When Equity Pretends to be Debt: The Anatomy of Financial Obligation in Insolvency Law

[Qazi is a student at Rajiv Gandhi National University of Law.]

The development of modern corporate finance has made the line between equity participation and debt financing less clear. Convertible debentures, redeemable preference shares, and structured notes are now in a grey area. By fusing the fixed-return characteristics of debt with the ownership risks of equity, these instruments put legal systems that rely on formal classifications to establish rights and remedies to the test. The Insolvency and Bankruptcy Code 2016 (IBC) in India, which gives financial creditors specific authority, such as the ability to start insolvency proceedings under Section 7 and take part in the committee of creditors, is where this conflict is most noticeable.

In this context, the Supreme Court of India in EPCC v. Matix Fertilisers was asked to decide whether the non-redemption of cumulative redeemable preference shares (CRPS) constitutes a default with respect to a 'financial debt' as that term is defined by the IBC. The question was whether CRPS should be regarded as financial debt, which implied a repayment obligation, or as share capital, which represented investment. The court also looked at whether preference shares could become debt instruments due to the redemption requirement under Section 55 of the Companies Act 2013 and the more general idea of the "commercial effect of borrowing" under Section 5(8)(f) of the IBC. Ultimately, the case shaped how Indian jurisprudence separates investor risk from creditor rights in a quickly changing financial landscape by testing the delicate intersection of corporate capital law and insolvency law. 

Defining Financial Debt under the Insolvency Framework: Three-Part Test for Financial Debt

To ascertain the exact parameters of what constitutes a financial debt under the insolvency framework, the court conducted a thorough analysis of Section 5(8) of the IBC.  It maintained that three necessary elements had to be present: (i) a legally binding commitment or debt; (ii) a real payment from the creditor; and (iii) consideration for the time value of money, usually in the form of interest or another type of financial return.  This three-part test prevents an unduly broad interpretation of the provision by guaranteeing that only legitimate credit transactions are included in the definition of financial debt.

The court made it clear that Section 5(8)'s subclauses (a) through (i) are illustrative rather than exhaustive, permitting interpretive flexibility without sacrificing definitional accuracy. By applying this test, it established a clear distinction between share subscriptions and debt transactions, concluding that even redeemable preference shares are capital contributions rather than borrowings. Instead of granting repayment rights, such instruments confer ownership and dividend rights. Unless the main goal of the investment is to generate compensation for time value, the existence of redemption clauses or fixed returns does not turn an equity instrument into debt.

The preference shares are a component of share capital and can only be redeemed with distributable profits or proceeds from a new issue, citing Sections 43 and 55 of the Companies Act 2013.  Therefore, unlike a creditor's absolute right to repayment, redemption is contingent upon the company's financial capacity.  As a result, the rights of preference shareholders are conditioned and cannot be enforced as debt commitments. There was no enforceable debt or default under Section 3(12) of the IBC, and no redemption could legally take place. EPCC's reliance on accounting treatment, pointing out that CRPS's designation as "unsecured loans" in financial statements cannot supersede contractual intent or statutory provisions.  It was held that the law, not accounting practices, determines an instrument's legal character.

Finally, the court rejected the argument on the grounds of Section 5(8)(f)'s "commercial effect of borrowing" clause.  It decided that in the absence of an unconditional repayment obligation, this clause cannot convert equity into debt. According to the board resolution and associated documents, the CRPS was not issued to hide a loan but rather to improve the debt-to-equity ratio and make future borrowing easier. According to the IBC, EPCC was not a financial creditor since there was no proof of any side agreements or legally enforceable repayment commitments, so the CRPS remained equity instruments.

Judicial and Comparative Perspectives: Interpreting Financial Debt through Case Law and International Frameworks

In Anuj Jain, IRP for Jaypee Infratech Limited v. Axis Bank Limited (2020), the court established a fundamental principle that financial debt is more than just transactional complexity and requires a substantive test of funds disbursal against time value considerations. The notion was expanded upon in Radha Exports (India) Private Limited v. KP Jayaram and Another (2020), which distinguished between shareholder rights and creditor claims, emphasising that equity participation does not always entail a debt relationship under the IBC. 

