Upon the commencement of JIL’s insolvency, the resolution professional disallowed the security created by JIL in favour of JAL as impermissible preferential transactions within the purview of the Insolvency and Bankruptcy Code, 2016 (IBC) and refused to recognise JAL’s lenders as financial creditors of JIL. While considering an application, the National Company Law Tribunal (NCLT) vindicated the resolution professional’s stand. However, on appeal, the National Company Law Appellate Tribunal (NCLAT) reversed the NCLT ruling and held in favour of JAL’s lenders. On a further appeal, the Supreme Court overturned the NCLAT’s order and reinstated the NCLT’s order. The highlights of the Supreme Court ruling are that, in the present circumstances, the IBC disallows the creation of a security by JIL in favour of the lenders of its parent company, JAL, in a preferential transaction. Moreover, the lenders to the parent company, JAL, cannot seek recognition of a status as financial creditors of JIL, and thereby exercise influence over JIL’s corporate insolvency resolution process.
This post briefly analyses the Supreme Court ruling on both counts, viz. (i) validity of preferential transactions in insolvency law, and (ii) recognition of third party security holders as financial credits of the corporate debtor.
Before delving into the legal principles the Supreme Court laid down, it would be useful to outline the nature of the third party security that the corporate debtor, JIL, created in favour of the lenders of its parent company, JAL. JIL created security for loans that JAL borrowed. JAL had originally created mortgages in favour of banks and financial institutions. JIL subsequently replaced the original mortgages with fresh mortgages it created, which are the subject matter of dispute before the Court.
Preferential transactions fall within the purview of section 43 of the IBC, the relevant extracts of which are set out below:
“(2) A corporate debtor shall be deemed to have given preference, if—
(a) there is a transfer of property or an interest thereof of the corporate debtor for the benefit of a creditor or a surety or a guarantor for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor; and
(b) the transfer under clause (a) has the effect of putting such creditor or a surety or a guarantor in a beneficial position than it would have been in the event of a distribution of assets being made in accordiance with section 53.
(3) For the purposes of sub-section (2), a preference shall not include the following transfer—
(a) transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee;
(4) A preference shall be deemed to be given at a relevant time, if—
(a) It is given to a related party …, during the period of two years preceding the insolvency commencement date; or
(b) a preference is given to a person other than a related party during the period of one year preceding the insolvency commencement date.”
In this light, the Supreme Court first considered whether the mortgages that JIL created in favour of JAL’s lenders are preferential transactions within the meaning of section 43. It noted that section 43(2) constitutes a legal fiction whereby transactions that fall within its scope are “deemed to be” preferential transactions that can be invalidated by the means specified in section 44 of the IBC. The deeming provision is such that it does not matter whether the transaction was actually preferential or was intended or anticipated to be so. All that the court or tribunal needs to consider is whether the transaction falls within the four corners of section 43(2) – if so the law deems it to be preferential, and that too regardless of the reality.
Applying this principle to the facts of the case, the Court found:
“In the scenario taken into comprehension hereinabove, there is nothing to doubt that the corporate debtor JIL has given a preference by way of the mortgage transactions in question for the benefit of its related person JAL (who has been the creditor as also surety for JIL) for and on account of antecedent financial debts, operational debts and other liabilities owed to such related person. In the given fact situation, it is plain and clear that the transactions in question meet with all the requirements of clause (a) of sub-section (2) of Section 43.”
Since the transactions place JAL (which was also incidentally a creditor of JIL) in a favourable position compared to the other creditors, the transaction is treated as a preferential one under section 43 of the IBC.
The deeming provision is also linked to the relevant time period stipulated in sub-section (4) of section 43, namely a period of two years in case of transactions with related parties and one year with other parties, in either case preceding the insolvency commencement date. In the present case, JAL’s lenders adopted an argument that such a look-back period can apply only after the commencement of the IBC and cannot related back to a period prior to the effectiveness of the legislation. In the present case, the insolvency commencement date for JIL was 9 August 2017, and hence the two-year look back period will extended until 10 August 2015, representing a period prior to the effectiveness of the IBC, which came into force in December 2016. However, the Supreme Court was not impressed with this argument. The intention of the legislature, which involves maximisation of value of assets of corporate debtors and balancing the interests of all stakeholders, need to be given effect to the fullest extent. Accepting the JAL lenders’ arguments will render the application of section 43 only after two years (in the case of related parties) of the effectives of the IBC, which could never have been the intention of the legislature.
