By Advik Rijul Jha, Advocate

Paschimanchal Vidyut Vitran Nigam Ltd v. Raman Ispat Private Limited and Others (2023 SCC OnLine SC 842) in Civil Appeal No. 7976 of 2019. (Decided on 17 July 2023)

Relevant Facts

The parties had entered into an agreement on 11.02.2010 for the supply of electricity. Clause 5 of the agreement provided that: “The outstanding dues will be a charge on the assets of the company. Before the sale is made, the outstanding dues will be cleared and, (in) the alternative the deed to agreements/sale will specifically mention the outstanding dues and the method of its payment.”

PVVNL raised bills for the supply of electricity to the corporate debtor from time to time.

Since the dues remained unpaid, PVVNL attached the corporate debtor’s properties by Order No. 1048, dated 12.01.2016. The Tehsildar, Muzaffarnagar by Order No. 1423F dated 23.01.2016, restrained the transfer of property by sale, donation or any other mode, and also created a charge on the properties. The corporate debtor initially underwent a resolution process under the IBC, however, that process was not successful. It, therefore, became subject to liquidation.

Under the final bill dated 27.01.2017, the total arrears due were Rs. 4,32,33,883/-. The District Collector issued notice for recovery of outstanding dues of Rs. 2,50,14,080/-, by auctioning movable and immovable properties located at Khasara No. 0.4710, on 05.03.2018. The liquidator alleged that unless the attachment orders of the District Collector, Muzaffarnagar and Tehsildar, Muzaffarnagar were set aside by the NCLT, no buyer would purchase the property of the corporate debtor due to uncertainty about the authority of the liquidator to sell the property. The liquidator also took the plea that PVVNL’s claim would be classified in order of priority prescribed under Section 53 of the IBC, and PVVNL would be entitled to pro rata distribution of proceeds along with the other secured creditors from the sale of liquidation assets.

The liquidator’s position ultimately led the NCLAT to direct the District Magistrate and Tehsildar, Muzaffarnagar to immediately release the attached property in its favour so as to enable the sale of the property, and after realisation of the property’s value, to ensure its distribution in accordance with the relevant provisions of the IBC. The NCLAT also endorsed NCLT’s reasoning that PVVNL fell within the definition of ‘operational creditor’, which could realize its dues in the liquidation process in accordance with the law.

Does the electricity act, being a special law, have primacy over the Insolvency and Bankruptcy Code which was a general law?

Issues

1. How does the priority of claims function as per the ‘Waterfall Mechanism’?
2. What is the distinction between secured and unsecured creditors? What is the order of precedence of Govt dues?
3. What is the effect of Section 77 of the Companies Act, 2013?

Judgement

Issue 1

The court while explaining the priority of claims as per the waterfall mechanism (Section 53 of the IBC) held that:

“The priority of claims, indicated in the hierarchy of preferences, under the waterfall mechanism is therefore : Firstly, insolvency resolution process costs and the liquidation costs; Secondly, workmen’s dues for the period of 24 months preceding the liquidation commencement date and debts owed to a secured creditor in the event such secured creditor has relinquished security; Thirdly, wages and any unpaid dues owed to employees other than workmen for the period of 12 months preceding the liquidation commencement date; Fourthly, financial debts owed to unsecured creditors; Fifthly, any amount due to the central government and the state government and debts owed to a secured creditor for any amount unpaid following the enforcement of security interest; Sixthly, any remaining debts and dues; Seventhly, preference shareholders; and Eighthly equity shareholders or partners. This hierarchy or order of priority thus accords government debts [clause (e)] and operational debts [clause (f)] lower priority than dues owed to unsecured financial creditors.”

As per the waterfall mechanism, debts owed to a secured creditor, whenever such secured creditor “has relinquished security in the manner set out in section 52” receive a fairly high priority.

The Insolvency Law Committee (2020) was also of the view that:

“this provision could not have been intended to provide secured creditors who relinquish their security interest, priority of repayment over their entire debt regardless of the extent of their security interest, as it would tantamount to respecting a right that has never existed. Further, if the “debts owed to a secured creditor” is not restricted to the extent of the security, there would be broad scope for misuse of the priority granted under Section 52(1)(b), as even creditors who are not secured to the full extent of their debt would rely on the mere fact of holding any form of security, to recover the entire amount of their unpaid dues in priority to all other stakeholders.”

It is thus, apparent, that 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. In case it chooses not to relinquish its security interest, and instead proceeds to enforce it without success or is unable to realize all its dues in the process of enforcement, it has to then perforce stand lower in priority, and await distribution of assets upon realization of the liquidation estate, by the liquidator, vis-à-vis the balance of its dues.

In case they opt to relinquish the security, their priority is ranked high; in case, they seek to enforce such security, subject to intimation and verification by the liquidator, they can proceed to do so. In the event of short fall, they rank lower in priority. This appears to be the reason, as is clear from the explanation provided in response to comments as a result of Parliamentary debates in 2018, that secured creditors opting not to relinquish their security interest are “presumed that such secured creditors have recovered most of their dues by enforcement of their security outside the liquidation proceedings”. There is sound logic in this, because those opting to ‘stand out’ and enforce security interest, are permitted to do so; in the event of excess recovery, they have to intimate and hand over such excess for distribution in liquidation proceeding; in case they are unable to recover their dues, for such of the dues as are outstanding, such secured creditors are ranked low.

The court also relied on Moser Baer Karamchari Union thr. President Mahesh Chand Sharma v. Union of India, 2023 SCC OnlineSC 547 to understand the nuances of the waterfall mechanism even though in the case it was dealt with in a different context.

