By Tanushree Dubey
Published on: 01 October 2023 at 13:50 IST
The waterfall system in Insolvency and Bankruptcy Code, 2016 is a well-organized plan that specifies the precise order in which a debtor’s assets will be distributed to various stakeholders, including creditors and stockholders. It is used in bankruptcy processes. When it comes to dividing up the debtor’s assets, this system is intended to ensure that the procedure is just, understandable, and foreseeable.
Its aim is to ensure that everyone involved in the process receives fair treatment and that the assets are allocated in a way that maximises fairness for everyone. The waterfall mechanism, along with its main components and historical development, will be covered in this article.
The central goals and components of the waterfall mechanism encompass:
- Establishing Priority and Hierarchy: The mechanism puts in place a clear hierarchy among different groups of claimants or creditors. This hierarchy is crucial for determining the sequence in which funds will be disbursed from the available assets. Typically, secured creditors are granted a higher position in the hierarchy, guaranteeing that their claims are satisfied before those of unsecured creditors.
- Distinguishing Secured vs. Unsecured Creditors: The mechanism makes a distinction between secured creditors and unsecured creditors. Secured creditors hold a security interest in certain assets of the debtor, which provides them with priority regarding those specific assets during insolvency. Unsecured creditors, lacking this security interest, usually find themselves lower in the order of priority.
- Consideration for Operational Creditors: Within the unsecured creditor category, operational creditors, such as suppliers and service providers, may be afforded a particular status and level of priority. In certain instances, they are given priority in asset distribution to ensure that crucial services can continue during insolvency proceedings.
- Treatment of Government Dues: Government dues, which encompass taxes and regulatory fees, are often treated differently in the hierarchy. They may be separately categorized and given precedence to guarantee prompt repayment of public debts.
- Equity Shareholders: Equity shareholders, who possess shares in the company, generally occupy the lowest position in the priority sequence. They are entitled to a portion of the remaining assets only after secured and unsecured creditors, as well as government dues, have received their allocations.
Priority of Dues under Section 53 of IBC
Section 53 of the Insolvency and Bankruptcy Code, 2016 (IBC), plays a pivotal role in defining the precise order of priority for asset distribution during insolvency proceedings in India. This section categorizes the various types of creditors and stakeholders and specifies the sequence in which they are eligible to receive payments. The priorities laid out in Section 53 are fundamental in maintaining equity and consistency within insolvency proceedings.
Key elements of Section 53 of the IBC include:
- Secured Creditors: Secured creditors, those who possess collateral or security interests in specific debtor assets, enjoy the highest priority. They are entitled to receive payments from the proceeds of their collateral before other claimants.
- Workmen’s Dues: Employee dues, especially those related to wages and employment benefits, are afforded a significant level of priority. This prioritization underscores the importance of safeguarding employees’ welfare during the insolvency process.
- Unsecured Financial Creditors: Following secured creditors and workmen’s dues, unsecured financial creditors, which encompass banks and financial institutions, hold the next level of priority. They receive their payments based on the available funds, after satisfying higher-ranking claims.
- Government Dues: Government dues, such as taxes and other statutory payments, occupy a distinct position within the priority hierarchy. They are typically categorized separately and granted priority to ensure the protection of the government’s financial interests.
- Remaining Unsecured Creditors: After addressing the above categories, any unsecured creditors left are eligible to receive payments from the available assets. This category might include trade creditors and other unsecured lenders.
- Equity Shareholders: Equity shareholders, representing ownership in the company, find themselves at the lowest tier of the priority order. They are entitled to receive payments only after all higher-ranking claims have been settled.
The waterfall mechanism, as outlined in Section 53 of the IBC, serves as the fundamental structure of insolvency proceedings in India. It lays out a precise hierarchy of priorities, ensuring equitable treatment for various stakeholders and guaranteeing an organized and fair distribution of assets. This mechanism is pivotal in upholding confidence in the insolvency process and facilitating the resolution of financial distress in a just and efficient manner.
‘Waterfall mechanism’ under IBC: Key provisions and Rulings
Section 53 of the Insolvency and Bankruptcy Code, 2016 (IBC) establishes a hierarchy for the settlement of debts. Whether it’s the distribution of assets during the liquidation process or the implementation of a resolution plan, both procedures are required to respect the prioritization outlined in Section 53 of the IBC
In the case of PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited, the Supreme Court ruled that income tax dues, considered as crown debt, do not take precedence over secured creditors who are private individuals. Similarly, in the case of Moser Baer Karamchari Union thr. President Mahesh Chand Sharma v. Union of India & Ors, the Supreme Court stressed the importance of priority payments under the Insolvency and Bankruptcy Code (IBC). It emphasized that the IBC provisions are well-considered and provide options to secured creditors while balancing their interests with other creditors in liquidation proceedings.
Similarly, in the case of Sundaresh Bhatt, Liquidator of ABG Shipyard v. Central Board of Indirect Taxes and Customs, it was established that the IBC takes precedence over proceedings under the Customs Act. This means that authorities cannot enforce taxes and levies under the Customs Act once the moratorium period begins.
