EPC v. Matix: Hierarchical Approach to Debt–Equity Classification under IBC

[Niharika is a student at National Law School of India University.]

Instruments which are termed as "hybrid securities" fit right between debt and equity to take advantage of different tax or legal rules. This recharacterization often upsets the balance between regular creditors and investors, as it allows those who should be taking the most risk to jump ahead in the payment line. Recently, the Supreme Court (SC) in EPC Constructions India Limited v. Matix Fertilisers and Chemicals Limited (EPC v. Matix) has asserted that liabilities arising from redeemable preference shares do not become due or payable unless the mandatory redemption conditions under the Companies Act 2013 (CA) are satisfied. What it means for the debt equity divide is that even if an arrangement which might have the substance of a loan, it cannot be treated as a 'debt' for insolvency purposes if the law classifies it as share capital.  

This article suggests a hierarchical framework for debt classification under the Insolvency and Bankruptcy Code 2016 (IBC) wherein company law constraints function as threshold gatekeepers that determine whether a legally enforceable debt can arise at all, while substance-over-from analysis is put to a secondary role assessing the character of obligations that have already crystallised in law.  It also argues that such an ordering is consistent with Geronimo’s residual-risk theory of equity which treats shareholders as residual claimants whose entitlement to repayment is inherently contingent and subordinate to creditors.

Financial Debt under IBC: Commercial Effect of Borrowing and Statutory Constraints 

Section 5(8) of the IBC defines financial debt as a debt along with interest if any which is disbursed against the consideration for the time value of money. Section 5(8)(f) serves as an important provision because it includes a very crucial ingredient i.e. any amount under any other transaction including forward sale or purchase agreements, having the ‘commercial effect of borrowing’ will be treated as a debt. At the first glance, the language of this provision leaves the interpretation to be open and ambiguous. However, SC in Global Credit Capital Limited v. Sach Marketing Private Limited (Global Credit) provided clarity on this ambiguity by ruling that for an amount to have the commercial effect of borrowing under section 5(8)(f), it is necessary to look past the face value of the written agreement to see if the transaction was in substance used as a tool for raising finance or not. This is important because the classification of financial instruments determines how risk is allocated between investors and creditors so as to determine who is entitled to fixed repayment and who bears residual risk. This allocation prevents investors from re-characterising equity as debt. 

However, while the court in Global Credit looked at economic substance for simple contracts, the recent EPC v. Matix judgment has suggested something different. Matix Fertilizers and Chemicals Limited (appellants) in this case chose to convert their debt into 8% cumulative redeemable preference shares. The court while ruling asserted that CA acts as a complete code governing share capital and Section 55 of the CA clarifies that the redemption of preference shares is a statutory process contingent upon the availability of profits or the proceeds of a fresh issue of shares. As, in the instant case, the company was making loss and no fresh issue had occurred, the redemption could not be considered ‘due or payable’. 

The court in EPC v. Matix judgment also discussed Sanjay D Kakade v. HDFC Ventures Trustee Company Limited (Sanjay Kakade) judgement wherein the National Company Law Appellate Tribunal (NCLAT) had adopted a substance-oriented approach to determine the nature of an investment. It is important to note that the court here did not outrightly reject the substance-over-form idea rather, it circumscribes the stage at which such reasoning may operate. The case of Sanjay Kakade involved a share subscription and shareholders agreement (SSHA) where the investor subscribed to equity and compulsorily convertible preference shares for a real estate project.

The tribunal noted that the SSHA and the subsequent "binding term sheets" provided for a mandatory exit mechanism with a guaranteed internal rate of return (IRR). Furthermore, the project required "further funding”, and the raising of funds through these agreements was deemed to have the commercial effect of borrowing. The NCLAT held that because the investment was made with the ‘intent’ of earning profit through a guaranteed IRR and involved a disbursal for the time value of money, it qualified as a financial debt under Section 5(8)(f). This ruling suggests commercial substance of the transaction over its formal legal structure by stating that if an equity linked instrument functionally operates as a loan which guarantees a fixed return and provides a time-bound exit it can be classified as a financial debt, allowing the holder to invoke section 7 of the IBC. 

If we read both the judgments closely, they establish a hierarchical framework for debt-equity classification. While Sanjay Kakade looks at the "commercial effect," EPC v. Matix is the most recent precedent creates a statutory boundary within which such substance-based analysis must operate. The court in EPC v. Matix makes it clear that Section 5(8)(f) of the IBC cannot be invoked to transform a clear equity investment into a debt obligation merely because an exit has become due, where company-law conditions governing repayment have not been satisfied. The consequence is that the "commercial effect of borrowing" clause cannot be used to override statutory compliance. The thresholds in this framework are examined below. 

A Hierarchical Framework for Debt Classification 

Statutory classification

The first threshold lies into determining whether the obligation to repay has legally solidified into a debt that is due and payable according to relevant provision of the company law. If we take for example of the EPC v. Matix judgement case, under Section 55 of the CA, the redemption of preference shares is contingent upon the existence of profits or fresh share proceeds. If these statutory conditions are not met, the amount is not due in law, regardless of the maturity date specified in the agreement.

Insolvency law should only deal with legal rights that already exist; it should not be used to create new rights or force early payments. If bankruptcy courts were allowed to change these original rights, it would encourage people to file for bankruptcy dishonestly just to get a better deal. By keeping rights the same as they were before the filing, the law protects the original order of investors and prevents anyone from manipulating the system to improve their financial position just because a company is failing. 

What the judgment implies is that if this threshold is not satisfied, no debt or default arises under the IBC as an absolute bar to section 7 application. Reinier Kraakman mentions that equity is defined by its residual and risk-bearing character and insolvency law cannot be permitted to dodge these constraints without collapsing the distinction between ownership and credit. With this argument, a preference shareholder remains an investor and cannot turn into a creditor simply because their exit is overdue.

Substantive characterisation

The second threshold considers that if the respective obligations successfully cross tier 1 -- for instance, if profits are available but the company refuses to pay -- the analysis can proceed to the statutory holding of Section 5(8) of the IBC. At this stage, the court will then have to apply the commercial effect of borrowing test like it did in the Global Credit, to induce the nature and character of the debt, which requires an assessment of whether the transaction reflects disbursal against consideration for the time value of money notwithstanding its formal description.

Justice Abhay S Oka, who authored this judgment, stressed that Section 5(8) of the IBC employs the expression ‘means and includes’ and that the part of the definition preceding the word ‘includes’ lays down mandatory conditions which must be satisfied before any transactions can fall within the inclusive categories of financial debt. This aligns with the limited but legitimate role of insolvency law in classifying existing obligations that substance-based analysis may be deployed to prevent formal labels from obscuring real credit relationships, but only where such analysis does not contradict the underlying legal architecture governing repayment rights. It is within this secondary domain that decisions such as Sanjay Kakade operate. In this case, the substance-based inquiry did not negate statutory capital rules but functioned to characterise an obligation that had already matured in law. 

By following this two-tier approach, it ensures that the nature of Section 5(8)(f) is not used to bypass the strict protections of share capital governed by the CA.

Conclusion 

The EPC v. Matix ruling clarifies that IBC is not a tool for ex post risk reallocation but a mechanism for enforcing rights that have already solidified under non-bankruptcy law. The threshold introduced in this article places company-law enforceability as a threshold condition and confines substance-over-form analysis to a secondary role. If the commercial effect of borrowing inquiry were applied without first establishing legal enforceability, it would allow such form-shifting to undermine the creditor-shareholder divide entirely. This way it also parallels the duty of the court to preserve the debt–equity boundary and protects the residual risk structure which is inherent in corporate finance.