Navigating the Tides: A Critical appraisal of Third-Party Security Holders in the Insolvency and Bankruptcy Code, 2016
Nidhi Singh
A student at National Law University, Jodhpur
Table of Contents
I. Introduction: An Overview of Third-Party Security Holders Under IBC
II. Assessing the Legitimacy: Examining the Validity of Third Collaterals
III. Guardians of Collateral: Comprehensive Analysis of the Implications
IV. Decoding the Rationale: Understanding the Basis for Supreme Court’s Position
V. Understanding the Essence of Implied Obligation
VI. Charting the Course: Effective Solutions for the Challenge
I. Introduction: An Overview of Third-Party Security Holders under IBC
In the expansive and intricately structured domain of Insolvency and Bankruptcy law, numerous pivotal judgments have played a crucial role in determining the rights and obligations of various stakeholders, which have shaped the legal landscape. Our courts have weighed in on the rights of creditors, elucidating the distinctions between “operational” and “financial” creditors, and the implications of these categorizations.[1] Moreover, they have delved into the intricate dynamics between creditors within the same class, paving the way for more equitable resolutions.
The cases of Swiss Ribbons and Essar Steel have stood out for their profound impact on the constitutional validity of differential treatment between operational and financial creditors, while also delineating the rights of inter se creditors and the role of the Committee of Creditors (“CoC”).[2] These landmark judgments have not only contributed to the robust evolution of the IBC but have also provided valuable precedents for addressing complex insolvency cases in the future.
The National Company Law Appellate Tribunal’s (“NCLAT”) pronouncement, “the existence of security interest in assets of the Corporate Debtor does not preclude the assets to be dealt with or sold in the Resolution Plan,”[3] sheds light on the rights of third-party security holders. This issue was deliberated upon and consequently, gained significant attention following landmark judgments such as Phoenix ARC, and Jaypee Infratech.[4] In another case, recently, the Supreme Court (“SC”) noted that the remedy against a third party is not available under Section66 of the Insolvency and Bankruptcy Code, 2016 (“IBC”).[5]
In the lending landscape of our country, third-party lending is a prevalent phenomenon, with numerous instances where loans have been secured by third parties through guarantees, mortgages, or pledges, making it imperative to safeguard the rights of these third-party lenders. The first notable case is Anuj Jain (IRP for Jaypee Infratech Limited) v. Axis Bank Limited[6], and the second is Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel.[7] Interestingly, both these judgments share a common thread in classifying third-party security providers as secured creditors rather than “financial creditors”.
By designating them as secured creditors, these rulings withhold a certain level of protection and recognition of the interests of third-party lenders. As secured creditors, they forfeit the right to actively participate in the insolvency resolution process and do not have a voice in the decision-making, particularly concerning the disposition of assets that serve as collateral for the loans. Despite the potential fallacies, these judgments have set a precedent for the treatment of third-party collateral holders in insolvency proceedings, offering them an influential role in the resolution process.
As the legal landscape evolves and more cases emerge, the treatment of third-party lenders and the classification of their rights will likely undergo further refinement and interpretation by the courts to strike a balance between protecting their interests and upholding the principles of insolvency and bankruptcy laws.
II. Assessing the Legitimacy: Examining the Validity of Third Collaterals
The utilization of third-party collaterals is a widely practiced norm in regular commercial transactions and is duly acknowledged and regulated by law, establishing its significance within the legal framework. Section185 and Section186 of the Companies Act, 2013, address the conditions under which a company can extend loans, provide security, or offer guarantees to specific individuals or entities.[8] These sections recognize and deal with the concept of security and guarantees, further reinforcing the legitimacy and relevance of third-party collaterals. Moreover, Section 2(1)(m) of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (“SARFAESI”) Act expansively defines “financial assets” to encompass mortgages, hypothecation, or pledges.[9]
As a financial asset is essentially owned by its holder, it logically follows that the holder should be entitled to exercise their rights as a financial creditor. Hence, it can be deduced that the intention was to grant third-party lenders or third-party collateral holders the status and rights of financial creditors in insolvency proceedings, particularly given that their assets frequently serve as security against loans.
