Position of Third Party Security after Jaypee Infratech

[Ankesh Kumar is a IV Year student at NLIU Bhopal]

Anuj Jain v Axis Bank Limited witnessed the Supreme Court ruling on two important matter in Indian insolvency law. As summarized in this post, while the Court set aside the transactions in question as being preferential within the meaning of section 43 of Insolvency and Bankruptcy Code, 2016 (IBC), it went on to decide that creditors taking third party security cannot be categorized as financial creditors within the meaning of sections 5(7) and 5(8) of the IBC. The matter in hand concerned the subsidiary company, Jaypee Infratech Limited (JIL), furnishing security by way of creation of mortgage to lenders of its holding company, Jaiprakash Associates Limited (JAL). In this post, I shall only critique the Court’s ruling with respect to third party security for and by body corporates.

Concept of Financial Debt

In arriving at its decision, the Court discussed at great length the essence and nature of financial debt and financial creditors, as captured in sections 5(8) and (7) respectively. It observed that, while the existence of financial debt was necessary for a creditor to be categorized as a financial creditor, financial debt in itself is necessitated by the presence of the key elements: ‘disbursement’ for ‘time value of money’. Notably, section 5(8) is a ‘means and includes’ styled definition, on which it observed:

“the argument that clauses (a) to (i) of Section 5(8) of the Code must all necessarily reflect the fact that a financial debt can only be a debt which is disbursed against the consideration for the time value of money, and which permeates clauses (a) to (i), cannot be accepted as a matter of statutory interpretation, as the expression “and includes” speaks of subject-matters which may not necessarily be reflected in the main part of the definition.”

However, the Court went on to hold that it has not been laid down as a rule of statutory interpretation that the ‘includes’ part could stand alone, disjunctively from and totally alien to the ‘means’ part.

Critical Analysis

At the outset, it is doubtful if this section of the judgement forms a part of its ratio decidendi. In another article, I have highlighted how Dr. A.R. Biswas has explained what would constitute ratio decidendi in a case. He states:

“But there is an important limitation on the rule-making power vested in Judges. And this is the principle which denies them the power to make binding rules unless they are relevant to the determination of actual litigation before the court. … No Judge ever lays down any general proposition of law and therefore one has to discover or abstract a ratio or principle from the facts of the case decided. Hence with the introduction of new facts, an extension of the ratio or principle takes place, though the authority of the previous cases is not thereby disavowed.”

It would be pertinent to note that the matter concerning third party security was never an issue before the National Company Law Appellate Tribunal (NCLAT) in Anuj Jain. This was also accepted in the Supreme Court judgement: “However, there remains another significant issue to be adjudicated herein, which, though not adverted to by NCLAT, is indeed involved in these matters.” However, the Court went on to lay down a blanket principle covering every case that a creation of security interest without actual disbursement to such person would not qualify as financial debt.

Secondly, the Court has recognized that a mortgage debt may amount to guarantee as laid down in State Bank of India v. Smt. Kusum Vallabhdas Thakkar. The traditional thinking has always been that, if one is giving out a third party security, he is essentially giving out a guarantee because mortgage includes a covenant to pay by definition. Nonetheless, immediately after such recognition, the Court has stated that a mortgage debt cannot qualify as financial debt for not satisfying the essential elements of section 5(8) ‘disbursement’ and ‘time value of money’ (‘means’ part of the definition). It is pertinent to note that section 5(8)(h) recognizes guarantee in the ‘includes’ part of the definition of financial debt. The Court, while discussing the essence and nature of ‘means and includes’ definitions, has accepted that “the expression “and includes” speaks of subject-matters which may not necessarily be reflected in the main part of the definition”. Therefore, the Court has visibly contradicted its own statement in this respect. In this context, when the Court has accepted that “a promise to create a mortgage, even if given by a third party and not by the borrower would be deemed to be for consideration; that even if no direct consideration had flown from the plaintiff to the defendant who made the promise to create the mortgage, anything done for the benefit of the principal debtor would be sufficient consideration to the surety for giving guarantee”, it would not be perverse to say that ‘disbursement’ and ‘time value of money’ elements, when met by the borrower, can be imported on the surety. Reading in this fashion, the ‘includes’ part of the definition would fall in consonance with the ‘means’ part of the definition.

Thirdly, such a decision goes against the object that IBC sought to achieve. In IBC’s Statement of Objects and Reasons, it has been highlighted how multiple fora that existed before IBC had been painstaking for parties involved. “These statutes provide for creation of multiple fora such as Board of Industrial and Financial Reconstruction (BIFR), Debts Recovery Tribunal (DRT) and National Company Law Tribunal (NCLT) and their respective Appellate Tribunals.” Keeping this mind, when the Court has accepted that secured creditors are free to enforce their security interest under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002, they have gone against the very object of IBC.

Furthermore, in Swiss Ribbons Pvt Ltd v. Union of India, it was accepted that:

“[t]he objective of the Insolvency and Bankruptcy Code, 2016 is to consolidate and amend the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time-bound manner for maximization of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders. An effective legal framework for timely resolution of insolvency and bankruptcy would support development of credit markets and encourage entrepreneurship. It would also improve Ease of Doing Business, and facilitate more investments leading to higher economic growth and development.

Above all, ultimately, the interests of all stakeholders are looked after as the corporate debtor itself becomes a beneficiary of the resolution scheme— workers are paid, the creditors in the long run will be repaid in full, and shareholders/investors are able to maximize their investment. Timely resolution of a corporate debtor who is in the red, by an effective legal framework, would go a long way to support the development of credit markets.”

[Emphasis added]

This decision would not only make lenders wary of giving credit on third party security which has been a common practice in the credit market, but it would also jeopardise creditors who have already given credit on the basis of third party security. In this regard, this judgement is per incuriam as (i) it makes the process lengthy, for creditors have to go to a different forum to enforce security interest, (ii) it does not balance the interests of all stakeholders, with secured creditors being important stakeholders as recognized in Committee of Creditors of Essar Steel India Limited v Satish Kumar Gupta, (iii) it hampers the development of credit market and entrepreneurship, and (iv) it acts a hindrance to the facilitation of investments and ultimately economic growth as a whole.

Fourthly, the Court has ignored the significance attached to secured creditors, as brought out in Essar Steel. The Court therein, while taking a cue from UNCITRAL Legislative Guide on Insolvency Law, had observed: “If the secured creditor is not bound by the plan, the election by the secured creditor to enforce its rights, such as by repossessing and selling the encumbered asset, may make reorganization of the business impossible to implement”.Moreover,while taking note of an IMF paper on Development of Standards for Security Interest, it had further observed: “Enforcement is a critical factor in the law and functioning of secured credit. A security interest is of little value to a creditor unless the creditor is able to enforce it in a predictable, efficient and timely manner vis-à-vis the debtor and third parties. An effective framework needs to allow quick and predictable enforcement both within and outside insolvency proceedings.” Moreover, the nature of a financial creditor as highlighted in the judgement to assess the viability of the corporate debtor and ensure its revival cannot be said to be absent in case of debt granted to a body corporate on security given by another body corporate. Notably, the Court had accepted in Swiss Ribbons and Essar Steel that most secured creditors are subsumed within financial creditors.

Conclusion

To this end, one may conclude the Court has apparently erred in its appreciation of the concepts of financial debt, financial creditor and secured creditor, perhaps not realizing the gargantuan blow that may befall the credit industry and prove deleterious in availing or securing loans in an already ailing credit market.

Ankesh Kumar

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