Supreme Court – The pledgee is not a financial creditor under the Insolvency and Bankruptcy Code – Litigation, mediation and arbitration

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On February 3, 2021, a three-judge bench of the Supreme Court of India rendered judgment in the case of Phoenix ARC Private Limited v Ketulbhai Ramubhai Patel(Judgement) judging that in the absence of an express obligation on the part of the pledgor to repay the amounts of the loan guaranteed by the pledge, the beneficiary/holder of this pledge (Pledge) will not be considered as a ‘financial creditor‘ of the pledgor under the Insolvency and Bankruptcy Code, 2016 (IBC).

Quick facts

(a) L&T Infrastructure Finance Company Limited (L&T) advanced a financial facility of INR 40 crore to Doshion Limited (Borrower) under the credit agreement of May 12, 2011 (Establishment
OK). Such a facility was among otherssecured by a pledge agreement dated January 10, 2012 (pledge agreement) where 40,160 shares of Gondwana Engineers Limited (GEL) were pledged by Doshion Veolia Water Solutions Private Limited (Wager) in favor of L&T.

(b) On December 30, 2013, L&T assigned all of its right, title and interest in the Financial Facility, including all security therein, to Phoenix ARC Private Limited (Phoenix ARC) under section 5 of the Securitization and Reconstitution of Financial Assets and Enforcement of Security Act 2002.

(c) On August 31, 2018, the National Company Law Tribunal (NCLT) admitted a petition filed by Bank of Baroda under Section 7 of the IBC to initiate a process for the resolution of corporate insolvency (CIRP) against the pledgor. In accordance with the beginning of the CIRP, Phoenix ARC filed its claim as financial creditor of the pledgor with the resolution professional.

(d) The resolution practitioner dismissed claims filed by Phoenix ARC that the pledgor’s liability was limited to the pledge of shares. Phoenix ARC then filed claims with the NCLT and the National Company Law Appellate Tribunal (NCLAT) to obtain instructions against the resolution professional to admit its claims and allow its participation in the creditors’ committee (CoC) of the pledgor. These claims were denied by both the NCLT and the NCLAT, pursuant to which Phoenix ARC filed this appeal in the Supreme Court.

(e) The essential question to be considered by the Supreme Court was whether Phoenix ARC could be considered a “financial creditor‘ within the meaning of Article 5(8) of the IBC on the basis of the pledge agreement.

Supreme Court decision

The Supreme Court observed that the pledger was not a party to the facility agreement under which the facility was granted to the borrower. Therefore, there was no direct obligation for the pledgor to pay for the facilities available to the borrower.

Section 5(7) of the IBC defines a financial creditor as any person to whom a ‘financial debt‘ is due, legally transferred or assigned. To decide the question before it, the Supreme Court considered the definition of financial debt within the meaning of the IBC. Section 5(8) of the IBC defines what constitutes financial debt and provides that the amount of liability under any guarantee or indemnity given in respect of specific items defined as constituting financial debt under of Article 5(8) (such as money borrowed on interest, amounts raised under credit facilities, debts relating to a hire-purchase agreement, etc.) would also be considered financial debt. Further, he observed that according to Sections 124 and 126 of the Contracts Act 1872, a contract of guarantee is a contract “to perform the promise or discharge the liability of a third party for default of it”.

Considering that a promise to release the liability of the borrower was absent from the underlying pledge agreement, the Supreme Court ruled that a pledge agreement is not akin to a guarantee and is therefore not guaranteed. not covered by Section 5(8) of the IBC. Since the pledgor had provided security only by pledging certain shares of GEL without promising to pay any sum to the creditor, the Supreme Court relied on its previous judgment in the matter of
Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited c. Axis Bank Limited and others and held that Phoenix ARC was, at best, a creditor secured as security but could not be a financial creditor within the meaning of Sections 5(7) and 5(8) of the IBC.

To analyse

a) The judgment is in line with the previous judgment of the Supreme Court in the matter of Jaypee Infratech Limited (Supra), where it held that a person having only a collateral security interest in the assets of a debtor company would not fall within the definition of financial creditor under subsections (7) and (8) of section 5 of the IBC. However, this creditor may be treated as a secured creditor under the IBC.

(b) As a result of this judgment, if a promise to release a borrower from liability is not provided for in a pledge agreement, the pledgee would not be a financial creditor and, therefore, would not be a member of the pledger’s CoC. However, such pledgee would be treated as a secured creditor for the purpose of distribution of proceeds under a plan of resolution or in liquidation.

(c) In order to ensure that a pledge agreement allows a bank/financial institution to be a member of the CoC and therefore to participate in the decision-making process, a bank/financial institution may, depending on commercial feasibility, seek to include clauses similar to those of a guarantee in pledge agreements. Alternatively, a bank/financial institution may consider obtaining a corporate guarantee to secure its participation in the CoC.

Originally published by Trilegal, February 2021

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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