Third Party Security Holders- Remediless under IBC?
- Maanvi Jain and Chandrasekhar Haridh
- Sep 18, 2020
- 13 min read
With a plethora of judgements on third party security holder’s rights under Insolvency and Bankruptcy Code,2016 (IBC), the recent Supreme Court judgement of Anuj Jain (IRP for Jaypee Infratech Ltd.) vs. Axis Bank [1] (JIL Case) seemed to have resolved some issues. However, it has raised certain questions on the third party security holders’ rights under IBC.
Facts of the case
ICICI Bank had extended loan to Jaiprakash Associate Limited (JAL) which is the holding company of Jaypee Infratech Limited (JIL). This loan was secured by JIL by way of a mortgage over its land. When JIL went into insolvency and CIRP was commenced, ICICI Bank filed a claim which was rejected by NCLT on the ground that ICICI Bank was not a financial creditor to JIL, which was the corporate debtor. NCLAT reversed the order of NCLT without substantiating sufficient reasons and this came to be challenged in Supreme Court.
Analysis of the case
I. Whether Mortgage Given by a Third Party to a Loan Transaction Comes within the meaning of “Financial Debt" under IBC? The Court discussed that in order for a claim to be accepted, the financial creditor should issue a financial debt to the corporate debtor. The court has analyzed S-5(8) of IBC in great length to hold that security given by a third party does not amount to financial debt. Financial debt means debt disbursed against consideration for the time value of money and includes the transactions mentioned in sub-clauses (a) to (i) of S-5(8). The following were the factors taken into account by the court to hold that mortgage given by a third party instead of borrower is not a financial debt-
(a) Whether the Requirement of Consideration under S-5(8) is satisfied?
An essential element of Financial Debt under section 5(8) of IBC is that the debt must have been disbursed against a consideration. In the present case, the debt has been disbursed against consideration to JAL, the borrower and not to the corporate debtor JIL. The case of State Bank of India vs. Smt Kusum Vallabhdas Thakkar [2] was discussed to understand whether promise given by a third party instead of borrower was for a consideration or not. In that case, the wife had decided to execute a mortgage deed over her property in favour of the bank for extending a loan to her husband’s firm. Usually, the liability of surety (wife in this case) and borrower (husband in this case) are co-extensive but in that case, the bank forbore itself from proceeding against the borrower husband. This act of forbearance at the desire of third-party wife was held to be enough consideration for creating mortgage by a third-party mortgagor under S-127 of the Indian Contract Act.
However, in the present case, the court held that consideration for mortgage under S-127 of the Contract Act,1872 is different from the requirements of consideration for the time value of money under S- 5(8) of IBC. The word mortgage has not been included in the categories mentioned in sub-clauses underS-5(8). Hence, the court held that while third party mortgages are valid and the bank will be an “indirect” secured creditor of JIL, but it will not be a financial creditor for the purpose of insolvency under IBC.
(b) Whether there is Disbursement as Contemplated under S-5(8)
The second emphasis was on the word “disbursed”. The Court emphasised that there must be a direct disbursement to corporate debtor, or that the debt issued must fit into one of the events or modes of disbursement as enumerated in sub-clauses (a) to (i) of Section 5(8). The case of IndiaBulls Housing Finance Ltd. Vs. Alpine Realtech Pvt. Ltd [3] (not referred in the JIL case) lays clarity on this point. In that case, the loan was disbursed directly in the account of corporate debtor, a real estate developer, for the purchase of flat by borrower. On default in payment by borrower, the corporate debtor was to cancel the allotment and return the money. The two considerations that were taken in regard by the court were the “disbursement” directly in the account of corporate debtor and the condition under clause (f) of S-5(8) of IBC which states that amount raised under a real estate project has the commercial effect of borrowing and is hence a financial debt. In the present case, loan was disbursed in the account of borrower, JAL and not the corporate debtor JIL. Further, the transaction did not fit into any of the events of disbursement mentioned in clauses (a) to (i) of S-5(8) such as any hire-purchase agreement, receivables sold, credit facility, derivative transaction or an indemnity obligation between corporate debtor and secured creditor. Thus, the court held that the mortgage fails on this count as well.
