Supreme Court Gives State Debts Priority Over Rights of Secured Creditors - International Law Office

International Law Office

Litigation - India

Supreme Court Gives State Debts Priority Over Rights of Secured Creditors

July 07 2009

Facts
Issue
Decision
Comment


The Supreme Court of India recently held that statutory first charge rights created by state legislation (ie, the Bombay Sales Tax Act 1959 and the Kerala General Sales Tax Act 1963) on the property of the dealer or any other person liable to pay sales tax will take precedence over central legislation that provides for recovery of debts and enforcement of security interests (ie, the Recovery of Debts due to Banks and Financial Institutions Act 1993 and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002).(1) This ruling will have a substantial impact on the rights of banks, financial institutions and other secured creditors to recover their dues.

Facts

Central Bank of India v State of Kerala
In Central Bank of India v State of Kerala(2) the appellant, a nationalized bank, granted cash and credit facilities to Kerala Refineries Ltd, which executed a mortgage of movable and immovable properties to secure repayment. As the borrower failed to repay the money owed, the appellant filed a civil suit, which was transferred to the Debt Recovery Tribunal.

The tribunal confirmed the suit and issued a recovery certificate. At this stage the revenue administrative officer issued notice to the borrower for recovery of sales tax, which stated that the borrower's properties had been attached and that steps were being taken to sell them. The revenue administrative officer claimed that by virtue of Section 26B of the Kerala General Sales Tax Act, the state government had first charge rights on the attached properties. The appellant challenged this notice by filing a petition under Article 226 of the Indian Constitution, contending that the Recovery of Debts Act, as a piece of central legislation, should prevail over the Kerala act. The single judge dismissed the appellant's contention and the appeal brought before the division bench was also dismissed.

The Thane Janata Sahakari Bank Ltd v The Commissioner of Sales Tax
In The Thane Janata Sahakari Bank Ltd v The Commissioner of Sales Tax(3) the appellant, a scheduled cooperative society incorporated under the Maharashtra Cooperative Society Act 1960, granted credit facilities to M/s Charishma Cosmetics Pvt Ltd Co by creating an equitable mortgage of its factory, land and building in favour of the bank. The company failed to repay the amount owed and therefore the appellant classified its account as a non-performing asset. The appellant initiated proceedings under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, took possession of the company's properties and sold them. Thereafter, the assistant commissioner of sales tax informed the appellant that sales tax dues constituted a first charge against the company under Section 38C of the Bombay Sales Tax Act, and issued notice to the appellant for recovery of a certain amount in addition to the auction proceeds. The bank filed a writ petition under Article 226 of the Indian Constitution, contending that as a piece of central legislation, the Securitization Act should prevail over the Bombay act. The division bench dismissed the contention, holding that as the Securitization Act does not provide for first charge rights, the first charge rights created by the Bombay act take precedence.

A special leave petition was filed to assess whether the High Court's action was justified.

Issue

An issue in these cases was whether Section 38C of the Bombay Sales Tax Act and Section 26B of the Kerala General Sales Tax Act and similar provisions contained in other state laws, by which first charge rights are created on the property of the dealer or such other person that is liable to pay sales tax, are inconsistent with the provisions of the Recovery of Debts Act on recovery of debt and of the Securitization Act on enforcement of security interest.

Furthermore, the court had to decide whether, by virtue of non obstante clauses (a device employed to give overriding effect to certain provisions over some contrary provisions that may be found either in the same legislation or in other legislation) contained in Section 34 of the Recovery of Debts Act and Section 35 of the Securitization Act, two pieces of central legislation should take precedence over two pieces of state legislation.

Decision

Granting the special leave petition, the Supreme Court agreed with the decision of the division bench. It reasoned that Article 254 of the Constitution, which states that laws made by Parliament prevail over laws made by the state legislatures, is invoked only when both central and state laws have been enacted on any of the matters enumerated in List III in the Seventh Schedule and there is a conflict between the two laws. Since the Recovery of Debts Act and the Securitization Act were enacted by Parliament under List I in the Seventh Schedule, and the Bombay and Kerala acts were enacted under List II in the Seventh Schedule, Article 254 cannot be invoked to challenge state laws on the grounds that they conflict central laws. There is no ostensible overlap between the two sets of legislation.

Further, both the Recovery of Debts Act and the Securitization Act under Section 34(1) and Section 35 respectively contain non obstante clauses. The non obstante clauses contained in these acts give overriding effect to the provisions of the acts only if there is anything inconsistent contained in any other law or instrument that has effect by virtue of any other law. As it is not possible to read any conflict or inconsistency between the provisions of the Kerala and Bombay acts on one hand and the provisions of the Recovery of Debts Act and the Securitization Act on the other, the non obstante clauses contained in the latter acts could not be invoked.

Finally, Section 38C of the Bombay act and Section 26B of the Kerala act create a first charge right on the property of the dealer or any other person liable to pay sales tax. However, no such provision has been incorporated in the Recovery of Debts Act and the Securitization Act, despite the granting of extraordinary power upon secured creditors to take possession and dispose of the secured assets without intervention by the court or tribunal. Further, while enacting these acts, Parliament was aware of the law giving priority to the state. This shows Parliament's intention not to create a first charge right in favour of banks, financial institutions and other secured creditors on the borrower's property. Therefore, Parliament did not intend to give the dues of private creditors priority over state debts.

Comment

This Supreme Court ruling clearly gives state debts priority over the rights of secured creditors. Such priority is given not only before the completion of the sale process under the Recovery of Debts Act or the Securitization Act, but also after the sale process. The sale would be subject to the charge of state authorities if dues were pending.

The implications of the ruling will be significant for secured creditors, as the creation of charge rights over the borrower's property by way of a mortgage or pledge may be insufficient to give clear title to the buyer in a sale process under the Recovery of Debts Act or the Securitization Act.

This decision may deter borrowers, as banks may be reluctant to provide cash and credit facilities against the creation of security where tax or customs defaults are discovered during the due diligence process.

For further information on this topic please contact Siddhartha Datta or Rohini Sisodia at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 2692 0500), fax (+ 91 11 2692 4900) or email (siddhartha.datta@amarchand.com or rohini.sisodia@amarchand.com).

Endnotes

(1) SLP (C) 24767/2005.

(2) CA 95/2005.

(3) CA 2811/2006.


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