Secured creditors not always financial creditors

By Karthik Somasundram, Sneha Jaisingh and Alabh Lal, Bharucha & Partners
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In Phoenix Arc Pvt Ltd v Ketulbhai Ramubhai Patel, the issue before the Supreme Court was whether a person holding a security interest over the assets of a corporate debtor in respect of the debt of a third party would be considered a financial creditor of the corporate debtor under the Insolvency and Bankruptcy Code, 2016 (code).

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Karthik Somasundram
Partner
Bharucha & Partners

Doshion had obtained financial facilities from L&T Infrastructure Finance Company. These debts were later assigned to Phoenix, the appellant. Doshion’s subsidiary, Doshion Veolia Water Solutions (corporate debtor), had pledged certain securities to secure Doshion’s borrowing through a pledge agreement. Corporate insolvency resolution proceedings were initiated against the corporate debtor when it defaulted on its borrowings. The appellant filed a claim with the resolution professional of the corporate debtor for the entire amount outstanding from Doshion on which Doshion had separately defaulted.

The resolution professional rejected the appellant’s claim on the grounds that the corporate debtor’s liability was limited to the value of the pledged shares. The appellant’s application to the National Company Law Tribunal seeking a direction that the resolution professional admit the claim was rejected. An appeal to the National Company Law Appellate Tribunal (NCLAT) also failed as the appellant had not disbursed any amount to the corporate debtor against the time value of money and was not, therefore, a financial creditor.

The issues which required determination were whether the pledge agreement could amount to a guarantee and whether such a guarantee could be considered a financial debt under the code. The court ruled that while the facility advanced to Doshion was a financial debt, the appellant’s arrangement with the corporate debtor was not one to perform Doshion’s promise or discharge its liability in the event of a default. The pledge agreement did not require that the corporate debtor discharge Doshion’s liability in the event of its non-repayment, and it was Doshion alone who had promised to discharge that liability. Therefore, the pledge agreement was not a guarantee as defined in section 124 of the Indian Contract Act, 1872.

Sneha Jaisingh,Bharucha & Partners
Sneha Jaisingh
Partner
Bharucha & Partners

With respect to the second issue, the court cited its earlier judgment in the case of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v Axis Bank Ltd and Ors, in which a similar issue concerning mortgage security had arisen. In that case, Axis Bank had been recognised as a financial creditor by the NCLAT, as the corporate debtor had mortgaged its assets to secure the borrowings of its holding company. The court reversed the NCLAT’s decision and held that, under the code, a person having only a security interest over the assets of a corporate debtor is distinguishable from a financial creditor who has a vested interest in the functioning of the corporate debtor. A third party to whom a financial debt is not owed cannot become a financial creditor of the corporate debtor.

The court relied on its judgments in Swiss Ribbons Pvt Ltd & Anr v Union of India & Ors and Pioneer Urban Land & Infrastructure Ltd v Union of India to hold that a debt would only be classified as financial debt if it was disbursed against the consideration for the time value of money. The court further ruled that since the corporate debtor had created security over its assets to secure a loan to Doshion, the appellant would only be a secured creditor and, in the absence of an express obligation in the pledge agreement to pay the outstanding amounts, the appellant could not be considered a financial creditor.

The Supreme Court has clarified the scope of financial debts and has relied on established principles to determine the nature of a debt. In order to proceed against a pledgor or any security provider for the entire outstanding amount, secured creditors must ensure that the pledge or security documents contain a specific obligation by which the security provider is liable for the discharge of the entire liabilities of the party on whose behalf security has been created.

Karthik Somasundram and Sneha Jaisingh are partners at Bharucha & Partners. Alabh Lal, an associate, assisted with the article

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