The court also disagreed with the decision of State Tax Officer v. Rainbow Papers Ltd, 2022 Livelaw (SC) 743 on which PVVNL had placed heavy reliance. In that case, the issue involved was the interpretation of Section 48 of the Gujarat Value Added Tax Act, 2003 which enacted that any amount payable towards tax or penalty by any person would constitute a ‘first charge’ on the property of such dealer or person. The State contended that the non-obstante clause in the state enactment and the non-obstante clause in the IBC operated at different fields, and the State had to be treated as a ‘secured creditor’ by virtue of Section 48 of the state act. This was rejected by the NCLT and the NCLAT. However, this court took note of Sections 30 and 31 of the IBC and certain other provisions. Moreover, the court observed that the NCLT did not notice the waterfall mechanism under section 53 and that it had erred in its judgement.

Issue 2

Section 53 of the Code places secured creditors who have relinquished their security above unsecured financial creditors. Thus, a clear distinction has been drawn between unsecured and secured creditors who join the liquidation proceedings for the purpose of the payment waterfall in case of liquidation. Unsecured creditors are ranked above secured creditors who have unpaid debts following enforcement of securities as it is presumed that such secured creditors have recovered most of their dues by enforcement of their security outside the liquidation proceedings.

The order of the NCLAT clarified that PVVNL came under the definition of ‘secured operational creditor’ as per law. This finding was not disturbed but rather affirmed by the impugned order. In these circumstances, the conclusion that PVVNL is a secured creditor cannot be disputed.

In response to the argument that the dues owing to PVVNL were technically owed to the “government” and so held a lower position in the order of priority of clearing, the Court stated that the term “government dues” is not defined in the IBC and only appears in the preamble. However, the waterfall mechanism gives on what constitutes such dues under Section 53(1)(e), which inter alia states that “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 the State” ranks lower in priority to the class of creditors described in Clauses (a) to (d) of Section 53(1).

As a result, the Central Government and State Government Dues are listed separately from other Creditors, including those who may have Secured Interest (in respect of which Amounts May Be Payable To Them), and are specified as a distinct Class. In the various reports that preceded the enactment of the IBC, as well as its Preamble, it was repeatedly mentioned that the priority of debts to the government, on account of statutory tax, or other dues payable to the Central Government or State Government, or amounts payable into the Consolidated Fund on account of either government, would be lowered. This indicates that these dues are distinct and must be treated as separate from those owed to secured creditors. The Central Government and State Government are defined by the General Clauses Act.

Issue 3

The liquidator had urged that without registration of charge, the same was unenforceable under liquidation proceedings. The Court upon a reading of Section 77 and 78 of the Company’s Act 2013, found that:

“Section 78 enacts, that when a company whose property is subject to charge, fails to register it, the charge holder (or the person entitled to the charge over the company’s assets) can seek its registration. Section 3(31) of the IBC defines “security interest” in the widest terms. In this court’s opinion, the liquidator cannot urge this aspect at this stage, because of the concurrent findings of the NCLT and the NCLAT that PVVNL is a secured creditor. The record further shows that after the NCLT passed its order, the appellant preferred its claim on 10.04.2018. Based on that application, the liquidator had filed an application before the NCLT for modification of its order dated 21.08.2018, and contended that PVVNL also came under the definition of ‘secured operational creditor’ in realization of its dues in the liquidation proceedings as per law. The application sought amendment of the list of stakeholders. The application was allowed. In view of these factual developments, this Court does not consider it appropriate to rule on the submissions of the liquidator vis-a-vis the fact of non-registration of charges under Section 77 of the Companies Act, 2013.”

Comments

The Supreme Court with this judgement gave clarity on the priority of claims according to the IBC and also demonstrated the use of the ‘Waterfall Mechanism’ given under Section 53 to arrive at the decision. The division bench of Justices S. Ravindra Bhat and Dipankar Datta held that Section 238 of the Insolvency and Bankruptcy Code overrides the provisions of the Electricity Act, 2003 and the IBC’s provisions consider secured creditors’ debts as having a higher standing than those owed to the federal or state governments.

Explaining the waterfall mechanism, the bench also said that the mechanism is based on a structured mathematical formula, and the hierarchy is established in terms of the priority of debt payments with a number of restrictions; eliminating any one of these restrictions or rearranging the hierarchy in the waterfall mechanism may cause a number of trips, disrupt the equilibrium’s overall operation, and cause stasis and instability. Every modification to the waterfall system will unavoidably have a cascading effect on the relative rights and interests of the operational creditors, the Central and State Governments, and secured creditors.

Adding some final comments, the judges said that depending upon the facts, in some cases, the waterfall mechanism in the Code may be more beneficial than the hierarchy provided under Section 326 of the Companies Act, 2013 and vice-versa. This position taken by the court also aligns with Sundaresh Bhatt, Liquidator of ABG Shipyard v. Central Board of Indirect Taxes and Customs, 2022 SCC OnLine SC 1101and Duncan Industries Ltd. v/s A.J. Agrochem, Civil Appeal 5120 of 2019.

With this judgment, there is hope for the IBC to achieve its objectives, and this is a step in the right direction. Even though it has been seven years since the operation of the IBC, 2016 the resolution of disputes and payment of dues have not been satisfactory. However, with judgments such as these, wherein the courts clarify the primacy of the IBC in respect of dues owed, there is the possibility of the objectives of the IBC will fructify. It sets a strong precedent by clarifying the primacy of IBC and the payment of dues under the waterfall mechanism. The impact of the judgement is likely to extend beyond this particular case, as it brings much needed clarity to the jurisprudence and operation of the waterfall mechanism and the primacy of dues thereunder.