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Archit Sinha*
I. INTRODUCTION
On April 25, 2024, the Supreme Court gave its judgment in in Global Credit Limited v Sach Marketing. The Court clarified the criteria via which a given debt is to be classified as ‘financial debt’. This judgment props NCLT Kolkata’s judgment from August last year, into light again.
The National Company Law Tribunal (“NCLT/AA”) Kolkata pronounced its order in EPC Constructions India Limited v Matix Fertilisers & Chemicals (“Matix Fertilisers”). EPC Constructions had filed an application under s/7 IBC claiming to be a financial creditor (“FC”). Matix had admittedly failed to make good on the debts owed to EPC. Admittedly, Rs. 250 Crore of debt borne out existing agreements were converted to 25 Crore Cumulative Redeemable Preference Shares (“CRPS”) at Rs 10/– share was issued to EPC at 8% interest and Rs. 20 Crore of interest aggregated each year for 3 years from 2015 to 2018. So, a total amount of Rs. 310 Crore was allegedly due to EPC. The NCLT dismissed the application and held that EPC being a “Preference Shareholder [was] not a Financial Creditor unless the Preference Shares become due for redemption” which had not happened on facts [p. 14.17] .
This post argues in favour of EPC Constructions by critiquing AA’s reasoning. The limited argument made herein is that a creditor who converts their debt into CRPS can also don the hat of a FC. Meaning that a mere conversion of debt into debt/equity instruments does not render a FC otherwise as evidenced through s/5(8)(c) IBC. This would make the inquiry u/s5(8)(f) fact specific. This follows the reasoning in Global Capital, as it emphasizes on a follows a factual inquiry for the determination of ‘financial debt’, and hence, the status as an ‘FC’. This post analyses the NCLT’s understanding of (a) CRPS viz. their status as ‘investment’, and ‘debt that is due’, (b) s/55 of the Companies Act (“CA13”), and (c) the interpretation of Accounting Standards (“AS”). Part II briefly summarises Global Credit and critiques the 2023 NCLT order. It offers a novel interpretation of s/5(8) IBC. Part III follows and analyses the AA’s treatment of CRPS and argues for differentiating their two forms under s/55 under CA13 and 53 of IBC. Part IV analyses AA’s treatment of the AS and argues for treating CRPS as debt.
II. GLOBAL CAPITAL'S ECHO IN THE CRPS SAGA
Section 5(8)(f) IBC defines ‘financial debt’. When read with 5(7) which defines an ‘FC’, 5(8) becomes crucial because it serves as the sole criterion that needs to be met before FCs can begin to claim their rights under the IBC. In this context, the SC via Global Capital gave the test for determining Financial and Operational Debt under the IBC.
Section 5(8) provides for one + six requirements (the implication of this phrasing will be explained later) that must be met to constitute financial debt. The relevant clause is 5(8)(f) which seemingly refers to amount raised under transaction having a commercial effect of borrowing. However, the SC holds 5(8)(f) to say that “the amount must be raised under any other transaction uncovered by (a)-(e)” [p. 16]. Finally, the SC gives true meaning to clause (f) by reading that words “commercial effect of borrowing” in it to qualify the ‘transaction’ and not the ‘amount’ raised under it.
This necessarily takes the SC to a factual inquiry as evident by its analysis on section 3(33) [p. 17]. Secondly, the Court also acknowledges “time value of money” in 5(8) as qualifying the whole of section. Meaning that all clauses in section 5(8)(a)-(i) must be disbursed with time value of money as a condition precedent to qualify as financial debt. This finally puts to rest the controversy on the reading of 5(8) vis-à-vis ‘transactions’ started by Pioneer Urban Land [p. 66, 67] and reinforced by Jaypee Infra [p. 43, 46] and Phoenix ARC [p. 44, 47].
The two aforementioned holdings will serve as the basis on which this post will argue on CRPS and their position as FCs.
A. The Dawning of Judgment: AA’s (Mis)Holdings
The section will analyse two holdings on CRPS and explore the unresolved question of whether a creditor who converts their debt into CRPS remains a creditor, thereby shedding light on the nuances and implications of this issue.
The AA makes two relevant holdings – (a) “CRPS [are] in the nature of an investment [but not] a debt, having commercial effect of borrowing,” [p. 14.10(f)]. Thus, (b) “Preference Shareholders (“PS”) are not creditors of a company unless their PS become redeemable” [p. 14.9, 14.7, 15].
