Financial Creditor Status & Hypothecation Deeds in IBC

Introduction

This article delves into a significant judgment by the Supreme Court of India, which meticulously examined the classification of creditors as ‘Financial Creditors’ under the Insolvency and Bankruptcy Code, 2016 (IBC). The ruling provides crucial clarity on interpreting Deeds of Hypothecation (DoH) and the contractual obligations that define a ‘financial debt,’ particularly in complex corporate structures involving pooled assets and inter-corporate liabilities.

1. Factual Background and Procedural History

The present appeals stemmed from a Corporate Insolvency Resolution Process (CIRP) initiated against Reliance Infratel Limited (RITL), also referred to as “the Corporate Debtor”. The CIRP began at the instance of Ericsson India Private Limited. Public announcements were subsequently made under Section 15 of the IBC, inviting claims from various creditors. The appellants, a batch of banks including China Development Bank, submitted their claims, asserting their status as ‘Financial Creditors’ of the Corporate Debtor. The Resolution Professional (RP) initially admitted these claims, thus including the appellants in the Committee of Creditors (CoC).

However, Doha Bank, claiming to be a direct lender and secured Financial Creditor of RITL, challenged the appellants’ classification as Financial Creditors before the National Company Law Tribunal (NCLT). Doha Bank contended that the appellants were not direct lenders to the Corporate Debtor and that their claims, based on various Deeds of Hypothecation (DoH), did not qualify them as Financial Creditors.

During the pendency of Doha Bank’s application, a Resolution Plan for the Corporate Debtor was approved by the CoC on March 2, 2020, and subsequently by the NCLT on December 3, 2020. Crucially, the NCLT approved the plan without deciding the pending application regarding the appellants’ Financial Creditor status. This led to an appeal before the National Company Law Appellate Tribunal (NCLAT), which, on January 19, 2021, directed the NCLT to decide Doha Bank’s application, noting that the Resolution Plan’s approval could be reconsidered based on the outcome.

Following this, the NCLT heard Doha Bank’s application and upheld the appellants’ status as Financial Creditors. This NCLT order was then challenged by Doha Bank before the NCLAT. The NCLAT, in its impugned judgment dated September 9, 2022, reversed the NCLT’s decision, holding that the DoH was not a deed of guarantee and that the Chargors (including the Corporate Debtor) could not be treated as guarantors. Consequently, the NCLAT set aside the NCLT’s order and remanded the case for consequential actions, effectively de-recognizing the appellants as Financial Creditors. This NCLAT judgment became the subject of the present appeals before the Supreme Court of India.

The core of the dispute revolved around the interpretation of the DoH, executed jointly by various “RCom entities” (Reliance Communications Infrastructure Ltd., Reliance Communications Ltd., Reliance Telecom Ltd., and RITL). These DoH created a charge over their common pooled assets to secure facilities advanced by the appellants. The appellants argued that a specific clause within the DoH created an obligation on each RCom entity, including the Corporate Debtor, to make good any shortfall in recovery of amounts after the realization of hypothecated assets, which they contended amounted to a guarantee.

2. Identification of Legal Issues

The Supreme Court primarily addressed the following pivotal legal questions:

• Classification as ‘Financial Creditors’: The central issue was whether the appellants could be classified as ‘Financial Creditors’ within the meaning of sub-section (7) of Section 5 of the IBC. This involved a thorough examination of whether the obligations undertaken by the Corporate Debtor under the Deeds of Hypothecation (DoH), specifically the covenant to pay any shortfall, constituted a ‘financial debt’ under Section 5(8) of the IBC.
• Classification as ‘Secured Creditors’ (Alternative Issue): In the event that the appellants were not classified as ‘Financial Creditors’, an alternative issue was whether they could still be classified as ‘Secured Creditors’ and, if so, whether they were entitled to receive a payout commensurate with their security interest.

3. Arguments of the Parties

Arguments on Behalf of the Appellants (China Development Bank & Ors.): The appellants strongly contended that they qualified as ‘Financial Creditors’ under the IBC. Their arguments were primarily based on the interpretation of the Deeds of Hypothecation (DoH) and the Master Security Trustee Agreement (MSTA).