By drawing parallels from the Companies Act and the SARFAESI Act, it becomes evident that third-party lenders or collateral holders should be acknowledged as financial creditors under the IBC. This recognition would not only safeguard their interests but also ensure a more cohesive and all-inclusive approach to addressing their rights within the insolvency resolution process.
III. Guardians of Collateral: Comprehensive Analysis of the Implications
The classification of third-party security providers as secured creditors rather than financial creditors significantly affects their rights in the insolvency process. There are a few key aspects to consider:
- Initiating CIRP Application: As per Section7, Section9 and Section10 of the Code, only a Corporate Debtor (“CD”), Financial Creditor (“FC”), or Operational Creditor (“OC”) can initiate the Corporate Insolvency Resolution Process (“CIRP”) by filing an application.[10] Since third-party security providers do not fall under either FC or OC categories, they cannot initiate the application themselves. Instead, they would need to file it as “Other Claimants” thereby, highlighting the unique position they hold in the insolvency proceedings.
- Representation in CoC: The CoC, which plays a crucial role in the resolution process, comprises only Financial Creditors as per Section21 of the IBC.[11] Consequently, third-party security providers, despite having a substantial interest in the resolution, do not have representation in the CoC. This lack of representation deprives them of a say in the resolution plan and decision-making processes, especially concerning the assets they hold security over.
Due to these implications of the classification, third-party security providers face several challenges. Firstly, they have a limited say in the resolution plan as they do not have a voice in the resolution plan, even if the plan involves dealing with the assets on which they hold security. This lack of participation can lead to unfavorable outcomes for them.[12] Secondly, restrictions on exercising security interest and the moratorium, during the CIRP process prevent them from exercising their security interest outside of the insolvency process. This limitation further hampers their ability to protect their interests effectively.
Alternatively, as secured creditors during the liquidation process, they gain more advantageous outcomes, including better realization of their security interests and a higher priority in the distribution of proceeds.[13] This creates a disparity in their treatment under different procedures of the insolvency process. The consequences of these distinctions can be significant and may deter lenders from providing such forms of lending in the future if they feel their interests are inadequately protected during insolvency proceedings. It also highlights the need for further refinement and clarification in the treatment of third-party security providers to ensure a more balanced and equitable approach within the insolvency framework.
IV. Decoding the Rationale: Understanding the Basis for Supreme Court’s Position
The SC’s position regarding third-party security providers and their classification as secured creditors was primarily based on two key stances:
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Need for a Direct Nexus:
The concept of a “direct nexus” was crucial in the SC’s examination of whether a particular party qualifies as a financial creditor under the Insolvency and Bankruptcy Code (IBC). To determine if a party owes a financial debt, reference was made to Section5(8) of the Code, which defines what constitutes a financial debt.[14]
According to Section5(8), there are three essential elements of financial debt. Firstly, it must be a debt i.e., must involve borrowing or indebtedness. Secondly, it must be “disbursed”, which implies that the amount should be paid out or distributed to the debtor/borrower. Lastly, it must have a time value of money, which refers to the interest or consideration for the use of money over time.[15] The SC focused on the aspect of “disbursed” and took the view that this disbursement must be made directly to the corporate debtor itself i.e., the beneficiary of such disbursement should be the corporate debtor.[16]
Notably, in Phoenix ARC vs. Spade Financials, the Court emphasized that disbursement is a ‘necessary condition’ for a debt to be classified as a financial debt, along with the other two conditions being satisfied.[17] The Code does not explicitly state that the disbursement must be made to the corporate debtor only. This led to differing opinions and interpretations, with the NCLAT in the case of B.V.S. Lakshmi holding that the disbursement need not necessarily be made to the corporate debtor alone.[18]
Thereby, the author understands that as the “direct nexus” requirement was not explicitly mandated in the IBC, and the scope of financial debt is inclusive of guarantees and indemnities, which are not provided solely by the corporate debtor, direct nexus should not be a mandatory criterion for determination of financial debt.
