Jaypee judgment creates a conundrum for lenders

By Soumyajit Mitra and Mohit Yadav, SNG & Partners

The Supreme Court (SC) in deciding several issues in litigation calling into question the meaning and scope of preferential transactions in corporate insolvency and the nature of financial debt particularly in relation to third-party mortgages, upheld an order of the National Company Law Tribunal (NCLT) that cancelled the mortgages created by Jaypee Infratech Limited (JIL) to secure the financial debts of its holding company Jaiprakash Associates Limited (JAL).

Soumyajit Mitra
Principal associate
SNG & Partner

The NCLT had allowed an application filed by the interim resolution professional appointed in the JIL corporate insolvency resolution process (CIRP) that sought the avoidance of certain transactions, in which JIL had mortgaged nearly 758 acres of land as collateral security for loans and advances made by the lenders of JAL, as being preferential, undervalued and fraudulent under sections 43, 45 and 66 of the Insolvency and Bankruptcy Code, 2016 (code).

In interpreting section 43 of the code, the SC held that the transfers in question could be considered outside the purview of section 43(2) only if it could be shown that they were made in the ordinary course of business or the financial affairs of the corporate debtor JIL and the transferees. The court further held that even if providing a security was in the normal course of business, it would be in the ordinary course of business of a particular corporate entity only if it was shown to be part of “the undistinguished common flow of business done”, and did not arise out of “any special or particular situation”.

Mohit Yadav
SNG & Partners

The SC further held that the ordinary course of business or financial affairs of JIL could not be considered to include the provision of mortgages to secure the loans and facilities obtained by JAL, particularly as this was at the cost of its own financial health. Therefore, these transactions were held to be preferential and the securities created by JIL over the properties in question were discharged in whole.

However, the lenders of JAL argued that the interpretation that the transactions were preferential would impact a large number of banking transactions and would adversely affect the economy. The SC rejected this argument and held that it was the duty of the banks to conduct due diligence to ensure the third party whose security is being taken, was not already indebted or in the red and was not likely to fail in dealing with its own indebtedness.

The lenders should also check that the third-party security was a prudent and viable one and is not likely to be adversely affected by any law. The SC noted that the banks could not plead ignorance about the actual state of affairs and financial position of JIL as they were also direct creditors of JIL, to the extent of the advances they had made to JIL.

The SC characterized the essential nature of a financial creditor as one who, apart from protecting its own interest, would be interested in the rejuvenation, revival and growth of the corporate debtor. Thus, if a lender having only a security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have its say in the processes contemplated by part II of the code, the growth and revival of the corporate debtor may be the casualty. Such a result would defeat the very objectives and purpose of the Code, particularly those provisions governing the CIRP.

Therefore, the SC held that the lenders to JAL, holding the mortgages in question would fall into the category of secured creditors. However, as such mortgages did not represent any loan, facility or advance to the corporate debtor nor towards protecting any facility or security of the corporate debtor, it could not be said that the corporate debtor owed them any financial debt within the meaning of section 5(8) of the code. Hence, such lenders to JAL did not fall into the category of financial creditors of the corporate debtor of JIL.

The decision of the SC in the present case may be treated as a seminal case in the jurisprudence of preferential transactions under sections 43, 45 and 66 of the code. Although in deciding whether the lenders to JAL can be categorized as financial creditors of JIL, the definition clauses of the code do support such an interpretation, it will be interesting to see what impact it has on financial creditors in situations where CIRPs start simultaneously against the principal borrowers and the third party security providers in respect of their existing claims filed with the resolution professional in those CIRPs.

SNG & Partners has offices in New Delhi, Mumbai and Singapore. Soumyajit Mitra is a principal associate and Mohit Yadav is an associate.

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