The conundrum of third-party security holders

By Satish Anand Sharma and Abhimanyu Chandan Rajguru, SNG & Partners

Much has been said about the obligation of a third-party security provider when a borrower enters the corporate insolvency resolution process (CIRP) under the Insolvency and Bankruptcy Code, 2016 (IBC). Under a financing transaction, a corporate borrower’s parent, group or associate entities offer a guarantee or a security, which may be by a pledge of shares or by mortgage or hypothecation of their assets. While guarantees are specifically included in the definition of financial debt under the IBC, the Supreme Court has, in the cases of Phoenix ARC Private Limited v Ketulbhai Ramubhai Patel (Phoenix) and Anuj Jain v Axis Bank Limited (Jaypee Infratech), clarified the status of such third-party security providers under CIRPs.

Satish Anand Sharma, Senior associate, SNG & Partners
Satish Anand Sharma
Senior associate
SNG & Partners

The court in Phoenix took a similar view to that which it took in Jaypee Infratech, in relation to the obligations of third-party security providers. In Jaypee Infratech, it was held that if a corporate debtor has mortgaged its property to the creditor to secure a loan advanced to a third party, the mortgage may fall within the definition of debt in section 3(11) of the IBC – but it is not a financial debt as defined in section 5(8).

In Phoenix, the lender had advanced a finance facility to a borrower, for which Doshion Veolia Water Solutions Private Limited (corporate debtor) had executed an agreement pledging 100% of its shareholding in Gondwana Engineers Limited as a security for the facility advanced to the borrower. A deed of undertaking was executed by the corporate debtor in favour of the lender as security for the facility advanced to the borrower. Subsequently all the rights, title and interest of the lender were assigned to Phoenix ARC.

The issue was whether Phoenix ARC was a financial creditor of the corporate debtor under the IBC, on the basis of the pledge agreement and the deed of undertaking. The Supreme Court answered this issue in the negative, holding that the essence of the definition of a “financial debt” in section 5(8), is that a financial debt is a debt which is disbursed against the time value of money. The second part of the definition sets out instances of financial debt, which include any amount of the guarantee or indemnity in accordance with section 5(8). The court noted that since a contract of guarantee is an undertaking to perform a promise, or discharge the liability of a third person in case of such third person’s default. In this case, the pledge agreement executed by the corporate debtor contained no such promise to discharge the liability, or perform the promise of the borrower. Therefore, the pledge agreement executed by the corporate debtor in favour of the lender was not a contract of guarantee. The court held that Phoenix ARC could not be considered a financial creditor solely on the strength of the pledge agreement executed in its favour by the corporate debtor for the facility advanced to the borrower.

Abhimanyu Chandan Rajguru, Associate, SNG & Partners
Abhimanyu Chandan Rajguru
SNG & Partners

Under section 124 of the Indian Contract Act, 1872, a contract of indemnity is a contract by which one party promises to save another from loss caused to him by the conduct of the promisor himself, or of any other person. The essence of such contract, again, is that there be a promise to discharge the liability of the borrower. However, in the Phoenix and Jaypee cases, the corporate debtors had neither given a guarantee to discharge the obligation, nor provided an indemnity, but had rather, merely provided security for the loans advanced to the third parties.

It is clear that any security provided by the corporate debtor in its capacity as a third-party security provider is a secured debt. However, a creditor in whose favour such security is created does not become a financial creditor under the IBC. Consequentially, such a creditor, despite being a secured creditor, cannot join the committee of creditors (CoC), and will thus, be unable to participate in its proceedings. During the CIRP, such creditor will also not be able to enforce its security interest, due to the moratorium, and the decision of the CoC will be binding on it, even though other options available to it may be more beneficial.

Lenders may avoid such an adverse scenario by ensuring that the security provided by the third party is backed by a corporate guarantee from the third party, or by an indemnity, in terms of section 5(8) of the IBC. Lenders will then be able to participate in the CoC during the CIRP of the third-party security provider.

Satish Anand Sharma is a senior associate and insolvency professional, and Abhimanyu Chandan Rajguru is an associate at SNG & Partners

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