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Obligation to Pay:
The presence of an obligation to pay was a significant aspect considered by the SC in determining the classification of third-party security providers as financial creditors.[19] The Court clarified that for the indirect lender class to hold itself as a financial creditor against the security provider, there must be a clear obligation on the part of the security provider to make the payment in case of default by the borrower.[20]
In Phoenix ARC vs. Ketulbhai Ramubhai Patel, the security provider had given a pledge, which involves providing assets as security for a loan taken by another person, creating a charge or lien on the asset. However, a pledge does not automatically imply a direct obligation on the security provider to make the payment if the borrower defaults.[21] In Anuj Jain (IRP for Jaypee Infratech Limited) vs. Axis Bank Limited, the security provider had given a mortgage, which is also distinct from a guarantee.[22] A mortgage involves providing assets as security for a loan, and similar to a pledge, it creates a charge on the asset without necessarily imposing a direct obligation on the security provider to pay if the borrower defaults.
The SC highlighted the crucial difference between a guarantee and a pledge/mortgage.[23] While a guarantee involves a direct obligation on the guarantor to pay the debt if the borrower defaults, a pledge/mortgage does not necessarily carry such an obligation. This distinction was central to the Court’s stance, as it clarified that merely providing security in the form of a pledge or mortgage does not automatically confer financial creditor status to the security provider.
The Court’s position ensures that the rights and responsibilities of third-party security providers are clearly defined and that they cannot be presumed to have an implicit obligation to repay the debt of the borrower. Instead, they retain their right to enforce the security interest immediately in case of borrower default without being required to assume the debt directly.
V. Understanding the Essence of Implied Obligation
The creation and nature of security interests have given rise to significant questions that necessitate careful examination. The author would address three crucial queries in this article:
a. Can security interest exist without an obligation to pay?
The concept of security interest involves providing an asset to secure a debt taken by another party. The central issue here is whether an obligation to pay is a prerequisite for the existence of a security interest. A landmark ruling in the case of Imperial Bank of India vs. Bengal National Bank clarified that security interest is intended to support an underlying debt.[24] This implies that a debt must exist for a security interest to be enforceable i.e., an obligation to pay is indeed fundamental to the concept of a security interest. Therefore, a self-standing security interest without an underlying obligation lacks meaning and is unlikely to hold legal validity.
b. Is security different from a guarantee?
The second question focuses on distinguishing security interest from a guarantee. While the Companies Act treats them as distinct concepts, the SC has clarified that while they may not be identical, they can share similarities in nature.[25] A guarantee creates a direct obligation to pay, as the guarantor becomes co-extensively liable for the debt in case of default by the borrower.[26] In contrast, a mortgage or pledge involves a pecuniary liability on the part of the security provider, necessitating fulfilment of the debt before the security interest can be exercised. Though they differ, they can still bear some similarities, and for practical and commercial feasibility purposes, it may be reasonable to include security, pledge, and mortgage within the scope of financial debt, akin to guarantees.
c. Does an obligation to pay have to be explicit?
The third question revolves around whether an obligation to pay must be explicitly stated in the relevant documents or if it can be inferred from the circumstances. In Phoenix ARC, the SC’s ruling raised concerns when it found that the trust deed between the lender and the security provider lacked an explicit clause imposing an obligation to pay on the security provider.[27] While the law may not explicitly mandate the presence of such an obligation, the Court’s decision suggests that clarity in the relevant documents is crucial for the security provider to be considered a financial creditor. This issue brings to light the importance of balancing intent and strict interpretation of the law.
As policymakers, legal experts, and stakeholders deliberate on these crucial questions, it becomes essential to strike a delicate balance between safeguarding the interests of the parties involved, ensuring the enforceability of security interests, and promoting commercial feasibility within the framework of financial transactions. Clarifying these aspects would contribute to a more robust and equitable resolution of matters involving security interests and their treatment under the applicable legal framework.
VI. Charting the Course: Effective Solutions for the Challenge
In cases where the principal borrower has already defaulted, leading to the initiation of the CIRP, practical measures can be taken to address the concerns raised by the SC’s rulings. Similarly, when CIRP has been initiated against the security provider without any default by the principal borrower, specific actions can be implemented to safeguard the interests of the lenders.
