The Hon’ble Supreme Court (“SC”) has in its judgment dated February 03, 2021 (“Judgement”), delivered by a three judge bench, in the matter of Phoenix Arc Private Limited v. Ketulbhai Ramubhai Patel [Civil Appeal No.5146 Of 2019], held that if a corporate debtor has only offered security by pledging shares, without undertaking an obligation to discharge the borrower’s liability, then the creditor in such a case will not become ‘financial creditor’ vis-à-vis the corporate debtor as defined under the Insolvency and Bankruptcy Code, 2016 (“IBC”).

Facts

Phoenix ARC Private Limited (“Appellant”) filed an appeal under Section 62 of the IBC against the judgment of the National Company Law Appellate Tribunal, New Delhi (“NCLAT”) dated April 09, 2019 wherein the NCLAT had dismissed the appeal filed by Appellant and held that pledge of shares in question did not amount to disbursement of any amount against the consideration for the time value of money and that it did not fall within the ambit of Section 5(8)(f) of the IBC. Previously, National Company Law Tribunal, Mumbai (“NCLT”) by order dated February 22, 2019 had rejected the miscellaneous application filed by the Appellant under Section 60(5)(c) of the IBC and held that the Appellant is not a financial creditor of Doshion Veolia Water Solutions Private Limited (“Corporate Debtor”).
The predecessor of the Appellant, L & T Infrastructure Finance Company Limited (“Lender”) advanced a financial facility of INR 40 crores repayable in 72 structured monthly instalments, to Doshion Limited (“Borrower”) (the parent company of the Corporate Debtor), by way of a facility agreement dated May 12, 2011 (“Facility Agreement”) executed between the Lender and the Borrower. The board of directors of Corporate Debtor passed a resolution on July 26, 2011 to give ‘Non-Disposal Undertaking’ in favour of the Lender whereby it was authorised to provide an undertaking to the effect that 100% of the Corporate Debtor’s shareholding in Gondwana Engineers Limited (“GEL”) shall not be disposed of so long as any amounts were due, payable and outstanding under the financial assistance provided by the Lender to the Borrower. The said deed of undertaking was executed by the Corporate Debtor in favour of the Lender (“Deed of Undertaking”) on January 10, 2012.

On January 10, 2012, an agreement was also executed between the Corporate Debtor and the Lender by which, 40,160 shares of GEL were pledged as a security (“Pledge Agreement”). Subsequently, by agreement dated December 30, 2013 (“Assignment Deed”), the Lender assigned all rights, title and interest in the financial facility including any security, interest therein in favour of the Appellant under Section 5 (Acquisition of rights or interest in financial assets) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

Subsequently, the Borrower failed to repay the loan as per the terms of the Facility Agreement. Therefore, the Appellant issued a notice dated February 19, 2014 and recalled the financial facility. Further, the Appellant filed an application before the Debts Recovery Tribunal, Ahmedabad.

In the interim, Bank of Baroda (“Intervenor”) filed a company petition before the NCLT under Section 7 of the IBC to initiate the corporate insolvency resolution process (“CIRP”) in respect of the Corporate Debtor which was admitted by an order dated August 31, 2018.Consequently, the CIRP commenced, thereby the interim resolution professional for the Corporate Debtor was appointed, who was later confirmed as the resolution professional (“Respondent”). Subsequently, the Appellant filed a claim for an amount of INR 83,49,85,667/- with the Respondent. The Appellant stated that pledge of shares by the Corporate Debtor was in essence a guarantee for financial debt and, therefore, Appellant was a financial creditor of the Corporate Debtor. However, the Respondent by e-mails dated September 20, 2018 and November 23, 2018, expressed an opinion that as per the Pledge Agreement, the Corporate Debtor’s liability was restricted to pledge of the shares only. The Respondent by e-mail dated December 04, 2018 rejected the claim of the Appellant as financial creditor of the Corporate Debtor on the ground that there was no separate deed of guarantee executed in favour of the Lender by the Corporate Debtor.

