The Death of the “Absolute Interest”

[The following guest post is contributed
by Aditya Swarup, who is an
Assistant Professor at the Jindal Global Law School]
In the seemingly
complex world of corporate finance, creditors often face questions on the kind
of security that ought to be taken by the them to support the loan to the
borrower, answers to which depend on the relationship between debt and equity
of the company. A further question arises on the kind of remedy available to
the creditor if the borrower defaults in repayment of the loan – whether the
remedy is personal or proprietary in nature? This question is significant
especially in light of the introduction of the Insolvency and Bankruptcy Code,
2016 (“Insolvency Code”) and the recent amendments to the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interests Act,
2002 (“SARFAESI Act”) (as amended on 12 August 2016) (“SARFAESI Amendments”).
In their simplest
terms, personal (or contractual) remedies are remedies that attach to the
“person”, while proprietary remedies attach to the property irrespective of the
person in possession of the property (save for a bona fide purchaser). The distinction gains significance in a
situation where the borrower is insolvent: a creditor with proprietary rights
gains priority over the general class of unsecured creditors, while a creditor
with personal remedies is in the same class as unsecured creditors. For
instance, X, acting in the capacity of a trustee, fraudulently transfers Rs. 10
crore belonging to A to company B, and B later becomes insolvent. At the time
of insolvency, B’s assets and liabilities are in the ratio of 1:4. In this
case, if A wants to exercise a personal remedy, A will only be entitled to recover
of a proportion of the liability owed to it, i.e. Rs. 2.5 crore. However, A can
also avail of a proprietary remedy claiming that since the money was
transferred fraudulently, A retained a beneficial interest in such money and
therefore can lay claim to the entire Rs. 10 crore and get it out of the asset
pool to the exclusion of all other creditors of B.
Kinds of absolute interests
In this sense,
one of the main drawbacks of personal remedies is that these remedies merely
entitle a creditor to prove the debt in liquidation of the insolvent debtor,
which generally result in recovery of little or none of the outstanding debt.
In contrast, a creditor who has a proprietary remedy can avail of the remedy
either outside liquidation altogether or at least in priority to the claims of
most other creditors. Proprietary remedies can arise out of either absolute (or
quasi security) or security interests. If the creditor has an absolute
interest, it is or becomes the absolute owner of the asset. A security interest
merely secures the creditor with the obligation to repay. The creditor does not
get title to the asset but can only sell the asset to recover its payments.
Examples of absolute interests include finance leases, receivables financing, retention
of title agreements and Quistclose trusts. Examples of security interests
include charges, pledges, mortgages and liens. Some of these absolute interests
are explained below:
(a)        Finance leases
A lease typically
involves the transfer of a right to enjoy property. In practice however, the
ownership of the property remains with the lessor and all that is transferred
is a right to enjoy the property. In the case of a finance lease, the creditor (lessor)
retains ownership in the assets for the duration of the lease during which time
the borrower (lessee) makes payments in installments towards the enjoyment of
the property. Once the duration of the lease is determined, the ownership in
the assets is transferred to the borrower. This is in contrast to an operating
lease where, upon determination of the lease, the ownership is still retained
by the creditor. Finance leases are a very common form of corporate finance,
especially in the aviation industry.
As regards
treatment of finance leases by the Indian Courts, while they were acknowledged
as a form of financing and considered different from ordinary leases, in Association of Leasing and
Financing Companies v. Union of India
, (2011) 2 SCC 352, the Supreme Court has held that in view
of the accounting standards, finance leases are required to be shown as assets
in the books of the lessee and not the lessor. This decision may create some
confusion in understanding who owns title to the asset when the borrower is
insolvent. I believe this was one of the questions in Mumbai International Airport Limited v. Commissioner of Service Tax,
WP 3013/2014, but has not yet been
adjudicated by the Hon’ble Bombay High Court.
(b)       Receivables financing
financing is usually achieved by transferring the title in the receivables to
the creditor (being the assignee) with the borrower (the assignor) collecting
the revenues arising from the receivables and holding the money in trust for
the creditor. However, since the title in the receivables is held with the
creditor, the credit risk is transferred to the borrower. Types of this
arrangement are also referred to as factoring and, as of 2009, the
amount of sales through factoring
was over 6 billion euros (both domestic
and international). In 2011, the Government introduced the Factoring Regulation Act, 2011, which sought to, for the first time,
regulate receivables financing in India.
(c)        Retention of Title
Though prevalent
in many forms, the most common example of retention of title transactions are
where the buyer acquires raw materials from a seller, and the seller also
extends credit to the buyer which can be paid after the buyer disposes off the
raw material or finished goods. In such a situation, since the seller is
exposed to a considerable credit risk, he or she agrees to retain title to the
raw materials/goods, even though they are in the possession of the buyer.
(d)       Quistclose trust
As stated in Twinsectra v. Yardley, [2002] 2 AC 164, where a creditor makes it clear that money is lent for a specific
purpose, and the purpose fails, the power of the borrower to use the money
disappears and the money is held by the borrower on resulting trust for the
creditor. Such a kind of trust amounts to a quasi-security interest since the
creditor then is entitled to a proprietary remedy and the money held on trust
is said to be outside the asset pool of the borrower in case of insolvency. The
trust was first recognized in Barclays Bank v. Quistclose Investments Ltd., [1970] AC 567, and hence the name
“Quistclose trust”. Quistclose trusts are recognized as resulting trusts and
enforceable in India (See also Canbank Financial Services
Ltd. v. Custodian
, (2004) 8 SCC 355 making reference to the principle).
The current status of “absolute
interests” in India
In theory, and at
least on paper before 2016, absolute interests were altogether considered to out
of the asset pool of a debtor and hence outside the purview of winding up and
