Beyond the Waterfall: The IBC's Digital Void

[Saksham is a student at Chanakya National Law University.]

The Insolvency and Bankruptcy Code (Amendment) Bill 2025 (2025 Bill) is an important and decisive intervention, especially to the “waterfall mechanism” outlined under the Section 53 of the Insolvency and Bankruptcy Code 2016 (the code). The 2025 Bill aims to clarify the question of stability and hierarchy; it also moves into the second phase of clarifying an area of ambiguity which relates to the inter-creditor agreements within this waterfall; insertion of an illustration in section 53(2) of the code enforces the validity of contractual agreements.

However, this was an opportunity missed; the code has been working in a paradigm of a traditional asset-based system, carefully patching the established cracks on the engine made structure to work with factories, machinery, and bank balances, and without being entirely aware of the imminent shift that is the digitalization of the corporate balance sheet. By not even considering the presence of cryptocurrencies, tokenized assets, and NFTs, the 2025 Bill overlooks a significant possibility of futurizing the code, which will result in the subsequent generation of insolvency cases not due to the incorrect interpretation of the established laws, but due to the complete lack of legislation for new asset types. 

Indian companies, both the tech startups and the old school conglomerates, have started to put digital assets on their balance sheets to invest, operate, and finance their operations; the silence of the code on how to treat the asset is no longer a small oversight; it is a legislative gap that is critically important.

A Deeper Dive into Understanding the 2025 Bill’s Proposal: A Judicial Battle

The priority framework under Section 53 became unsettled after the Supreme Court’s ruling in the case of State Tax Officer v. Rainbow Papers Limited (Rainbow Papers), wherein the court altered the established priority system of liquidation proceedings of a company by putting the government tax dues from their designated low priority under Section 53(1)(e) of the code to the same priority as to of the secured creditors under Section 53(1)(b) of the code.

Further, in the case of PVVNL v. Raman Ispat, the Apex Court rejected the view taken in Rainbow Papers partially and reaffirmed the main intent behind the code, to make the code efficient by keeping the government tax dues in a lower priority list than that of a secured creditor, as the parliament designed it. But it never overruled Rainbow Papers, and left a score of interpretation for these dues to be understood as secured debt. It was also held in the PR Commissioner of Income Tax v. Monnet Ispat and Energy Limited case, by the Apex Court, that the income tax dues cannot take precedence over dues that are owed to secured creditors. The 2025 Bill merely tries to fix the existing problem of hierarchy, which is eventually very visible in these cases, and a major problem stands unnoticed.

By doing this, it has managed to rectify a major mistake in jurisprudence and provide much-needed reassurance to the credit markets. However, at the same time, this same attention to rectifying a historical error of the judicial system makes the 2025 Bill an anachronism. It starkly misses an opportunity to modernize the code by taking cognizance of digital resources and formulating guidelines for the same, and it also fails to recognize the different types of governmental claims. These are duly recognized in the UK after the revised position of the Enterprise Act 2002 in 2020, where certain tax debts, VAT, and Pay As You Earn income tax are given secondary preference in the creditors' list. The bill could have adopted a more critical approach, just like the UK.

Three Model Problems with These Digital Resources and The Framework

The incorporation of digital resources in a business bankruptcy is a complex problem that is not only deep but also multi-dimensional as a result of an inherent lack of doctrinal fit with the major principles of the code. To begin with, it is not clear in Indian law whether digital assets should be a sui generis category, intangibles, or goods. In other words, they are legally ambiguous property. This uncertainty pervades the whole procedure, whether it be the definition of the estate or the Liquidator's powers. 

Second, the control mechanism challenges conventional conceptualizations of possession; the obligation of a Liquidator of the estate of one person to have the possession of the estate, as provided under Section 35 of the code, becomes meaningless when the asset is controlled by a private key which is lost or withheld, or is held by the custodian of a third-party in an uncooperative jurisdiction. 

