Third Party Security Not a Financial Debt – Supreme Court Shows the Path
-Richa Pathak (LL.M., LSE, IIM-A) and Mansi Mishra (4th, B.A.LL.B. (Hons.), National Law Institute University, Bhopal)
After almost four years since the Insolvency and Bankruptcy Code, 2016 (“IBC”) came into force, the Supreme Court of India finally had the opportunity of clearing the air around treatment of third-party security claims under a corporate insolvency resolution process (“CIRP”). A third-party security means a security which has been created by a party over its own assets for securing the repayment of a debt disbursed in favour of a party other than the party providing such security. A consistent view on the ambit of Section 5(8) of IBC qua third-party securities was given by the Court in two judgments recently Phoenix ARC Pvt. Ltd. v. Ketulbhai Ramubhai Patel (2021) ibclaw.in 04 SC (“Phoenix ARC Case”), decided on 3 February 2021, and in the case of Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited Etc. Etc.  ibclaw.in 06 SC, (“Jaypee Infratech Case”) decided on 26 February 2021. This article seeks to discuss the aforementioned rulings and highlight its implications on the fate of third-party securities vis-à-vis IBC.
Jaypee Infratech Case
In this case, Axis Bank (“Axis”) had provided financial assistance to Jaiprakash Associates Ltd. (“JAL”), which is the holding company of Jaypee Infratech Ltd. (“JIL”). JIL had mortgaged its several properties as collateral securities for the advanced made by Axis to JAL. Subsequently, when CIRP was initiated against JIL, Axis claimed to be a financial creditor of JIL and demanded its inclusion in the committee of creditors with voting rights. This claim was rejected by the Interim Resolution Professional of JIL. As a result, Axis filed an application before the National Company Law Tribunal (“NCLT”), which upheld the decision of the Interim Resolution Professional. Later, the National Company Law Appellate Tribunal (“NCLAT”) had allowed Axis’s appeal, as a result of which JIL preferred an appeal before the Supreme Court.
One of the issues before the Court was whether Axis could be treated as a financial creditor in the CIRP of JIL basis the third-party mortgage created to secure JAL’s loans. The Court undertook a detailed analysis of the concept of ‘financial debt’ defined under Section 5(8) of IBC and revisited its judgment in the case of Swiss Ribbons (P) Ltd. v. Union of India  ibclaw.in 03 SC. While doing so, the Apex Court noted that one element which is common in all the items mentioned in sub-clauses (a) to (i) of Section 5(8) is the existence of debt that has been disbursed against the consideration for time value of money. Further, the definition cannot be construed in a manner wherein the existence of ‘disbursement’ can be done away with merely because ‘consideration for time value of money’ is present. The judgment rendered by the Apex Court itself in Pioneer Urban Land & Infrastructure Limited v. Union of India  ibclaw.in 13 SC was relied upon to hold that every secured creditor is a creditor and every financial creditor is also a creditor, but every secured creditor may not be a financial creditor. The thin line distinguishing the both was derived from the reasoning that financial creditors are involved in assessing the viability of a corporate debtor from the very beginning. This involvement may be missing in case of a third-party security. Accordingly, a third party to whom a corporate debtor does not owe a financial debt cannot be treated as a financial creditor for the purpose of CIRP. Therefore, the claim of Axis was rejected.
Phoenix ARC Case
As per the factual matrix of the Phoenix ARC Case, L&T Infrastructure Finance Company (“L&T”) had entered into a facility agreement with Doshion Limited (“DL”). Under the Schedule named “Security Creation”, a non-disposal undertaking was issued by the board of directors of Doshion Veolia Water Solutions Private Limited (“Corporate Debtor”) in favour of L&T, wherein the former undertook that 100% of their shares in Gondwana Engineers Limited (“GEL”) shall not be disposed so long as any amount remained outstanding under the facility agreement. Thereafter, a pledge agreement was executed between the Corporate Debtor and L&T whereby 40,160 shares of GEL were pledged as a security. Subsequently, the right, title and interest, including with respect to the security, in the facility were assigned to Phoenix ARC Pvt. Ltd. (“Phoenix ARC”). DL eventually failed to repay as per the terms of the facility agreement. In a separate set of events, an application under Section of the IBC was filed against the Corporate Debtor which was admitted by the NCLT. As a corollary, Phoenix ARC filed its claim with the appointed Resolution Professional (“RP”), and the latter opined that the debt owed to Phoenix ARC is in nature of a security and hence, cannot be admitted as a financial debt. When the matter went before the NCLT, it was argued by Phoenix ARC that the pledge of shares is in nature of a guarantee which would make it a financial creditor of the Corporate Debtor. The NCLT rejected such a view, as a corollary of which Phoenix ARC preferred an appeal before the NCLAT and subsequently the Apex Court.
Before the Supreme Court, it was vehemently contended by Phoenix ARC that the liability of the Corporate Debtor is co-extensive to that of DL because the former is a surety of the latter. Hence, the creditor has a right to pursue a remedy against the surety before proceedings against the principal debtor. In other words, “any security that would permit the right of action against the third party that is not the borrower, would amount to guarantee”. Reliance for the same was placed on Section 123 of the Indian Contract Act, 1872 (“Contract Act”). On the other hand, the RP argued that Section 5(8) of IBC includes only guarantee, and not any other instrument in the nature of guarantee. Accordingly, the issue before the Apex Court was whether Phoenix ARC was a financial creditor within the meaning of Section 5(8) of IBC on the strength of the pledge agreement. The Court noted that a contract of guarantee means a contract to perform the promise, or discharge the liability of a third person in case he commits a default. The pledge agreement in question is limited to pledge of 40,1160 shares as security, and the Corporate Debtor has not promised to discharge the liability of DL. It was ultimately concluded by the Court that at best Phoenix ARC will be a ‘secured creditor’ of the Corporate Debtor, but not a financial creditor.
The above two judgments rendered by the Supreme Court has nullified the claims of lenders holding a third-party security demanding to be treated as financial creditors under IBC. The unfavourable consequence flowing from such a position is that such secured creditors would not be made a part of committee of creditors and have no say in rejecting resolution plans that do not satisfy their claims as per their expectations. The rulings have also brought into light the difference between a contract of guarantee and creation of security. While a contract of guarantee makes a surety liable for discharge of liability of a principal debtor, creation of security binds the provider of such security only to the extent of the security interest created.
The Apex Court has outrightly rejected the concept of a mortgage or a pledge in the nature of a guarantee. Especially in Phoenix ARC Case, the claim for treating pledge agreement in the nature of a guarantee was rejected because a deed of guarantee was absent. This stance of the Court is not necessarily in line with practice in the United Kingdom, which is also a common law country like India, where if a third-party security does not contain any personal obligation to pay on the part of the mortgagor, it can be treated like a limited recourse guarantee. Furthermore, the principle in the landmark case of Boston v. Salmon  2 Ch 48 dictates that the rights and duties applying with respect to indemnities and guaranties are also applicable to a third-party security. Hence, the Supreme Court has set a slightly different precedent that its other common law counterparts. This blanket bar on third-party security not being treated in the nature of guarantee also runs the risk of undermining the settled position of law that a contract of guarantee need not be express, it can be implied from the terms agreed upon by the parties. Nevertheless, the key takeaway as per the law, as it currently stands, remains that lenders need to be cautious while accepting third-party securities, and incorporate explicit guarantee provisions if they wish the doors of committee of creditors to remain open to them.