Substance over Form: Supreme Court’s Approach to Security Deposits as Financial Debt in Insolvency Cases
Urja Joshi
Law Graduate, B.B.A, LL.B (Hons.),
SVKM’s Narsee Monjee Institute of
Management Studies (NMIMS), Bangalore
&
Soumya Tongaonkar
Final Year, B.A., LL.B. (Hons.),
SVKM’s Narsee Monjee Institute of
Management Studies (NMIMS), Bangalore
Introduction
One of the prominent features of the Insolvency and Bankruptcy Code 2016 (IBC) is its classification of debts into “operational debt” and “financial debt” thereby leading to operational and financial creditor.
Operational debt under Section 5(21) of IBC is characterized as a claim or due payable for services and goods consumed (instances include payments to employees and suppliers or any arrangements for providing services). Financial Debt under Section 5(8)(f) of IBC is characterised as claim or due payable along with an accrued interest representing a financial relationship as it is disbursed against the consideration of “Time Value of Money” (TVM).
It is important to highlight that as per the Insolvency Law Committee Report of 2018 the TVM implies “The words “time value” have been interpreted to mean compensation or the price paid for the length of time for which the money has been disbursed. This may be in the form of interest paid on the money, or factoring of a discount in the payment.”
This categorization is essential not just for organization, but because the rights, duties and procedural framework for debt recovery vary between financial and operational creditors.
Additionally, the priority of claims during an insolvency proceeding is determined by this classification.
IBC under its Section 53 which is its waterfall mechanism, follows a prioritisation of claims. The classification of security deposits would not only help in identification of the priority of distribution of proceeds but also factor in the representation in the Committee of Creditors (CoC).
The Security Deposits play an integral role in commercial transactions and contractual agreements, serving as a form of financial security or collateral. In such transactions, the core benefit lies in mitigating risk through the security deposit, which addresses potential loses and non-performance of the obligations. The importance of security deposit is outlined in Section 51 of the Indian Contract Act 1872 which essentially deals with reciprocal promises, wherein the security deposit can be considered one such consideration for performance of a contract. Additionally, the Section 55 (6) of Transfer of Property Act 1882 also highlights the payment of premium which can be construed as security deposit as part of the lease agreement. It was only IBC which didn’t have security deposits considered as financial deposits.
Brief Contextual Background
In many cases, the Supreme Court of India (SC) has addressed issues regarding the categorization of creditors when the law was unclear. These complexities often require judicial interpretation to ensure fair treatment and uphold the principles of the IBC.
In Pioneer Urban Land and Infrastructure Ltd. & Anr. v. UOI & Ors. (2019) ibclaw.in 13 SC, the SC upheld the 2018 amendment and provided homebuyers with the status of financial creditors by interpreting TVM and broadening its ambit by highlighting that, TVM should be construed not just as regular returns i.e. interest in this context but as a concept which that exists and can take various forms of such economic benefit. The advance payments made by homebuyers were considered as financial debt as the amount held TVM as the advance repayment provided economic benefit to the developer by not approaching a banking institution.
In New Okhla Industrial Development Authority (NOIDA) v. Anand Sonbhadra(2022) ibclaw.in 38 SC, the SC in this case ruled that Noida’s land lease dues weren’t financial debt and outlined that for a ‘debt’ to be considered ‘financial debt’ there has to be disbursement of monies from the creditor to the debtor which wasn’t the case here and so, NOIDA was put in operational creditor category.
In M/s Consolidated Construction Consortium Limited v. M/s Hitro Energy Solutions Private Limited (2022) ibclaw.in 09 SC, the SC said that an amount given as advance for obtaining goods or service shall be categorized as operational debt and the person who pays it shall be an operational creditor.
Recently, in Global Credit Capital Limited & Anr. v. Sach Marketing Pvt. Ltd. & Anr. (2024) ibclaw.in 125 SC, the SC delved into the categorization of financial and operational creditors in the context of “security deposits”, providing further guidance on this intricate matter.
Factual Matrix of the Case
The case revolves around two agreements dated 1st April 2014 and 1st April 2015 between a corporate debtor and Sach Marketing Pvt. Ltd. (SM), wherein SM was appointed as a ‘Sales Promoter’ for the debtor’s beer business in Ranchi. The 2014 agreement required SM to deposit a minimum security of Rs.53,15,000/- which would carry 21% annual interest, with the debtor paying interest on Rs.7,85,850/-.
