Pledging shares does not create a financial creditor

By Shweta Bharti and Nitesh Sachdeva, Hammurabi & Solomon
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In Phoenix Arc Pvt Ltd v Ketulbhai Ramubhai Patel, the Supreme Court held that a creditor cannot be a financial creditor on the basis of a pledge agreement unless that agreement contains an undertaking to repay the debt of the corporate borrower.

Shweta Bharti
Senior partner
Hammurabi & Solomon

The lender, L&T Infrastructure Finance Company Limited, advanced a financial facility of 400 million (US$5.5 million) to Doshion Limited, the holding company of the corporate debtor, Doshion Veolia Water Solutions Private Limited. The corporate debtor and the lender entered into a pledge agreement by which 40,160 shares of another company were pledged as security. In a separate agreement, the lender assigned to Phoenix all rights, title and interest in the financial facility, including any security or interest thereon.

A corporate resolution process was initiated against the corporate debtor and Phoenix lodged a claim with the interim resolution professional (IRP) of the corporate debtor. The IRP rejected the claim of Phoenix on the basis that the agreement restricted the liability of the corporate debtor to the pledge of the shares only. The IRP also rejected the claim of Phoenix to be a financial creditor of the corporate debtor. The National Company Law Tribunal and the National Company Law Appellate Tribunal upheld these decisions in the light of the provisions of section 5(8) of the Insolvency and Bankruptcy Code, 2016 (code). Phoenix appealed against these decisions

The court was dealing with the question of “whether the appellant can be a ‘financial creditor’ solely on the basis of this pledge agreement” and analysed the provisions of sections 5(7) and 5(8) of the code, which respectively define financial creditor and financial debt. Relying on its own judgments in 2019 in Swiss Ribbons Pvt Limited and Anor v Union of India and Ors and Pioneer Urban Land and Infrastructure Limited and Anor v Unions of India and Ors, the court held that, for a creditor to become a financial creditor, a financial debt must be owed to them. The creditor may be a principal creditor to whom the financial debt is owed, or he may be an assignee of that debt. Following the analyses in these earlier cases, the Supreme Court held that an entity that has only a security interest over the assets of the corporate debtor, even if they fall within the definition of a secured creditor by virtue of collateral security extended by the corporate debtor, is not a financial creditor as defined in sections 5(7) and 5(8).

Nitesh Sachdeva, Senior associate, Hammurabi & Solomon
Nitesh Sachdeva
Senior associate
Hammurabi & Solomon

The court further relied on the cases of Swiss Ribbons and Anuj Jain v Axis Bank Limited in analysing the liability arising out of a guarantee or indemnity under the Indian Contract Act, 1872 (act). Section 126 of the act defines a contract of guarantee as including an agreement to perform the promise or discharge the liability of a third person in case of their default. In the present case, the assignment to the appellant did not contain an undertaking by the corporate debtor to discharge the liability of the borrower, and was therefore not a guarantee. The appellant was at best a secured creditor as against the corporate debtor and not a financial creditor under sections 5(7) and 5(8) of the code.

The Supreme Court therefore upheld the decision of the IRP as approved by the NCLT and the NCLAT, and held that the appellant was not a financial creditor of the corporate debtor. However, the court also made it clear that the observations in this judgment are meant only to decide the claim of the appellant to be a financial creditor within the meaning of sections 5(7) and 5(8) of the code.

While the present case may be thought of as merely upholding the court’s earlier ruling in Anuj Jain, it may be thought to carry more weight as it was decided by a larger bench.

This judgment has appropriate and important lessons for those undertaking commercial, corporate, banking and financial transactions. It is now clear that creditors holding third party securities are not financial creditors under the code, and that their debt claims will not stand against the grantors of such securities or corporate debtors. A third-party security agreement should contain an undertaking by the corporate debtor to discharge the liability of the borrower. Only then will the security be a guarantee and fall within the definition of financial debt under the code.

Shweta Bharti is a senior partner and Nitesh Sachdeva is a senior associate at Hammurabi & Solomon

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