The current global financial crisis, probably the worst since the international economic depression of the 1920s, has brought several financial giants to insolvency. Panic-stricken lenders and investors have called in their cash, leaving companies cash-starved, with almost no means of getting refinancing on acceptable terms—and this has further resulted in repayment defaults. While less severe in India, repayment defaults are also becoming a cause of concern for financiers here.
Illustration: Jayachandran / Mint
Typically, a lender ensures repayment of debt by creating a security in its favour on the borrower’s assets. This allows a lender to have direct recourse for recovering a debt by liquidating the borrower’s assets, rather than filing contentious recovery claims. It is a settled position that a lender whose security interest is registered—in other words, a secured lender—gets priority in recovery of dues over a lender with an unregistered security interest. However, as an exception to this general rule, amounts owed to the state treasury, such as property taxes or excise dues, may in certain situations get priority over the dues of secured lenders.
Under Indian law, if state dues have been secured through a first charge created specifically by a statute, such dues are paid out first and only then are the balance proceeds used to pay secured creditors (except in cases of winding up). It is, therefore, important for banks and financial institutions to recognize the priority accorded to state dues.
A case at hand is the recent Supreme Court decision in Central Bank of India v. State of Kerala (27 February). In this case, on the borrower’s default, the lender obtained a decree for sale of the borrower’s assets from the debt recovery tribunal. However, before the decree could be executed, the local tax authority attached the borrower’s assets and issued notices for auction to recover the outstanding sales tax dues. The lender challenged the auction notices on the ground that its dues as a secured creditor should get priority over the sales tax dues of the state. The Supreme Court remained unimpressed with the lender’s challenge and held that sales tax dues of the state would get priority in payment, since the Kerala General Sales Tax Act, 1963, contained a clause creating a first charge in favour of the state on sales tax dues. Significantly, the court observed that though the Banks and Financial Institutions Act, 1993, and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002, were enacted with the aim of ensuring expeditious recovery of dues by lenders, these statutes did not create a charge in favour of lenders or give priority to the dues of any lenders with relation to the state. Thus, one would have to analyse the relevant statute (including state-specific statutes) in every case to determine if state dues would get priority.
Another noteworthy issue arises when the state fails to claim its dues at the time of enforcement of security or at the time of liquidation sale and, meanwhile, lenders are paid from the sale proceeds. The moot point then is whether such a sale is contingent on the payment of such state dues by the buyer before the buyer can derive a good title. In some cases, the relevant authority, that is, the sub-registrar of assurances, has refused to register the title of the buyer on the ground that there were existing unpaid statutory dues on the property purchased.
This question was addressed by the Supreme Court to some extent in the case of AI Champdany Industries Ltd v. Official liquidator (19 February). Here, the official liquidator sold the assets of a company in liquidation on an “as-is-where-is basis” while there were some municipal claims outstanding. The municipality had, however, not filed its claims before the liquidator. After the assets were sold, the municipality claimed arrears of property tax from the buyer. The court held that municipal tax dues under the relevant property tax law did not create any encumbrance on the property and these are considered to be a personal liability of the defaulter, which could not be passed on to the buyer. Further, the court said that in this case, the municipality could at best be regarded as an ordinary unsecured creditor, required to stand in queue with all others similarly placed.
This is as far as the court went; it did not specifically comment on the issue of the buyer’s title being contingent on clearance of state dues and the sub-registrar’s power to decline registration of title. So the question remains alive and it will be interesting to see how the legal position evolves on this. Also, importantly, in this case, the fact was that the municipal tax was not secured by a statutory charge which, if it had been otherwise, may have led to a different outcome.
A further interesting development on this subject is the Delhi high court decision of BSES Rajdhani Power Ltd v. Saurashtra Color Tones Pvt. Ltd (2 July). In this case, the applicant purchased a property and applied for a new electricity connection. The electricity distribution company (BSES) refused to provide a new connection until the outstanding dues of the previous owner had been cleared. However, the Delhi Electricity Regulatory Commission had issued a tariff order which imposed an obligation on an applicant applying for a new electricity connection to pay all outstanding electricity dues. On the basis of this tariff order, the court held that BSES could compel the applicant to pay the arrears of the previous owner and could refuse to supply electricity to the premises on account of such non-payment.
Contrasting this case with the Champdany Industries case, the law that emerges is that while state dues such as municipal claims are the liability of the defaulter and should not pass to the buyer, under certain situations, such as where there is an order compelling a person to pay outstanding dues, the purchaser may still have to bear the previous owner’s liabilities.
What should be noted is that a lender seeking security or purchasers acquiring assets must conduct a thorough diligence on outstanding state dues before creating a charge or acquiring a property. Since some dues may not be discovered through inspection of public documents, it is advisable for all parties concerned to obtain adequate representations and indemnities to protect their interests.
This column is contributed by Garima Bharati of AZB & Partners, Advocates & Solicitors.
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