Third, their high volatility poses a valuation abyss, and is a mockery of the principle of fair and equitable distribution under section 53 of the code, as the value of a claim can come to double and half between the liquidation order and the ultimate distribution. Lastly, their presence in decentralized and worldwide networks counters the territorial assumption of the IBC, producing unresolvable conflicts of the law. All these traits leave a legal vacuum that the existing framework is not fit to address.

The Parallel of the Trust Asset: Unbroken but Critical Inequity

One notable, significant, and unaddressed weakness of the existing system is how to treat digital assets owned by a corporate debtor in a fiduciary or custodial capacity, which is the situation that is perfectly illustrated by a bankrupt cryptocurrency exchange. The 2025 Bill's encompassing, perhaps disagreeable formulation of "trust taxes" (GST/TDS) clearly shows the Parliament's intention to differentiate between assets held within a fiduciary role and assets held by companies. Conversely, such an emphasis has led to a conceptual blind spot. The 2025 Bill utterly disregards the position of customer-held cryptocurrencies in bankruptcy, assets that are the pinnacle of modern "trust property." Unlike common unsecured claims, such assets are distinctive, recognizable, as well as always economically held by the company in question. 

As a result, the 2025 Bill is a missed opportunity to modernize the code. Extending the "trust asset" principle beyond taxes to specifically include digital assets and requiring their segregation and return to customers would be a novel and essential amendment that would stop a regressive wealth transfer from individual asset holders to business creditors. Any commingling of these customer-owned assets related to the corporate liquidation property and distributing it among the general creditors of the company would be an injustice of a gigantic moral hazard and would be tantamount to authorizing the misappropriation of client funds to settle corporate debts. 

This more urgent dilemma of trust is disregarded in the blanket subordination of all government dues provided in the 2025 Bill, despite being pro-credit. The code does not have any explicit, clear mechanism, similar to the client money rules in securities regulation, to ring fence and give back such beneficiary-owned digital assets, which means that thousands of retail customers would be vulnerable to disastrous losses in a company's insolvency.

The Proposed Taxonomy: A Principle-based Framework for Integration

A new, principle-grounded taxonomy is needed to maneuver through the new territory by logically incorporating the claims of digital assets into the hierarchy of Section 53 of the code. This framework makes economic substance more important than technological form to establish a new sub-hierarchy in the waterfall. The specialized costs incurred in securing, valuing, and liquidating the digital assets should be classified as liquidation costs in Section 53(1)(a) of the code, since they are needed to preserve the estates.

Second, customer assets in a proven fiduciary position should be granted a super-priority, either omitted from the estate or placed on par with workmen’s dues, to avoid the massive unfairness of the assignment of their recovery to general creditors. In the case of consensual lending, validly perfected security interests in digital assets ought to correctly locate a creditor in the secured creditor category pursuant to Section 53(1)(b) (ii) of the code. On the other hand, it would only be correct that the holders of utility tokens, who would essentially be claimants to an unrendered service, should be included in the category of unsecured creditors. Lastly, the general liquidation estate would include digital assets that the company owns for its beneficial investment purposes. This categorical method gives the transparency and fairness that the code is deficient.

A Blueprint for IBC to be Future Ready: A Conclusion

The specified gap needs to be bridged by a two-pole approach of legislative change and an elaborate regulation framework. At the legislative level, the IBC needs to be revised to first revise Section 3(27) of the code’s definition of property to specifically cover virtual digital assets to put a stop to the underlying ambiguity. 

Second, Section 3(31) of the code, which defines what constitutes “security interest,” should be amended to include the interests taken over digital assets by the use of prescribed methods, such as smart contracts and possession of private keys. Third, a new proviso should be added in Section 36 that assets which are possessed as the fiduciary or custodial possession are not part of the liquidation estate. 

At the same time, the Insolvency and Bankruptcy Board of India needs to be empowered by a statute to develop a regulatory framework of support. These would contain requirements regarding secure corporate custody solutions, such as multi-signature wallets with escrow procedures to be accessed by Liquidators; the development of requirements in the field of valuing volatile assets; and model clauses in the development of security interests and their perfection. It is only by adopting such a cumulative and proactive approach that the code can be changed to become not a statute that addresses conflicts in the past, but one that is able to address the complexities of the future.