Rethinking 'Third-Party Security Providers’ Liability Under the IBC

Introduction

Post introduction of the new insolvency regime in India under the Insolvency and Bankruptcy Code, 2016 (“IBC”), a lot has been discussed and debated on the extent of liability of a third-party security provider when a borrower is dragged into the insolvency resolution process (CIRP) proceedings under the IBC. Typically in a lot of financing transactions, to secure any financing availed by a corporate borrower, its parent entity(s) or group companies offer a guarantee or security. While the position as to the treatment of such ‘guarantor’ under the IBC is generally understood clearly now, the recent judgment of the Hon’ble Supreme Court in ‘Phoenix Arc Private Limited vs. Ketulbhai Ramubhai Patel settles the conundrum as regards the treatment of such ‘third-party security provider’ in CIRP proceedings.

Facts of the case

Vide the terms of facility agreement dated May 12, 2011, a facility of approximately INR 40 Crores (“Facility”) was extended by the L and T Infrastructure Finance Company (“Original Lender”) to Doshion Limited (“Borrower”). As security for the Facility, Doshion Velio Water Solutions Private Limited (a subsidiary company of the Borrower) (“Corporate Debtor”) executed a non-disposal undertaking and pledge, whereby the Corporate Debtor committed that it will not dispose off its 100% (one hundred percent) shareholding in Gondwana Engineers Limited (“GEL”) as long as any amounts were outstanding in relation to the Facility.) The Corporate Debtor also pledged 40,160 (Forty Thousand and One Hundred and Sixty) shares of GEL held by it in favour of the Original Lender.

Subsequently, by an agreement dated December 30, 2013, the Original Lender, assigned all rights, title and interest in relation to the Facility including any security, interest therein in favour of Phoenix ARC Pvt. Ltd. (“Assignor”), under Section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Thereafter, pursuant to default by Borrower, the Assignor instituted proceedings before the Debts Recovery Tribunal, Ahmedabad.

Subsequently, a section 7 application was filed by the Bank of Baroda on August 31, 2018, to initiate CIRP proceedings against the Corporate Debtor in the National Company Law Tribunal, Mumbai (“NCLT”) which was admitted. Pursuant to the commencement of CIRP, the Assignor then filed its claim for an amount of approximately INR 83 Crores with the resolution professional (“RP”), under the extant provisions of the IBC. The same was rejected by the RP and the NCLT (upon an application made to the NCLT) on the ground that the Assignor was not a ‘financial creditor’ under Section 5(8) of the IBC.

Aggrieved by the judgment of the NCLT, an appeal was filed by the Assignor before the National Company Law Appellate Tribunal (“NCLAT”). The NCLAT dismissed the appeal by holding that the pledge of shares under the Pledge Agreement in question does not amount to “disbursement of any amount against the consideration for the time value of money” and thus, does not fall within the purview of sub-clause (f) of sub-section (8) of Section 5 of the IBC. Hence, an appeal was then filed before the Supreme Court.

What the Supreme Court Held

The Supreme Court analyzed whether the Corporate Debtor owed any financial debt to the Assignor within the meaning of the IBC. While it was argued on behalf of the Assignor that the Corporate Debtor pledging its shares in GEL was “to give indemnity for a credit facility and which is in a sense of guarantee” and hence constituted a ‘financial debt’ under Section 5(8)(i) of the IBC, the Supreme Court upheld the decision of the NCLT and NCLAT. The Supreme Court noted that it is not the case that the “Corporate Debtor has entered into a contract to perform the promise, or discharge the liability of Borrower in case of his default”; it was the Borrower who had undertaken to repay the Facility and as such the pledge and non-disposal undertaking provided by the Corporate Debtor does not itself amount to a contract of guarantee within the meaning of Section 126 of the Indian Contract Act, 1872.

The Apex Court also relied on its earlier judgments in Swiss Ribbons (P) Ltd. v. Union of India and Pioneer Urban Land & Infrastructure Ltd. v. Union of India wherein the Supreme Court distinguished ‘financial debt’ from that of other debts, such as a ‘mortgage debt’ (when a corporate debtor is only mortgaging its property to secure the debts of a third party borrower). Along the same lines, it held that a “person 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 not be covered by the financial creditors”, within the pertinent sections of the IBC. Accordingly, the Supreme Court rejected the contentions of the Assignor that an indemnity/security provider obligations of the Corporate Debtor should be read to constitute a guarantee.

At best, it was noted, that such Assignor can be a ‘secured creditor’ by virtue of the Corporate Debtor extending the security, but will not qualify or be treated as a ‘financial creditor’ under the IBC. The Court also refused to entertain the submission made on behalf of the Assignor that the Corporate Debtor has been the direct and real beneficiary of the Facility advanced to the Borrower.

Implications

The Supreme Court did not explicitly deal with the issue on whether or not once the Facility was recalled, the Corporate Debtor was also, simultaneously called upon to repay the Facility and its related dues, and whether such claim was made only once CIRP was initiated against the Corporate Debtor. However, this judgment makes it quite clear that all security providers/secured debtors may not qualify as owing ‘financial debt’ to a lender thereby making him a ‘financial creditor’ within the meaning of the IBC.

Given this context, it becomes very important to draft security documents such that all third party security providers also undertake to repay the debt owed by the borrower, wherever possible. This will blur the lines between other forms of security and guarantees, but if such an obligation is not cast upon third-party security providers the lender(s) may find themselves unable to access remedies under the IBC against such security providers.