent is to give preference to secured and unsecured creditors and dues to employees and workmen over such government dues. The Bankruptcy Law Reform Committee’s recommendation can also interpret this intent. In its final report, the BLRC recommended: “to keep the right of the Central and State Government in the distribution waterfall in liquidation at a priority below the unsecured financial creditors in addition to all kinds of secured creditors.” Doing so is not detrimental to the government as it would lead to more significant economic growth and better revenue for the exchequer.

Conclusion

Uncertainty has been caused by the differences in legislation regarding establishing a charge over the taxpayer’s property. There doesn’t appear to be any rationale for such divergence in the context of IBC-related issues. The IBC’s preamble states that one of its goals is “alteration in the order of priority of payment of Government dues.” However, classifying statutory obligations as “secured creditors” would appear to be at odds with such a purpose, needing immediate legislative intervention to end the controversy.