Secured Creditors Vis-À-Vis Debt Recovery: A Positive Step

Recently, the Madras High Court in an important decision, State Bank of India v. TheTax Recovery Officer, has clarified the quandary holding that the interests of secured creditors like banks override those of the tax department. The HC categorically spelt out that the rights of secured creditors under Section 26E of the SARFAESI and Section 31B of the RDBA must prevail over Section 281 of the Income Tax Act, 1961 (“ITA”) in cases of conflict. Given this context, this article seeks to discuss the judgment in three parts. Firstly, it analyses the decision in context of the emerging judicial trend on the proposition and the object of the laws in question. Secondly, it will examine an important caveat central to these issues which was incidentally overlooked by the HC in the judgment. Thirdly, it will argue for a broader and more expansive application of the legal principle undergirding the HC’s rationale in its verdict.

Facts

A few parties to this case were certain banks and financial institutions (“secured creditors”) who had extended financial assistance to some borrowers while creating a mortgage in their favour by way of executing mortgage deeds. However, upon the borrowers defaulting on the payment of the sanctioned loan amounts, arbitration proceedings were initiated by the secured creditors against the borrowers. It was during these proceedings that the tax department passed an order attaching the properties subject to the mortgage deeds between the secured creditors and the borrowers with a view to recover their outstanding tax dues.

Challenging the tax department’s order of attachment, the secured creditors filed writ petitions before a Single Judge bench of the Madras HC which ruled in favour of the tax department stating that statutory dues will prevail over those of the secured creditors, citing the doctrine of ‘constitutional priority’. This order was challenged by the secured creditors in this case. Additionally, the tax department also challenged one of the judgments of the Single Judge bench which held that Section 281 of the ITA does not create a ‘charge’ in favour of the revenue authority and that secured creditors enjoy a higher priority of charge by virtue of Section 26E and Section 31B of the SARFAESI and RDBA respectively.

Judgment

Presented with a couple of questions for consideration, the HC, at the outset, enunciated that the power of the government to impose taxes is an inherent and central aspect in the capacity of its role as a sovereign. The only restrictions imposed on a statutory authority are the ones enshrined in the Constitution. Notably, while adjudicating on the nature of charges created by various tax legislations, the HC declined to accept the Single Judge bench’s reliance on the doctrine of constitutional priority on the basis of precedents stating that while statutory dues will take precedence over unsecured creditors, they will not prevail over claims of secured creditors in the absence of an express provision in a particular tax legislation.

However, the principal question before the bench (which is also the focus of this article) is the scope of Section 281 and the nature of its operation in relation to Section 26E of the SARFAESI and Section 31B of the RDBA. Noting the purpose of the aforementioned provisions of the two laws as non-obstante clauses, the HC observed that the primary purpose of incorporating such devices in legislation is to give them an overriding power over other laws in matters of conflict. It was pertinently noted that the now operative sections, having been introduced to cure the defects of the non-obstante clauses existing earlier, are not just limited to resolving inconsistencies or conflicts, but are also applicable in protecting the rights of secured creditors, giving their claims primacy over any dues payable to the Central, state or any local authority. In its considered opinion, the bench ruled that the relevant provisions of the two recovery laws, being broadly phrased, will have precedence over Section 281 of the ITA.

Analysis

Judicial Trend And Legislative Intent

The emerging judicial trend pertaining to disputes involving a conflict between a ‘first charge’ provision of a tax legislation and the provisions protecting the rights of a secured creditor under SARFAESI and RDBA appears to be in favour of creating a primacy of the claims of a secured creditor over those of the State. One of the most notable cases dealing with the conundrum was a Supreme Court (“SC”) decision in Central Bank of India v.State of Kerala. In this case, the primary issue for consideration before the SC was whether a state tax legislation providing for the creation of a first charge in its favour would prevail over the relevant provision of the two debt recovery laws. The SC held that due to the absence of any clear provision in either of the two statutes giving primacy to secured debtors over first charge holders in case of a conflict with a tax law containing an express first charge provision, neither SARFAESI nor RDBA would prevail over the state tax legislation.

However, this decision was passed before 2016 when the Centre amended Chapter IV-A of SARFAESI (containing Section 26E which gives priority to secured creditors) and introduced Section 31B to RDBA. The effect of this decision was nullified not only by the central amendments to the two laws but also by a decision of the Kerala HC in State Bank of India v. Stateof Kerala where the HC ruled that, due to the presence of Section 26E and 31B in the SARFAESI and RDBA respectively, the claims of secured creditors like banks and other financial institutions would enjoy a priority even greater than the statutory first charge created by a tax legislation in favour of the government.

