One other prism for reviewing escrow and custodial agreements? – Finance and banking

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introduction

Escrow and custody account (BETWEEN) Mechanism1, a common feature of infrastructure projects, has its origin in one of the first guidelines of the Reserve Bank of India (RBI) on infrastructure financing, namely circular on the financing of infrastructure projects of April 23, 1999 with the file number IECD. No. 26 / 08.12.01 / 98-99, published by RBI. Under the TRA mechanism, control of future cash flows is removed from the borrower and transferred to an independent agent called the TRA agent / trustee (who is appointed and acts on behalf of the lenders). With such earmarking of cash flows, allocations in a pre-determined manner for various purposes, including debt servicing, for government and statutory fees, operating and maintenance costs (among others) can be made and transparently monitored. After meeting pre-defined expense items (usually in accordance with pre-approved budgets), a residual cash flow is made available to the borrower if certain conditions are met (typically known as payment terms or distribution terms). While TRA agreements may vary in terms of specific heading and overall look and feel, much of the core message and content is primarily based on the above.

In this part of (the intended) three-part series of articles on this subject, we limit our analysis to the treatment / priority of state and statutory taxes over the rights of creditors.

Treatment of state and statutory duties on trust and deposit accounts in the light of the Insolvency and Bankruptcy Act, 2016 (IBC)

Position (as it currently stands?) In front of IBC

Under the TRA arrangements, state and statutory taxes (for which a separate sub-account is usually created for payment) take precedence in terms of the use / end-use of revenue or other revenue. Sometimes regulations can also be found giving priority to government and statutory taxes in the event of competing payments / a liquidity gap (on a certain date / in a certain period of time) in order to meet all liabilities transferred. One of the main (historically) reasons for this priority is that state and statutory taxes smack like “crown debts,” whereby the principle of priority of crown debts is based on the principle of necessity and public order – the state is entitled to money through taxes because the state, if it does not receive any income and has the necessary resources, cannot perform its tasks at all. The Hon’ble Supreme Court of India also ruled that tax arrears owed to the state may take precedence over private debt in terms of common law doctrine regarding the priority of crown debt (common law doctrines would be within the meaning of Article 372 (1) of the Constitution of India) 2. Viewed from a different angle, the government and state authorities would have the right to seize the assets and recover the tax debt from the disposition of those assets if the tax debt remains unpaid, thereby affecting the functioning of the project as a whole and being the top priority for the state and legal charges within the TRA waterfall would be justified.

IBC – Rights of Lenders in Liquidation

While the Companies Act (2013 and 1956) specifies a special distribution priority in the event of a company’s liquidation, IBC is a derogation from Section 53. In a liquidation scenario, crown debt (government and statutory fees) rank behind bankruptcy / liquidation process costs , the worker fees / fees of the secured creditors, the workers (other than workers) and the financial debt to unsecured creditors. There are now several court rulings that have recognized the rights of government agencies in relation to such fees due to unsecured business creditors.

That begs the question

Since this is specifically a liquidation scenario, the question naturally arises why TRA agreements should not give priority to state and statutory taxes, as this can be relevant both in the normal course of business and during the bankruptcy process of companies (CIRP) and also because any TRA agreement that contains a waterfall / distribution mechanism that violates Section 53 of the Code will in any event be overridden.

Treatment of state and statutory charges in CIRP / liquidation

It is true that the rights of the banks / financial institutions affected under the IBC system are protected in both the case of CIRP and in the event of liquidation, as they are the financial creditors, with state and legal fees recognized as operating debts and the Apex court has confirmed more than once that equality applies and that financial and operational creditors are on a different basis3.

Overall position

The overall concept on this issue has evolved due to the adoption / enforcement of the Code, which has led to amendments to the Companies Act 20134, and now, in the event of a company being wound up under the aegis of the courts, state and statutory levies no longer receive the same priority. There are changes to certain other laws5 relating to debt recovery that can be said to originate in the adoption of the Code, but these are not of direct concern for the purposes of this policy.

Then why look around?

It should be noted that the Hon’ble Supreme Court of India, in one of its recent rulings on the matter, ruled that a secured creditor’s fees would be preferred to crown debt unless a law gives priority to crown debt6. To that end, we are calling the primary judicial finding in this decision the Connectwell Principle.