Thereafter, the Appellant filed miscellaneous application before the NCLT, seeking a direction to the Respondent to admit the claim of the Appellant as a financial debt with all consequential benefits. However, the NCLT rejected the application. Subsequently, the NCLAT dismissed the appeal filed by the Appellant. Aggrieved by the judgment of the NCLAT, the Appellant filed an appeal before the SC.

The relevant provisions in the instant case include Sections 5(7) (definition of financial creditor), 5(8) (definition of financial debt), 3(10) (definition of creditor) and 3(11) (definition of debt) of the IBC.

Issue

Whether the Appellant is a financial creditor qua the Corporate Debtor basis the Pledge Agreement and the Deed of Undertaking executed with the Lender.

Arguments

Contentions raised by the Appellant:

There is a debt which is payable by the Corporate Debtor to the Appellant. The Appellant had stepped into the shoes of Lender by virtue of the Assignment Deed. The Appellant is a financial creditor within the meaning of Section 5(8)(b) read with Section 5(8)(i) of the IBC. The Lender (Appellant) had full rights to pursue against the surety even before the Borrower. The Borrower had borrowed a financial facility and therefore, Corporate Debtor undertook a liability, by creating a security interest in the form of pledge of shares of GEL in favour of the Lender.
A concern was raised that if the Appellant was not accepted as financial creditor as per the provisions of the IBC, it consequently would leave the Appellant effectively remediless inasmuch as the Appellant could not enforce the guarantee during the subsistence of moratorium period. Further, if the resolution plan was passed without any redress to the Appellant, the Appellant shall be gravely prejudiced since recovery of the claim amount from the Corporate Debtor will be impossible.

The Corporate Debtor in effect had provided a guarantee to Lender against the debts due from the Borrower, and in case of non-payment, a charge subsisted upon the 100% shareholding of GEL. The liability of the Corporate Debtor, who is the surety, was co-extensive to that of the Borrower under Section 128 of the Indian Contract Act, 1872 (“1872 Act”).

Appellant submitted that any security that would permit the right of action against a third party that is not the Borrower, would amount to guarantee. The mere fact that Corporate Debtor has not borrowed money from the Appellant, could not absolve the Corporate Debtor from its liability as guarantor. The term guarantee is not to be understood narrowly but broadly to include any security created by third party to secure repayment of financial debt including a pledge of shares. Therefore, the pledge of shares by Corporate Debtor to secure the loan advanced to the Borrower amounts to a guarantee. The Appellant further submitted that the judgment of the SC in the case of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and others, [(2020) 8 SCC 401], which was also relied upon by the Respondent, had been rendered in a specific facts scenario, which do not apply to the present case.

Contentions raised by the Respondent:

The Appellant is not a creditor of the Corporate Debtor in any nature whatsoever. The Appellant has no right of recovery of any debt from the Corporate Debtor. The Appellant only had a limited right of enforcing and realising the value of the shares held by the Corporate Debtor of GEL which are provided as a security for the financial assistance extended to the Borrower as per the Pledge Agreement.

The Pledge Agreement cannot be equated with guarantee as both are absolutely different in terms of their ramification and implication as per the provisions under the 1872 Act. Section 5(8)(I) of the IBC takes within its ambit any liability arising out of a guarantee for any of the items referred to in sub-clauses (a) to (h) of Section 5(8) of the IBC only, and not any other instrument that is in the nature of a guarantee. The Corporate Debtor has not executed any deed of guarantee with the Appellant to perform the promise, or discharge the liability of a third party in case of his default. In the event of default by the Borrower, the Appellant has the limited right to realise the money by selling the shares pledged. The Corporate Debtor had not promised to repay the debt that was recoverable from the Borrower. The Appellant cannot claim their Pledge Agreement to be a guarantee as there is no deed of guarantee executed.

The Respondent and the Intervenor contended that the object of the IBC is entirely different. IBC is not a mechanism for recovery of any amount. As an admitted fact, the Appellant has already moved the Debt Recovery Tribunal, Ahmedabad, for recovery and realisation of its dues.

