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  • Madhav Goel

The Lack of an 'Economics' Perspective in Interpreting the Insolvency and Bankruptcy Code 2016

- Madhav Goel†

In this piece, Madhav Goel examines why secured creditors differ from other corporate debtors under the IBC and warns against treating the government as a secured creditor as it may discourage private entities from lending at lower rates, negatively impacting credit creation. The piece argues that secured and financial creditors should have repayment priority in resolution plans because they are better equipped to drive credit and investment growth. Finally, the piece argues that Rainbow Papers suggests a solution to prioritize government dues by including clauses in legal instruments that create a security interest in the government's favor.


Certain recent decisions of the Supreme Court, such as Vidarbha Industries Power Ltd v. Axis Bank Ltd, have been the subject of intense debate and criticism due to the possibility that they will frustrate the Insolvency and Bankruptcy Code 2016 (‘the Code’) in its objective of initiating and effectuating time bound resolution and restructuring of insolvent companies.

One such decision is the Supreme Court’s ruling in State Tax Officer (1) v. Rainbow Papers Ltd (‘Rainbow Papers’). The case arose out of the judgement of the National Company Law Appellate Tribunal where it was held that the Government could claim first charge over the property of the corporate debtor by virtue of Section 48 of the Gujarat Value Added Tax 2003 (‘the GVAT Act’). The GVAT Act provides for first charge on the property of an Assessee in respect of any amount payable by the Assessee on account of tax under the said act. The NCLAT ruling also held that Section 48 of the GVAT Act could not prevail over Section 53 of the Code. The conflict between the two laws arose because the GVAT Act treated tax dues as secured debt by creating the first charge through Section 48, whereas the Code (Section 53 in particular) treated any and all dues owed to the Government as unsecured, operational debt. The issue arose out of objections filed by the Government against a resolution plan that did not provide for the repayment of tax dues under the GVAT Act owed by the corporate debtor at the start of the Corporate Insolvency Resolution Process (‘CIRP’), and considered the corporate debtor’s tax dues as having been waived off. The Supreme Court thus had to analyse whether Section 53 of the Code would prevail over Section 48 of the GVAT Act, and consequently relegate the tax owed under the GVAT Act to the category of operational debt falling under section 53(1)(e)(i) of the Code for the purposes of determining its priority under the waterfall mechanism. The waterfall mechanism, established by Section 53 of the Code, determines the order in which the proceeds realised from the sale of the corporate debtor’s assets, either through a resolution plan or through liquidation, will be distributed amongst its various creditors and stakeholders. At the top of the pecking order are secured creditors (a creditor having a security interest/first charge/lien over the assets of the corporate debtor in its favour for the enforcement of the debt obligation), workmen, and financial creditors (a creditor that has lent money to the corporate debtor for interest), whereas towards the bottom of the order are operational creditors (a person/entity to whom the corporate debtor owes money on account of goods and/or services purchased), the Government, and shareholders.

The Supreme Court, inter alia, held that any resolution plan that altogether ignores statutory demands payable to any Government or legal authority would not pass the muster of Section 30(2) of the Code. The Supreme Court agreed with the argument that Section 48 of the GVAT Act, by creating a charge in respect of an Assessee’s property for payment of the tax, created a security interest in favour of the Government, and the Government was thus a secured creditor for the purposes of the Code. The Court further held that there was no conflict between Section 48 of the GVAT Act and Section 53 of the Code. It concluded that as far as tax dues under the GVAT Act are concerned, the Government is a secured creditor, and the debt under GVAT Act will be treated as per Section 52 or Section 53(1)(b)(ii), and not as per Section 53(1)(e)(i) of the Code (as the case maybe), given that a security interest can also be created by operation of law.

This judgement sets a problematic precedent as far as the Code and its objectives are concerned as it treats secured creditors and the Government at par, despite the express language of the Code and the fact that the two are vastly differently placed qua the corporate debtor. This will discourage the flow of cheaper credit in the economy, reduce the recoveries made by financial institutions in the CIRP, negatively impact the overall investment expenditure, and provide a roadmap for the Government to ensure all its dues are accorded a high priority in the waterfall mechanism as opposed to the current situation where they are fairly low in the pecking order. A purely textual interpretation of the two laws mightpoint towards a similar conclusion that the Apex Court reached, though as this article will argue, that is not necessarily the case. However, if the exercise of interpreting the conflict between the two laws is done keeping in mind what the Code seeks to achieve as well as the basic economic principles of insolvency resolution, it will be clear that the Supreme Court has erred in reaching the conclusions that it has.