(c) Interpretation of the terms “Means” and “include” under S-5(8)
Section 5(8) begins by stating- “Financial debt means ......” and then goes on to enumerate the instances of transactions that come under the definition by stating “... and includes-”. These instances are mentioned in the sub-clauses of section 5(8).The terms “means” and “includes” were read together and the court held that the sub-clauses (a) to (i) of S- 5(8) should be embodied by the essential element of “consideration” and “disbursal” stated in the principal clause of the section or at least the characteristics of essential elements. This is a different stance from its previous judgement in Pioneer Urban Land & Infrastructure Ltd vs. UOI [4], wherein, it had held that “and includes” speaks of transactions which may not be satisfying the main part of the definition. The Court in JIL Case also emphasized on S-5(8) being exhaustive for the purposes of interpretation by court and observed that this did not preclude the legislature from making any changes and adding additional transactions by way of amendment to the section. However, as of now, the definition being exhaustive, third party mortgage or pledge do not form part of the definition as they lack the essential elements of “consideration” and “disbursement” peculiar in interpretation for S-5(8) as discussed above and do not find a mention in the clauses (a) to (i) of S-5(8).
(d) Whether the term “Secured Creditors” is different from “Financial Creditors”?
The contention raised by the respondents, that according to a previous judgement of the Court in Essar Steel Ltd. vs. Satish Kumar Gupta [5] (Essar Case), the term “secured creditors” is subsumed in "financial creditors” was rejected by the court in the present case. The Court in this case formed a new distinction between “direct” secured creditor and “indirect” secured creditor and held that not all secured creditors are financial creditors. The Court held that only direct secured creditors form part of financial creditors for the purpose of insolvency. The Court further stated that the indirect secured creditors have rights under liquidation and SARFAESI once the moratorium is over. This distinction of holding third party security holders as indirect secured creditors, who would otherwise be in the class of secured financial creditors is unprecedented and a peculiar feature of the JIL Case. In this regard of proceeding outside IBC, it is pertinent to mention the case of ICICI Bank vs. Varun Corporation Ltd [6], where the NCLT had allowed the third-party security provider to proceed outside of IBC under S-52(1)(b). However, this is possible only if the Corporate Insolvency Resolution Process fails.
(e) Whether Mortgage/Pledge is different from Guarantee for the purposes of S-5(8)?
The Supreme Court did not weigh the contention of the Respondent that a mortgage is in the nature of a guarantee limited to the value of security. This contention requires addressal by the court as mortgage is essentially a pecuniary liability secured by the mortgaged asset. This argument has some weight evidenced by the legal requirement of issuing a notice to the borrower and the third-party mortgagor to pay up the liability before selling the mortgaged asset. This means that a mortgagee can proceed against the property only once the demand for discharging the pecuniary liability is not fulfilled. The Court overruled the NCLT Mumbai judgement in SREI Infrastructure Finance Limited v. Sterling International Enterprises Ltd [7], wherein this contention was upheld. This setting aside has been done without enlisting essential differences between a mortgage and a guarantee so as to disqualify the former while the latter is qualified for inclusion in the insolvency process. Another important contention raised by the appellant, but not commented upon by the Supreme Court was that the general covenants in mortgage deeds do not create an obligation on mortgagor. These covenants contain stipulations such as- (i) the terms of loan agreement will be incorporated in the mortgage deed or (ii) the mortgagor’s liability shall be co-extensive with the borrower’s liability. Such terms are incorporated in a mortgage deed to establish a direct creditor-debtor relationship between mortgagor and third-party security holder. It is undeniable, that such clauses continue to be used in third-party mortgage deeds and will come up for scrutiny before the courts in future. II. Whether Guarantee needs to be Invoked for Allowing as a Claim under IBC? The question whether there should be a default by the mortgagor for the invocation of mortgage and whether the invocation needs to have been mandatorily done before the start of moratorium for allowing the claim under IBC came up for consideration in the JIL Case. The Court, however, held that the question of default and invocation is purely academic in the present factual matrix and does not arise as third-party mortgage is not a financial debt. However, this question of default and invocation is important in light of the third-party security of guarantee, which is covered under the definition of financial debt under S-5(8) according to the JIL Case. Secondly, even in the light of uncovered third party securities under S-5(8) like mortgage, it is a common banking practice to execute a formal guarantee deed along with giving third party security. Thus, the Court lost the opportunity to provide much needed clarity on the question of whether there needs to be a default by the guarantor for the invocation of guarantee and the invocation needs to be done before the start of the moratorium for allowing the claim under IBC. The position of law as it stands now on this aspect is discussed next.
