[Tejas A. Jha is an Advocate, practicing in New Delhi]
Recently, a major cause of concern has been highlighted by legal experts in regard to financial creditors seeking to invoke pledged shares in the corporate debtor. The concern is that when the said pledged shares are invoked, the financial creditor’s seat in the committee of creditors of the corporate debtor (“CoC”) may be put to challenge on the grounds that they are a ‘related party’ according to the Insolvency and Bankruptcy Code, 2016 (“IBC”). This concern arises from a conjunctive reading of two recent judgments of the Supreme Court and the Bombay High Court, respectively.
This post seeks to allay these concerns and argue instead that the insolvency jurisprudence in India firmly protects the rights of financial creditors in the insolvency proceedings, while also keeping intact their contractual rights to invoke a pledge.
The Supreme Court in PTC Financial v Venkateswarlu (2022) held that when a pledge is invoked and, consequently, the pledged shares are transferred by a financial creditor to itself, the said transfer does not amount to an ‘actual sale’ in terms of section 177 of the Indian Contract Act, 1872 (“Contract Act”). Section 177 of the Contract Act bestows a right on the pledgor, following the invocation of the pledged shares, to redeem its shares from the pledgee until an ‘actual sale’ of the said shares. Therefore, the Court concluded that although the transfer of pledged shares does make the pledgee the ‘beneficial owner’ of the shares, the pledgor may pay the debt owed to the pledgee and resume ownership of the said shares before an actual sale to a third party.
World Crest v Yes Bank
The Bombay High Court, in World Crest v Yes Bank (2022), held that a pledgee who has invoked and transferred the pledged shares to itself has the proportionate voting rights as per the percentage of shares held by it as a beneficial owner. Essentially, the Court confirmed that even though the transfer of pledged shares is not an ‘actual sale’ according to PTC Financial, the beneficial owner retains the voting rights that an actual owner would have in terms of the share percentage.
Pledgee as a ‘Related Party’
Writing on this issue, some have pointed out a conjunctive reading of the above judgments of the Supreme Court and the Bombay High Court leads to a situation where a financial creditor invoking the pledged shares of a corporate debtor becomes a ‘related party’ as defined in the IBC.
Section 5(24)(j) of the IBC defines “‘related party’, in relation to a corporate debtor” as inclusive of “any person who controls more than twenty per cent of voting rights in the corporate debtor on account of ownership or a voting agreement” (emphasis supplied). Further, section 21(2) and the first proviso thereunder, of the IBC, states:
“(2) The committee of creditors shall comprise all financial creditors of the corporate debtor:
Provided that a financial creditor or the authorised representative of the financial creditor referred to in sub-section (6) or sub-section (6A) or sub-section (5) of section 24, if it is a related party of the corporate debtor, shall not have any right of representation, participation or voting in a meeting of the committee of creditors” (emphasis supplied).
The above provisions of the IBC establish that any person (including a company or body corporate) holding over 20 percent of voting rights in a corporate debtor, on account of ownership of shares or a voting agreement, will be barred from a seat in the CoC of the corporate debtor. A standard share pledge agreement grants all the voting rights in relation to the pledged shares to the pledgee once the pledge is invoked. Thereby, a share pledge agreement is also a voting agreement in terms of the definition of ‘related party’ according to the IBC.
Thus, logically, when a financial creditor of the corporate debtor invokes more than 20 percent of the shares of the corporate debtor pledged, it also gains proportionate voting rights. Hence, the said financial creditor would then technically be a ‘related party’ of the corporate debtor and consequently be barred from occupying a seat in the CoC of the corporate debtor as per section 21(2) of the IBC. This obviously leaves the said financial creditor in the unenviable position of choosing either a seat on the CoC or exercising its contractual rights to invoke the pledge on the shares.
In this light, authors raising this issue have suggested that an urgent amendment is required in the IBC to protect and confirm the rights of a financial creditor to have its say in the CoC, while simultaneously exercising its valid contractual rights over shares pledged to them as security. Until then, they warn, a resolution professional can exploit this lacuna and the financial creditors’ seat in the CoC can validly be challenged.
However, this assessment misses a major judgment of the Supreme Court, which clearly paves the path for any such challenge of the financial creditors’ seat in CoC on the basis of them holding voting rights through invocation of pledged shares to surely fail.
Phoenix vs Spade
The Supreme Court in Phoenix v Spade (2021) undertook a detailed exercise of interpreting ‘related party’ in accordance with the IBC and the bar against such related parties from being a part of the CoC of the corporate debtor.
The Court held that “while understanding the meaning of ‘related party’ in the context of the IBC, it is important to keep in mind that it was defined to ensure that those entities which are related to the Corporate Debtor can be identified clearly, since their presence can often negatively affect the insolvency process” (emphasis supplied).
Further, the Court held: “The objects and purposes of the Code are best served when the CIRP is driven by external creditors, so as ensure that the CoC is not sabotaged by related parties of the corporate debtor. This is the intent behind the first proviso to Section 21(2)…”. The Supreme Court clearly states that this intent is key for determining who must (or must not) be disqualified under section 21(2) of the IBC and “whether the object and purpose for which the proviso was enacted, are fulfilled by the literal interpretation of the first proviso” (emphasis supplied).
Hence, the Court notes, “we would need to consider the meaning of the first proviso in the light of the context, object and purpose for which it was enacted. The purpose of excluding a related party of a corporate debtor from the CoC is to obviate conflicts of interest which are likely to arise in the event that a related party is allowed to become a part of the CoC” (emphasis supplied).
In light of the above, the Court concluded that “the exclusion under the first proviso to Section 21(2) is related not to the debt itself but to the relationship existing between a related party financial creditor and the corporate debtor. As such, the financial creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC” (emphasis supplied).
Pledgee is not a ‘Related Party’
In light of the Supreme Court’s ruling in Phoenix, when a challenge to the seat of a financial creditor is brought on the basis that it has voting rights of over 20 percent of the shares by way of invoking a pledge, the question that is to be answered is whether the financial creditor is actually related to the corporate debtor, whereby it will have a conflict of interest as a member of the CoC, or whether it has a bona fide claim over the seat.
Accordingly, the answer must surely be that such a financial creditor, being a beneficial owner of over 20 percent of the shares of a corporate debtor by virtue of legally invoking a pledge, continues to have a bona fide and valid claim to a seat in the CoC. There arises no conflict in the mind of such a financial creditor and it continues to be an ‘external creditor’ for the purposes of IBC, and therefore must not be disqualified from its rights.
Importantly, a contrary reading of section 21(2) of the IBC, to the one above, would also run against the doctrine of harmonious construction whereby courts must read the conflicting provisions of two different legislation in such a manner as to ensure that one does not defeat the purpose of the other. Thus, any reading of section 21(2) cannot nullify the rights of a pledgee bestowed through provisions under the Contract Act.
Although a literal reading of the provisions of the IBC do seem to operate against the rights of a financial creditor at first glance, the Supreme Court has clearly established that all courts will be bound by its precedent to ensure that the financial creditors’ rights as a pledgee under the Contract Act along with its right of membership in the CoC of the corporate debtor under the IBC, are both upheld as valid in law. A mere inadvertent lacuna arising from a literal reading of the provisions of the IBC cannot be allowed to demolish the rights of a financial creditor which have been intentionally bestowed by the law.
– Tejas A. Jha