THE GUARANTEE FOR THE FINANCIAL CREDITOR AND RIGHTS OF THIRD-PARTY SECURITY HOLDER: DEBATE CONTINUES
Updated: May 15
This post has been authored by Mrinal Sharma and Shikha Pandey, third-year students at National Law University and Judicial Academy, Assam.
Image Credits: Alamy Stock Photos
The Insolvency and Bankruptcy Code (Code) was introduced in 2016 and since then it has clamped its foot stoutly into the legal arena through various case laws and amendments. The Hon’ble Supreme Court's judgement in the case of Phoenix Arc Private Limited v. Ketulbhai Ramubhai Patel, dated February 3, 2021, has cleared the mist regarding the inclusion of the creditor as the financial creditor by a Pledge Agreement. Although the judgment widely discussed the concept of financial creditor, it has left some questions unanswered. This article critically analyses the judgment passed by the Apex court by discussing the core legal issues, its loopholes and suggesting a way forward.
The company named L & T Infrastructure Finance Company (L&T) provided financial lending of Rs. 40 crores to Doshion Limited (Borrower) under a facility agreement signed between the two companies on 12.05.2011 (Facility Agreement). Security creation was mentioned in schedule IV of such facility agreement. The Doshion Veolia Water Solutions Private Limited (corporate debtor) passed a resolution on July 07, 2011 to give Non-Disposal Undertaking in favour of L&T containing the non-disposal of their 100% shares in Gondwana Engineers Limited (GEL) unless all the payment is made. On January 10,2012, a Pledge Agreement was signed (Pledge Agreement) between the corporate debtor and L&T to secure such facility whereby 40,160 shares of GEL were pledged as security. The lender on December 30, 2013, by agreement, transferred all title, rights and interest in the financial facility, which also includes security, in favour of Phoenix Arc Pvt. Ltd (Appellant) under Section 5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
When the corporate debtor failed to square the loan, the Bank of Baroda, on August 08, 2018, filed a petition under Section 7 of the Code to initiate the Corporate Insolvency Resolution Process (CIRP) in National Company Law Tribunal (NCLT). On the initiation of the Resolution Process, Phoenix Arc Private Limited asserted that they should be considered as the financial creditor under Section 5 sub-section (8)(i) of the Code. The contention was rejected by the Interim Resolution Professional, NCLT, Mumbai as well as the Appellate Tribunal on the ground that liability of the pledger is limited only to pledge of shares. Therefore, Phoenix Arc Private Limited filed the present appeal before the Apex court.
The key question before the Supreme Court was to decide whether the Phoenix ARC is a financial creditor under Section 5(8) of the Code or not, based on the Pledge Agreement?
3. ARGUMENTS ADVANCED
The contention of Phoenix Arc Private Limited was based on the interpretation of Section 5 sub-section (8)(i) of the Code. Firstly, it was contended that the liability of the debtor extends to Phoenix Arc Private Limited. If Phoenix Arc Private Limited is not considered as a financial creditor, then they will be left without any remedy and will not be able to enforce the guarantee at the time of the moratorium period. Secondly, it was contended that if not included as the financial creditor, then, the resolution plan will be passed without any redress to the Phoenix Arc Private Limited which will take away the advantage that a creditor has over the security.
The defendant, on the other hand, contended that Phoenix Arc Private Limited is not a creditor of any nature because the Pledge cannot be included as a guarantee under the Section 126 of the Indian Contract Act, 1872. It was argued that Section 5 sub-section (8)(i) of the Code talks only about such liability from a guarantee which falls under items referred in sub-clauses (a) to (h) of the said section and does not extend to any other form or nature of the guarantee.
4. DECISION OF THE SUPREME COURT
The Supreme Court in this case, while referring to Section 126 of the Indian Contract Act, 1872, observed that the obligation on the pledger to pay for the default on the part of the borrower does not exist in the present case because the pledger was not the party to the Facility Agreement.
The Supreme Court also relied upon the meaning of “contract of guarantee” under Section 126 of the Indian Contract Act, 1872. Contract of Guarantee is a contract to “perform the promise” or “discharge the liability”, of a third person in case of his default and concluded that the corporate debtor has not entered into any contract of guarantee and the Pledge Agreement cannot be considered as a guarantee for the same. The term “discharge of liability” was discussed at length. Section 126 defines a contract of guarantee as the contract to “discharge the liability” of a third person in case of a default. The court was of the view that Pledge Agreement was only limited to the pledge of 40,160 shares as a security and the corporate debtor never promised to discharge the liability of the borrower.
The term financial creditor is defined under Section 5(7) of the Code as the person to whom a financial debt is owed. The Court observed that the definition of financial debt contains the expressions such as “means” and “includes”. It is defined as a debt with interest “which is disbursed against the consideration for the time value of money” and includes various type of amount mentioned in the main part of the definition. The court was of opinion that the “includes” part can stand alone, separately from the “means” part.