The law on guarantee states that once the guarantee is invoked, the liability of surety and borrower becomes co-extensive and the creditor can proceed against both. For invoking guarantee, there should exist a default as has been held in Edelweiss ARC vs. Viceroy Hotels Ltd.[8] and Edelweiss ARC Vs. Orissa Manganese Minerals Ltd [9].
However, the definition of claim under IBC says that obligation lies no matter the debt has matured or not. This reason was relied in the case of Axis Bank vs. Edu Smart [10] and Andhra Bank vs. M/s. F.M. Hammerle Textile Ltd. [11] to hold that claim can lie against guarantor despite of no default or invocation of guarantee.
Both judgements are from NCLAT and hence here lies an anomaly. However, since IBC overrides any law in case of conflict and there is a specific provision in IBC that allows claims irrespective of whether debt matured or not, the intention of legislature can be inferred to override the general law that the creditor can proceed against the guarantor under IBC only on default and invocation. Hence, the Axis Bank judgement seems to be good law.
Lacunae in the Supreme Court Judgement
(a) No Rights Afforded to Third Party Security Holder During Insolvency Resolution Process
In the present case, the Court held that the third party secured creditor has no rights during the insolvency resolution process, however it can go against the corporate debtor under S-52(1)(b) of the IBC or the provisions of SARFSESI, once there is no successful resolution plan or the charge on the asset has not undergone any modification under the resolution plan.
However, in situations where the corporate debtor has not reached the stage of liquidation but where it is at the insolvency stage, the committee of creditors is free to deal with the third-party security and dispose it in any manner it pleases. It is at this stage that the third party secured creditor will be left remediless. For example, in the case of Edelweiss ARC Vs. Orissa Manganese Minerals Ltd [12], the pledger’s shares were to be subject to selective capital reduction process and were to be reduced to zero according to the resolution plan, with the approval of Committee of Creditors, leaving the creditor remediless. The Supreme Court has not tackled this problem despite the fact that this question was raised by the respondent.
In the Essar Case, it was discussed that the plan may provide for either satisfaction or modification of any security interest of a secured creditor. This, however, should not be possible without the creditors’ approval as mentioned in the World Bank Report, 2015 titled “Principles for Effective Insolvency and Creditor/Debtor Regimes”[13]. Section-31(1) of IBC also states that the plan will be binding on all stakeholders including dissenting creditors involved in the plan. It can therefore be inferred that since the secured creditors of the third-party corporate debtor are not involved in the plan, their security should not be dealt without their consent. The Court in the JIL Case, failed to appreciate the provisions of this section. The same argument was advanced in Essar Case to protect the interest of promoter guarantors whose right of subrogation was being taken away in the resolution plan without them being involved in the plan. However, it was held that the decision of the committee of creditors would be binding on them. Hence, through the Essar judgement, the conclusion can be drawn that the security of these creditors can be dealt within the resolution plan with the approval of the committee of creditors, leaving them remediless. It is however pertinent to mention that the promoter guarantors were responsible for the insolvent state of the company in Essar case and hence it is considered justified to take their rights without their approval. That is however not the case with third party security holders (especially in the present case) and this issue needs to be separately decided by the courts.
