[Manav is a student at NALSAR University of Law.]
It is commonplace in financing transactions to see a third-party creating a security interest in favour of a lender for a credit facility extended to the borrower. However, in the event of the insolvency of the provider of security interest, these third-party security holders have not been classified as financial creditors, which would directly impair their ability to participate in the resolution process since they would not be a part of the committee of creditors (CoC) or be allowed to vote on the resolution plans and would most likely diminish their recovery. In light of the same, it becomes important to analyse the trajectory and the development of law in respect of the treatment afforded to third party security holders and discuss the practical implications of the same.
Jaypee Infratech and Phoenix ARC: A Step in the Wrong Direction?
Upon perusal of the decisions of the Supreme Court (SC) in Anuj Jain (IRP for Jaypee Infratech Limited) v. Axis Bank Limited (Jaypee Infratech) and Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel, (Phoenix ARC) we see a flawed approach taken in respect of the classification of third-party security holders which overlooks commercial realities and customary banking practices.
In Jaypee Infratech, the lenders of Jaypee Associates Limited (JAL) had a security interest (through a mortgage) created in their favour by Jaypee Infratech and were not classified as financial creditors by the SC and were rather classified merely as ‘secured creditors’. The SC's reasoning was based on the following: (a) that a financial creditor must prove that the corporate debtor owes a financial debt to such financial creditor which the JAL lenders failed to show; and (b) that a third-party security holder is only interested in realizing the value of its security and not concerned with the revival of a corporate debtor.
It can be seen that the court has taken a very narrow view of the definition of 'financial debt' under Section 5(8) of the Insolvency and Bankruptcy Code 2016 (IBC) by holding that since there was no disbursement of debt against consideration of time value of money to the lenders, there would not be any financial debt. This is because it is a very well-established position of law that the creation of security for securing the performance of an obligation or payment is inextricably linked to the underlying debt or obligation i.e., debt subsists within the security interest. On the basis of this position, it can be argued that the person creating the security interest is undertaking to repay the debt owed to the creditor to the extent of the security interest and therefore also be considered as a financial creditor of the debtor. In light of the same, such a transaction can be construed to be a guarantee since the third party is intending to discharge the obligation of the debtor to the extent of the security and therefore could classify such interest holders as a financial creditor under Section 5(8)(h) of the IBC.
Even in Phoenix ARC, the SC accepted the line of reasoning adopted in Jaypee Infratech, while refusing to classify the lenders of another entity as financial creditors when they held a security interest through the pledge of shares created by the corporate debtor. Furthermore, the notion that security interest holders are not interested in the revival of the corporate debtor would be misplaced. This is because it assumes that financial creditors would not have highest recovery as their first priority and at the same time assuming that the security interest beneficiary would not want better resolution of the corporate debtor also seems erroneous. Such a decision would render the mortgage/pledgee remediless without any fault on their part.
Therefore, it can be seen that the aforementioned decisions ignore commercial reality of third-party security transactions being commonplace. By classifying beneficiaries of the security interest as merely secured creditors under Section 5(30) of the IBC would leave them out of the decision-making process in respect of the resolution plan and could lead to their security interest being extinguished without them having any say in the same.
Amtek Auto: Filling the Gap and the Practical Challenges
While the aforementioned decisions did settle the position on the classification of such beneficiaries, it left the question open with respect to the remedy that they could seek. In the M/s Vistra ITCL (India) Limited v. Dinkar Venkatasubramanian (Amtek Auto), the corporate debtor pledged shares in favour of the appellant for the loan facilities extended by the latter to certain group entities and the said pledge agreement was vaporised under the resolution plan. In this situation, the SC correctly identified the peculiar situation of the security holders i.e., not only were they denied the benefit of realising the security interest but also excluded from the ambit of the decision-making process by not being treated as financial creditors.
Such a line of argumentation was also adopted by the SC in Jaypee Kensington Boulevard Apartments Welfare Association & Others v. NBCC (India) Limited and Others (Jaypee Kensington), which also held that the extinguishment of a third-party mortgage interest without allowing for their participation was a violation of due process of law. Moreover, in SREI Infrastructure Finance Limited v. Sterling International Enterprises Limited [MA 1584/2018 in CP 402/2018 (NCLT Mumbai)] as well, a violation of natural justice was recognised when the third-party mortgagee was excluded from resolution process by the refusal to classify them as a financial creditor.
Until Amtek Auto, the precedents in this regard did not shed light on the treatment to be afforded to the third-party security holders under the Resolution Plan and particularly in Jaypee Kensington the SC restricted its opinion to the fact that a third-party security interest cannot be extinguished without ‘assigning any value’.
However, in Amtek Auto, the SC put forth a two-fold solution: (a) the third-party security holders are to be treated as secured creditors by the resolution applicant (RA) which would entitle them to retain the security interest and would be entitled to retain the security proceeds on the sale of the security, and (b) the treatment as a secured creditor which would entitle them to enforce the security interest upon the conclusion of the corporate insolvency resolution process (CIRP).
This raises a few issues to address in respect of its practical implications:
First, while it is a welcome move in favour of the secured creditors, it is likely to have an impact on the interest of the RA. This is because the secured creditors are now being brought into the CIRP, albeit without a voting right, and the RA would be disincentivised from bidding for those assets which are ‘stuck’ or discount the value of those assets from the resolution plan to be put forth before the CoC. This would have the effect of carving out the assets of the corporate debtor since there is a possibility that these assets will not go along with the rest upon conclusion of the CIRP. Further, it also has the possibility to impact the clean slate theory, since there is a chance that the security holders initiate litigation post the implementation of the resolution plan to enforce the security interest which would only go to drag on the insolvency process and add to the costs of the successful RA.
Secondly, there is no clarity on the amount that is to be paid to the secured creditors in this respect going by the precedent in Jaypee Kensington. While operational and dissenting financial creditors are paid the minimum liquidation value, there is no mandate for the successful RA to pay the same to the secured creditors. Expectedly, this can lead to disagreements on the amount to be paid to such creditors as well as contentions regarding the identification of a desirable asset of the creditor’s choice for enforcement as seen in IDBI Bank Limited v. Jaypee Infratech Limited.
To resolve this issue and assure the payment of at least the minimum liquidation value, it would require an amendment to include secured creditors within the ambit of Section 30(2)(b) of the IBC.
Conclusion
It is quite clear that both Jaypee Infratech and Phoenix ARC have taken a restrictive approach on grounds of extent of obligation and ultimate intent of such creditors which has limited the ability of third party security holders to participate in the CIRP. While Amtek Auto does widen the regulatory protection afforded to such creditors, there is a need for a legislative amendment as aforementioned to bring about a consistency in the treatment given to the security holders under a resolution plan.
Nevertheless, to avoid the exclusion from the CoC, third party security providers could undertake an obligation to repay the debt as well (i.e., a covenant to pay) which could be construed as a guarantee, thereby as financial debt, and allow the security holders a say in the CIRP and determine the actions to be taken with respect to their security.