Supreme Court on Third Party Security under IBC- A view from Ivory Tower?

Introduction

In its landmark judgment in Indra Sawhney v. Union of India[i], a nine judges constitution bench of the Supreme Court of India reminded themselves that, “… judges who are entrusted with the task of fostering an advance social policy in terms of the constitutional mandates cannot afford to sit in ivory towers keeping Olympian silence unnoticed and uncaring of the storms and stresses that affect society”.

The trajectory and development of India’s insolvency and commercial law has been set back by the recent judgement of the Supreme Court, in Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited Etc. Etc.[ii] (“Jaypee Judgement-SC”), by overlooking commercial realities and customary banking practice.

Our analysis attempts to demonstrate that the Supreme Court’s ruling that lenders having only a security interest in the assets of the judgement debtor, cannot be treated as financial creditor under the Insolvency and Bankruptcy Code, 2016 (“IBC”), is flawed and merits reconsideration.

In the Jaypee Judgement-SC, the Supreme Court dealt primarily with the issue of preferential transactions under Section 43 (Preferential Transactions and Relevant Time) of the IBC and the extent and scope of financial debt under Section 5(8) of the IBC. The present analysis is restricted to discussing the findings relating to the issue of whether security created in favour of third parties by the corporate debtor, is a financial debt. The analysis does not extend to dealing with the issue or details of the preferential transaction.

Brief Facts

Briefly, Jaypee Infratech Limited (“JIL” or “Corporate Debtor”) mortgaged its immovable properties, as security for a loan provided to Jaypee Associates Limited (“JAL”), i.e. the parent company of the Corporate Debtor. During the corporate insolvency resolution process (“CIRP”) of JIL, the resolution professional refused to recognise the JAL lenders as financial creditors of JIL. The NCLT, Allahabad upheld the decision of the resolution professional. However, in an appeal, the NCLAT overturned the decision of the NCLT, Allahabad and allowed the JAL lenders to participate in the CIRP of JIL.

The Supreme Court (in appeal) upheld the judgement of the NCLT, Allahabad and ruled that the JAL lenders cannot be treated as financial creditors of JIL. The Supreme Court’s reasoning is based on three grounds: (a) a financial creditor must prove that the corporate debtor owes a financial debt to such financial creditor which the JAL lenders failed to show; (b) a third party security provider is only interested in realizing the value of its security and not concerned with the revival of a corporate debtor; and (c) Section 5(8) of the IBC conspicuously omits mortgage within its definition and requires disbursement against the consideration of time value of money. Consequently, the ratio of State Bank of India v. Smt. Kusum Vallabhadas Thakkar[iii] (“Kusum Vallabhdas”) cannot be applied for determining what a financial debt is for the purposes of the IBC.

A financial creditor must prove financial debt

According to the Supreme Court, a “financial debt” under the IBC, mandates the existence of a debt. Consequently, a third party to whom a corporate debtor does not owe a financial debt cannot be regarded as a financial creditor of such corporate debtor. The Supreme Court thus restricted the class of financial creditors under the IBC to either a principal debtor or assignee of such principal debtor.

It is submitted that the Supreme Court has overlooked two important aspects of the matter. First, Section 5(8) of the IBC does not contemplate loan disbursal only to the corporate debtor. The inclusion of a guarantee or indemnity under Section 5(8) (i) of the IBC, suggests that the legislature never intended limiting the definition only to disbursements to the corporate debtor. Indeed, cross-collateralisation of loans is common banking practice among group companies. For instance, in case of a guarantee or indemnity the loan is disbursed to the borrower and not to the guarantor or indemnifier of such borrower. The Supreme Court overlooked the fact that the legislature has treated assignee of a financial creditor as a financial creditor, although the loan is not disbursed by such assignee.

Secondly, the omission of a mortgage or any third-party security from the definition of “financial debt”, was because the expression ‘surety’, encompasses a ‘mortgage’. In other words, there was no need to expressly provide for a mortgage within the definition Section 5(8) of the IBC, as it was included within the embrace of the expression ‘surety’, as explained by the Gujarat High Court in Kusum Vallabhdas.