Even outside the scope and scope of the Code, which concerns income tax debts or duties according to the Central Goods and Services Tax Act of 2017, in practice in practice with the creation of securities (or others), permits (for the creation of asset collateral) are in accordance with the relevant legal provisions7 or independent confirmation (often at regular intervals) of the absence of tax debts would have been obtained.

In addition, the Hon’ble Supreme Court of India8 also recognized that Section 31B of the Debt Reclamation and Bankruptcy Act 1993 and Section 26E of the Securitization and Restoration of Financial Assets and Security Enforcement Act 2002, respectively, alleged Prioritize the recovery of secured creditors over state and statutory taxes. While state tax law gives priority to state and statutory taxes, key laws in India’s Constitution take precedence with regard to Article 246 of the Constitution. As a result, several high courts believe that the secured creditor can claim the sales proceeds from the sale of secured assets in priority over state and statutory charges, even if state and statutory charges are outstanding and have been claimed9. Based on the above and the Connectwell Principle, while government agencies may exercise their right to judge their debts and thereby seize assets, the fees owed to secured creditors will always prevail and will prevail10 of these state and statutory fees.

Even if one takes into account the larger basket of state and statutory taxes (such as the definition of ‘statutory duties’ or ‘taxes’ in TRA agreements or loan agreements is usually broader), state pension fund or employee insurance or similar statutory provisions include mandatory payments / provisioning, the special purpose vehicles hosting the project usually never have workers on their roles as EPC contracts and O&M contracts are seldom executed in-house. As a result, compliance thresholds are usually not triggered under various labor laws in India.

Conclusion

Although the risks in connection with garnishments and garnishment orders cannot be ruled out and such procedures remain real possibilities in the event of tax losses or defaults, from the point of view of the lender it is time to check whether state taxes or other statutory taxes must be contractually highest Priority. With respect to TRA agreements and how they are drafted, there is no better time to assess whether separate sub-accounts are required for government and statutory levies, or whether it is more appropriate to treat them as part of the larger outflow from an operating / O&M account or debt service payment account. Since conflicts between contractual provisions and what can be provided for in law / court decisions or what results from them should always be avoided, this is one of the aspects in TRA agreements that one has to consider when adapting TRA agreements to the current legal situation should check? / court order?

Footnotes

1. Sometimes named differently – for example as an escrow account. To distinguish between the TRA mechanism and the escrow mechanism, however, reference can be made to the circular on the financing of infrastructure projects of April 23, 1999 with reference number IECD No. 26 / 08.12.01 / 98-99 of the Reserve Bank of India.

2. Dena-Bank vs. Bhikhabhai Prabhudas Parekh & Co, [2000
(5) SCC 694].

3. Committee of Creditors of Essar Steel India Limited vs. Satish Kumar Gupta and Others, [2019 SCC Online 1478].

4. Section 326 of the Companies Act, 2013.

5. Section 31B of the Debt Collection and Bankruptcy Act, 1993 and Section 26E of the Securitization and Restoration of Financial Assets and Security Interest Enforcement Act, 2002 – Also discussed further in this article.

6. Connectwell Industries Pvt. Ltd. vs. Union of India, (2020) 5 SCC 373].

7. For example, under Section 281 (1) of the Income Tax Act 1961.

8. UCO Bank & Others vs. Dipak Debbarma & Others, [2017
(2) SCC 585] – When interpreting Art. 246, the constitutional order must be taken into account, which visualizes a federal structure that gives the Union parliament and the legislative bodies of the states full autonomy in their respective / delimited areas of law. In the event of a conflict, it is simply the task of the Constitutional Court to examine whether the conflict can be resolved by recognizing the mutual existence of the two laws. If this is not possible, the parliamentary legislation would take precedence according to Article 246 paragraph 1 and the state legislation must give way, although the state legislation falls within the delimited area (List II). This is the principle of federal supremacy embodied in Article 246 of the Constitution.

9. Axis Bank Limited vs. Maharashtra State and Anr., 2017 (3) AIR (Bom) R 305.

10. For the purposes of this Agreement, we have not considered a situation where a government agency is proceeding under the Bankruptcy and Bankruptcy Act 2016 for its proceedings owed because in such a scenario, even if the government agency initiates CIRP, it would be considered a proceeding in rem becomes due to Swiss Ribbons Pvt. Lmt. vs. Union of India (2019 SCC OnLine SC 73), and a secured creditor always takes precedence over the government according to the code.

The content of this article is intended to provide general guidance on the subject. You should seek expert advice regarding your specific circumstances.