Observations of the Supreme Court

Transaction:
The Corporate Debtor was not a party to the Facility Agreement executed between the Borrower and the Lender. It was the Borrower who had promised to repay the loan of INR 40 crores as per the terms of the Facility Agreement. ‘Schedule-IV’ of the Facility Agreement provided for ‘Security Creation’ which, inter alia, included, a pledge of 100% equity shares together with all accretions thereon of GEL. Subsequently, 40,160 shares of GEL were pledged, by executing the Pledge Agreement and the Deed of Undertaking, between the Lender and the Corporate Debtor. The SC observed that it transpires that since some shares of GEL were also held by the Corporate Debtor (the subsidiary of the Borrower), the same were also pledged with the Lender as additional security.

Analysing provisions of the IBC and the 1872 Act:

The SC perused the provisions of the IBC and noted that, Section 5(7) of the IBC defines ‘financial creditor’ as any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to. The word ‘guarantee’ and ‘indemnity’ under Section 5(8)(i) of the IBC have not been defined in the IBC. As per Section 3(37) of the IBC, words and expressions used that are not defined in the IBC, but defined in the 1872 Act, shall have the meaning respectively assigned to them.

Therefore, the SC noted that, Section 126 of the 1872 Act defines ‘Contract of guarantee’ as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The SC observed that, the Corporate Debtor had not entered into a contract to perform the promise, or discharge the liability of Borrower in case of default. The SC noted that the Pledge Agreement was limited to pledge of shares as security. The promise as made by the Borrower in the Facility Agreement to discharge the liability of debt of INR 40 crores was not undertaken by the Corporate Debtor. Therefore, the Pledge Agreement and Deed of Undertaking executed between the Lender and Corporate Debtor could not be termed as contract of guarantee within the meaning of Section 126 of the 1872 Act.

The SC noted that the fundamental requirement for a creditor to be recognized as a financial creditor under Section 5 of the IBC, is that there must be a financial debt which is owed to that person irrespective of him being the principal creditor to whom the financial debt is owed or an assignee in terms of extended meaning. The SC further observed that, the definition, by its very frame, cannot be read so expansive/ infinitely wide, that the essential requirements of disbursement against the consideration for the time value of money could be forsaken in the manner that any transaction could standalone to become a financial debt. Further, the SC noted that Sections 5(7) and 5(8) prescribe the transactions vis-à-vis a corporate debtor. Therefore, for the Lender to be designated as a financial creditor of the Corporate Debtor, it had to be proved that the Corporate Debtor owed a financial debt to the Lender.

The SC noted that, the Respondent had relied on two-judge bench judgment of Jaypee Infratech Limited v. Axis Bank Limited (supra) wherein one of the issues raised was similar to the issue raised in this Judgement, therefore, the paragraphs 46 to 50.2, containing an elaborate analysis on the meaning of ‘financial debt’, ‘financial creditor’ under Section 5 of the IBC and ‘debt’ and ‘secured creditor’ under Section 3 of the IBC were extensively noted by the SC in this Judgement.

Ambit of a financial creditor and a creditor under the IBC:

The SC noted that the generic term ‘creditor’ is defined to mean any person to whom the debt is owed. Further, it is clarified that it includes a ‘financial creditor’, a ‘secured creditor’, an ‘unsecured creditor’, an ‘operational creditor’, and a ‘decree-holder’. A “secured creditor” as per Section 3(30) of the IBC means a creditor in whose favor a security interest is created; and “security interest”, as per Section 3(31) of the IBC, means a right, title or interest or claim of property created in favor of or provided for a secured creditor by a transaction which secures payment for the purpose of an obligation.

The SC further noted that, under Section 3(11) of the IBC ‘Debt’ means a liability or obligation in respect of a claim which is due from any person and that it includes a ‘financial debt’ and an ‘operational debt’.Further, Section 5(8) of the IBC defines ‘financial debt’ as debt along with interest, if any, which is disbursed against the consideration for the time value of money and the second part of the definition provides instances/ methods to raise financial debt.

The SC observed that the conjoint reading of the statutory provisions with the enunciation of the SC in Swiss Ribbons Private Limited and Another. v. Union of India and Others. [(2019) 4 SCC 17], clarified the scheme of the IBC, and the intention of the legislature, of the expression ‘financial creditor’ to mean a person who has direct engagement in the functioning of a corporate debtor; who is involved right from the beginning while assessing the viability of a corporate debtor; engaging in restructuring of the loan as well as in re-organization of a corporate debtor’s business.

