Understanding Financial and Operational Debt Under IBC

Introduction

The Supreme Court of India, in Global Credit Capital Ltd. v. Sach Marketing Pvt. Ltd. (2024 LiveLaw (SC) 331), examined the criteria distinguishing financial debt from operational debt under the Insolvency and Bankruptcy Code, 2016 (IBC). This ruling reinforces the principle that financial debt must involve the disbursal of funds with the commercial effect of borrowing, providing clarity for insolvency proceedings.

Facts of the Case

The dispute arose from two agreements dated April 1, 2014, and April 1, 2015, between the corporate debtor, M/s. Mount Shivalik Industries Ltd., and the first respondent, Sach Marketing Pvt. Ltd. These agreements appointed the first respondent as a Sales Promoter and required them to deposit a minimum security amount with the corporate debtor, earning 21% annual interest.

Following insolvency proceedings initiated by Oriental Bank of Commerce under Section 7 of the IBC, the first respondent initially filed a claim as an operational creditor but later reclassified itself as a financial creditor. The National Company Law Tribunal (NCLT) rejected the claim, but the National Company Law Appellate Tribunal (NCLAT) reversed the decision, holding that the first respondent qualified as a financial creditor.

Issues Before the Court

1. Whether the security deposit paid by the first respondent constituted financial debt under Section 5(8) of the IBC.
2. Whether the claim had any correlation to the service rendered, making it operational debt under Section 5(21) of the IBC.

Arguments

Appellant’s Arguments:

• The agreements clearly indicated a service contract.
• The security deposit was a prerequisite for appointment as a Sales Promoter, not a financial facility.
• The transaction lacked intent to raise finance.
• Reliance was placed on Swiss Ribbons Pvt. Ltd. v. Union of India (2019) and Pioneer Urban Land & Infrastructure Ltd. v. Union of India (2019) to argue that financial debt must involve money disbursed for the time value of money.

Respondent’s Arguments:

• The agreements functioned as financial transactions rather than service agreements.
• The security deposit was repayable with 21% annual interest, indicating the commercial effect of borrowing.
• The corporate debtor acknowledged the liability and accounted for interest payments.
• Cited Anuj Jain v. Axis Bank Ltd. (2020) and Phoenix ARC Pvt. Ltd. v. Spade Financial Services Ltd. (2021) to assert that the transaction fell under the ‘catch-all’ clause of Section 5(8)(f) of the IBC.

Court’s Reasoning

The Supreme Court upheld the NCLAT’s ruling, emphasizing the following key findings:

• The test for financial debt requires disbursal of money for time value consideration.
• The agreements did not correlate the security deposit with the service aspect of the contract.
• The corporate debtor’s financial statements treated the security deposit as a liability and recorded interest payments.
• Clause (f) of Section 5(8) includes transactions having the commercial effect of borrowing.
• The repayment obligation and fixed interest component confirmed that the security deposit qualified as financial debt.

Conclusion

The Court reaffirmed that for a claim to be an operational debt, it must relate to goods or services provided. Since the security deposit had no direct relation to the services purportedly rendered, it could not be classified as operational debt. Instead, it met the criteria for financial debt, entitling the first respondent to be recognized as a financial creditor under the IBC.

This ruling reinforces the importance of assessing the real nature of transactions beyond their nomenclature and provides a clear precedent for similar disputes under the IBC.

FAQs:

1. What is the difference between financial debt and operational debt under the IBC?

Financial debt involves a loan or monetary disbursement with a repayment obligation and interest, while operational debt arises from the supply of goods or services.

2. Can a refundable security deposit with interest be treated as financial debt?

Yes, if the deposit includes a repayment obligation and interest, it may be considered financial debt due to its commercial effect of borrowing, as clarified by the Supreme Court.

3. Does the name or title of an agreement decide if it’s a financial transaction?

No. Courts look at the actual content and economic effect of the transaction. A contract labeled as service-related can still be financial in nature if it involves borrowing characteristics.

4. What is the ‘commercial effect of borrowing’ under the IBC?

It refers to any transaction where money is disbursed and is expected to be repaid with interest or financial return, even if it’s not a formal loan.

5. Can a party change their creditor classification during insolvency proceedings?

Yes, but they must prove their claim meets the legal definition under the IBC. The tribunal will assess whether the claim qualifies as financial or operational based on evidence, not the label used.

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