The 2015 agreement had identical terms, except the debtor was to pay interest on Rs.32,85,850/- at 21% per annum. After insolvency proceedings were initiated against the corporate debtor by Oriental Bank of Commerce on 12th June 2018, SM filed a claim of Rs.53,15,000/- as a financial creditor on 19th September 2018, which was initially partly accepted but later rejected by the Resolution Professional. SM challenged this before the NCLT and NCLAT. While the NCLT rejected SM’s plea, the NCLAT allowed the appeal and held that SM was indeed a financial creditor, not an operational creditor, by its judgment dated 7th October 2021.
This NCLAT judgment became crucial in related appeals by four other creditors with claims totalling over Rs.2.62 crores, whose claims as financial creditors were also initially rejected but later allowed by the NCLAT based on its findings in SM’s case.
Analysis
The SC’s ruling in the present case hinges on the interpretation of the terms “financial debt” and “operational debt” as defined under the IBC. This distinction is crucial in determining the legal and financial implications for the parties involved, particularly concerning the rights and obligations of the creditor and debtor.
- Test for determining Financial Debt
According to the IBC, financial debt is defined by three key criteria along with making it necessary to have an existence of a debt involving a principal amount which accrues interest making sure that the debt is quantifiable as an associated cost of borrowing.
- disbursal of money,
- time value of money, and
- the commercial effect of borrowing.
The appellants argue that the security deposit is not a financial debt but rather a conditional payment for securing a service appointments as it does not exhibit the typical features of a financial debt.
In contrast, the first respondent highlights the commercial aspects of the transaction to support their view that the security deposit qualifies as financial debt. They point out that the security deposit carries an interest rate of 21% per annum, which is a characteristic of financial debt. Additionally, the corporate debtor has treated this deposit as a liability by deducting Tax Deducted at Source (TDS) on the interest paid, thereby recognizing the interest obligation over multiple financial years. This recognition by the corporate debtor indicates that they view the security deposit and its associated interest as a financial obligation.
- Judicial Interpretation and Precedents
The court scrutinizes precedents to elucidate the nature of such transactions. In cases like Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited (2020) ibclaw.in 06 SC, the SC took a nuanced approach of highlighting the difference between mortgage and financial debt and outlining that holding a security interest doesn’t qualify a creditor to be financial creditor and for the debt to be financial debt there has to be disbursement of funds to the corporate debtor and that it must be against the consideration for TVM implying invocation of corporate guarantee is not enough to create a financial debt with the guarantor company.
In Phoenix ARC Private Limited v. Spade Financial Services Limited (2021) ibclaw.in 03 SC, the court held that the collusive commercial arrangement between the creditors and debtors do not constitute a financial debt which adds a new dimension to evaluating what qualifies as financial debt beyond just the form of the transaction.
These cases demonstrate that the nomenclature used in agreements cannot obscure their true substance and financial implications. It is essential to look beyond the terminology and examine the actual nature and impact of the transactions involved. The essence of the transaction, including how it is managed and reported financially, takes precedence over its nominal designation. This principle ensures that the true economic realities are acknowledged and appropriately handled in legal and financial contexts.
In this context, the expansive provision under Section 5(8)(f) of the IBC, which covers any transaction with a commercial effect akin to borrowing, is especially crucial. The claim that the security deposit acted as a strategic tool for raising finance further solidifies its classification as financial debt rather than operational debt.
- Commercial Reality and Intention
Despite the appellants’ assertion that the security deposit was merely a performance guarantee for promotional services, the court said that the structured repayment terms and the high interest rate has an intention of a financing arrangement. This interpretation aligns with the notion that the form and substance of a transaction must be consistent with its commercial reality. The absence of service provision, as highlighted by the first respondent, further undermines the claim of the transaction being purely operational.
The SC observed that the written arrangements between the corporate debtor and SM for the transfer of funds fulfilled the definition of ‘transaction’ under Section 3(33) of the IBC the corporate debtor’s financial statements reflected the interest paid to SM on the security deposit amount under the headings ‘long-term loans and advances’ and ‘other long-term liabilities’.
This accounting treatment was a pivotal factor that led the SC to conclude that the amount raised under the agreements had the ‘commercial effect of borrowing’.
Drawing from the reasoning in Pioneer Urban Land, the Court reiterated that clause (f) of Section 5(8) is a residuary provision capturing transactions that have the economic realities of a borrowing arrangement, despite their form. In the present case, the corporate debtor’s accounting treatment mirrored the intent of raising finance through these agreements, akin to borrowings.
Through this expansive interpretation of ‘commercial effect of borrowing’ under Section 5(8)(f), the SC has effectively prevented formalistic interpretations from subverting the IBC’s substantive objectives. The Court’s approach accords primacy to the commercial substance and economic realities of transactions, rather than being constrained by their form or nomenclature in the underlying agreements.
