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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

1. INTRODUCTION


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.


2. BACKGROUND


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