From Rainbow to Reform: Rethinking Government Claims and Creditor Hierarchy in Indian Insolvency Law

The law must clearly lay out the priority of distributions in bankruptcy to all stakeholders. The priority must be designed so as to incentivise all stakeholders to participate in the cycle of building enterprises with confidence.¹

Introduction

In light of recent judicial decisions, namely, State Tax Officer v. Rainbow Papers Ltd.² (Rainbow Papers case) and Paschimanchal Vidyut Vitran Nigam Ltd. v. Raman Ispat (P) Ltd.³ (PVVNL case), Government of India is looking to make changes to the Insolvency and Bankruptcy Code. According to a report dated 14-4-2025⁴, the Centre intends to change the corporate insolvency framework to give better clarity, particularly on how to handle statutory dues and claim priorities, that has been altered by recent Court interpretations.

On the account of this news, it is critical to understand the cause of this confusion and its legal basis. In the Rainbow Papers case⁵, the Supreme Court ruled that if a charge is created by a statue then such statutory authority shall be considered a secured creditor under the Insolvency and Bankruptcy Code, 2016 (IBC).⁶ However, this stance was eventually overturned in the PVVNL case⁷, when the Court indicated that Rainbow Papers case⁸ should be confined to the specific facts of that case and failed to take into account the waterfall mechanism under Section 53 IBC.⁹ Following this, other review petitions were filed contesting in the Rainbow Papers case¹⁰ (for example, Sanjay Kumar Agarwal v. State Tax Officer (1)¹¹). The Supreme Court declined to hear the review petitions because the requirements of a review petition were not met.¹²

This paper, firstly, outlines the background of the three key cases, secondly, it aims to examine the implications of classifying government authorities as secured creditors under the IBC as held in Rainbow Papers judgment¹³, thirdly, the paper analyses the concept of security interest and secured creditors under the Code using the Ministry of Corporate Affairs (MCA) discussion paper, fourthly, it examines a nature-based classification of government dues to assess their eligibility for the status of a secured creditor, and fifthly, it offers suggestions that may be considered for inclusion in the upcoming IBC amendment.

The journey from Rainbow Papers to Sanjay Kumar Agarwal

The ambiguity pertaining to the placement of the government dues under Section 53 IBC began with the Supreme Court’s ruling in Rainbow Papers¹⁴ decision in September 2022. In this case, the Court determined that a charge arising from a legislation constitutes a “security interest”, therefore holding that a statutory authority shall be treated as a secured creditor under the IBC. It further determined that Section 48, Gujarat Value Added Tax Act, 2003 (GVAT Act) was not in conflict with Section 53 IBC. Consequently, liabilities under the GVAT Act were to be classified as “secured debts”, falling under Section 53(1)(b)(ii) IBC, which determines the asset allocation during insolvency.

On July 2023, however, in PVVNL judgment¹⁵, the Supreme Court revisited this matter, the case was regarding Electricity Act, 2003. The Court ruled that Section 238 IBC, a non obstante clause, overrides conflicting sections of the Electricity Act, 2003, even though Sections 173 and 174, Electricity Act, 2003 also contain non obstante clauses. This case determined that Rainbow Papers case¹⁶ had not taken into account the priority allocation process given in Section 53 IBC, and so its ratio cannot be applied to the matter at hand. It also stated that Rainbow Papers¹⁷ ruling should be confined to its fact specific cases.

Finally, on October 2023, in Sanjay Kumar Agarwal judgment¹⁸, the Court dismissed various review petitions challenging the Rainbow Papers¹⁹ decision. The Court held that the review petitions failed to show any apparent error. They highlighted that a difference of opinion among Judges on an equal strength Bench cannot lead to a review. Furthermore, the Court ruled that Rainbow Papers case²⁰ had taken into account Section 53 while giving the judgment and that it would be wrong to claim that the decision was made in ignorance of the IBC’s waterfall mechanism.

Statutory authorities as secured creditors under the IBC

In Sanjay Kumar Agarwal case²¹, the Court clarified that Rainbow Papers case²² did not fail to take into account Section 53 IBC. Nevertheless, the position taken by the Court is alarming. The author argues that, while the judgment referred to Section 53, its engagement with the provision was superficial, failing to address the legislative intent and economic reasoning underlying the prioritisation framework given in Section 53 IBC.

To fully comprehend the problems arising from Rainbow Papers case²³, one must first understand the economic backdrop in which the IBC was enacted.²⁴ During mid-2010s, banks experienced a sharp surge in non-performing assets (NPAs).²⁵ By 2015, NPAs totalled Rs 3.5 lakh crore.²⁶ The share of NPA in 2017 increased to 6 per cent after Reserve Bank of India (RBI) implemented the classification rules in 2016,²⁷ exposing the depth of financial hardship. Simultaneously, bank recovery rates remained poor, averaging only 26.4 per cent,²⁸ with public sector banks (PSBs) performing substantially worse than their private counterparts.²⁹ With PSBs accounting for over 70 per cent of India’s banking assets and receiving over Rs 70,000 crores in capital infusions between 2007 and 2015,³⁰ the banking crisis directly impacted the government’s fiscal health. This demanded a major revamp of the insolvency regime, which led to the enactment of the IBC.

