ARTICLE
3 April 2025

A Document's Title Alone Cannot Define Its True Nature, Clarifies Supreme Court

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AJA Legal

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The Insolvency and Bankruptcy Code, 2016 ("Code") has been a cornerstone of India's restructuring framework, yet its evolving nature often leaves room for judicial interpretation.
India Corporate/Commercial Law

The Insolvency and Bankruptcy Code, 2016 ("Code") has been a cornerstone of India's restructuring framework, yet its evolving nature often leaves room for judicial interpretation. As courts navigate its complexities, each ruling refines the balance between creditor rights and debtor obligations. In a landmark judgment, the Hon'ble Supreme Court ("Supreme Court") has now reinterpreted the concept of guarantees and security interests under the Code, setting a precedent that has the potential to redefine financial creditor claims and security enforcement in insolvency proceedings.

In a significant judgment dated December 20, 2024, in China Development Bank vs. Doha Bank Q.P.S.C. and Ors.1, the Supreme Court examined the crucial question of whether the appellants could be classified as "Financial Creditors" under Section 5(7) of the Code and, in the alternative, whether they could at least be recognized as Secured Creditors entitled to receive payments in accordance with their security interest. The judgment lays down a precedent in determining financial debt and security arrangements, having far-reaching implications for the interpretation of financial instruments entered into between various parties and the involvement of creditors in the Committee of Creditors ("CoC").

The case arose in the backdrop of the Corporate Insolvency Resolution Process ("CIRP") initiated against Reliance Infratel Limited ("RITL"/ "Corporate Debtor"), which is a part of the larger Reliance Communications group including Reliance Communications Infrastructure Ltd. ("RCIL"), Reliance Communications Ltd. ("Rcom"), Reliance Telecom Ltd. ("RTL") and RITL (collectively referred as "RCom entities"). The appellants had filed their claims as Financial Creditors of RITL, which were admitted by the Resolution Professional ("RP"), thereby including them within the CoC of the RITL. However, Doha Bank, a secured Financial Creditor, filed an application ("Doha Bank's Application") before the National Company Law Tribunal ("NCLT"), challenging the classification of the appellants (except the appellant in Civil Appeal No. 7434 of 2023) being treated as Financial Creditors. Doha Bank argued that the appellants were not direct lenders to the Corporate Debtor and could not claim such status merely on the basis of the terms of the Deeds of Hypothecation ("DoHs").

While, Doha Bank's Application was pending adjudication, the CoC approved the Resolution Plan submitted by Reliance Digital Platform and Project Services Ltd, the Successful Resolution. The same was subsequently approved by the NCLT on December 3, 2020. The said approval was later challenged before the National Company Law Appellate Tribunal ("NCLAT"), which in turn directed the NCLT to first adjudicate on Doha Bank's Application and subject to the outcome, reconsider the approval of the Resolution Plan. Accordingly, before the NCLT, the appellants, to substantiate their arguments, placed reliance upon the DoHs entered into by all RCom entities, including the Corporate Debtor. It was contended by the appellants that vide these DoHs a common security pool was created wherein the RCom entities, including the Corporate Debtor, had hypothecated their properties in favour of a Security Trustee. Further, the RCom entities had undertaken to cover any shortfall in debt repayment if any entity defaulted. The appellants also argued that this arrangement effectively created a financial obligation on all RCom entities, such that they became co-obligors to pay the debt. Thus, this structure vested in them the position of Financial Creditors as per the terms of the Code.

The NCLT upheld the status of the appellants as Financial Creditors. However, this decision was subsequently overturned by the NCLAT, which ruled that the DoHs were not deeds of guarantee but rather created a security interest in the favor of the Security Trustee. The NCLAT emphasized that the DoHs were executed solely between the RCom entities and the Security Trustee and, therefore, did not constitute a contract of guarantee under the Indian Contract Act, 1872 ("Contract Act"). Consequently, the NCLAT set aside the NCLT's ruling and directed the declassification of the appellants as Financial Creditors, thereby excluding them from the CoC.

Aggrieved by the NCLAT's decision, the appellants approached the Supreme Court. In addition, a Civil Appeal No. 7434 of 2023, was also filed by a bank who had not been a party to the appeal before the NCLAT.

Before the Supreme Court, the appellants contended that, despite being titled as hypothecation agreements, the DoHs contained clear provisions obligating the Corporate Debtor to cover any deficiency in repayment, effectively making it a guarantor. They relied on the terms of the Master Security Trustee Agreement ("MSTA"), whereby the Corporate Debtor had covenanted to repay the loans of other RCom entities, hypothecated its assets on a first-ranking pari passu basis, and expressly agreed to cover any shortfall in the realization of secured debts. The appellants also relied on the NCLT's interpretation of Section 126 of the Contract Act, which defines a contract of guarantee as an agreement to perform the promise or discharge the liability of a third person in case of default. Since the Corporate Debtor had undertaken to pay amounts due and payable by other RCom entities, the appellants argued that this constituted a contract of guarantee under Section 5(8) of the Code.