In a similar situation and prior to Jaypee Judgment-SC, the NCLT, Mumbai in SREI Infrastructure Finance Limited v. Sterling International Enterprises Ltd [iv](“SREI Infra”) relied on the Transfer of Property Act, 1862 to conclude that in case of a mortgage, there is inherent assurance to repay the mortgagee and consequently, such mortgagee deserves to be treated as a financial creditor.

Mortgagee not interested in revival of the Corporate Debtor

The Court reasoned that including JAL lenders as financial creditors of JIL, would defeat the objective of the IBC, as according to it, the mortgagee would only be interested in realising the value of its security and not in the revival of JIL. The Supreme Court heavily relied on Swiss Ribbons Pvt Ltd. & Ors. v. Union of India & Ors.[v](“Swiss Ribbons”) which while holding that there is an intelligible differentia between financial creditors and operational creditors under IBC, clarified that financial creditors are involved with assessing the viability of a corporate debtor and consequently, are better placed to revive a corporate debtor under the IBC as compared to operational creditors.[vi] In our view, the Supreme Court in Swiss Ribbons has aptly differentiated between financial creditors and operational creditors on the basis of involvement of financial creditors in the affairs of a corporate debtor. However, it is difficult to agree with the Supreme Court that a person having only security interest over assets of a corporate debtor has no interest in the growth and revival of such corporate debtor. Such an interpretation will render a mortgagee remediless without any fault on his part. The NCLT, Mumbai in SREI Infra rightly observed that if a mortgagee, being a stakeholder in the mortgaged property, is left out of the process of approving or rejecting a resolution plan then it will be a clear case of violation of natural justice.

The ratio of Kusum Vallabhdas cannot be applied under the IBC

The Gujarat High Court in Kusum Vallabhdas has aptly ruled that, “it is, therefore, fallacious to say that the defendant is not a debtor and, therefore, the defendant could not have created a mortgage in favour of the creditor”. Further, it held, “just as the principal debtor can create a mortgage of his immoveable properties, a third person can also agree to create a mortgage so as to secure the dues of the principal debtor. In that manner, he becomes a surety to the extent of the security or the mortgage”.

The court in Kusum Vallabhdas also appreciated the commercial aspect of third-party security and observed that “In the present-day world of commerce, a person may not have sufficient security to offer for obtaining advances from financial institutions even though satisfying the requirements. In such cases, he draws upon resources of others by asking them to give guarantee and also security for the performance of that guarantee and it is perfectly legitimate and legal way of conducting such commercial transactions. In fact, Chapter VIII of the Contract Act deals with indemnity and guarantee and provides for this kind of tripartite arrangement.”

Interestingly, the Supreme Court in Jaypee Judgement-SC did not declare Kusum Vallabhdas as bad in law, but instead refused to apply it for determining third party security as financial debt under the IBC. Further, the Supreme Court ignored the commercial aspect of creating third party securities which was rightly noted in Kusum Vallabhdas. Financing on the basis of third-party security or guarantee is an established banking practice which often assists funding to those borrowers who are unable to offer their assets as security. The banks and financial institutions enter into such transactions on daily basis and as pointed out in Kusum Vallabhdas such transactions are perfectly legitimate and legal.  It is submitted that the ratio of Kusum Vallabhdas case applies squarely to the IBC and is not in conflict with the provisions of IBC.

Conclusion

It is submitted that the Jaypee Judgment-SC is not in sync with either the market expectations/requirements or the objective of the IBC. Excluding third party security transactions from the purview of IBC will create grave challenges for banking system and will hamper credit flow in the system. The upshot of the judgement is that mortgagees will have no say in approval of any resolution plan.

The judgement is productive of grave public mischief and it would in the interest of time be best if the definition of ‘financial debt’ be amended to include a mortgage (and other third party securities like pledge), due to the time

[i] 1992 Supp (3) SCC 217.

[ii] Civil Appeal Nos. 8512-8527 of 2019.

[iii] 1991 SCC Online Guj 14.

[iv] C.P. 402 of 2018.

[v] Writ Petition (Civil) No. 99 of 2018.

[vi] Refer para 28 of Swiss Ribbons.