The Evolving Interpretation Of Financial Debt In Insolvency: Insights From China Development Bank V. Doha Bank

Posted On - 7 January, 2025 • By - Amiy Kumar

Introduction

The definition of “financial debt” under the Insolvency and Bankruptcy Code, 2016 (IBC) has been a subject of ongoing legal and academic discourse. The recent Supreme Court judgment in the case of China Development Bank v. Doha Bank addressed the classification of creditors under the IBC.[1] It specifically focused on whether entities with security interests in a corporate debtor’s assets but without direct lending relationships with the debtor could be considered “financial creditors.”

Factual Background of the Case

  • Judgment Under Appeal: The appeals arise from the NCLAT judgment dated 9th September 2022, concerning the appellants’ status as ‘Financial Creditors’ under S. 5(7) of IBC.
  • Parties and Key Entities:
    • Appellants: Included in the CoC by the Resolution Professional as Financial Creditors of Reliance Infratel Limited (RITL).
    • Respondents: Doha Bank (1st Respondent) and the RCom entities (RCIL, RCom, RTL, and RITL).
  • Primary Issues:
    • Whether the appellants qualify as ‘Financial Creditors’ under IBC.
    • Alternatively, whether they can be classified as ‘Secured Creditors’ entitled to payments based on their security interests.
  • Claims Submission and Challenges:
    • Appellants filed claims under S. 15 of the IBC, which were admitted, and they were included in the CoC.
    • Doha Bank objected, arguing the appellants were not direct lenders to the Corporate Debtor and challenged their classification as Financial Creditors based on the Deeds of Hypothecation (DoH).
  • Resolution Process Developments:
    • A Resolution Plan for RITL was approved by the CoC and the NCLT, despite Doha Bank’s objections.
    • NCLAT directed NCLT to decide on Doha Bank’s application, with implications for the approved Resolution Plan.
  • Deeds of Hypothecation (DoH): The DoH was executed by RCom entities to create a charge over their properties to secure facilities availed by any RCom entity, with each entity agreeing to be liable for shortfalls in debt repayment.
  • NCLT and NCLAT Rulings:
    • NCLT upheld the appellants’ status as Financial Creditors, but the respondents challenged this in NCLAT.
    • NCLAT ruled that the DoH did not constitute a deed of guarantee, de-recognizing the appellants as Financial Creditors and remanding the case to NCLT for further action.

Parties’ Submissions

Appellants’ Submissions

  • Nature of the Master Security Trustee Agreement (MSTA) and DoH: The appellants argue that the Corporate Debtor’s obligations under the MSTA and DoH qualify as a guarantee under S. 126 of the Indian Contract Act, 1872. These obligations, including a promise to pay shortfalls and the creation of a charge over pooled assets, demonstrate a financial commitment.
  • Classification as Financial Creditors: The Corporate Debtor’s promise to cover shortfalls meets the definition of “financial debt” under S. 5(8) of the IBC. Citing the Kotak Mahindra Bank case[2] and Orator Marketing case[3], they argue financial debt includes obligations tied to financing, justifying their classification as financial creditors.
  • Obligations under the DoH: Clauses 5(iii) and 16(viii) of the DoH impose a personal obligation on the Corporate Debtor to pay shortfalls. These provisions, exceeding standard hypothecation terms, align with the IBC’s definition of financial debt.
  • Moratorium under Section 14 of IBC: The appellants argue the moratorium bars claim enforcement but preserves creditor rights in insolvency. Citing Essar Steel[4], they highlight its role in equitable creditor treatment within the CIRP framework.
  • Participation in the Corporate Insolvency Resolution Process (CIRP): The appellants emphasize their claims were admitted during the CIRP and they actively participated as secured financial creditors. Excluding them now would violate the principles of fairness upheld in IBC proceedings.
  • Interpretation of Contracts: The appellants cite multiple cases to argue for interpreting the MSTA and DoH holistically, ensuring the contracts’ purpose and obligations are upheld.
  • Alternative Argument: The appellants alternatively argue they are entitled to payouts reflecting their security interests, even if not classified as financial creditors. This position aligns with the Vistra ITCL case, which upheld equitable treatment for creditors with security interests.[5]

