IBC: Intent continues to prevail over form

By Charanya Lakshmikumaran and Puneeth Ganapathy, Lakshmikumaran & Sridharan

The Insolvency and Bankruptcy Code, 2016 (code) whose objectives and implementation constantly appear to be in opposition, continues to provide material for purposive interpretation by the Supreme Court. The recent decision of Anuj Jain v Axis Bank Ltd and Others, gave one more such opportunity to the court.

Charanya Lakshmikumaran
Lakshmikumaran & Sridharan

Policy against preferential transactions: Controlling stakeholders of financially stressed companies (company) may resort to transferring value away from it for their personal benefit. In such circumstances, in order to protect other stakeholders in the company the code provides that when the company enters insolvency proceedings the resolution professional can seek to avoid previous preferential transactions made by the company. This effectively reverses the detrimental impact of such transactions on the assets of the company. In Anuj Jain, assets were mortgaged by Jaypee Infrastructure Limited (JIL) as security for existing borrowings of its parent company, Jaiprakash Associates Limited (JAL). The resolution professional in the insolvency of JIL sought to avoid these mortgages as being preferential transactions. This would ensure that JIL’s assets would not be encumbered by the mortgages, and would be better valued. The Supreme Court agreed that these were preferential transactions, thus releasing the assets of JIL from the mortgages.

Puneeth Ganapathy
Principal Associate
Lakshmikumaran & Sridharan

However, the code accepts as valid those transactions made in the ordinary course of business of the corporate debtor or the transferees, in this case the lenders. The lenders holding these mortgages argued that their transactions were covered by this exemption. A literal interpretation of the provision would mean that as long as the preferential transactions were in the ordinary course of business of the lenders they would be protected. The Supreme Court, however, held that “or” was to be read as “and” reasoning that this better served the objectives and purposes of the code. The court decided that if the literal interpretation were applied, a large proportion of preferential transactions would be excluded from insolvencies as having been made in the ordinary course of business of either the company or the transferee. However, the objective of the code was generally against preferential transactions, which deplete the assets of the debtor company. The Supreme Court held that it had to be shown that the mortgages as preferential transactions were made in the ordinary course of business of the debtor company and the transferee.

The court also held that a mortgage being given by a subsidiary in financial difficulties in favour of lenders of its parent, could not be seen as being in the ordinary course of business of that subsidiary. Thus, accepting the assets of a financially weak subsidiary as security for the borrowings of the parent, may no longer be prudent for lenders. Such transactions may become worthless after being avoided as preferential transactions.

Definition of financial creditor: Financial creditors as a class of creditors have been given a special position in the code, including the resolution of the insolvency of the debtor. In Anuj Jain, lenders of JAL wanted to be treated as financial creditors of JIL on the strength of the mortgages over JIL’s assets. This would enable them to take part in the resolution and insolvency of JIL, although their loans were only made to JAL.

The Supreme Court held that a financial creditor was one who had loaned money to a corporate debtor and would be interested in its restructuring. A financial creditor is someone who is always interested in the viability of the borrower company and thus is given a pivotal role to play during the corporate insolvency resolution process under the code. When third-party security is obtained for such loans, the lender is presumably not interested in the viability of the third-party company since the lender does not provide any loan to it. It thus does not act as a financial creditor of this third-party company as contemplated under the code. The court said that giving a contrary, expansive definition to the term financial creditor would enlarge the committee of creditors, thereby complicating the insolvency resolution process.

A lender will accordingly be a financial creditor under the code in insolvency proceedings only of the direct borrower company, not in the insolvency proceedings of any third-party company that has only provided security for the borrowing.

While this rationale may seem applicable to other categories of third-party collateral security, the application of this decision to each category will have to be settled by the courts. However, it appears that the purposes of the code and its underlying policy objectives will remain the bedrock for judicial interpretation.

Charanya Lakshmikumaran is a partner and Puneeth Ganapathy is a principal associate at Lakshmikumaran & Sridharan.

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