A full bench of the Hon’ble Supreme Court comprising of Justices Ashok Bhushan, R. Subhash Reddy and M. R. Shah in the case of Phoenix Arc Private Limited v. Ketulbhai Ramubhai Patel, REED 2021 SC 02502 held that a creditor will be secured creditor and not ‘financial creditor’ under Insolvency and Bankruptcy Code, 2016, if a corporate debtor has given security only by pledging shares, without undertaking to discharge borrower’s liability. The brief facts of the case, the issue involved and the analysis of the ruling have been provided below.
L&T Infrastructure Finance Company Limited (lender) advanced a financial facility to Doshion Limited (borrower). In turn, the directors of subsidiary of borrower, Doshion Velia Water Solutions Private Limited, granted a pledge to lender over certain shares it held in Gondwana Engineers Limited (GEL). Thereafter, lender assigned its rights, title and interest, including security interest in the financial facility in favour of Phoenix Arc (Appellant), who sought to establish itself as a financial creditor of Doshion Velia Water (Corporate Debtor) as part of the Corporate Insolvency Resolution Process (CIRP) initiated against it.
The Appellant stated that pledge of the shares by the corporate debtor was in essence a guarantee for financial debt and, therefore, appellant was a financial creditor of the corporate debtor. The Resolution Professional (Respondent) in CIRP of Corporate Debtor expressed an opinion that as per the Pledge Agreement submitted by the Appellant, the Corporate Debtor's liability was restricted to pledge of the shares only.
The Appellant thereafter approached the National Company Law Tribunal, Mumbai (NCLT) seeking a direction to the Respondent to admit the claim of the Appellant as a financial debt with all consequential benefits including voting rights in the Committee of creditors (CoC) of the Corporate Debtor. The NCLT rejected the Appellant’s application holding that the Applicant's status as financial creditor of the Corporate Debtor is not proved in the light of Section 5(8) of IBC. The National Company Law Appellate Tribunal (NCLAT) also upheld the order of NCLT and hence, the present appeal has been preferred by the Appellant.
The question that arose for consideration before the Supreme Court was whether the Appellant would come within the purview of ‘financial creditor’ under section 5(8) of the IBC on the strength of Pledge Agreement entered into with the lender.
The Supreme Court was mainly concerned with the precise wording of the definition of financial debt contained in section 5(8) of IBC. The first part of definition provides that a financial debt means a debt “which is disbursed against the consideration for the time value of money”. In interpreting this part in the context of a third party security, the court relied on Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited Axis Bank Limited and others, REED 2020 SC 02502 wherein it was held that a person having only security interest over the assets of Corporate Debtor, even if falling within the description of ‘secured creditor’ by virtue of collateral security extended by the corporate debtor, would not be covered by the financial creditors as per definitions contained in sub-section (7) and (8) of Section 5 of IBC. Hence, even in the present case where Corporate Debtor has only extended a security by pledging certain shares of GEL, the Appellant at best will be secured creditor but shall not be a financial creditor within the meaning of Section 5 sub-sections (7) and (8) of IBC.
On the other hand, the second part of the definition is an inclusive one and lists out various relationships that would be considered to fall within the definition of financial debt. Section 5(8)(i) contains the liability of the Corporate Debtor under an indemnity or guarantee within the purview of a “financial debt”. As per Section 126 of the Indian Contract Act, 1872, a contract of guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of his default. Evidently, both the expressions “perform the promise” or “discharge the liability” relate to “a third person”.
In the present case, the Pledge Agreement does not contain any contract that the promise which was made by the borrower in the Facility Agreement to discharge the liability of debt is undertaken by the corporate debtor. It was the borrower who had promised to repay the loan in Facility Agreement to and it was borrower who had undertaken to discharge the liability towards lender. Moreover, the Pledge Agreement does not contain any contract that corporate debtor has contracted to perform the promise, or discharge the liability of the third person. Hence, the Pledge Agreement and undertaking given, cannot be termed as contract of guarantee within the meaning of Section 126.
Accordingly, in light of the foregoing reasoning, the court upheld the order of NCLAT. Hence, this judgment creates a distinction between a person who gives guarantee to the lender to discharge the liability of the borrower to pay the loan and a person who merely pledges its shares without any such undertaking to repay the outstanding dues of the borrower.