The Insolvency and Bankruptcy Code, 2016 (IBC) confers certain powers and rights on the financial creditors. On the one hand, the financial creditors enjoy a preference over the operational and government creditors in the waterfall mechanism for the distribution of liquidation proceeds of an Indian company, on the other, the financial creditors become members of the committee of creditors (CoC) in the corporate insolvency resolution process (CIRP). The IBC has set out various matters that would require approval of the CoC - in some cases, by way of a simple majority and in some critical issues (such as approval of the resolution plan or deciding on commencement of the liquidation proceedings), by 2/3rd voting powers.
The voting powers of the CoC members will be proportional to the claims admitted by the resolution professional. Therefore, it becomes imperative for the resolution professional to categorise the claims according to their status under the provisions of the IBC. To be classified as a financial creditor and become a member of the CoC, the claim submitted by the creditor must qualify as 'financial debt'.
The term 'financial debt' has been defined in the IBC to mean a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes, inter alia, the amount of any liability in respect of any of the guarantee or indemnity for money borrowed against the payment of interest. It is a settled position under the Indian law that the guarantor's liability is coextensive with that of the principal borrower. Therefore, in the event of payment default by the principal borrower, the lender shall have the option to initiate proceedings against the corporate guarantor under the IBC without being required to proceed against the principal borrower for recovery of the unpaid debt.
In the case of China Development Bank v. Doha Bank1, the Supreme Court of India (Supreme Court) clarified the status of indirect lenders in view of the terms and conditions of the deeds of hypothecation executed by Reliance Infratel Limited (Reliance Infratel).
Reliance Infratel was admitted to CIRP under the IBC. Reliance Infratel along with its group entities, namely, Reliance Communications Limited, Reliance Telecom Limited and Reliance Communications Infrastructure Limited (all four entities are collectively referred to as "RCOM Entities") entered into a master security trustee agreement with Axis Trustees Services Limited (ATSL) under which ATSL was acting as common security trustee with respect to the securities created by the RCOM Entities (including Reliance Infratel) in favour of lenders comprising of (i) Assets Care & Re-Construction Enterprise Limited (in its capacity as Trustee of ACRE-41-Trust), (ii) Shubh Holdings Pte. Limited, (iii) China Development Bank and (iv) Export-Import Bank of China (collectively referred to as "Lenders"). To secure the financing facilities extended by the Lenders, RCOM Entities jointly executed 4 (four) deeds of hypothecation (collectively referred to as "Hypothecation Deed"). Under the Hypothecation Deed, each of RCOM Entities agreed to make good of the shortfall or deficiency in the recovery of amounts after the realisation of the hypothecated assets.
In the CIRP of Reliance Infratel, the resolution professional admitted the claims submitted by the Lenders as financial debts and classified the Lenders as financial creditors of Reliance Infratel. Accordingly, the Lenders were included in the CoC of Reliance Infratel. As members of the CoC, the Lenders participated in the decision-making on critical matters, including approval of the resolution plan for the revival of Reliance Infratel. Doha Bank approached the National Company Law Tribunal (NCLT) and challenged the said decision of resolution professional to classify the Lenders as financial creditors. Doha Bank contended, inter alia, that (i) the Lenders were not direct lenders to Reliance Infratel as no money was lent/disbursed by the Lenders to Reliance Infratel, (ii) the Hypothecation Deed is not in the nature of corporate guarantee but only as an undertaking to pay the amount of RCOM Entities by taking steps to realise and sell security hypothecated, and (iii) no counter indemnity obligation in respect of a guarantee, indemnity, bond, documentary, letter of credit was issued by Reliance Infratel in favour of the Lenders. Accordingly, as per submissions of Doha Bank, the Lenders were not financial creditors of Reliance Infratel.
The NCLT considered the submissions made by the parties and held that the Hypothecation Deed contains an undertaking on the part of RCOM Entities (including Reliance Infratel) to pay the shortfall or deficiency in the amount realised by the security trustee after enforcing the security interest and that such undertaking was in nature of a guarantee. As such, the Lenders were rightly categorised as financial creditors of Reliance Infratel.
However, the National Company Law Appellate Tribunal (NCLAT) had a different view. The NCLAT stated that the 'Deed of Hypothecation' merely creates security interest and that a mere security of interest created by hypothecation or mortgage does not constitute a financial debt. To constitute a guarantee, there needs to be an express or unequivocal promise to discharge the liability of the principal borrower in case of any default. Merely a clause that deficiency would be recouped would not constitute the guarantee. The definition of financial debt under the IBC is exhaustive and the 'Deed of Hypothecation' does not fall within its ambit. The NCLAT held that RCOM Entities could not be treated as guarantors within the meaning of the Indian Contract Act, 1872.
The Lenders reached the Supreme Court against the NCLAT's ruling. The Supreme Court examined the terms of the Hypothecation Deed and the financing documents in view of the provisions of Section 1262 and Section 1273 of the Indian Contract Act, 1872, and reiterated that a contract becomes a guarantee if the contract is to perform the promise or discharge the liability of a third person in case of default. Thus, when a person enters a contract to perform or discharge the liability of a third party, the contract becomes a contract of guarantee. The Supreme Court relied on its earlier ruling in Phoenix ARC Private Limited4 wherein it held that the key words in Section 126 of the Indian Contract Act, 1872 are contract "to perform the promise" or "discharge the liability", of a third person. Both the expressions "perform the promise" or "discharge the liability" are related to a third person.
The Supreme Court finally concluded that in terms of the Hypothecation Deed and the financing documents, Reliance Infratel had undertaken to discharge the liabilities of other RCOM Entities (the borrowers). As such, these borrowers are third parties as far as Reliance Infratel is concerned. The relevant provision of the Hypothecation Deed, that contains an undertaking on the part of Reliance Infratel to discharge the liabilities of the borrower entities in the event of default, amounts to the guarantee provided by Reliance Infratel to the Lenders in terms of Section 126 of the Indian Contract Act, 1872.
Our comments
The IBC entrusts the CoC with the task of identifying the most feasible and viable resolution plan to revive the business of the corporate debtors. While approving the resolution plan, the CoC has a right to approve the manner of distribution of the amount offered by the resolution applicant, which may take into account the order of priority amongst creditors as laid down in the waterfall mechanism, including the priority and value of the security interest of a secured creditor. The Indian courts have held that the commercial wisdom of the CoC is of paramount importance without any judicial intervention. In this light, the Supreme Court's judgment is an important development as it clarified the scope of corporate guarantee and affirmed the status of indirect lenders as financial creditors under the IBC. This would be equally important from the borrower entities' point of view since in financing transactions, the group entities generally execute various security documents including deed of hypothecation to secure the interests of lenders. In case the financing documents contain an undertaking on the part of the group entities to pay outstanding debts of the principal borrowers on the occurrence of a payment default on the part of the principal borrowers, such undertaking could be viewed as a corporate guarantee giving the lenders/financiers the statutory right to proceed against such group entities under IBC if the principal borrower commits a payment default.
Footnotes
1. 2024 SCC OnLine SC 3829
2. Section 126 of the Indian Contract Act, 1872- A 'contract of guarantee' is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the 'surety', the person in respect of whose default the guarantee is given is called the 'principal debtor', and the person to whom the guarantee is given is called the 'creditor'. A guarantee may be either oral or written.
3. Section 127 of the Indian Contract Act, 1872- Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee.
4. Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel, (2021) 2 SCC 799: 2021 SCC OnLine SC 54
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