Reinstating the primacy of commercial creditors

The legal fraternity confronted a significant conundrum over the landmark 2022 Supreme Court ruling, in State Tax Officer v Rainbow Papers, which effectively altered the priority hierarchy of asset distribution repaying dues owed under the Insolvency and Bankruptcy Code, 2016 (IBC).

Section 3(31) of the IBC provides the definition of “security interest” to mean right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation, including mortgage and charge hypothecation.

Another important provision, section 53, provides for the hierarchy of distribution of assets following the resolution process. First, workmen dues and dues to secured creditors are kept in hierarchy, and dues to the central or a state government are kept under clause 53(1)(e), which is even below the debt owed to unsecured creditors.

Rainbow Papers case elevates government dues

When the Rainbow Papers reached the Supreme Court, the question arose over whether the government (central or state), while claiming their dues under any statute, would be treated as a secured creditor in terms of the IBC provisions of section 3(31).

The Supreme Court held that the government would be a secured creditor, as it was held under section 3(30) of the IBC that a secured creditor is a creditor in whose favour security interest is created.

It was further held that the security interest could be created by operation of law. The reasoning provided was that the definition of secured creditor in the IBC does not exclude any government authority.

As a result of this judgment, not only the government but many land holding authorities, including the New Okhla Industrial Development Authority, made a quantum leap and treated themselves at par with secured creditors under section 53(1)(b)(ii) instead of under section 53(1)(e).

2026 IBC curbs government priority

The Rainbow Papers ruling was although doubted by the Supreme Court, in Paschimanchal Vidyut Vitran Nigam v Raman Ispat, in 2023. However, it was not authoritatively overruled and continued to hold the field.

Fortunately, the legal anomaly did not remain unnoticed, with the legislature passing the Insolvency and Bankruptcy Code (Amendment) Act, 2026. Most notable was a significant amendment to the IBC as far as section 3(31) is concerned. This amendment was accompanied by an explanatory note with the prefix, “for the removal of doubts”.

The explanation clarifies that security interest shall exist only if it created right, title or interest, or claim to a property pursuant to an agreement or arrangement by the act of two or more parties – and shall not include a security interest created merely by operation of any law for the time being in force.

As such, the amendment was introduced as explanatory in nature and therefore will retain its character of retrospective operation.

It also provides that a government could not claim the status of secured creditor on account of mere operation of law. Such status can only be achieved by an overt act of entering into any agreement, such as mortgage, hypothecation or pledge.

The second significant change under this vertical is yet another explanation added to section 53(1)(3)(i), which provides that the amount due to the government shall be payable under section 53(1)(3)(i) only up to a claim of two years. Any remaining claim will slip further down the pecking order as a residuary claim clause.

The government, therefore, cannot take benefit of its own inaction and jump the queue of secured creditors.

2026 amendments remedy legal malady

By way of the 2026 amendments, this malady has been remedied. Now the government dues and dues of statutory authorities cannot take preference unless these authorities amend their contracts into specific agreements of mortgage, hypothecation or pledge. This comes as a relief for secured creditors.

Ateev Kumar Mathur is a partner (head of litigation practice) at SNG & Partners