The SC contrasted the position and role of a financial creditor with that of a person having only security interest over the assets of the corporate debtor. The latter shall have only the interest of realizing the value of its security, there being no other stakes involved and least any stake in the corporate debtor’s growth or equitable liquidation, while the former would, not only safeguard its own interests, but would also be interested in rejuvenation, revival and growth of the corporate debtor, thereby safeguarding the interests of other stakeholders. The SC noted, if a person having only security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have consequential benefits, rights/opinions in the CIRP and/or liquidation process as contemplated under the IBC, the growth and revival of the corporate debtor may be the casualty. Such result would defeat the very objective of the IBC, particularly of the provisions aimed at CIRP.

The SC, therefore, concluded that a person such as the Lender, having only security interest over the assets of the Corporate Debtor, even if falling within the description of ‘secured creditor’ by virtue of collateral security extended by the Corporate Debtor, would nevertheless stand outside the sect of ‘financial creditors’ as per the provisions of the IBC. Hence, it would remain a debt alone and cannot partake the character of a ‘financial debt’ within the meaning of Section 5(8) of the IBC.

Thus, the security interest by way of the Pledge Agreement created in favor of the Lender, made the Lender a secured creditor only. The SC observed that on reading all the defining clauses harmoniously, it is clear that the legislature has maintained a distinction amongst the expressions ‘financial creditor’ and ‘secured creditor’. The SC concluded that every secured creditor and financial creditor would be a creditor; but every secured creditor may not be a financial creditor.

The SC observed that, the analysis as stated above and the consequent ratio of Jaypee Infratech Limited v. Axis Bank Limited (supra) were completely applicable to the present case, since herein the Corporate Debtor had only extended a security by pledging shares of GEL. The SC observed that therefore, the Pledge Agreement and the Deed of Undertaking, executed subsequent to the Facility Agreement, were security in favour of the Lender, who at best will be secured creditor and not the financial creditor qua the Corporate Debtor within the meaning of Sections 5(7) and 5(8) of the IBC.

Decision of the Supreme Court

The SC upheld the decision of the Respondent as approved by the NCLAT that, the Appellant was not a financial creditor of the Corporate Debtor and it also held that the miscellaneous application was rightly rejected by the NCLT.

However, the SC clarified that the observations made in this Judgement were only for deciding the claim of the Appellant as the financial creditor within the meaning of Sections 5(7) and 5(8) of the IBC and, therefore, shall have no bearing on any other proceedings undertaken by the Appellant to establish any of its right(s) in accordance with law. Thereby, the SC dismissed the appeal.

Vaish Associates Advocates View:

The SC distinguished the role of a financial creditor and secured creditor. The SC by this Judgement clarified that if the Corporate Debtor does not owe a financial debt to the Lender, then the Lender cannot be recognized as a financial creditor. The SC observed that, methods for raising debt may include modes prescribed in sub-clauses (a) to (f) of Section 5(8) of the IBC. Further, the judiciary has on multiple occasions clarified without an iota of doubt that for a debt to become ‘financial debt’, the fundamental principle is that the debt must exist and that it ought to be a disbursal against the consideration for time value of money, even if the mode of raising debt is not necessarily as stated in the section, it must at least have the features which could be traced to such essential elements in the principal clause of Section 5(8) of the IBC.

The SC observed the unique position that the financial creditor holds, due to its own direct involvement in a functional existence of the corporate debtor. The SC observed that the financial creditors are entrusted with the task of ensuring the sustenance and growth of the corporate debtor, akin to that of a guardian. In other words, in the context of CIRP, this class of stakeholder, namely, financial creditor, is entrusted by the legislature with such a role that it would look forward to ensure that the corporate debtor is rejuvenated and gets back on its wheels with reasonable capacity of repaying its debts and to discharge its various obligations. Therefore, the role of financial creditors and the consequential benefits they receive, including the voting rights in the committee of creditors, aim for the resolution of the corporate debtor.

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For more information please write to Mr. Bomi Daruwala at [email protected]

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