The relation between the Code and the Indian Contract Act was elaborated by the court. While discussing the definitions of “indemnity” and “guarantee”, the court observed that the meanings of the said terms are not defined under the Code, under Section 124 and 126 of the Indian Contract Act, 1872 and will carry the same meaning as per Section 3 sub-section (37) of the Code.
The Supreme Court while referring to its own judgements in Swiss Ribbons (P) Ltd. v. Union of India and Pioneer Urban Land & Infrastructure Ltd. v. Union of India and Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and others held that a person who is interested in the asset of the corporate debtor is limited to only security and would not fall under the definition of a financial creditor under Section 5(7) and (8) of the Code. The reasoning behind such a conclusion was that if the person having only security interest over the assets of the debtor is included in the category of financial creditor and allowed to have certain rights in the insolvency process then such inclusion will hamper the growth and revival of the corporate debtor. A financial creditor is focused more on recovery of debts rather than the revival of the corporate debtor and therefore cannot be involved in such resolution process making it merely as a casualty. The Pledge Agreement is restricted to the shares of Gondwana Engineers Limited and cannot be extended to the meaning of guarantee under Section 126 of the Indian Contract Act, 1872. Therefore, the Phoenix Arc Private Limited can be considered as secured creditor at most.
5. CRITICAL ANALYSIS
The judgement of the Supreme Court concluding that if the person has only security interest, which is collateral in nature, then such person cannot be included under the definition of the financial creditor under Section 5 of the Code has loopholes on the following grounds-
5.1 Not taking the rights of third-party security holders into cognizance.
The judgement in the present case did clear the doubts regarding the definition of a financial creditor but has again left the creditors remediless when different types of security (mortgage) are put on the line by the corporate debtor. The Supreme Court has failed to consider certain points regarding the rights of the third-party security holders. In the situation where a resolution plan, under the Code, assimilates the security advantage of a third-party security holder then such a resolution plan will be inadequate for not considering the secured interest of such creditors. A resolution plan passed without participation of such creditors in committee of creditors (CoC) will be a failed plan.
5.2 Creating Anomaly between the rights of Secured Creditors and the execution of a Resolution Plan
Under the Code, the terms secured creditor and financial debt are not linked with each other instead secured creditor is simply defined as the creditor in whose favour an interest is created for security. Further Section 53(1)(b) (ii) of the Code talks about the debts related to the secured creditor in which no such terms such as financial debt is mentioned, therefore, we can say that a third-party security holder, in the cases of Pledge Agreements, can either sell the assets and get payments or can opt-out of winding up. As per the case in hand it is held that third-party security holder having a Pledged Agreement is not a financial creditor and can be considered as a secured creditor, keeping the powers of a secured creditor to enforce such security under Insolvency and Bankruptcy Board of India (Voluntary Liquidation) Regulations, 2017 (Liquidation Regulations) in abeyance.
5.3 Need for the change and its aftermath
The Court from its previous judgments has set a precedent that is against the third-party security holders. There is a need for a change that can create a balance between the rights of such holders and the objective of the Code. Keeping third-party security holders outside the ambit of financial creditors will create a plethora of problems for the banking sector which will leave an effect on the credit flow system in the country. The banking sector will focus more on direct security from its lenders which will make the lenders pull back from such borrowings. This judgment will not only affect the creditor-borrower relationship in future but will also hamper and jeopardize the creditors who have already taken such security in terms of providing the loan.
Certain other aspects need to be taken into consideration before diverting to a different path. The inclusion of third-party security holders as a financial creditor will surely bring relief but if not regularized, can turn out as a Pandora box for the government. Third-party Security holders, if included as financial creditor, should be given certain rights through which they can have a say in the resolution process. These rights should be limited but concrete in a way that such security holders should not be able to exploit the resolution process and give a setback to the debtor.
The Supreme Court and NCLT’s with cases involving third party security holders, have laid down a blanket principle that "creation of security interest without actual disbursement to such person would not qualify as financial debt". However, if we step into the shoes of creditors appealing for such inclusion, they believe that considering them under the category of financial creditors will give them the chance to liquidate the asset, secured with them, as per their choice. However, if they are not included in the CoC then they won’t have the right and protection which a normal creditor has (also includes dissenting creditors) and this will tantamount a grave injustice on such creditors.
The Supreme Court has time and again interpreted the meaning of financial debt and the terms related to the inclusion of security under the formation of guarantee. In the present case, the court made it crystal clear that if a promise to discharge the liability of a borrower is not provided in a Pledge Agreement, the pledgee would not be a financial creditor and consequently, would not be a member of the CoC of the pledger.
But denying the third-party security holder the right of financial creditor is a big problem in itself. Instead of having such a tight fist approach the court and the tribunals could have considered such creditors as the financial creditor and have imposed certain regulations such as once the resolution plan is finalized it will be binding on them and approving them to the status of dissenting creditor or approving creditor. The Apex court should take a slightly different road rather than the current tight fist approach and provide such creditors with something by which they can protect their rights in such a seesaw situation.