insolvency in India. The definitions of “property” and “transfer of property”
under the Presidency Towns Insolvency Act, 1909 did not specifically cover
absolute interests and there is little evidence to show that they were enforced
as such. Similarly, the original un-amended SARFAESI Act defined “security
interest” as follows:
“(zf) ‘security interest’ means right,
title and interest of any kind whatsoever upon property, created in favour of
any secured creditor and includes any mortgage, charge, hypothecation,
assignment other than those specified in section 31”.
Section 31 of the
SARFAESI Act specifically excluded creation of security on any aircraft and
“any contract in which no security interest has been created”. However, it is
submitted that the enactment of the Factoring Regulation Act, 2011, the
SARFAESI Amendments and the Insolvency Code have sounded the death knell of absolute
interests in India. The relevant provisions in the SARFAESI Amendments and
Insolvency Code read as follows:
Clause (zf) of section
2 of the SARFAESI Act now reads:
“(zf) ‘security interest’ means right,
title or interest of any kind whatsoever upon property created in favour of any
secured creditor and includes-
(i) any mortgage, charge, hypothecation,
assignment or any right, title or interest of any kind, on tangible property, retained
by the secured creditor as an owner of the property
, given on hire or
financial lease or conditional sale or under any contract which secured the
obligation to pay any unpaid portion of the purchase price of the asset or any
obligation incurred or credit provided to enable the borrower to acquire the
intangible property; or…”
Section 3(27) of
the Insolvency Code states:
“(27) ‘property’ includes money, goods,
actionable claims, land and every description of property situated in India or
outside India and every description of interest including present or
future or vested or contingent interest arising out of, or incidental to,
Section 3(31) of
the Insolvency Code states:
“(31) ‘security interest’ means right,
title or interest or a claim to property, created in favour of, or provided for
a secured creditor by a transaction which secures payment or performance of an
obligation and includes mortgage, charge, hypothecation, assignment and
encumbrance or any other agreement or arrangement securing payment or performance
of any obligation of any person”
Section 3(34) of
the Insolvency Code states:
            “‘transfer of property’ means transfer of
any property and includes a transfer of any interest in the property and
creation of any charge upon the property”
Analysing these provisions,
it could be argued that the absolute interests enumerated above have no further
relevance in law and are treated on par with security interests. Surprisingly,
the notes and clauses and the Joint Parliamentary Committee Reports to either of these legislation do not
mention why there was a need to bring out such a change in the definition of
security interests. Hence, today, if a company becomes insolvent, all the
assets of the company, irrespective of whether or not they are owned by the
company, will be considered as part of the asset pool and distributed in
accordance with section 53 of the Insolvency Code. If absolute interests were
excluded, then the holder of these absolute interests would not have had to
account for deductions such as the insolvency resolution costs, liquidation
costs and workmen’s dues.
That being said,
there is still room for the enforceability of Quistclose trusts in India and
taking property which is the subject matter of such a trust away from the asset
pool. This could be because Quistclose trusts (and trusts in general) involve
the bifurcation of legal and beneficial ownership unlike absolute interests.
The legal ownership of the property is with the borrower but the beneficial
ownership is with the creditor. It is for this reason Quistclose trusts are
also called quasi-security interests. The definitions of the two legislations
do not deal with it, and doing so may also be inconsistent with the Indian
Trusts Act, 1882.
The road ahead
The seeming
abolition of absolute interests in India is problematic because there doesn’t
seem to be any debate in the formal legislative aids as to why such amendments
were passed. A “seeming abolition” because even though it could be argued that
the Insolvency Code and SARFAESI Act only refuse to recognise such interests
and they could still be enforced in property and trust law (when the borrower
is not insolvent), the difference in the remedies in enforceability would most
times come about when the borrower is insolvent. As stated earlier, the
advantages of proprietary remedies are the priority they give to the creditor
in the event of the borrower’s insolvency and the remedy is meaningless if the
interest is not recognised in law. There is a movement in some common law
countries (New Zealand, Canada and Australia) to outline provisions for
registration and perfecting absolute and quasi-security interests so as to
identify all the assets of the company. The reasons and the need for such a
scheme seem to be clearly elucidated in those jurisdictions. Further, the need
for proprietary rights and remedies has been acknowledged as well.
Surprisingly, the required sophistication of analysis in order to clarify
issues of absolute and quasi-security interests seems woefully absent during
the insolvency reform process in India. The consequences of the recent amendments
and the status of proprietary remedies in India are yet to be seen, and are
sure to exercise the minds of lawyers and courts in the near future.
– Aditya Swarup

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • Instant:
    On the first blush, in discussing the 'death of absolute rights',there is an important aspect- vitally impacting, adversely so,hence requiring to be kept in sharp focus- is the amendment of the Constitution made not long ago. That is the 44th Amendment of 1978.As independently viewed, the violent change reprehensibly ushered in, in the concept of 'property', may be said to have had the effect of driving the last nail on the coffin of 'absolute rights'.

    Attention may be drawn to the published article (Lci website) @- LAW vs Case Law on 'FLATS' (MOFA) – Property Law, in which a brief account been given and personal viewpoints shared (ref. opening paragraphs).

  • A quick question: Does the Code not cover absolute interest under Section 36(4)-rendering apprehension about "all the assets of the company, irrespective of whether or not they are owned by the company, will be considered as part of the asset pool" to rest. Also, the secured creditor under rare circumstances would choose the waterfall of Section 53, but instead realize his interest under Section 52, resulting in deduction of only the resolution costs and not liquidation costs or workmen dues. Would be glad to be corrected/answered.

Top Posts & Pages


Recent Comments


web analytics

Social Media