Preference Shareholders as Financial Creditors -Only where investors’ exit includes fixed return on investment?
Sanjana Muraleedharan
Senior Associate, Keystone Partners, Bengaluru
The National Company Law Appellate Tribunal, Delhi (“NCLAT”) in Sanjay Kakade v. HDFC Ventures Trustee Company Ltd and Ors. (2023) ibclaw.in 751 NCLAT, has held that investor holders of preference shares under a Share subscription and shareholders Agreement are financial creditors for the purposes of Section 7 of the Insolvency and Bankruptcy Code, 2016 (‘IBC’), though in very limited circumstances.
BRIEF FACTS
The Appellant Sanjay D Kakade was the promoter of the Kakade Estate Developers (‘Corporate Debtor’). A share subscription and shareholders agreement (‘SSHA’) was executed on 14.05. 2008 between the promoters (including the Appellant) and the Investors including IL&FS Trust Company Ltd, IIRF Holdings XIV Limited, Edward Mauritius Limited, HDFC Ventures Trustee Company Limited. In terms of the SSHA, a sum of INR 72,86,65,720 was subscribed towards equity shares and compulsorily convertible preference shares (‘CCPS’). A supplementary agreement was also executed on 11.07.2008 between the parties under which an additional 15,000 CCPs were subscribed to for a sum of INR 15 Crore.
As the proposed project for which the Investment was made could not be developed, a Binding Term Sheet (‘Term Sheet’) was executed in 2015 between the Corporate Debtor, Promoters, IIRF Holdings XIV Ltd. and IL&FS Trust Company Limited (“Investors’). Under the Term Sheet an exit was to be provided by the Promoters to the Investors with an exit consideration Internal Rate of Return of 17% from 10.03.2015.
Disputes arose between the parties which culminated in a Consent Arbitral Award dated 19.01.2021 (‘Consent Award’) under which INR 120 Crore was to be paid to the Investors by the Promoters and the Corporate Debtor in two tranches on or before 25.11.2020 and 25.08.2021, failing which the entire INR 120 crore would be payable at once with 15% applicable interest from 25.08.2021 till realization.
The exit consideration was not paid, resulting in the Investors initiating insolvency proceedings under Section 7 of the IBC before the National Company Law Tribunal, Mumbai (‘NCLT’). On 29.03.2023, the NCLT admitted the Corporate Debtor into Insolvency. Sanjay Kakade, in his capacity as a promoter of the Corporate Debtor, challenged the admission order in an appeal before the NCLAT.
CONTENTIONS OF THE PARTIES
The Appellant Promoter contended that the transaction with the Investors was not in the nature of a “commercial borrowing” for the “time value of money” in order to constitute a Financial Debt under Section 5(8)(f) of the IBC. The underlying transaction was one of share purchase and the Investors being 98.98% shareholders were to be regarded as shareholders or promoters of the Corporate Debtor. The Appellant further argued that the obligation on the Corporate Debtor to pay any exit consideration to the Investors was present only in the Consent Award (and not in the underlying transaction where such obligation was only on the Promoters). The Appellant took the position that the Consent Award ipso facto cannot give rise to a financial debt.
The Investors argued that on account of the default clause under the SSHA, the Investors became entitled to an exit consideration with an internal rate of return to the extent of 15% per annum compounded annually. The investment being a debt arising out of a transaction for profit had the commercial effect of a borrowing and was therefore a Financial Debt in terms of Section 5(8)(f). Furthermore, under the Consent Award, that it was the Corporate Debtor that had undertaken to indemnify the Investors for liabilities arising from the failure to perform their obligations by the Promoters. The Debt was therefore against the Corporate Debtor itself and not the Promoters.
DECISION OF THE NCLAT
The primary issue before the NCLAT was whether the Investment by the Investors under the SSHA, the Term Sheet and the Consent Award had the effect of a Financial Debt in default entitling the Investors to maintain an application under Section 7 of the IBC.
The NCLAT relied on the Judgment of the Supreme Court in Pioneer Urban Land & Infrastructure Ltd. v. Union of India (2019) ibclaw.in 13 SC (‘Pioneer’) which held that Section 5(8)(f) of the IBC would subsume within it amounts raised under transactions, though not necessarily loan transactions, so long as they have the commercial effect of a borrowing and pertinently that it fulfilled the condition of the disbursement being against consideration for the “time value of money”.
The exit consideration to the Investors under the SSHA, the Term Sheet and the Consent Award provided the Investors an Internal Rate of Return on their Investment from March 2015. The Consent Award also provided for an additional guarantee by the Promoters and joint and several liability of the Corporate Debtor and Promoters for payment of the exit consideration to the Investors. The NCLAT taking into account these terms, and the language of the SSHA which made it clear that the transaction was for “further funding” of the Corporate Debtor for the purpose of its business of construction of buildings and townships concluded that the transaction did in fact have the “commercial effect of a borrowing”.