Interestingly, while the original mortgages were created in favour of JAL’s lenders before the look-back period, the re-mortgages were created within such period. Here, the Court was rather clear that upon release of the original mortgages, they ceased to exist. The re-mortgages have the effect of creating security afresh; hence, the timing of the re-mortgages would be relevant for considering whether they are within the temporal limits of the look-back period.
Exception: Ordinary Course of Business
Although transactions are deemed to be preferential in the manner discussed above, they can be excluded if they are considered to be “in the ordinary course of the business or financial affairs of the corporate debtor or the transferee”. The Supreme Court had to deal with an essential interpretational question: does the transaction have to be in the ordinary course of business with reference to the corporate debtor (i.e., JIL), the transferee (i.e., lenders of JAL), or both. This is in view of the disjunctive term “or” used in section 43(4). Here, the Court applied a purposive interpretation, relying on its own earlier landmark decision, to conclude that the expression “or” must be read as “and”. If not, it expressed the fear that almost any transaction entered into for the benefit of a transferee (here, the lender banks of JAL) will fall within the exclusionary provision, thereby frustrating the broader statutory provision surrounding the invaliding of preferential transactions. Hence, it is necessary for establish that the transactions were in the ordinary course of business of both JIL as well as JAL’s lenders.
Here, the Court found it difficult to accept that granting a security in favour of the lenders of a holding company would be in the corporate debtor’s ordinary course of business and financial affairs. Hence, the exclusionary provision would not have the effect of sanitizing the otherwise invalid preferential transactions.
In concluding its finding on the validity of preferential transaction, the Court also set out a helpful guide (in paragraph 28.1 of the judgment) that would enable resolution professionals to deal with situations involving such transactions by corporate debtors.
Third Party Security and Financial Creditors
Although the Court invalidated the preferential transactions, and although not necessary in the case, it went on to deal with the second question whether the lenders of JAL can be treated as financial creditors of JIL. While the Court did deliberate and rule on the issue in detail, this portion of the decision is arguably obiter dicta. Moreover, the NCLAT had not ruled on this particular issue.
Here, the Court relied on its exposition in Swiss Ribbons Private Limited v. Union of India, wherein the constitutionality of the classification between financial creditors and operational creditors was called into question. It also expounded on the role of a financial creditor in the context of a corporate debtor’s insolvency. A financial creditor ought not to consider merely the ability of recovery of its debtors from the corporate debtor, but also the revival of the corporate debtor. The Court noted:
“44. As noticed, the root requirement for a creditor to become a financial creditor for the purpose of Part II of the Code, there must be a financial debt which is owed to that person. He may be the principal creditor to whom the financial debt is owed or he may be an assignee in terms of extended meaning of this definition but, and nevertheless, the requirement of existence of a debt being owed is not forsaken.
45. … Therefore, for a person to be designated as a financial creditor of the corporate debtor, it has to be shown that the corporate debtor owes a financial debt to such person. Understood this way, it becomes clear that a third party to whom the corporate debtor does not owe a financial debt cannot become its financial creditor for the purposes of Part II of the Code.”
Hence, the person in whose favour a corporate debtor creates a third party security cannot be considered its financial creditor. Such a person cannot be entrusted with the task of ensuring the sustenance and growth of the corporate debtor, as its role is only to recover through enforcement of the security against the corporate debtor.
Summing up its decision on the issue, the Court stated in the context of beneficiaries of third party security: “… it cannot be said that the corporate debtor owes them any ‘financial debt’ within the meaning of Section 5(8) of the Code; and hence, such lenders of JAL do not fall in the category of the ‘financial creditors’ of the corporate debtor JIL.”
The IBC has already been the subject-matter of a great deal of interpretation by the Supreme Court. The present case adds to the development of the jurisprudence in the legislation, especially in relation to preferential transactions and their validity, which has not received as much attention in the past.