• Nature of Obligation in DoH as Guarantee: The appellants argued that the DoH, executed jointly by the RCom entities (including the Corporate Debtor), contained a three-fold obligation. Firstly, the Corporate Debtor, as a Chargor and Obligor, covenanted to pay the appellants the amount due under the facilities availed by other RCom entities (RCom and RTL). Secondly, a charge was created over its entire asset pool. Thirdly, and most critically, under sub-clauses (ii) and (iii) of Clause 5 of the DoH, the Corporate Debtor expressly agreed to make good any shortfall in the realization of outstanding debt to the appellants if the charged assets were insufficient. The appellants asserted that this undertaking to pay the shortfall amounted to a “promise to pay” and was therefore in the nature of a guarantee under Section 126 of the Indian Contract Act, 1872. They highlighted that the Corporate Debtor, though not a direct borrower, undertook to discharge the liability of a third party in case of default.
• “Financial Debt” Definition: The appellants argued that the definition of ‘financial debt’ under Section 5(8) of the IBC is inclusive and not exhaustive. They asserted that the guarantee provided by RITL-Corporate Debtor for the financial facility availed by other RCom entities would constitute a ‘financial debt’ under Section 5(8)(i) of the IBC, thereby entitling them to be classified as Financial Creditors. They cited judicial precedents to support that debt need not be directly disbursed to the Corporate Debtor.
• Enforceability of Contract by Beneficiary: It was submitted that the Security Trustee acted for the benefit of the secured lenders (appellants) as direct beneficiaries under the DoH, and a beneficiary to a contract can enforce it even if not a direct party.
• Impact of Moratorium: The appellants argued that the moratorium under Section 14 of the IBC only bars recovery or enforcement actions outside the resolution process but does not extinguish any rights or claims.
• Consistency in CIRP: The appellants contended that the entire CIRP had proceeded on the understanding that they were Financial Creditors, having participated and voted in the CoC as such. They argued against overturning this status at a belated stage when the Resolution Plan proceeds were pending distribution.
• Alternative Claim as Secured Creditors: In the alternative, the appellants argued that even if not classified as Financial Creditors, they should still be entitled to a payout commensurate with their security interest, as their security interest could not be extinguished during the CIRP. They highlighted that their security interest was accepted by the RP.

Arguments on Behalf of the Respondents (Doha Bank Q.P.S.C. & Ors.): The respondents vigorously opposed the appellants’ classification as Financial Creditors, primarily by asserting that the DoH did not constitute a contract of guarantee.

• DoH as Simple Hypothecation Deed: The respondents argued that the DoH was merely a simple document hypothecating properties of the borrowers (RCom entities) in favor of the lenders (appellants) represented by the Security Trustee. They contended that the DoH only had two parties – the Chargors (including the Corporate Debtor and other RCom entities) and the Security Trustee – thereby failing to meet the essential tripartite requirement (Guarantor, Principal Debtor, Creditor) for a contract of guarantee under Section 126 of the Contract Act. They cited Phoenix ARC Pvt. Ltd. v. Ketulbhai Ramubhai Patel.
• Interpretation of Clause 5(iii) of DoH: The respondents submitted that Clause 5(iii) of the DoH merely outlined the process for the Security Trustee to enforce the security and account for sales/realization and expenses. They argued that the Chargors’ agreement to pay any shortfall or deficiency in expenses referred only to those expenses incurred in enforcing the security, not the principal debt of other entities. They emphasized that a contract should be interpreted as it reads, without supplementation or addition by the court.
• Contingent Contract and Moratorium: The respondents argued that even if a portion of Clause 5(iii) were a separate agreement, it would be a contingent contract under Section 32 of the Contract Act, contingent on the sale of hypothecated properties and a shortfall in realization. They contended that this contingent contract ceased to exist once the moratorium under Section 14 of the IBC came into force on May 15, 2018, as the hypothecated property could no longer be sold. Consequently, no shortfall could arise, making the obligation to meet it moot.
• CIRP Focus on Revival, not Enforcement of Security: They submitted that the IBC’s focus is on the revival of the Corporate Debtor, not the enforcement of security interest during CIRP, which becomes impossible once a moratorium is applied.
• No Direct Loans to Corporate Debtor: The respondents asserted that the appellants were direct lenders to the other three RCom entities (RCom and RTL), not the Corporate Debtor (RITL), as the Corporate Debtor had not availed any loans or facilities from the appellants.
• No Guarantee in Financial Statements: They pointed out that the Corporate Debtor’s financial statements, both before and after the CIRP, did not reflect the MSTA or DoH as a guarantee.
• Resolution Plan Finality: The respondents argued that once the Resolution Plan was approved by the CoC and the NCLT, it could not be challenged, and the appellants, having voted for it, could not unilaterally reserve their right to seek amendments. They claimed the appellants had opted to forgo their security benefit by approving the plan.

4. Court’s Analysis and Reasoning

The Supreme Court undertook a comprehensive analysis of the legal nature of the Deeds of Hypothecation (DoH) and their implications for the appellants’ status as ‘Financial Creditors’ under the IBC.

