An arrangement involving a third party security is not uncommon in commercial financing transactions. Here, a person (“A”) creates a security in favour a creditor (“B”) who provides financing to a third party (“C”). While a number of contract law and commercial law issues likely arise in such third party security, of immediate relevance is a scenario where A were to become insolvent in terms of the Insolvency and Bankruptcy Code, 2016 (“IBC”). In such a case, a question arises whether B can be treated a “financial creditor” of A for purposes of A’s corporate insolvency resolution process under the IBC, even though B directed its financing towards C.
Twin Situations before the Court
This is not a novel question, as it arose before a two-judge bench of the Supreme Court in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited (decided 26 February 2020, and discussed here). In that case, the corporate debtor, Jaypee Infratech Limited (JIL), mortgaged some of its assets in favour of certain and banks and financial institutions for loans they advanced to JIL’s parent company, being Jaiprakash Associates Limited (JAL). JAL, which is a publicly listed company, held 71.64% equity shares in JIL. In that sense, the mortgages created by JIL in favour of JAL’s lenders constitute third party security. After an analysis of the provisions of the IBC as well as its objectives, the Court found that banks holding third party mortgages cannot be treated as financial creditors of the corporate debtor. It rationalized that financial creditors ought not to merely consider a recovery of the debts owed to them, but they must also have an interest in the revival of the corporate debtor. Since a third party security holder’s interest is steeped in recovery rather than revival, such a person cannot be entrusted with responsibility for the insolvency process.
The issue resurfaced before a three-judge bench of the Supreme Court in Phoenix Arc Pvt. Ltd. v. Ketulbhai Ramubhai Patel (decided 3 February 2021). The facts of this case bear some similarities and a few differences with Jaypee Infratech. In Phoenix Arc, L&T Infrastructure Finance Company Limited advanced a financial facility to Doshion Limited. In turn, a subsidiary of Doshion, being Doshion Velia Water Solutions Private Limited (the corporate creditor in this case) granted a pledge to L&T Infrastructure Finance over certain shares it held in Gondwana Engineers Limited. Thereafter, L&T Infrastructure Finance assigned its rights, title and interest in the financial facility in favour of Phoenix Arc, who sought to establish itself as a financial creditor of Doshion Velia Water as part of the corporate insolvency resolution process initiated against it. To compare, there is a similarity between the Jaypee Infratech and Phoenix Arc in that the borrower and security provider bore a parent and subsidiary relationship respectively in both cases, while the nature of the security differed: a mortgage of immovable property in Jaypee Infratech against a pledge of shares in Phoenix Arc.
Ruling in Phoenix Arc
The Supreme Court was concerned with the precise wording of the IBC and, in particular, section 5(8), whose relevant parts are extracted below:
“Section 5(8) “financial debt” means a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes—
…
(b) any amount raised by acceptance under any acceptance credit facility or its dematerialised equivalent;
…
(i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clauses (a) to (h) of this clause”
As the Court noted, there are two parts to the definition. The first and main part is a rather exhaustive one, as it uses the word “means” and requires the existence of a disbursal of funds in consideration for the time value of money. In interpreting this part in the context of a third party security, the Court relied extensively on its earlier decision in Jaypee Infratech to suggest that the requirement of a “disbursal” of a debt is a sine qua non for the creation of a financial debt. In a third party security, the creditor has not disbursed any funds to the person creating the security (such as the corporate debtor who is the pledgor). Instead, the creditor has disbursed funds to another person, being the parent entity of the corporate debtor. The Court laid emphasis on the exact direction in which the disbursal flows, to hold that the disbursal of funds by the creditor has to be to the corporate debtor and to none else.
That leads us to the second part of the definition of “financial debt” in section 5(8), which is an inclusive one and lists out various relationships that would be considered to fall within the definition. Sub-section (i) (extracted above) captures liability of the corporate debtor under an indemnity or guarantee within the purview of a “financial debt”. Hence, it is necessary to consider whether a third party security (such as a pledge in this case) amounts to an indemnity or guarantee so as to constitute a financial debt for the purposes of the IBC. Cross-referring to the definition of a guarantee under section 126 of the Contract Act, 1872, the Court found that a guarantee requires the corporate debtor to “perform the promise, or discharge the liability” of the borrower in case it defaults. After analysing the pledge agreement in Phoenix Arc, the Court found that no such obligation of the corporate debtor existed under it, and hence the pledge agreement cannot be termed as a guarantee for purposes of the IBC. For these reasons, the Court concluded that Phoenix Arc (or even its predecessor L&T Infrastructure Finance) cannot be treated as a “financial creditor” of the corporate debtor, Doshion Velia Water, for its pledge of shares as a third party security for financing obtained by its parent company, Doshion.
Analysis and Conclusion
At one level, Phoenix Arc can be considered as merely following the footsteps of Jaypee Infratech. However, it arguably performs a more material role. As noted earlier, the question of whether holders of third party security can be considered “financial creditors” was obiter dicta in Jaypee Infratech. However, since that was the nub of the issue in Phoenix Arc that was also decided by a larger bench, its ruling carries greater weight.
The Supreme Court’s determination provides valuable lessons relating to practice in the areas of banking, credit and security. A standalone third party security is not optimal for the holder of such a security in the event that the provider of the security were to go into insolvency process under the IBC. One viable method to overcome this constraint is for the third party security to be structured as one that support a guarantee. Returning to the example with which we began, A must first issue a guarantee in favour of B to ensure the performance of obligations by C towards B. In order to secure its guarantee, B can either create a mortgage (as in Jaypee Infratech) or pledge of shares (as in Phoenix Arc) or other form of security. This would ensure that even though there is no disbursal of funds from B to A (which only flow to C) so as to fall within the main part of the definition of “financial debt” under section 5(18) of the IBC, it would bring such a transaction within the purview of the inclusive part of the definition in sub-section (i) as a guarantee. Courts have been clear that they are unwilling to imply a guarantee in a third party security document. The next best avenue is for the parties to make such a guarantee explicit.