On the other hand, the respondent argued that the DoHs were merely documents hypothecating certain properties of the RCom entities in favor of the appellants/third-party lenders, represented by the Security Trustee. It is argued that the DoHs were only between two parties i.e., the RCom entities (which includes the Corporate Debtor and three other RCom parties) and the Security Truste, lacking the essential elements of a guarantee, which requires the presence of three parties, the Guarantor, Principal Debtor, and Creditor. Therefore, the DoHs were not in conformity with the requirements of Section 126 of the Contract Act. It is also argued that the DoH was subject to the realisation of hypothecated assets, which became impossible due to the moratorium imposed under Section 14 of the Code. Since the hypothecated property cannot be sold, there could be no question of sale or realization and as there would not be any shortfall, the question of meeting the shortfall would not arise.

The Supreme Court, on careful consideration, noted that the title of a document alone does not determine the legal nature of the document, rather the obligations under the agreement are decisive in determining whether it constitutes a contract of guarantee. The Court ruled that according to the terms of the DoHs, the Corporate Debtor had explicitly undertaken to meet the shortfall in repayment of the secured facilities extended to RCom and RTL. This, in turn, constituted an obligation to pay the liability of third parties, thereby fulfilling the essential requirements of a contract of guarantee under Section 126 of the Contract Act. The Court further analyzed the role and function of the Security Trustee under the MSTA and DoHs, observing that the Security Trustee was appointed to act on behalf of Secured Lenders and was authorized to enforce security interests upon default. Furthermore, according to the terms of the MSTA, the Secured Lenders had authorized the Security Trustee to execute security documents, accept hypothecation, and enforce security. The Court observed that the assets of all four RCom entities, including the Corporate Debtor, were hypothecated as first-ranking pari passu charge in favour of the Security Trustee in order to secure the obligations of RCom and RTL, the actual borrowers. Therefore, the Security Trustee, acting on behalf of the appellants, had the authority to take possession, sell, or otherwise dispose of the hypothecated assets in the event of default.

Supreme Court also pointed out under Section 3 (11) of the Code "debt" is a liability or obligation in respect of a claim which is due from any person and includes a financial debt or operational debt and as noted earlier, a claim is a right to payment whether or not, such right is reduced to judgment and whether it is disputed or undisputed. The right to payment can be legal, equitable, secured or unsecured. Hence, even if there is a liability or obligation in respect of a payment which is being disputed, it still amounts to a claim. Further, once there is a liability or obligation in respect of a claim, it becomes a debt and once there is a financial debt, the person to whom a debt is due, becomes a Financial Creditor. Furthermore, a contract becomes a guarantee when the contract is to perform the promise or discharge the liability of a third person in case of default. Therefore, when a person enters into a contract to perform or discharge the liability of a third party, the contract becomes a contract of guarantee and thus, the claim need not be contingent upon an actual default rather, if a financial liability exists, even if disputed, it qualifies as financial debt. The Court also emphasized that the existence of a moratorium under Section 14 did not negate a creditor's right to claim, and the requirement to demonstrate a cause of action for invoking a guarantee was not necessary under Section 3(6) of the Code. In view of the above, the Supreme Court set aside the NCLAT order dated September 9, 2022, and reinstated the NCLT's order dated March 2, 2021, reaffirming the classification of the appellants as Financial Creditors.

In conclusion, while Supreme Court relied on some parts of HoDs to establish Corporate Debtor's liability as a guarantor, it seems to have not considered the precedents set in Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited,2 and Phoenix ARC (P) Ltd. v. Ketulbhai Ramubhai Patel,3 where it was ruled that a mere security interest does not confer financial creditor status. This raises a serious question, if a deed of hypothecation can be construed as a deed of guarantee, does this interpretation extend to all security documents containing similar covenants?

Thus, the judgment marks a significant shift in the understanding of financial debt and security instruments under the Code. At the same time, by recognizing the Corporate Debtor's obligation to cover shortfalls as a contract of guarantee, the Court has reinforced the enforceability of security interests under hypothecation agreements, potentially strengthening the rights of secured creditors.

This newfound judicial stance could provide lenders with stronger claims in insolvency proceedings, ensuring better recovery prospects. However, it also blurs the long-standing distinction between security instruments and guarantees, creating uncertainty in financial transactions. Ultimately, while the judgment strengthens creditors' rights, it also opens the floodgates to potential challenges in structuring security arrangements, leaving stakeholders to grapple with its broader implications.

Footnotes

1 2024 SCC OnLine SC 3829

2 2019 SCC OnLine SC 1775

3 (2021) 2 SCC 799

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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