However, there was a shift in this position due to the Supreme Court’s judgment in the State tax officer v. Rainbow Papers Ltd In this ruling, contrary to its previous decisions, the Supreme Court emphasized the non-obstante clause of the Gujarat Value Added Tax (GVAT) Act. It held that a “security interest” under the IBC can also be established by operation of law and a statute, granting government authorities the status of secured creditors. This decision led to confusion in the IBC regime, as state tax departments started filing claims anew in ongoing liquidation proceedings, seeking equal treatment with first-priority secured creditors.
The Ministry of Corporate Affairs (MCA) expressed concerns about this situation on a January 18, 2023 discussion paper. In an effort to clarify the treatment of security interests created by statutes, the MCA proposed amendments to the Code. While the MCA’s proposal was pending, the Supreme Court’s recent judgment in the matter has cleared the uncertainty created by the Rainbow Papers ruling. It once again affirmed the overriding effect of the IBC in insolvency proceedings.
Landmark Ruling
Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Private Limited
In the Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Private Limited case, a significant legal precedent was established in the context of insolvency and debt repayment in India.
The case revolved around Raman Ispat Pvt. Ltd., a corporate debtor that had an electricity supply agreement with PVVNL. According to this agreement, any outstanding dues would be treated as a charge on the assets of the corporate debtor, as per the provisions of the Electricity Act, 2003, and related regulations.
When Raman Ispat failed to clear its electricity dues, PVVNL attached the corporate debtor’s properties under the District Collector’s orders. Subsequently, Raman Ispat went into liquidation, and the liquidator argued that PVVNL’s claim should be classified according to Section 53 of the Insolvency and Bankruptcy Code, 2016 (IBC), which determines the priority of debt repayment.
The PVVNL case holds significant relevance for several reasons such as:
Clarity on Priority: The case provided much-needed clarity on the priority of debt repayment in insolvency cases, particularly concerning government dues versus private creditors’ claims.
Section 238 of the IBC: The Supreme Court, in this case, upheld that Section 238 of the IBC takes precedence over the Electricity Act. It clarified that debts owed to creditors under the IBC have a higher priority than electricity dues payable under the Electricity Act.
Private Creditor Emphasis: The judgment emphasized the importance of honoring private financial commitments within the insolvency regime. It signaled a shift in the precedence of repayment obligations, favoring unsecured creditors over government dues.
State Tax Officer v. Rainbow Papers Ltd Ruling
Prior to the PVVNL case, the State Tax Officer v. Rainbow Papers Ltd. case set a different precedent. In Rainbow Papers, the Supreme Court ruled that when a security interest is established in favour of the government for tax claims under the Gujarat Value Added Tax Act, 2003, the government assumes the role of a secured creditor within the context of the IBC. This ruling stated that any resolution plan omitting payment of such taxes or statutory dues owed to the government would not align with the provisions of the IBC and would not be legally binding on the State.
Precedence of Rainbow Papers:
The Rainbow Papers ruling, until the PVVNL case, held precedence, and it regarded government claims, particularly tax claims, as secured creditor claims under the IBC.
How PVVNL Overruled the Rainbow Papers Case:
In the PVVNL case, the Supreme Court effectively overruled the Rainbow Papers case through its judgment and the following key observations:
- Section 53 of the IBC: The Supreme Court in the PVVNL case highlighted Section 53 of the IBC, which establishes a structured order of debt settlement during insolvency. This section prioritizes insolvency resolution process costs, dues to secured creditors who waive their security interest, and workmen’s dues. Notably, it places government-related dues lower in priority compared to secured creditors, unsecured creditors, and operational creditors.
- Distinct Treatment of Government Dues: In PVVNL, the Supreme Court emphasized that government-related dues should be treated distinctly and separately from the debts owed to secured creditors. This distinction was not adequately recognized in the Rainbow Papers ruling.
- Failure to Acknowledge the IBC Provisions: The Supreme Court, in the PVVNL case, pointed out that the Rainbow Papers judgment failed to acknowledge the provisions of the IBC, which grant higher priority to dues payable to secured creditors over those owed to the Central or State Government.
In essence, the PVVNL case has effectively reset the legal precedent, favouring private creditors’ rights and establishing a clear hierarchy in debt repayment, overriding the previous ruling in the Rainbow Papers case. It ensures that creditors under the IBC, both secured and unsecured, hold precedence over government obligations when resolving insolvency matters, marking a significant shift in the interpretation of the law.
Conclusion
The overriding of the Rainbow Papers ruling by the Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat Private Limited case represents a crucial correction in the interpretation of insolvency and debt repayment laws in India. The PVVNL case rightly re-established the order of priority, emphasizing the supremacy of the Insolvency and Bankruptcy Code (IBC) in governing insolvency proceedings.
It clarified that government dues, while important, should not take precedence over the rights of private creditors, ensuring a fair and equitable distribution of assets. This decision brings clarity and consistency to the insolvency process, upholding the principles of fairness and transparency that underlie the waterfall mechanism outlined in Section 53 of the IBC