The comparative international landscape exhibits a sophisticated approach to hybrid financial instruments, in contrast to India's more formalistic framework. Under UK accounting standards like IAS 32, which prioritize substance over form, preference shares with mandatory redemption or fixed dividend obligations are classified as financial liabilities. Similar nuanced economic substance tests are used by US courts and tax authorities to determine whether an instrument should be treated as debt or equity, taking into account the underlying risk allocation and return characteristics. 

The Innoventive Industries Limited v. ICICI Bank (2018) precedent demonstrates that Indian jurisprudence maintains a stringent standard that requires both a clear debt existence and payment default. This approach is consistent with a conservative regulatory philosophy that values maintaining legal certainty and safeguarding corporate capital. It also highlights the tension that exists between traditional legal classifications and the complexity of modern financial instruments. 

The judicial reasoning integrates these points of view to produce a comprehensive framework that goes beyond straightforward definitional boundaries. By emphasizing the essential elements of financial debt actual funds disbursal, consideration for time value, and a clear obligation to repay the court has emerged with an interpretive approach that finds a balance between regulatory integrity and business pragmatism. This approach recognizes that financial instruments are not static legal constructs but rather dynamic mechanisms for capital allocation and risk management. 

Balancing Statutory Consistency and Financial Innovation in Debt Classification

The vital distinction between debt and share capital, demonstrates a strong commitment to statutory coherence, and keeps insolvency law from superseding the Companies Act's capital maintenance principles. The court upheld contractual certainty and commercial discipline by restating that the IBC is intended to handle actual insolvencies rather than investor exits. It held that debt is extinguished once a creditor voluntarily converts debt into share capital.  This deters equity holders from abusing Section 7 in order to obtain coercive recovery and gives businesses the assurance that a delayed redemption due to insufficient profits cannot result in insolvency.

The decision is unduly formalistic and ignores circumstances in which redeemable preference shares serve as debt in the economy by providing fixed maturity and returns that are not reliant on profits. Modern hybrid instruments that function as loans may not be recognized due to the court's restrictive interpretation of Section 5(8)(f) ("commercial effect of borrowing"). India's form-based approach might not keep up with financial realities, in contrast to countries like the US and the UK where mandatory redeemable shares are frequently regarded as liabilities.

In practice, creditors who convert debt into preference shares have to acknowledge that they are no longer considered creditors. Instead, instruments should be structured as debentures, convertible bonds, or secured loans with separate redemption or guarantee clauses for those who want to keep the ability to repay. In order to guarantee that only valid debt is not equity claims masquerading as debt qualify under the IBC, the ruling also instructs NCLTs and resolution professionals to evaluate the actual legal and economic nature of instruments.

Conclusion: Linking Legal Form with Financial Reality 

The Supreme Court's ruling in EPCC v. Matix Fertilisers upholds the integrity of corporate capital law within the IBC framework by restating the crucial differentiation between creditor debt and shareholder investment. By holding that cumulative redeemable preference shares represent share capital rather than financial debt, the court appropriately prevented the IBC from turning into a tool for investors seeking to redeem rather than settle insolvency. The decision also emphasizes the growing tension between legal formality and financial innovation, though. Modern instruments often make it difficult to distinguish between debt and equity, and a purely form-based approach may overlook their true economic substance. Although the court's reasoning ensures clarity and predictability, it runs the risk of underrecognizing hybrid financing arrangements that functionally resemble borrowings. 

The decision cautions investors to carefully structure transactions using convertible notes, debentures, or explicit redemption covenants if they wish to protect creditor rights. However, it may also deter restructurings from converting debt to equity, which could restrict attempts at flexible recapitalisation. In the future, Indian insolvency law must evolve into a well-rounded framework that honours the framework of corporate law while allowing interpretation to be guided by economic realities. Thus, EPCC v. Matix Fertilisers is both a reaffirmation of legal principles and a call for doctrinal flexibility in the face of complex modern finance.