• Amar Gupta

Rainbow Papers Judgment: A Step Backwards in Insolvency

[Amar is a Partner at JSA. The following article was first published on Lexology.]


In its decision in Ghanashyam Mishra and Sons Private Limited v. Edelweiss Asset Reconstruction Company Limited (Ghanashyam Mishra), a bench of three Judges of the Supreme Court of India held that “harmonious construction of clause (10) of Section 3 of the I&B Code read with clauses (20) and (21) of Section 5 thereof would reveal, that even a claim in respect of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority would come within the ambit of ‘operational debt’. The Central Government, any State Government or any local authority to whom an operational debt is owed would come within the ambit of ‘operational creditor’ as defined under sub­section (20) of Section 5 of the I&B Code.”


The court then went on to hold that any debts in respect of payment of dues arising under law, including those owed to the Central Government, any state government or any local authority, which do not form a part of the approved resolution plan, shall stand extinguished. Further, once a resolution plan is duly approved by the Adjudicating Authority, the claims provided in the resolution plan shall stand frozen and will be binding on all stakeholders. The phrase ‘all stakeholders’ includes the government or any other authority.


The decision assured the prospective resolution applicants that the Insolvency and Bankruptcy Code 2016 (“Code”) does not accord any special treatment to statutory dues and the claims of government authorities. These claims and dues will fall in the category of operational debt, and they can be dealt with and provided for in the same manner as any other operational debt. The authoritative pronouncement on this issue by the court reinforced the ‘clean slate’ theory propounded by it to bolster the insolvency law regime under the Code and brought stability to it.


That is until another bench perceived the issue differently and reached a totally contrary conclusions, yet again, without engaging with the binding precedents.


Section 48 of Gujarat Value Added Tax Act 2003 creates first charge on the property of a dealer. In Sales Tax Officer (1) v. Rainbow Papers Limited (Rainbow Papers), a case decided by two Judges bench of the Supreme Court, it was argued that the charge so created on the assets of the corporate debtor qualifies as ‘security interest’ under the Code and the tax department was, therefore, a ‘secured creditor’ for the purpose of Section 53 of the Code (order of priority of creditors for distribution of proceeds of liquidation assets). The appellant also challenged the rejection of the claim on the ground that it was belated. The court accepted the argument of the state and held that state was a ‘secured creditor’. It also ruled that the timeline prescribed under the Code for the various stages of the proceeding under it is directory and not mandatory, and the state’s claim for statutory dues could not have been ignored on account of delay. With the two issues answered, the court could have, and I submit, should have concluded the determination. But it did not.


The court proceeded to expound on the treatment of debts owed to the state government and public authorities. It observed “if the resolution plan ignores the statutory demands payable to any state government or a legal authority. Altogether, the adjudicating authority is bound to reject the plan”. The court then said that “if a company is unable to pay its debts, which should include its statutory dues to the government and/or authorities and there is no plan which contemplates dissipation of those debts in a phased manner, uniform proportional reduction, the company would necessarily have to be liquidated and its assets sold and distributed in the manner stipulated in section 53 of IBC”.


These observations have drastic consequences. The plain meaning of these observation is that the resolution plan must mandatorily provide for payment of statutory dues and the debts owed to government and public authorities. A resolution plan must make provision for such debts and provide “dissipation of those debts in a phased manner”, else “the company would necessarily have to be liquidated and its assets sold and distributed….” Quite clearly, these observations are directly in conflict with the ruling in Ghanshyam Mishra and knocks the bottom out of the ‘clean slate’ theory which has been the cornerstone of insolvency law regime in India.


One could argue that these observations are not the ratio decidendi (rationale for the decision) of the judgment but obiter dicta (observations made in the passing). If it were a decision of a High Court, one could have thus ignored these observations as not binding. However, since this is a decision of the Supreme Court, even the obiter dicta will be binding on the lower courts, and most certainly the NCLT, the forum for resolution of debt under the Code.


The judgment in Rainbow Papers requires immediate review, else it will have deleterious impact on the insolvency law regime under the Code. It will deter potential bidders due to additional risks and uncertainty on account of pending or potential statutory and government demands. Thus, there will be fewer bidders, lower valuations, and, consequently, larger haircuts for the creditors.

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