Whose Loan Is It Anyway? The Indian Supreme Court's Turncoat On 'Financial Creditors'
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Imagine a company X, incorporated as a special purpose vehicle (SPV), by company Y (its holding company) for undertaking a particular infrastructure project. The contractual framework involves borrowing of capital by Y by mortgaging X’s land/assets. The consortium of lenders extending finance would offer facilities at a lower rate of interest as the loans are collateralized by X’s assets, such that upon Y’s failure to repay, the obligation to repay the facilities foists upon X.
The above described arrangement, i.e. third-party mortgage financing, wherein the lenders’ interest is secured by the assets of a third party (often an associate company of the principal debtor), is a common feature of infrastructure financing.
However, the Supreme Court in its recent decision in Anuj Jain v. Axis Bank Limited (February 2020) has inter alia held that such third-party mortgages are not akin to guarantee obligations and such lenders, will not be permitted to participate in the CIR process of the subsidiary, or be able to file their claims as financial creditors, when such subsidiary undergoes insolvency under the Insolvency and Bankruptcy Code, 2016 (Code). The decision was pronounced in reference to Jaypee Infratech Limited’s (JIL) CIR process, where its mortgagees (lenders of its holding company Jaiprakash Associates Limited, or JAL) were precluded from filing their claims before the resolution professional and sitting on its committee of creditors (CoC).
This lis needs to be examined in the context of the Code which has conceived the idea of a CoC. The CoC mostly comprises of ‘financial creditors’ (FC), typically banks and financial institutions of a debtor, which possess the requisite financial acumen, and ostensibly, the maximum skin of the game. Since FCs are placed high in the claim settlement process and enjoy extensive decision-making powers, who can be classified as a FC under the Code has acquired importance.
The Code has defined FCs as those who have extended financial debt, i.e. advances which in essence are commercial borrowings, with an element of assured returns. While interpreting the Code, tribunals, especially NCLAT (Appellate Tribunal), while posed with this question, have proceeded to define FCs to include guarantors, put-option holders, flat allottees and even third-party mortgagors.
The Supreme Court has echoed this sentiment and in its landmark decision in 2019 (Swiss Ribbons v Union of India), has lucidly defined FCs in the context of their envisaged roles. FCs have been defined to mean and include such parties that are owed financial debt and possess requisite financial acumen (ie. the ability and resources to assess the viability of a debtor prior to lending) referring to banks and financial institutions. The Supreme Court has stressed this as the vital difference between FCs and operational creditors, and as the reason for grating them priority in the waterfall of claims and in the CIR process decision-making.
However, the Supreme Court in Anuj Jain (supra.) has held that JAL Lenders (comprising of prominent banks such as Axis Bank Limited, ICICI Bank Limited etc.), are not FCs as do not possess this requisite interest in resuscitation of its subsidiary (JIL), as they were the lenders of the holding company only.
The reasoning adopted by the Supreme Court appears to be flawed, at the outset. Despite recognizing that third-party mortgage obligations mirror guarantee obligations, the Court has proceeded to hold that they will still not constitute financial debt, contrary to the provisions of the Code and its own prior decision where it affirmed that guarantors are FCs under the Code. Further, it has held that disbursal to be an intrinsic factor in determining what constitutes financial debt and since third-party mortgagees do not disburse debt, they cannot fall within the purview of this definition. This, too, is contrary to the Code, which recognizes guarantee and indemnity obligations (which do not involve disbursal) to be financial debt and those extending it as financial creditors. This narrowing of the definition of financial creditors has threatened the position of guarantors and those who lend basis security.
Until the Supreme Court in a future decision restores third-party mortgagors to the status of financial creditors, this judgment will continue to have ramifications on lenders, and borrowers looking to finance their projects at a reasonable rate of interest. Lenders who will be excluded from participating in time-bound CIR processes and will have to individually file applications before high courts/debt recovery tribunals to enforce their security interests, procedures which may take months to lead to fruition. This will disincentivize them from accepting third-party properties as security and compel them to extend facilities at higher rates of interests.
The Supreme Court has not only deviated from its previous decision in Swiss Ribbons case but also from another landmark decision in the case of Essar Steel Limited where the importance of secured lending was discussed extensively. One can only hope that the Court renders a future decision to set right the wrongs in Anuj Jain case or a clarification is issued by the regulator.
*Samudra Sarangi (Partner, Law Offices of Panag & Babu); Srishti Khare (Associate, Law Offices of Panag & Babu)