This legal position has been followed by the Gujarat HC in Kalupur Commercial Cooperative Bank Ltd v. State ofGujarat where the HC while ruling in favour of the bank gave primacy to Section 26E over Section 48 of the Gujarat Value Added Tax Act which created a first charge in favour of the state tax department. Similarly, the Bombay HC in, Jalgaon Janta Sahakari Bank Ltd. & Anr. v. JointCommissioner of Sales & Anr, held that the claims of a secured creditor would enjoy a greater priority over those of the state tax authority in the event of a secured asset’s sale under the SARFAESI or the RDBA. Therefore, the decision of the Madras HC appears to be in consonance with the discernible legal trend of making statutory first charge holders, like the tax department, subordinate before secured creditors like banks giving effect to the broad and overriding power of the amended non-obstante clauses in the two laws.

Notably, the purposive interpretation of the HC in the judgment has respected the purport of the SARFAESI and RDBA. Section 281 makes a charge/mortgage in certain transactions falling within its ambit void. The judgment pertinently noted that the direct conflict between the aforementioned section and the relevant provisions of the SARFAESI and RDBA would have destroyed the foundation which the two debt recovery laws are premised upon, that is, the existence of a valid charge/mortgage. In the absence of a purposive construction, the operation of Section 281 would have done away with the protection rendered by SARFAESI/RDBA to secured creditors thereby defeating the object and intent of the two laws in providing a more efficient legal remedy to secured creditors to take errant borrowers to task, facilitate greater debt repayment, create a creditor and business friendly ecosystem and consequently usher in greater economic growth. The HC’s decision has given a welcome fillip to these fundamental objectives. More importantly, it has restored a legal remedy to secured creditors who otherwise would not have been able to claim priority under SARFAESI/RDBA due to overlapping income tax proceedings of various financial years at a given point of time.

Allied Provisions And The CERSAI Registration-- Some Overlooked Caveats?

Section 20 of the SARFAESI provides for the creation of the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI), a database where secured creditors like banks are required to register the security interest which they create on movable and intangible assets. Mortgages too need to be registered under the CERSAI. The decision of the Bombay HC in the Jalgaon Janta Sahakari Bank case (cited above), relying on Section 26D of the SARFAESI, categorically holds that registration of the security interest with the CERSAI is mandatory for a secured creditor to legally enforce a security interest under Chapter III of the SARFAESI. The registration being a necessary condition, a secured creditor shall lose his right to enforce a security interest and his priority over other (namely, statutory) dues if he fails to register the charge with the CERSAI. In other words, the protection and priority offered to the claims of secured creditors under the non-obstante clause (Section 26E) are subject to this precondition under Section 26D. The decision of the Madras HC, couched in facts involving a secured creditor enforcing its security interest under SARFAESI, fails to consider this aspect while deciding the validity and precedence of the secured creditor’s claim vis-à-vis those of the tax department.

While the decision reinforces the primacy of SARFAESI’s object and the power of Section 26E, an isolated reading of the facts with only these provisions might lead to a misplaced conclusion. Therefore, it is essential to read the decision in conjunction with Section 26B and 26C (2). Section 26B empowers the tax department to register the specificities of the attachment order with the CERSAI. Section 26C (2), importantly, states that priority of dues in a dispute will be decided on the order of registration. Therefore, if the tax department files its charge with the CERSAI before the secured creditor registers its security interest, then the government’s claims would take precedence over those of the secured creditor as per the statutory scheme of the SARFAESI.

Extension Of The Principle To Insolvency

The judgment comes as a ray of hope for secured creditors and reinforces the purport of the two debt recovery laws. Fundamentally, the verdict deals with the claims of secured creditors and their priority in case of a conflict with statutory dues and clearly establishes the primacy of the former while upholding the interests of secured creditors. Therefore, this legal principle must be extended in similar cases of conflict occurring in disputes under the IBC. A liberal application of this proposition will protect several secured creditors whose interests stand threatened by the recent Rainbow Papers judgment of the SC which brought statutory dues within the ambit of ‘secured debt’ for the purposes of distribution of liquidation proceeds under Section 53 of the IBC. This application, apart from strengthening the non-obstante clause (Section 238), would be harmonious with the IBC’s legislative intent of creating a creditor-friendly insolvency regime in the country.

While the HC’s decision is a welcome step towards protecting the rights and interests of secured creditors in debt recovery matters, it must be noted that only high courts have so far adjudicated on the priority of the dues of secured creditors conflicting with statutory dues. A judgment of the SC affirming these principles would crystallize the legal position on the matter. It will also be interesting to see how courts interpret the postulates in this decision and apply it to similar disputes in the future.

Views are personal.