Surprisingly, considerations of economics and finance did not find any place in Rainbow Papers, despite it being a purely economic law concerning itself with issues of business, finance, and the free market. What is unique about the Code, as compared to previous insolvency and restructuring legislations, is that departs significantly from principles like primacy of statutory dues, interventionist role of the executive and the judiciary, etc., and establishes a regime more grounded in economic and business realities. The waterfall mechanism of Section 53 and the primacy given to the commercial wisdom of the Committee of Creditors are a few tenets that point towards this paradigm shift, and are indicative that any purposive interpretation of the Code requires that it be interpreted while keeping economic and business principles in mind. Considering the issues arising for adjudication qua the Code from the lens of ‘Law and Economics’ will ensure the development of the law in a manner that helps the Code achieve its aims of ensuring timely resolution of insolvent companies and better flow of credit in the market, and also allow the Code to develop in a way that help India become a business-friendly jurisdiction. Regrettably, the Supreme Court does not do that in Rainbow Papers.

In order to achieve that end, i.e., interpreting the conflict between the two laws keeping in mind what the Code seeks to achieve as well as the basic economic principles of insolvency resolution, this article will analyse the issue from an economic prism, something that the Supreme Court did not do. Rather than adopting a textual interpretation like the Supreme Court did, it will consider the issue from the lens of ‘Law and Economics’, i.e., applying economic theory and method to the practice and interpretation of law. It will analyse why and how secured creditors are different from other creditors of a corporate debtor (including the Government), and argue that treating the Government as a secured creditor can be a dangerous precedent that deters cheaper, secured lending by private entities, thus negatively impacting the credit creation process in the economy. It will then argue that secured creditors are given priority in the distribution of funds obtained in a resolution plan because they are better placed to use those funds to drive the growth of credit and investment expenditure in the economy, as opposed to Government spending. This position, the article will proceed to establish, is directly in consonance with one of the key objectives of the Code, i.e., the establishment of a debt recovery mechanism for credit institutions in order to ensure better, cheaper flow of credit to financially healthy industries in order to fuel economic expansion. Finally, the article will argue that Rainbow Papers will provide the Government, both Central and State, the ability to bypass the Code and ensure that its dues are not treated at the bottom of the waterfall mechanism but are accorded a higher priority, by simply inserting clauses in each statute and legal instrument that creates a security interest/first charge in the Government’s favour. Thereafter, the article will provide brief conclusions of the analysis and the arguments presented in this article.

Firstly, the Court failed to grasp the logic behind the separate treatment of secured creditors from the rest. Secured creditors strike a very different bargain with the corporate debtor. How so? Secured creditors, who are generally financial creditors, typically provide vast amounts of capital/credit to the debtor, in comparison to other creditors. This capital is generally provided upfront, and its repayment schedule is spread over the long run. Other forms of credit are smaller in quantity, and payment thereof by the debtor is typically more immediate/short term. Consequently, as far as repayment is concerned, the risk that the secured creditor bears is higher than that borne by others. Despite the higher repayment risk, which should warrant a greater interest rate, secured creditors provide capital at cheaper interest rates than other creditors. This they do in lieu of the security interest. It is this guarantee (of sorts) that incentivises secured creditors to provide cheap and large amounts of capital with long term repayment schedules. For the foregoing reasons, secured creditors are typically accorded priority in repayments under insolvency frameworks around the world. On the contrary, the Government does not provide any cheap capital or bear any business risk when taxing an economic entity under statutes such as the GVAT Act. The IBC is an attempt at reforming the insolvency regime in India to bring it in line practices followed around the world. It is designed to ensure that those who are better suited to provide cheaper capital for investment expenditure get priority in the distribution of proceeds obtained from the resolution plan so that they have greater funds to disburse amongst industrial units capable of undertaking such risks. The distribution mechanism of Section 53 of the Code, i.e., the waterfall mechanism, is designed in such a fashion that it reflects the value of each class of creditor to the corporate debtor and the credit creation process of the economy. Accordingly, secured creditors and financial creditors have been accorded a higher priority than operational creditors, shareholders, etc. Therefore, the treatment of government dues at par with those of secured creditors, notwithstanding the provisions of the GVAT Act, is directly in contravention to this basic economic principle, besides the express provisions of the Code. Rainbow Papers treats the two differently placed creditors similarly and scuttles the economic result the Code seeks to achieve. Such preferential treatment of government dues, against economic logic as well as against the express provisions of the Code, will only disincentivise secured creditors from lending cheap capital to economic entities, because their security interests under the Code have been prejudiced. This will have a tendency to restrict the flow of credit instead of augmenting it, thus defeating the very purpose sought to be achieved by the IBC.

