[Analysis] Rainbow Papers v. Raman Ispat | The Puzzling Paradox of Legal Priorities

Table of Contents

1. Introduction
2. Govt. secured the status of a ‘secured creditor’ in the case of Rainbow Papers Ltd
3. Amounts due to Government are ranked in same manner as those of ‘secured creditors’ in the case of Raman Ispat (P.) Ltd.
4. Provisions relating to ‘waterfall mechanism’
5. Supreme Court rejected review petition against its Rainbow Papers decision
6. IBC must be amended to provide equitable scheme of distribution through a separate waterfall mechanism
7. Conclusion

1. Introduction

The Insolvency and Bankruptcy Code (IBC) is a crucial piece of legislation in India designed to streamline and modernize the country’s insolvency and bankruptcy procedures. At the core of insolvency law lies the priority order, often referred to as the ‘waterfall mechanism’ outlined in section 53 of the IBC. A pivotal concern within the hierarchy of secured creditors is whether the statutory claims, backed by provisions in respective laws granting the Government secured creditor status, will be accorded equal ranking with other secured creditors. Alternatively, they may be relegated to the fifth priority position as stipulated by section 53(1)(e), creating a state of uncertainty.

At the centre of the uncertainty, two significant Supreme Court rulings have emerged. The first one is in the matter of State Tax Officer v. Rainbow Papers Ltd. [2022] 142 taxmann.com 157 (SC) dated September 6, 2022. The second one pertains to the matter of Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat (P.) Ltd. [2023] 152 taxmann.com 421 (SC) dated July 17, 2023.

2. Govt. secured the status of a ‘secured creditor’ in the case of Rainbow Papers Ltd

In the case of Rainbow Papers Ltd., the Apex Court ruled that section 48 of the Gujarat VAT Act is not contrary to or inconsistent with section 53 or any other provisions of the IBC. Thus, the ‘State’ is considered a secured creditor under the GVAT Act. The term ‘secured creditor’ pertains to a creditor in favour of whom security interest is created. The IBC’s definition of a secured creditor does not exclude any Government or Governmental Authority.

Therefore, if a resolution plan approved by the CoC disregards statutory demands payable to a secured creditor, including the State under the GVAT Act or any legal authority, the NCLT is bound to reject the said resolution plan. Consequently, the corporate debtor would be subject to liquidation and its assets would be sold and distributed in manner as specified in section 53 of the IBC.

3. Amounts due to Government are ranked in same manner as those of ‘secured creditors’ in the case of Raman Ispat (P.) Ltd.

In the case of Raman Ispat (P.) Ltd, the Apex Court ruled that amounts due to the Government (i.e., payable into Consolidated Fund of India or Consolidated Fund of a State) are ranked in the same manner as those of secured creditors who do not relinquish their security interest.

A secured creditor has to take a calculated decision, at the outset of the liquidation process, whether or not to relinquish its secured interest. In case it does so, its dues rank high in the waterfall mechanism.

The Gujarat Value Added Tax Act, 2003 (GVAT) no doubt creates a charge in respect of amounts due and payable or arrears. It would be possible to hold [in the absence of a specific enumeration of government dues as in the present case, in section 53(1)(e)] that the State is to be treated as a ‘secured creditor’.

However, 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 – and in the present case, having lower priority.

4. Provisions relating to ‘waterfall mechanism’

Sec 53 of the IBC deals with the provisions related to the distribution of assets. It outlines the order of priority for the distribution of proceeds from the sale of liquidation assets, commonly referred to as the ‘waterfall mechanism’.

The proceeds from the sale of liquidation assets shall be distributed in the following order of priority namely –

(a) the insolvency resolution process costs and the liquidation costs paid in full;

(b) the following debts which shall rank equally between and among the following :

• • workmen’s dues for the period of twenty-four months preceding the liquidation commencement date; and
  • debts owed to a secured creditor in the event such secured creditor has relinquished security in the manner set out in section 52;

(c) wages and any unpaid dues owed to employees other than workmen for the period of twelve months preceding the liquidation commencement date;

(d) financial debts owed to unsecured creditors;

(e) the following dues shall rank equally between and among the following:

• • 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, if any, in respect of the whole or any part of the period of two years preceding the liquidation commencement date;
  • debts owed to a secured creditor for any amount unpaid following the enforcement of security interest;

(f) any remaining debts and dues;

(g) preference shareholders, if any; and

(h) equity shareholders or partners, as the case may be.

5. Supreme Court rejected review petition against its Rainbow Papers decision

On October 31, 2023, the Supreme Court rejected the review petition filed for review of the order passed by this Court in the matter of Rainbow Papers. The review petition was rejected on grounds, (a) that the grounds of review of a judicial verdict are set in Order XLVII Rule 1 of the Code of Civil Procedure, and the applicant has to demonstrate that there was an error apparent on the face of record and (b) it is not correct to say that the Apex Court had not considered the priority order.

On the other hand, the Apex Court had not only considered the waterfall mechanism u/s 53 but also other provisions of IBC for deciding the priority for the purpose of distributing proceeds from the sale of liquidation assets. Accordingly, granted the status of equivalence to the State Govt.

Supreme Court also rejected the review petition on the ground that a co-ordinate bench cannot comment upon the discretion exercised or judgement rendered by another co-ordinate bench of the same strength.

6. IBC must be amended to provide equitable scheme of distribution through a separate waterfall mechanism

It was observed that during the CIRP, many disputes arose concerning the distribution of proceeds, raising concerns about inequitable distributions among creditors. Subsequently, the MCA vide discussion paper dated January 18, 2023 proposed amending the IBC to establish an equitable scheme for the distribution of proceeds received under a resolution plan, introducing a separate ‘waterfall mechanism’ in the CIRP. This aims to ensure a more equitable distribution process for all stakeholders.

The discussion paper also addressed the treatment of government dues. All debts owed to both the Central Government and the State Governments, irrespective of whether they are secured creditors pursuant to a security interest created by a mere operation of statute, shall be treated on par with other unsecured creditors.

Further, it will be clarified that only where the security interest is created pursuant to a transaction of the Central Government or a State Government with CD, the Government will continue to be treated as a secured creditor in the order of priority.

7. Conclusion

The current situation leaves all liquidators in a perplexing dilemma. It’s undeniable that none of the liquidators would have treated government claims on an equal footing. Many liquidations might have already been completed, and substantial distributions could have occurred. It’s crucial to understand that if a statute can confer secured creditor status, there’s nothing preventing the government from bestowing such a status through statute amendments.

As a result, it’s crucial for legislators to step in without delay. Leaving this gap unaddressed comes at a significant cost, as it disrupts both ongoing and completed liquidations. With over 55% of liquidations already running for more than two years, the nation cannot afford any uncertainty regarding such a vital legal provision.