(b) Third Party Security Holders Have No Remedy Against Successful Resolution Applicant
The next question that comes up for consideration is whether these “indirect” secured creditors can proceed against the surviving corporate debtor once the moratorium comes to an end if their security is not sold or reduced to zero and survives the resolution plan. This was discussed in the case of Andhra Bank vs. M/s. F.M. Hammerle Textile Ltd. [14] and Edelweiss ARC Vs. Orissa Manganese Minerals Ltd. [15] In these cases, the NCLAT held that guarantee can be invoked once the moratorium is over against the successful resolution applicant (RA). In the Andhra judgement, the court had also mentioned that secured creditor can proceed against the RA as the rights of creditor do not extinguish, if the claim is not taken care of in the resolution plan. The Supreme Court in the present case has not considered this issue despite recognizing the bank's rights as secured creditors of JIL for all purposes other than insolvency. The secured creditors have to relinquish the encumbrances over assets as a quid pro quo for discharge of their debt by the RA under the resolution plan. But secured creditors whose claims are not considered in the resolution plan still hold the encumbrances over the assets and should have the right to proceed against the surviving corporate debtor (or RA if it has acquired that asset with the encumbrance). In the Essar Case, it was held that the RA cannot be hoarded with “undecided claims” and hence all claims should be decided by the resolution professional. This was to prevent the RA from facing any claims in future, that it was not aware of. An argument can be advanced that the RA is aware of the claims which are decided by resolution professional and rejected (which are otherwise very valid, but rejected only for reasons such that the Claimant is an "indirect secured creditor") for the purpose of insolvency. This is true because the resolution professional is bound to give all the information relating to claims to the RA under S-29(2) of IBC. Therefore, RA is aware of the possibility of these claims arising post the successful insolvency resolution plan. Thus, this addresses the worry of the court in the Essar case and these claims can be allowed against RA. Referring back to first principles, legally the charges of secured creditors are extinguished post a successful resolution plan due to the fact that they are enfranchised by way of a seat in the Committee of Creditors. In the absence of the same, extinguishment is arbitrary and is a statutory breach of promissory estoppel. However, due to non-addressal of the issue in the present case, the effect of the Essar Case that disputed claims that were rejected by the resolution professional or not decided by the NCLT or NCLAT stand extinguished post a successful resolution plan still stands. This precedent, which is detrimental to third party secured creditors and operational creditors, may warrant reconsideration.
Proposed Strategies and Solutions
(a) The Security Holder Can Proceed Against Principal Borrower
The secured creditors can proceed against the principal borrower instead of the third-party mortgagor under IBC. However, since the principle borrower has himself provided no security, the creditor will come as unsecured financial creditor to the principal borrower reducing their rights in the committee of creditors and resolution plan considerably. This will substantially reduce the financial and legal practicalities of creditors taking security from third party and reduce their confidence in lending against such securities considerably.
(b) Limit the Quantum of the Claim to the Value of Security
One of the reasons, why the claim of the third-party security provider against mortgagor/pledger is denied is because the claim is filed for the whole amount of debt and is not limited just till the value of security. This is denied because the security holder may end up recovering more than the value of the security since in most resolution plans, the payment to a class of creditors is calculated as a percentage to their total debt and not the security. For example- In a situation, if it is decided under the resolution plan that all financial creditors will be repaid equal percentage of their debt, then the financial creditor can recover more than the value of its security. This scenario is possible as it has been held in Essar judgement that it is up to the wisdom of committee of creditors to approve a resolution plan which may propose equal percentage of distribution to all creditors. Hence, to avoid that, another solution is that it is suggested to accept claim of secured creditor and limit it to the value of security and not the whole debt by bringing in a special provision in IBC to that effect.
(c) A Small Tweak to IBC to Discharge these kind of Claims
As has been discussed above, it would be grave injustice if the security is sold or reduced to zero, and the secured creditor is left remediless since they were not a part of resolution plan and it should not be binding on them. In the Essar Case, rejected claims were accepted at a belated state at a notional value so that the resolution plan becomes binding on these claimants, leaving them remediless. The purpose was to restore confidence in RA that they would not be faced with any “undecided claims” or else in future it would deter them from submitting plans.
To balance the interest of both the RA and the secured creditor, it is suggested that a provision for discharge of their claims be made a part of the resolution plan. Something similar was done in the Essar steel case, before the NCLAT, where the RA had offered to establish an escrow account to provide certain amounts for discharge of disputed claims.
It is pertinent to mention that if the creditor cannot proceed against the asset (it is irrelevant whether it is with corporate debtor or RA), the purpose of giving them rights as secured creditors for purposes other than insolvency by the Supreme Court in the present case becomes otiose and futile.
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