Secondly, the Court failed to grasp the economic objective of the Code. It is not meant to just restructure insolvent companies. It is designed to serve another purpose, i.e., provide financial entities with a more robust mechanism for enforcing debt obligations, and ensuring that the insolvency resolution process is not a hapless exercise that leaves them with nothing compared to what they lent to the corporate debtor. The ultimate aim of the Code is to ensure better, cheaper flow of credit to financially healthy industries in order fuel economic expansion. This is why financial creditors and secured creditors have been given a superior status when it comes to priority in distribution of proceeds, as compared to operational creditors and the Government. This is also why secured creditors, who are generally financial creditors, have been given the option of exercising their security interest outside the purview of the waterfall mechanism. This superior status and the option to exercise their security interest outside the purview of the waterfall mechanism has been given to secured and financial creditors in recognition of their security interest, as well as based on the fact that the amounts recovered by secured and financial creditors during the corporate insolvency resolution process will directly determine the quantum of investible funds in the economy. The higher it is, the better for the economy. Given the general expertise of secured and financial creditors to assess the state of economy and the markets, they have been given the choice to decide on the most suitable option so that they can get the best deal possible— enforcing their security interest or going through the waterfall mechanism.

The basic economic logic behind the Code is to help infuse capital in the credit market, which is best equipped to direct funds towards investment expenditure. The Indian economy was dealing with a twin balance sheet affecting primarily banks and infrastructure companies, i.e., banks had an overwhelming proportion of bad loans that were not going to be paid back by the borrowers, and infrastructure companies had massive debt obligations that they could not meet. Over time, due to a variety of factors, this crisis has morphed into a four balance sheet problem, encompassing banks, infrastructure companies, non-banking financial companies (NBFC), and real estate companies. As a consequence, these four key drivers of long term, capacity building investment do not have adequate resources to extend credit and drive crucial investment in the economy. To add further woes, the erstwhile recovery and restructuring framework of India was ineffective and plagued with delays. This was a key driver for the enactment of the Code. Given this economic context, it is even more imperative that the Code works efficiently. This purpose will not be achieved, in any shape or form, if the Government is to be treated as a secured creditor. It is simple economics. The more the investible funds in the credit markets, the greater its flow and investment. Alternatively, the larger the share of the Government in the pool of investible funds, the lesser the investment in the economy. Investible funds flowing into the credit market through financial entities typically get routed towards capital expenditure that leads to capacity building and growth. Alternatively, the bulk of the money spent by the Government is on revenue expenditures, i.e., expenditure incurred for the normal running of government departments, various services, interest payments on debt, subsidies, etc. that does not lead to any such capacity generation. For example, the Central Government’s expenditure in Financial Year 2022-23 is expected to be in an 81-19 ratio, i.e., only 19% of the money that will be spent by the Central Government will be capital expenditure, the highest in nearly two decades. The Code seeks to avoid this situation where the Government gets priority and consequently a large share in the distribution process, and seeks to ensure that funds recovered from the CIRP go to financial institutions that are better placed at allocating those funds for investment. This intent is evident from the Code’s departure from previous insolvency and restructuring regimes in which Government dues were given primacy over other dues. In fact, one of the Code’s explicit aims is the “alteration in the order of priority of payment of Government dues”. Rainbow Papers strikes a wrecking ball at the heart of this philosophy, and neuters a key tenet of the Code by following a hyper technical and textual interpretation of the conflict between the GVAT Act and the Code.

Finally, the Court did not consider the possible fallout of its decision. Currently, all Government dues are ipso facto treated under Section 53(1)(e)(i) of the Code. Notably, this covers not only tax dues, but includes other non-statutory dues as well. Rainbow Papers has given the Government, both Central and State, a way of preventing their dues from being relegated towards the bottom of the waterfall mechanism. Each Government can now, by creating security interests in its favour in all its tax/economic statutes, contracts, instruments, etc. ensure that its dues are treated as secured debt, instead of as operational debt. Evidently, all that is needed is the insertion of a simple clause to effectuate that aim. This will not only protect the interests of the Government in case of a successful CIRP, but even in cases of liquidation, the Government will be able to exercise its security interest under Section 52, and will not have to wait in line if the liquidation proceeds are distributed as per the waterfall mechanism. Consequently, the priority given to secured and financial creditors, for reasons highlighted above, will vanish and the country’s insolvency regime will effectively return to the erstwhile setup of according Government dues priority, directly against the settled principles of insolvency economics as well as the stated objectives of the Code. Governments will thus be able to achieve indirectly what they could not achieve directly. Clearly, such an outcome is not desirable, if the Code is to achieve its aim of restructuring insolvent businesses while also providing an efficient mechanism for lending entities to recover their fair share through the CIRP.


This analysis clearly points to the fact that a purposive interpretation of the Code and its conflict with the GVAT Act, keeping in mind basic principles of economics and finance, could not have led to the conclusion that the Supreme Court reached in Rainbow Papers. In fact, it becomes clear that the Court’s interpretation is bizarre if economic principles infuse our understanding of the provisions of the Code and the conflict that the Court had to settle. The presence of an ‘economics perspective’ would have probably led to a different decision, one that would not have dealt such a serious blow to the Code.

†Madhav Goel is an advocate practicing in Delhi. He is a graduate of Campus Law Centre, University of Delhi, and St. Stephen's College, University of Delhi.

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