The question the AA fails to frame and adjudicate on is whether a creditor who converts his outstanding debt into CRPS continues to remain a creditor (“impugned question”). This is relevant because it gives scope for a creditor to don the hat of a PS too, instead of the status of ‘creditor’ and ‘PS’ becoming an either/or option. Additionally, this question mirrors the facts of the case as well because debt was admittedly converted to CRPS solely for repayment. Additionally, on principal there is merit in framing it as it also shifts the inquiry into factors that lead to creditors losing/maintaining their status as ‘creditors’ post-conversion. None of the judgments on this issue [1] frame the question in this manner, leading to a vacuum in law as to factors that erode a creditor’s status. Thus, (a) in Matix Fertilisers if viewed in context of the impugned question, systematically sheds light on these factors, as the next section will show.
B. Interpreting 5(8) as a Conditional Canvas
This part focuses on interpreting s/5(8), particularly “commercial effect of borrowing” under 5(8)(f). The AA’s analysis of CRPS missed the broader context of the transaction’s commercial impact and the factors that constitute ‘financial debt’. It argues that s/5(8) should be viewed conditionally, requiring the transaction to meet specific criteria under 5(8)(a)-(i). This perspective shifts the inquiry from the instrument (CRPS) to the nature of the transaction, emphasising the importance of the “time value of money” across all conditions in 5(8)(a)-(i).
In s/5(8)(f), “commercial effect of borrowing” stands out because it can either be read to qualify “amount” or a “transaction”. The AA analyses CRPS on the former threshold to find that they lack this effect. This implies two things – (1) focus of the inquiry is the status of CRPS, meaning that (2) the AA misses s/5(8)(f) reference to “transactions” for “commercial effect of borrowing.” Hence, the conversion, i.e., the transaction is never analysed, rendering the inquiry incomplete.
This is precisely why s/5(8) needs to be read as a conditional section as to what constitutes ‘financial debt’ to give meaning to “transaction” in 5(8)(f). Implying that “transactions” must also meet the criteria under 5(8) in addition to having the “commercial effect of borrowing” before being classified as ‘financial debt’.
Thus, the merit in framing the impugned question and such a reading of 5(8) is that it allows for a factual assessment of the nature of the amount both pre-and post-conversion to CRPS. This shifts the focus of inquiry from the effect of the agreement (CRPS) to the agreement itself. Resultantly, 5(8) in addition to being a definition section can be read as a conditional section. This is where “time-value of money” in s/5(8) also becomes a relevant factor because per the scheme of 5(8), it applies vertically throughout conditions (a)-(i).
C. Unveiling the Melody of S/5(8)
This section proposes a thorough evaluation of the transaction's effect, the status of the creditor post-conversion, and the converted amount under s/5(8). This approach acts as a comprehensive checklist for identifying ‘financial debt.’ It argues that the focus should be on the conversion agreement for “commercial effect of borrowing” and if it meets the “time value of money” criteria.
In effect, a comprehensive evaluation of (i) the effect of transaction, (ii) the status of the convertor, and (iii) the status of the converted amount under 5(8) is made possible. It then acts as a checklist to find ‘financial debt’. Otherwise, like in Matix Fertilisers and all cases in footnote 7, the analysis by the AA begins by applying s/5(8) to the converted instrument, capturing only (iii).
Analysing the AA’s conclusion in Matix Fertilisers via the purported reading of 5(8), the focus of the inquiry becomes the conversion agreement. This means that the first question is whether the impugned agreement (and not CRPS) has the “commercial effect of borrowing” in s/5(8)(f). Secondly, the vertical criteria in 5(8), i.e., “time value of money” applies to both – transaction and CRPS. This is where 5(8)(c) applies because it qualifies “amount pursuant to … similar instruments.”
So, the questions that the AA should have answered are – whether the agreement has “the commercial effect of a borrowing” [s/5(8)(f)]; If the issued CRPS come under “any other instrument” [5(8)(c)] and; Whether the agreement and debt are disbursed against “time value of money” [s/5(8)]. 1 and 3 are purely factual questions. Hence, the subsequent analysis by the AA, i.e., s/55 CA13 should have reflected the same.
III. CRPS: DIVERGING PATHS & AA'S PRE-EMPTIVE ASSESSMENT
The AA differentiates between PS and equity shares to hold that a cumulative PS gets “priority in liquidation process per s/53 IBC” [p. 14.10(e)]. The reason for the same is that as per s/55 CA13, there is a procedure in place to redeem PS. So, allowing PS to initiate CIRP would “tantamount to preferential payment to shareholders, contravening the waterfall under s/53 IBC” [p. 13.2(ii)(c)].
This holding ignores the nature of CRPS on facts. There exist cumulative shares in preference to (inter alia) dividend and capital.[2] Section 53 IBC talks about “proceeds from sale of liquidation assets” of a company, meaning that “preference shareholders” in 53(1)(g) must be understood as preference to company’s capital. On facts, the preference is admittedly on interest on cumulative dividend [p. 6(3)]. So, there is no scope to bring in 53 IBC for the proposition that PS in general have a claim under the waterfall. Section 53 makes it abundantly clear that the scope is limited to PS in context of equity which is tied to the assets of the company. When CPRS are tied not to equity but solely to dividend, this reasoning becomes inapt.
In effect, PS as to dividend are not covered u/s 53 IBC, implying that pre-conversion creditors upon conversion somehow lose their status as such and along with it, their rights in IBC. And owing to the aforementioned logic employed by the AA, PS as to dividend will never get any claims to their amounts under the IBC. But if the focus of the inquiry becomes the agreement as argued, there are delineated factors meeting which PS holders continue to enjoy the rights they always. These factors include “commercial effect of borrowing”, “time value of money” with focus on the transaction in question, and s/ 5(8)(c) which allows CRPS to have the effect of ‘financial debt’.
The AA further reads section 55 of CA13, disconnected from facts, to provide the sole mechanism for the redemption of PS as out of the “profits of the company” or “proceeds of fresh equity” [p. 14.8]. Since the company was not making any profits, it holds “the non-redemption of PS does not result in PS-holder becoming creditors or the carrying value of preference shares and dividends becoming a debt” [p. 14.9] This highlights the effect of not addressing the impugned question. The three-pronged inquiry in II(B) would have allowed room to assess facts to bring out “borrowing effect” (etc.). The merit in the same is that (1) it gives a true meaning to s/5(8)(f), and the understanding of ‘financial debt’ therein, in line with Global Capital; (2) by focusing on the ‘transaction’ for the commercial effect, it removes redundancy that came along with the emphasis on ‘amount’ since an amount with such effect is simply ‘debt’ u/s 3(11) and; (3) it systematically deals with the impugned question and sheds light on factors that allow classification as ‘financial debt’, thereby allowing FCs to be CRPS holders simultaneously. Thus, preserving and giving effect to the rights of a creditor which they already had under the IBC before the conversion of their debt to such instruments covered by s/5(8)(c).
Such is evident from s/55 CA13 reasoning because, on facts, it is admitted that “the preference shares were to be redeemed not out of the profits, but out of the proceeds of fresh issue of shares” [p. 12.3(b)] Thus, debt has become ‘due’ as the “equity was admittedly raised by CD” as reflected in its balance sheet [p. 12.5(c)].
IV. GUIDING LIGHTS, ACCOUNTING STANDARDS & MORE
This post has so far argued that (1) s/5(8) is conditional, leading to (2) the impugned inquiry necessarily being factual. This section follows through and answers the framed questions to establish on facts that CRPS constituted ‘financial debt’.
Borrowing effect is brought out by the conversion agreement. Admittedly, EPC’s BoD resolved to treat the converted amount as an ‘investment’[p. 8.4], which brings in time-value of money. Further, the record makes it clear that the purpose of issuing CRPS was to make good on the Rs. 572.72 Crore OD due to EPC [p. 6(3), 8.3-8.5, 8.7]. Lastly, Indian Accounting Standard (Ind AS) 32 supports a factual inquiry – “the substance of a financial instrument, rather than its legal form, governs its classification in balance sheet.”
Factually, the CD had admittedly classified PS per AS32 paragraph 18 [p. 12.4]. There is no scope for application of the non-obstante clause of IBC u/s238 because there is no conflict hereunder. IBC is silent as to the kinds of PS holders. S/53 only takes into account those in relation to equity. Thus, there is a vacuum concerning other PS holders. In this context, aid can be imported via the AS to understand how these instruments are understood in law elsewhere.
Arguendo assuming a purely factual analysis is rejected, even the regulators treat PS as a borrowing by differentiating them from equity shares. The former do not carry voting rights unless dividend is unpaid for 2 years as per Companies Act 2013 s/47(2) second proviso. The AA reads this to conclude that PS “enjoy voting rights in every resolution” [p. 14.7].
It misses the distinction between the two for 2 years. Further, the Takeover Regulations do not treat PS (unless convertible) as equity shares.[3] In fact, Consolidated FDI Policy treats only fully convertible PS as equity shares for the computation of foreign investment.[4] RBI defines external commercial borrowings in form of “non-convertible, optionally convertible or partially convertible preference shares” [5] and treats PS as debt.[6] Further, SEBI DIP guidelines treated redeemable PS as outstanding debentures in terms of prospectus disclosure requirements,[7] which is a debt instrument. Similarly, ICDR Regulations, 2009 which replaced the DIP guidelines treat redeemable preference shares akin to debentures,[8] signifying that such instruments are not understood as purely equity anywhere in law. Regulators across the board seem to be falling in line in treating CRPS as debt.
