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The Woes Of 3rd Party Security Holders Under The Insolvency & Bankruptcy Code, 2016

The rights of 3rd party security providers under the Insolvency and Bankruptcy Code 2016 have been the subject of much debate and discussion. Under a financing transaction the parent, associate or subsidiary company of the Corporate Debtor offer a guarantee or a security which could be achieved by a pledge of shares or hypothecation of assets or even by virtue of mortgage. Guarantors are very much financial creditors, being expressly mentioned in Section 5(8) of The Insolvency and Bankruptcy Code 2016. The questions which arose before the Apex Court in the case of Anuj Jain[1] and Phoenix ARC[2] was whether –“whether 3rd party security providers can said to be Financial Creditor’s within the meaning of the IBC”?

Anuj Jain v/s Axis Bank Ltd:

In this case Axis Bank had lend financial assistance to Jaiprakash Associates, which was the holding company of Jaypee Infrastructure Ltd. Jaypee Infrastructure mortgaged several of its own properties to secure the debt of Jaiprakash Associates. CIRP commenced against JIL. The Resolution Professional rejected the contentions of Axis Bank that it was a Financial Creditor, and did not allow them to be a part of the Committee of Creditor’s.

NCLT allowed the application filed by the Resolution Professional filed under Section 43 of the Insolvency & Bankruptcy Code 2016 and passed an order affirming the stand of the RP that Axis Bank was not a Financial Creditor. NCLAT reverses the ruling, Supreme Court said that the transaction in question, creation of security interest in favour of 3rd partiers to secure the debts of the holding company within 2 years of commencement of CIRP place the holding company in a more advantageous position, than it normally would be under regular distribution under Section 53 of the Code, and hence the said transaction is said to be preferential within the meaning of Section 43, and hence Axis Bank in whose favour the security interest was created is not a financial creditor in terms of the Code.

Phoenix ARC Private Limited v Ketulbhai Ramubhai Patel:

In Phoenix, the lender had advanced a finance facility to a borrower, for which Doshion Veolia Water Solutions Private Limited (corporate debtor) had executed an agreement pledging 100% of its shareholding in Gondwana Engineers Limited as a security for the facility advanced to the borrower. A deed of undertaking was executed by the corporate debtor in favour of the lender as security for the facility advanced to the borrower. Subsequently all the rights, title and interest of the lender were assigned to Phoenix ARC.

The issue was whether Phoenix ARC was a financial creditor of the corporate debtor under the IBC, on the basis of the pledge agreement and the deed of undertaking. The Supreme Court answered this issue in the negative, holding that the essence of the definition of a “financial debt” in section 5(8), is that a financial debt is a debt which is disbursed against the time value of money. The second part of the definition sets out instances of financial debt, which include any amount of the guarantee or indemnity in accordance with section 5(8).

The court noted that since a contract of guarantee is an undertaking to perform a promise, or discharge the liability of a third person in case of such third person’s default. In this case, the pledge agreement executed by the corporate debtor contained no such promise to discharge the liability, or perform the promise of the borrower. Therefore, the pledge agreement executed by the corporate debtor in favour of the lender was not a contract of guarantee.

The court held that Phoenix ARC could not be considered a financial creditor solely on the strength of the pledge agreement executed in its favour by the corporate debtor for the facility advanced to the borrower.

Conclusion:
As per Section 124 of the Indian Contract Act, a contract of indemnity as per which one party promises to save the other from loss caused to him by the conduct of the promisor itself. The main part of the contract is that there is a promise to discharge the liability of the borrower. In both the Phoenix and Jaypee case there is no guarantee to discharge the debts of the borrower by the Corporate Debtor, only security was provided to secure the debts of the borrower.

It has therefore been clearly elucidated now that the security which is provided by the Corporate Debtor as a 3rd party security provider is a secured debt, however it will not result in a financial debt, and the person in whose favour it is created cannot be termed as a financial creditor, and cannot be a part of the Committee of Creditor’s. They will also be barred from enforcing their security interest during the CIRP due to the ongoing moratorium.

Lenders can avoid this scenario by ensuring that the security which is being provided by them is backed up by a guarantee or indemnity under Section 5(8) of the IBC. By virtue of this the will be entitled to participate in the Committee of Creditors.

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