The question then considered was whether the investment could be considered one of disbursal against the “time value of money” for the purposes of Section 5(8). In answering this question in the affirmative, the NCLAT relied on the provisions of the Term Sheet and the SSHA which assured the Investors a 15% Internal Rate of Return on their investment. The NCLAT further noted that the Section 7 Application filed was not only based on the Consent Award but also all the previous transactions including the SSHA.
Pertinently, the NCLAT distinguished its earlier judgment in Raj Singh Gehlot v Vistra (ITCL) India Ltd. (2022) ibclaw.in 558 NCLAT, where an admission order of the NCLT under Section 7 of the IBC had been set aside on the basis that an investment made under a Share Subscription and Shareholders Agreement would not come within the purview of a financial debt in terms of Section 7 read with Section 5(8) of the IBC. The NCLAT in Raj Singh Gehlot (supra) had inter alia observed that the Financial Debt must be through disbursal of funds and must carry an interest element. Investment made with the object of profit sharing would not constitute a Financial Debt. One of the factors employed by the NCLAT in Sanjay Kakade (supra) in distinguishing the judgment in Raj Gehlot was that the return on investment in Sanjay Kakade (supra) carried a “time value of money” component to the consideration, presumably the Internal Rate of Return assured in the exit consideration (unlike in the facts in Raj Gehlot where a coupon rate return on the debentures was deleted by the parties in an amendment to the SSHA).
On the above reasoning that the Debt was in the nature of a “Financial Debt” and the Investors “Financial Creditors”, the NCLAT dismissed the Appeal and upheld the order of admission of the Corporate Debtor into insolvency.
OBSERVATIONS ON THE JUDGMENT
A reading of the NCLAT’s reasoning indicates that not all investor shareholders would be regarded as Financial Creditors, even where the investment is in the nature of a “commercial borrowing”. As in the present case (save for in the Consent Award), the obligations for Investor exit in shareholder agreements usually lie with the Promoters. Where there is no obligation of payment against the Corporate Debtor directly, there can be no question of a debt or financial debt against the Corporate Debtor.
The NCLAT’s distinguishing of the judgment in Raj Gehlot (supra) on the basis of there being no equivalent to the Internal Rate of Return component in the SSHA in Raj Gehlot (supra) would indicate that a fixed payment of interest (or its equivalent) on the investment is necessary to satisfy the requirement of consideration for the “time value of money” for shareholder investors. Though subsequently set aside by the Supreme Court for being barred by limitation, the same interpretation was adopted by the NCLAT in Pushpa Shah and Another v IL&FS Financial Services Limited and another, [2019] ibclaw.in 25 NCLAT.
The interpretation adopted in Raj Gehlot, Sanjay Kakade and Pushpa Shah (supra) appears to be a deviation from the language of Section 5(8) under which “financial debt” is defined as a “debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes” interest on the debt disbursement is not mandatory for the consideration to be against “the time value of money”. This is also consistent with the Supreme Court’s reasoning in Pioneer which accepts that interest is not an essential to constitute “time value of money”. In Pioneer, the Supreme Court on the question of homebuyers as Financial Creditors accepted that the disbursement of a financial debt must be returned to the creditor with the “money’s equivalent” in order to be regarded as consideration against “time value of money”.
One could argue that even an exit clause such as a buy back by the Company of the Investor shares on an as converted basis at fair market value as on the exit date would constitute a potential and significant appreciation on the original investment and therefore satisfy the requirement for consideration against the time value of money even in the absence of the SSHA stipulating the rate of return. This interpretation however was rejected by the NCLT, Mumbai in Hubtown Limited v GVFL Trustee Company Pvt. Ltd., CP 4128/IB/MB/2018 (29.11.2021) where it was held that Internal Rate of Return cannot be equated with interest payments to constitute consideration for the time value for money. The NCLT in Hubdown held that the relevance of Internal Rate of Return for an investor in shares is in relation to expected profits, dividend pay out and capital appreciation of the shares which is distinguishable from the nature of interest charged on a loan.
The NCLAT’s reasoning in Sanjay Kakade, Raj Gehlot and Pushpa Shah (supra) though opening up the way for investor shareholders to claim the status of Financial Creditors under the IBC is still based on an interpretation of Financial Debt which places primacy on the presence of interest based returns.
Disclaimer: The Opinions expressed in this article are that of the author(s). The facts and opinions expressed here do not reflect the views of IBC Laws (http://www.ibclaw.in). The entire contents of this document have been prepared on the basis of the information existing at the time of the preparation. The author(s) and IBC Laws (http://www.ibclaw.in) do not take responsibility of the same. Postings on this blog are for informational purposes only. Nothing herein shall be deemed or construed to constitute legal or investment advice. Discussions on, or arising out of this, blog between contributors and other persons shall not create any attorney-client relationship.
Follow for daily updates: