– Shruti Sethi†
SHORTCOMINGS OF THE CURRENT POSITION OF LAW
While the abovementioned judgements clearly establish that beneficiaries of third party security cannot be categorized as ‘financial creditors’ in the insolvency process of the Security Provider, the following arguments against the present position may be made:
- Interests of group companies are inter-twined:
The rationale given by the Supreme Court in the Jaypee Judgement and the Phoenix ARC Appeal Judgement is that for a debt to be a financial debt ‘it needs to be disbursed against the consideration for the time value of money’ and since no disbursement of consideration was made to the Security Provider the lenders cannot be categorized as ‘financial creditors.’
However, in relation to the consideration, one may argue that advancing credit to a group company may be consideration enough for another group company to create security interest in favour of the lender. This is because business enterprises often conduct their operations from several separate entities for variety of reasons like: (a) to separate functions for administrative ease; (b) to control many businesses with a minimal capital investment; (c) to comply with various legal requirements; (d) to minimize liability or to insulate certain assets from liability for other activities; and (e) probably most important, to avoid taxation. One may argue that the owners of the group may have little or no concern for the independent profitability of one of the group companies but would be concerned for the profitability of the overall group.
This commercial arrangement may also be the reason why business owners decide to provide third party security in the first place. Business owners should not be permitted to hold a group company as an integral part of their business operation while availing a loan and then call foul during insolvency proceedings when a creditor attempts to hold such company liable for its dues.
The current approach of the Courts in rejecting the claims of beneficiaries of third party security as ‘financial debt’ and only permitting them to be ‘secured creditors’ makes little sense in terms of the business considerations that lead to the formation of a group or business enterprise. Control by, and benefit to, the parent or affiliate and even withdrawal or commingling of assets are entirely natural from a business point of view. The existing law seems to set up the subsidiary as an entity in a platonic world of ideas and assumes that it has both a will and raison d’etre (reason for being) of its own.
Further, it is an established position of law that: (a) security provided for performance or payment of an obligation is inextricably linked to the underlying debt or obligation; and (b) debt is an essential element of a security interest and it subsists within a security interest. By creating a security interest in favour of the creditor, the Security Provider undertakes to repay the debt owed to the creditor to the extent of the security interest, in the event the borrower is unable to do so. Therefore, just like the borrower, the Security Provider should also be considered as a debtor of the creditor.
Separately, one may argue that by a strict interpretation of the law, the definition of ‘financial debt’ does not provide whom the amount is required to be disbursed to. However, this argument was rejected by the NCLT in the matter of ICICI Bank v Anuj Jain without being adequately argued or addressed. The NCLT merely mentioned that “the contention that the definition of financial debt does not envisage that the disbursement of debt has to necessarily to the corporate debtor is completely untenable in law”. The Supreme Court in the Jaypee Judgement and the Phoenix ARC Appeal Judgement also did not consider this argument.
- Conflict with provisions dealing with liquidation:
The IBC provides that in case of liquidation, a ‘secured creditor’ may enforce his security outside the liquidation process being conducted by the liquidator. Therefore, since beneficiaries of third party security will be ‘secured creditors’ they can stand outside the liquidation process and enforce their security (like a mortgage) to receive payments.
Further, the IBC provides that on approval of a resolution plan by the NCLT, the plan shall be binding on all the stakeholders involved. IBBI (Liquidation Process) Regulations, 2016 define a stakeholder to mean “stakeholders entitled to distribution of proceeds under Section 53 of the IBC (which includes debts owed to secured creditors)”. Since beneficiaries of third party security will be ‘secured creditors’ and will be entitled to distribution of proceeds under Section 53, they would be categorized as a stakeholder under the IBC.
This creates an unusual situation where lenders benefitting from security interest are not allowed to be a part of the resolution process of the Security Provider but may enforce their security in the event of liquidation. This contradiction was not evaluated by the Supreme Court in the Jaypee Judgement and the Phoenix ARC Appeal Judgement.
Such a conflicting reading of the IBC would encourage beneficiaries of third party security to attack the resolution process arguing that a plan which has not been approved by them cannot take away their security and any such attempt at doing so would be against the principles of natural justice. Uncertainty in the process and fear of long drawn litigations may also discourage interested bidders.
- Rationale of differentiating between ‘financial creditors’ and ‘secured creditors’ not accurate
In the Jaypee Judgement, the Supreme Court relied upon the Swiss Ribbons Judgement to elaborate upon the ‘parenting’ role of a financial creditor. It emphasized that for a creditor to be categorized as a ‘financial creditor’ its stakes have to be intrinsically inter-woven with the well-being of the corporate debtor.
This distinction by the Supreme Court seems like a stretch because the discussion in the Swiss Ribbons Judgement was in relation to the difference in roles of a financial creditor as opposed to an operational creditor (and not a secured creditor). Further, given the commercial reality of the world, arguing that
- a ‘financial creditor,’ (which may include foreign banks, investors etc.) would not have the highest recovery as their first priority seems unreasonable; and
- the beneficiary of a security interest (which may as well be a public sector bank) would not want a better resolution of the Corporate Debtor seems erroneous.
In the opinion of the author, the intentions of the lenders would not depend on whether they are direct lenders to the Corporate Debtor but on their internal board approved policies and organizational objectives.
- Ignorance of contractual provisions
Security documents typically contain a covenant to pay providing that upon any failure by the borrower, the Security Provider shall duly and punctually make payment of the amounts due. Furthermore, the Transfer of Property Act, 1882 while defining a mortgage provides that “a mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, an existing or future debt, or the performance of an engagement which may give rise to a pecuniary liability.” This implies that debt is an essential ingredient of a mortgage.
In this regard the Courts have also mentioned that “there may be a debt without a mortgage but there can be no mortgage without a debt. Properties are offered as security only for securing recovery of debt. If debt is repaid the mortgage ceases to be a mortgage.” The Supreme Court in the Jaypee Judgement did not consider this contention.
As it currently stands, the Supreme Court in the Jaypee Judgement and the Phoenix ARC Appeal Judgement read with the CIRP Amendment Regulations, does not provide any flexibility in relation to contractual provisions imposing a payment obligation (in case of default of the borrower) on the Security Provider.
One may also argue that at least claims up to the value of the security interest should be admitted as ‘financial debt’ in the insolvency process of the Security Provider. This is because at the time of disbursement of debt the Security Provider undertakes and covenants to repay the debt obligation of the borrower to the extent of the value of the security interest. However, as it currently stands, claims of a beneficiary of third party security up to the value of the asset on which security interest has been created by the Security Provider cannot be considered as ‘financial debt’.
Currently, beneficiaries of third party security cannot be categorized as ‘financial creditors’ in the insolvency process of the Security Provider. This article attempts to steer the discussion in a different direction and provides reasoning why beneficiaries of third party security should be categorized as ‘financial creditors.’ The only way around this unusual position taken by the Supreme Court in the Jaypee Judgement and the Phoenix ARC Appeal Judgement and the IBBI in the CIRP Amendment Regulations seems to be an introduction of guarantee obligation in the clause on covenant to pay in the security documents – as guarantee obligations are covered specifically under the definition of ‘financial debt’.
The judiciary and the legislature in India should endeavor to provide protection to creditors during the insolvency process of Security Providers. If not, such lenders (including foreign lenders) may decide not to advance the loan/invest in India.
† Shruti Sethi is a senior associate at AZB & Partners, Mumbai.