The Bankruptcy Law Reforms Committee (BLRC) in 2015 proposed that government dues be placed below both secured and unsecured financial creditors in the liquidation waterfall mechanism. This strategy was intended to ensure credit flow to financial creditors, promote unsecured lending, lower capital costs, promote entrepreneurship and, ultimately, drive economic growth. As a beneficiary of economic growth, the Government was positioned to gain from such a framework.³¹

The Rainbow Papers case³² overlooked these underlying economic and policy concerns before concluding that the statutory dues shall classify as secured debt under the IBC. As a result, financial creditors would be compelled to take bigger haircuts, reducing overall recoveries and slowing the flow of credit in the economy.³³ As a result, economic growth may suffer, ultimately putting the government’s fiscal health at risk. The lack of a deeper analysis of these issues strengthens the author’s contention that the judgment only superficially addressed Section 53 and was inadequately reasoned.

Furthermore, in Rainbow Papers case³⁴, the Court relied on the definitions of “secured creditor”³⁵ and “security interest”³⁶ to classify the State as a secured creditor, demonstrating an inadequate engagement. If the Court had delved one step deeper, it would have come across the term “transaction”,³⁷ which is an important factor in assessing the existence of a valid security interest. This key factor was neglected, and if it had been fully examined, the outcome of the case may have been different, an argument that the author will elaborate on in the following section of the paper.

Security interest, secured creditor and transactions within the IBC

The reasoning of the Judges in Rainbow papers case³⁸ was based on a twofold step where they looked at the definition of a secured creditor and security interest to conclude that government should be considered as a secured creditor. Section 3(30) IBC defines secured creditor as a creditor in whose favour security interest is created. A security interest is defined by Section 3(31) IBC as a right or claim to property created to secure payment for a secured creditor through a transaction. Section 3(33) IBC defines a transaction as a written agreement or arrangement for the transfer of assets, cash, goods, or services from or to the corporate debtor. When the definitions are taken together, it can be concluded that the legislative goal underlying the term “security interest” was to only include cases in which the corporate debtor engaged in a voluntary transaction. The Court’s approach in Rainbow Papers case³⁹, which treats a charge formed by the operation of law as a security interest, clearly undermines the legislative intent reflected in the relevant definitions.

In line with this interpretation, the Ministry of Corporate Affairs⁴⁰ attempted to resolve the interpretational concerns raised by the Rainbow Papers⁴¹ ruling. Specifically, para 14.1 of the document explained that the term “transaction” means that a security interest must result from an agreement or consensual arrangement by the asset holder, giving rights on the other party. Furthermore, MCA highlighted the intent behind using the term “transaction”, which is to enter into voluntary transactions.⁴² Therefore, strengthening the argument that the intent of the legislature behind the definition of security interest under the IBC is intended to include only consensual transactions between parties, rather than interests created unilaterally via the operation of a statute.

A way forward: Nature-based classification of governmental dues

A way forward should be considered taking into account the original purpose of the IBC. Financial creditors play an important role in ensuring that money flows in the economy. Their financial health has a direct impact on how the economy runs, which ultimately impacts the government’s fiscal health, and therefore, they should be prioritised. However, it would be unwise to treat all government payments as low priority in every situation. For example, there could be instances where a loan was obtained from a government owned bank. In such cases, the Government acts as a financial creditor, and these obligations should ideally be treated likewise as of the secured creditors. This is because government owned banks like any other secured financial creditor play a crucial role in the economy and contribute to the economy’s cash flow.⁴³ As a result, this paper proposes that priority under the waterfall mechanism should be determined by the nature of the transaction rather than the identity of the creditor.

The PVVNL case⁴⁴ advanced a nature-based classification of dues but did not fully appreciate the logic for prioritising secured financial creditors. The Court specified that payments owed to statutory corporations with separate juristic identities, such as the PVVNL case⁴⁵, do not constitute “government dues” under the Section 53(1)(f) IBC. Instead, such entities can be categorised according to the nature of their transaction with the corporate debtor.⁴⁶ However, the Court did not address the broader policy rationale, as stated in the BLRC Report⁴⁷, that government dues are purposely subordinated to protect the credit ecosystem. Unlike the Government, which has other ways to recover debts, financial creditors rely significantly on timely repayment.⁴⁸ Undermining their priorities risks destabilising financial markets and the economy as a whole. Thus, while the PVVNL case⁴⁹ accurately identified the nature of transaction-based classification, it missed an opportunity to underscore the legislative intent underlying the IBC’s waterfall hierarchy.

Government dues should be classified under the IBC based on two fundamental factors: Whether the debt is financial or operational in nature, and the intrinsic character of the obligation itself.⁵⁰ It is critical to recognise that not all government claims should receive equal consideration in the priority framework. Statutory dues or claims that do not originate from a voluntary, transactional relationship should not be automatically classified as secured debts. Giving such dues more priority contradicts the IBC’s objective and upsets stakeholder balance. In matters involving governmental dues where the legal position is ambiguous,⁵¹ courts should consider the original legislative intent as well as the Code’s broader economic objectives. This will not only assure conformity with the IBC’s goal, but also provide clearer guidance for future cases.⁵²

Legislative recommendations for the upcoming amendment

To provide a fair distribution of proceeds during liquidation and improve recoveries for financial and operational creditors, Section 53(1) IBC should be amended as follows⁵³:

(1) Section 53(1)(b)(ii) should state that priority is to be given only to financial debts owed to secured financial creditors who have given up their security interest under Section 52 IBC.

(2) Section 53(1)(d) should be amended to prioritise solely financial debts payable to unsecured financial creditors, preserving a clear distinction between secured and unsecured debt classes.

(3) Section 53(1)(e)(i) should be expanded to encompass all dues owed to the Federal and State Governments, local Governments, and any payments secured through statutory arrangements or legal obligations imposed by operation of law.