• Interpretation of Deeds of Hypothecation (DoH) and Contract of Guarantee: The Court emphasized that the true nature of a document is to be discerned from its entire content and the rights and results flowing therefrom, not merely its nomenclature or isolated clauses. It stressed giving efficacy to the contract rather than invalidating it, adopting a common-sense approach to interpretation.
  • Parties to the DoH: The Court rejected the NCLAT’s finding that the DoH only had two parties (Chargors and Security Trustee). It noted that under the Master Security Trustee Agreement (MSTA), the Security Trustee was appointed to act for the benefit of “Secured Lenders” (appellants). Thus, the Security Trustee accepted security on behalf of the appellants, making the appellants beneficiaries to the DoH. The Court found that the DoH involved three parties: the Security Trustee (acting for appellants/creditors), the Corporate Debtor (Chargor/Guarantor), and the other RCom entities (Principal Debtors/Borrowers).
  • “Promise to Discharge Liability of Third Party”: The Court meticulously examined Clause 5(iii) of the DoH. It found that this clause not only provided for the enforcement of security interest but also contained a specific undertaking by each Chargor (including the Corporate Debtor) to “pay on demand by the Security Trustee… any shortfall or deficiency thereby shown” after the realization of hypothecated assets. The Court interpreted this “latter part of clause 5(iii)” to mean that if, after selling the hypothecated assets, there was a shortfall in discharging the liabilities of RCom or RTL (the principal debtors of the appellants), the Corporate Debtor (RITL) was obligated to pay that shortfall. This explicit promise by the Corporate Debtor to discharge the liability of third parties (RCom and RTL) to the appellants constituted a “contract of guarantee” as defined under Section 126 of the Indian Contract Act, 1872.
• “Financial Debt” under IBC: The Court affirmed that Section 5(8) of the IBC, which defines “financial debt,” is inclusive. Crucially, it highlighted clause (i) of Section 5(8), which includes “the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clause (a) to (h) of this clause” as a financial debt. The Court reasoned that since the underlying loans availed by RCom and RTL from the appellants fell within Section 5(8)(a) (money borrowed against interest), the guarantee provided by the Corporate Debtor (RITL) for these facilities under the DoH squarely fell within Section 5(8)(i). This meant that it was not necessary for the Financial Creditor to have directly disbursed funds to the Corporate Debtor for it to be considered a ‘financial debt’.
• Impact of Moratorium on Contingent Contract Argument: The Court addressed the respondents’ argument that the DoH was a contingent contract that ceased to exist upon the declaration of moratorium under Section 14 of the IBC, as hypothecated property could not be sold. While not explicitly rejecting the “contingent contract” argument on its own terms, the Court’s primary focus was on the nature of the obligation itself. By finding a direct guarantee under Section 126 of the Contract Act and Section 5(8)(i) of the IBC, the Court implicitly held that the liability stemming from the guarantee was not solely contingent on the sale of hypothecated assets but on the default and shortfall, irrespective of whether the assets could be liquidated during moratorium. The moratorium, as argued by the appellants, only bars enforcement outside the CIRP, not the existence of the debt or claim itself.
• Consistency and Estoppel: The Court also implicitly considered the consistency argument, noting that the CIRP had proceeded on the basis of the appellants being Financial Creditors. While the Court ultimately ruled on the legal interpretation of the documents, the procedural history reinforced the appellants’ position.

5. Final Conclusion and Holding

The Supreme Court concluded that the National Company Law Appellate Tribunal (NCLAT) erred in holding that the Deeds of Hypothecation (DoH) did not constitute a deed of guarantee and that the appellants were not ‘Financial Creditors’.

The Court held that the specific covenant within Clause 5(iii) of the DoH, wherein the Corporate Debtor (RITL) undertook to pay any shortfall or deficiency in the realization of outstanding debts owed by other RCom entities (RCom and RTL) to the appellants, unequivocally amounted to a “contract of guarantee” under Section 126 of the Indian Contract Act, 1872.

Furthermore, the Court ruled that this liability arising from the guarantee fell squarely within the definition of “financial debt” under Section 5(8)(i) of the Insolvency and Bankruptcy Code, 2016. The fact that the appellants had not directly disbursed funds to the Corporate Debtor was irrelevant, given that the guarantee was for an underlying financial facility to a third party.

Consequently, the Supreme Court set aside the impugned judgment of the NCLAT and upheld the NCLT’s order which had recognized the appellants as ‘Financial Creditors’. The judgment reinforces the principle that the substance of a contractual obligation, rather than its mere nomenclature, determines its legal character under the IBC. It clarifies that a third-party guarantee, even if embedded within a hypothecation deed, can establish a ‘financial debt’ for the guarantor, entitling the beneficiary to the status of a ‘Financial Creditor’ in insolvency proceedings.

FAQs:

1. What determines if someone is a ‘Financial Creditor’ in insolvency cases?

In insolvency cases, a ‘Financial Creditor’ is typically someone to whom a ‘financial debt’ is owed. This includes direct loans, but also liabilities arising from guarantees for financial facilities, as defined under the Insolvency and Bankruptcy Code.

2. Can a Deed of Hypothecation also act as a guarantee for debt?

Yes, a Deed of Hypothecation, while primarily creating a charge on assets, can also contain clauses where one party undertakes to cover any shortfall in the debt of a third party, effectively acting as a guarantee.

3. What is a “contract of guarantee” under Indian law?

A “contract of guarantee” is an agreement where one person promises to perform the obligation or discharge the liability of a third person in case of their default, involving three parties: the creditor, the principal debtor, and the surety (guarantor).

4. How does a court interpret a legal document like a hypothecation deed?

Courts interpret legal documents by examining their entire content and the true intent behind the clauses, rather than relying solely on the document’s title or isolated terms, to give effect to the contract.

5. Does an insolvency moratorium prevent a creditor from claiming their debt?

An insolvency moratorium generally restricts recovery or enforcement actions against a corporate debtor outside the resolution process, but it does not extinguish the underlying debt or the creditor’s right to submit their claim within the insolvency proceedings.

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