Lastly, on ‘investment’ and its connection with “time-value of money”, FEMA Regulations, recognise FDI in the form of PS separate from investment via equity shares.[9] The point is to show that CRPS stand out vis-a-vis other instruments because the FEMA framework recognises it as a valid route for investment in addition to via equity shares. This brings in the ‘time-value of money’ condition for financial debt and it shows the statutory intent to treat CRPS separate from equity shares. The sole relevance for ‘FDI’ being brought here is to bring out the aspect of ‘investment’. This links them to the idea of ‘investment’ which as per Global Capital [p. 20(b)], HDFC Ventures Trustee Company v Kakade Estate Developers relates to “time-value” of money [p. 4.10, 4.11.1, 4.11.2].
V. CONCLUSION
This post has dissected the flawed reasoning of the AA on its categorisation of CRPS on facts by drawing upon insights from Global Capital. By reframing the inquiry to focus on the conversion agreement and the factual elements surrounding it, it becomes clear that creditors who convert their outstanding debt into CRPS can retain their status as FCs.
The larger implications of this argument are significant. If CRPS can be considered as financial debt, it challenges the traditional boundaries between equity and debt, impacting how preference shareholders are treated under insolvency proceedings. This shift allows for a nuanced understanding that not all investments in a company are created equal. Unlike ordinary equity or typical preference shares, CRPS in the present case embody characteristics such as time value of money and the commercial effect of borrowing, aligning them more closely with debt instruments than equity investments.
What is at stake is the potential for CRPS holders to assert themselves as financial creditors, thereby participating in the Committee of Creditors and influencing the insolvency resolution process. This could alter the landscape of creditor hierarchies and recovery mechanisms vis-à-vis operational debtors-CRPS holders who can now possibly force themselves into COC, double-claiming of benefits by CRPS holders as FCs and shareholders, and the consequently even use NCLT as a recovery mechanism. However, a systematic inquiry as argued under s/5(8) can serve as a check. Additionally, this inquiry does not generate new rights for new players in the IBC framework. Meaning that only PS holders who were FCs earlier get back their rights under the IBC. So, CPRS holders have always had the right to be a part of the CoC, CIRP, etc.
Lastly, this post has unintentionally dived into the debate on IBC, and a corporate entity being at the juncture of equity and debt. The status of CRPS (on facts) represents a tug’o war between precisely these concepts. Principally, at least, there seems to be no clear winner.
[1] See HDFC Ventures Trustee Company Limited v Kakade Estate Developers Private Limited Company Petition (IB) No. 747 of 2022; Radha Exports v. KP Jayaram (2020) 10 SCC 538; Aditya Prakash Entertainment Private Limited v Magikwand Media Private limited 218 SCC Online Bom 551 [9]; Lalchand Surana v. M/s Hyderabad Vanaspathu Ltd. 1988 SCC Online AP 290 [6]; Hindustan Gas & Industries Ltd. v Commissioner of Income Tax 1978 SCC Online Cal 410 [10]-[13]; Teq Green Power XIII Private limited v REMC Limited 2023 SCC Online Del 1718 [20], [26].
[2] See s/ 43 Companies Act 2013; Geoffry Morse ed., Palmer’s Company Law (25th edn. vol I Sweet & Maxwell 2017) [6.123] 6027.
[3] SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 [Last amended on February 07, 2023] regulation 10(1)(h).
[4] DPIIT, Ministry of Commerce and Industry, Consolidated FDI Policy (Effective from October 15, 2020) section 2.1.5 and “note”, Annexure 4 [1.1]
[5] RBI Master Circular on External Commercial Borrowings and Trade Credits, issued on July 1, 2011, Part I (a).
[6] ibid Part I (c).
[7] SEBI (Disclosure and Investor Protection) Guidelines 2000 [updated upto Feb 24, 2009 ] Schedule VIIA clause 6.1.1 ‘Order Of Presentation Of Disclosures In Prospectus’ IX (22).
[8] SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, Schedule VIII ‘Disclosures in Offer Document, Abridged Prospectus And Abridged Letter Of Offer,’ XI ‘Other Regulatory and Statutory Disclosures’ (V).
[9] FEMA (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2017, reg.2(v), schedule V (B)(1)(e) and (E)(k).
*Archit Sinha is a 3rd year BA.LLB (Hons.) student at the National Law School of India University, Bangalore.