Firstly, in situations where CIRP is initiated with default by the principal borrower, it is crucial to ensure that lenders, including third-party collateral holders, can be considered as financial creditors. This can be achieved by explicitly stipulating in transactions that in case of default by the principal borrower, the obligation to pay will first transfer to the security provider. Only if the security provider fails to fulfil the payment obligation, the indirect lender (third-party collateral holder) can then exercise the security interest. By including these terms, a direct nexus is established, an obligation to pay is defined, and the indirect lender can rightfully hold itself as a financial creditor for the security provider as well.
Secondly, when CIRP is initiated against the security provider without any default by the principal borrower, particular attention should be given to the drafting of agreements. Defining the event of default to encompass the initiation of any insolvency or liquidation proceedings against the security provider is essential. Upon the occurrence of such a default, the principal borrower should be required to make an immediate prepayment. If the principal borrower fails to fulfill this prepayment obligation, the responsibility shifts to the security provider to make the payment. Once the obligation is transferred to the security provider, they can be treated as a financial creditor, and the security interest will be dealt with in the resolution plan.
In both cases, by incorporating clear terms and obligations in agreements, the parties involved can ensure compliance with the SC’s criteria for financial creditor classification. These steps enable lenders and third-party collateral holders to participate actively in the resolution process, safeguard their interests, and maximize recovery in the event of insolvency.
Thereby, proactive, and precise drafting, along with a clear understanding of the legal implications, will play a crucial role in navigating these scenarios and providing practical solutions for lenders and third-party collateral holders.
Reference:
[1] M/s Vistra ITCL (India) Limited v. Dinkar Venkatasubramanian, (2023) ibclaw.in 62 SC.
[2] Swiss Ribbons Pvt. Ltd. v. Union of India, (2019) ibclaw.in 03 SC [90], [91].; Committee of Creditors of Essar Steel India Limited (through authorized signatory) v. Satish Kumar Gupta and Others, [2019] ibclaw.in 07 SC.
[3] Edelweiss Asset Reconstruction Company Ltd. Vs. Mr. Anuj Jain, RP of Ballarpur Industries Ltd., (2023) ibclaw.in 420 NCLAT.
[4] Phoenix ARC Pvt. Ltd. Vs. Ketulbhai Ramubhai Patel, (2021) ibclaw.in 04 SC, February 3, 2021 (“Phoenix ARC”); Anuj Jain (IRP for Jaypee Infratech Limited) v. Axis Bank Limited, [2020] ibclaw.in 21 SC (“Jaypee Infratech”).
[5] Gluckrich Capital (P.) Ltd. v. State of West Bengal – Diary No. 6732 of 2023.
[6] Jaypee Infratech, supra 4.
[7] Phoenix ARC, supra 4.
[8] Companies Act, Act No. 18 of 2013, Acts of Parliament, Section 185-186 (India).
[9] The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, Act No. 54 of 2002, Acts of Parliament, Section 2(1)(m) (India).
[10] The Insolvency and Bankruptcy Code, Act No. 31 of 2016, Acts of Parliament, Section 7, 9-10. (India).
[11] Id. at Section21.
[12] Supra note 5.
[13] The Insolvency and Bankruptcy Code, Act No. 31 of 2016, Acts of Parliament, Section 52. (India).
[14] The Insolvency and Bankruptcy Code, Act No. 31 of 2016, Acts of Parliament, Section 5(8). (India).
[15] Id.
[16] Phoenix ARC, supra note 4.
[17] Phoenix Arc Private Ltd. v. Spade Financial Service Ltd.,(2021) ibclaw.in 03 SC.
[18] Dr. B.V.S. Lakshmi v. Geometrix Laser Solutions Private Limited, (2017) ibclaw.in 91 NCLAT.
[19] Phoenix ARC, supra note 4.
[20] Id.
[21] Phoenix ARC, supra note 4.
[22] Jaypee Infratech, supra note 4.
[23] Id.
[24] Imperial Bank of India vs. Bengal National Bank, Privy Council Appeal No. 112 of 1930, May 21, 1931.
[25] Phoenix ARC, supra note 4.
[26] The Indian Contract Act, Act No. 9 of 1872, Acts of Parliament, Section126. (India).
[27] Phoenix ARC, supra note 4.
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