Position of compulsorily convertible debentures during insolvency proceedings

The Insolvency and Bankruptcy Code, 2016 (Code) is still a progressive code, which is not fully developed. Almost every case under this code is coming into headlines, even the adjudicating authorities are having a different opinion and are not strictly relying upon the previous judgements, due to which setting a precedent under this law is not kind possible as each case is of a different kind in one way or the another. Several questions are left unanswered in the code, the law is silent on many points, which are later answered by the Adjudicating Authority i.e. National Company Law Tribunal (NCLT) or the Appellate Authority i.e. National Company Law Appellate Tribunal (NCLAT).

DEBENTURES

Debentures are a kind of bond or as we may say a different type of debt instrument that are issued by private entities, since it is one of the only two ways available to raise funds i.e. debt and equity, for borrowing money from the public at a fixed rate of interest. Debentures are unsecured debt because there is no collateral against it. Since debentures haven't any collateral backing, they have to rely upon the creditworthiness and popularity of the provider for support.

Now the first question that arises is that whether the Debentures can be considered as a debt under this code or not, since they lack the basic element of being called a debt. 

To answer this question, section 5(8)(c) of the Code has defined ‘financial debt’ as “any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;”. The NCLAT Delhi bench, in the case of Neelkanth Township & Construction Pvt. Ltd. v. Urban Infrastructure Trustees Ltd, REED 2017 NCLAT Del 08514 held that Debentures come within the meaning of ‘Financial Debt’ as defined in clause (c) of sub-section 8 of Section 5. The NCLAT Delhi again in the case of Maif Investments India Private Ltd. v. Ind-Barath Energy (Utkal) Limited, REED 2019 NCLAT Del 04547, held that debentures constitute as a ‘financial debt’ under Section 5(8)(c) of the Code.

Although there are different types of debentures like Secured, Unsecured, Redeemable, Irredeemable, Partially Convertible, Non-Convertible and a few others in this article our focus will be strictly on Compulsory Convertible Debentures.

COMPULSORY CONVERTIBLE DEBENTURES (CCD)

The Compulsory Convertible Debentures (CCD) are the type of instruments that are converted into equity after a specific period of time on a particular date. These mandatorily get converted after the maturity date which is pre-decided. CCD is not considered as a proper debt instrument since they lack the basic criteria to be classified as a debt, collateral. Since these get converted into equity after a point of time, they are neither considered as a pure stock nor as a pure bond.

Now another question, which is unanswered, arises that how the CCD will be treated during the Corporate Insolvency Resolution Process (CIRP) of an entity since they are neither debt nor equity and how they will be treated during the CIRP will have a huge impact on the CCD holders.

The principal bench of NCLT Delhi answered this question in the case of SGM Webtech Private Ltd. v. Boulevard Projects Private Ltd., REED 2020 NCLT New Delhi 01641. The factual matrix of this case was that Ziasses Ventures Limited (Ziasses) invested around Rs.24.99 crores towards issuance of CCD and Rs.10 towards one share and by virtue of this investment, Ziasses got participation rights along with affirmative rights in the Corporate Debtor i.e. Boulevard Projects Pvt. Ltd, looking at the nature of CCD. Ziasses claim to be added to the list of Financial Creditors was denied by the Resolution Professional on the grounds that under the Foreign Exchange Management Act (FEMA) rules and regulations, the investment made by Ziasses against the debentures will be treated as Equity. On rejection by the Resolution Professional, an application was filed to be added to the list of financial creditors on the grounds of holding CCD which did not reach the maturity date.

Ziasses argued that the Corporate Debtor’s balance sheet showed the investment as a long term borrowing and showed that Tax Deducted at Source (TDS) was paid on interest over the debentures. Further, it argued that after treating it as a debt, the Resolution Professional cannot go against the statement in the Balance Sheet of the Corporate Debtor.

The Resolution Professional counter-argued that Ziasses, by virtue of having participated in control over the affairs of the Company and there is an affirmative vote in favour of the applicant, although the investment is shown as CCD, since the debenture sum is not repayable, it cannot be called as debt. Further, the Resolution Professional argued that under the FEMA regulations, convertible debentures come under the definition of ‘Capital’.

The Principal Bench allowed the application filed by Ziasses and made several observations, it was held that since the Code has an overriding effect on other legislation by virtue of Section 238 of the Code, it will include the FEMA Rules and Regulations also. The bench further observed that at the time of winding up of a company, whatever is shown as Debt in the books of the company shall continue to be treated as debt and whoever is shown as a Shareholder shall continue as a Shareholder and thus Ziasses’ investment will be treated as debt and not equity. After the maturity period, those Debentures will convert into Equity shares but until that time they will be treated as Debt and the Corporate Debtor shall pay fixed returns to Ziasses. The Principal Bench allowed the Interim Application and directed the Resolution Professional to admit Ziasses as a Financial Creditor. 

COMMENTS

I think, the NCLT has made an error while deciding this issue, since they relied on the general understanding of a debenture which represents a debt that is to be repaid over a period of time and CCD do not fulfil the basic requirement of being a debt instrument. Under Section 5(8) of the Code, interest is also present along with ‘financial debt’, which has to be paid from time to time to the debtors. Further, under section 3(11) of the code, debt is defined as a liability in respect of a ‘claim’ which is defined under section 3(6) as a right to payment, regardless of whether it is secured, unsecured, dispute, undisputed, matured or unmatured. The Hon’ble Supreme Court in the case of Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited etc., REED 2020 SC 02502, held that the ‘financial debt’ should be disbursed against consideration and it is the basic element of a ‘financial debt’.

CCDs, which lack the basic element of being called a debt, which is a liability, were still considered as a Debt by the NCLT. This case, acting as a precedent, might affect many companies going under the CIRP, affect other actual creditors against whom the Corporate Debtor has a real liability, which is to be paid, keeping in mind the limited resources available and are not called debt just because the Code has an overriding effect on other laws and considers normal debentures as debt.