Respondents’ Submissions

  • Nature of the DoH: The respondents argue that the DoH is a simple hypothecation agreement between the Chargor (Corporate Debtor and RCom entities) and the Security Trustee, lacking the essential elements of a guarantee under Section 126 of the Contract Act, as held in the Phoenix ARC case.[6]
  • Contingent Obligation in Clause 5(iii): Clause 5(iii) creates a contingent obligation under Section 32 of the Contract Act, triggered only if hypothecated properties are sold and shortfalls arise. The Section 14 IBC moratorium made this impossible, as supported by the Western Coalfields case.[7]
  • No Guarantee in the DoH: The DoH does not promise repayment of borrower liabilities but merely creates a security interest, as reflected in clauses 2, 3, 5, and 9. This aligns with the Anuj Jain case, which held that a security interest alone does not constitute financial debt.
  • Uncrystallized Financial Debt: The claim relies on a contingent event that never occurred, preventing the crystallization of financial debt and disqualifying the appellants as Financial Creditors.
  • Corporate Debtor’s Limited Obligations: The MSTA only required property hypothecation, not guarantees. The Corporate Debtor did not borrow from appellants or guarantee their loans, as confirmed by its financial statements and the CoC minutes.
  • CoC’s Commercial Wisdom and Moratorium Effect: The appellants approved the Resolution Plan, which extinguished their security interests and treated all creditors equally, focusing on revival. Revising the plan now would undermine CoC’s commercial decisions and IBC objectives, as upheld in the Essar Steel case.[8]
  • Binding Nature of the Resolution Plan: The respondents argue that the appellants accepted the pari passu distribution of the Resolution Plan, which was duly approved with 100% CoC consent. Allowing amendments would undermine the CoC’s commercial wisdom and disrupt the IBC’s objectives.
  • IBC as a Revival Tool, Not Recovery Mechanism: The IBC aims to revive Corporate Debtors, not recover loans. Treating hypothecation as a guarantee would contradict its principles and create an unwarranted precedent.

The Court’s Reasoning and Decision

The Court considered the parties’ submissions and analyzed the relevant precedents cited in detail to conclude the following:

  • Guarantee and Financial Debt: A guarantee provided by a corporate debtor, even if no money is directly lent to the debtor, can be classified as a financial debt under S. 5(8) of the IBC. If the corporate debtor guarantees a loan or financial facility extended to another party (such as the borrower RCom or RTL), it may still be liable under the guarantee even if no funds were directly disbursed to the debtor.
  • Legal Definition of “Guarantee”: The concept of guarantee is outlined in S. 126 of ICA. A contract is a guarantee when one person promises to discharge the liability of a third party in case of default by that third party. Therefore, if the corporate debtor agrees to repay the liabilities of another (such as RCom or RTL), it can be seen as providing a guarantee.
  • Effect of the DoH: The DoH plays a significant role in securing financial facilities granted to RCom and RTL. Even though the corporate debtor is not the primary borrower, it has hypothecated assets and agreed to discharge the liability in case of a shortfall from the sale of the hypothecated assets. This obligation is viewed as a guarantee under Section 126 of the Contract Act.
  • Contingent Liability and Default: A key argument in the case is whether a default has occurred under the DoH. The IBC’s definition of “financial debt” does not require a default for the debt to exist. A person is a financial creditor if a financial debt is owed to them, even if no default has occurred yet. The moratorium imposed under S. 14(1) of the IBC does not extinguish the claim, but it may prevent the enforcement of the claim, such as the sale of hypothecated assets.
  • Moratorium and Contingent Claims: The imposition of a moratorium under the IBC may prevent the realization of contingent claims, such as the shortfall from the sale of hypothecated assets. However, the claim itself does not vanish; it just cannot be enforced during the moratorium period. The contingent nature of the claim (due to the potential shortfall) does not make it invalid.
  • Definition of Financial Debt: S. 5(8) of the IBC defines “financial debt” as a debt along with interest, if any, disbursed against the consideration for the time value of money. The definition is inclusive, meaning that the scope of financial debt can be interpreted broadly, allowing the judiciary to include various financial arrangements not explicitly mentioned in the IBC.
  • Financial Creditor: S. 5(7) defines “financial creditor” as any person to whom a financial debt is owed, including those to whom the debt has been legally assigned or transferred. Financial creditors are entitled to initiate CIRP under S. 7 of the IBC.
  • Time Value of Money: The core concept of financial debt is the “time value of money,” which refers to the price associated with the waiting period for an investment to mature or for income to be earned. The Black’s Law Dictionary defines “time value” as the price related to the length of time an investor must wait before an investment matures or generates income.
  • Judicial Interpretation: The judiciary has played a significant role in interpreting the definition of financial debt, extending it to include certain arrangements that were not traditionally considered financial debts.
    • Interest-Free Loans: The Supreme Court has ruled that interest-free loans fall under the definition of financial debt, affirming that the time value of money, even in the absence of interest, qualifies as a financial debt.
    • Security Deposits: Security deposits, when they earn interest or are otherwise used to repay financial obligations, can be classified as financial debt.
    • Corporate Guarantees: Corporate guarantees provided by a debtor for loans taken by group entities can qualify the lender as a financial creditor.
    • Collective Investment Schemes: Investment schemes where investors are promised returns based on the time value of money can be classified as financial debt under the IBC.
    • Assured Returns in Real Estate Transactions: In Nikhil Mehta and Sons (HUF) v. AMR Infrastructure Ltd., NCLAT ruled that the “assured returns” paid by a real estate developer to investors were linked to the time value of money and therefore qualified as financial debt.[9]

Conclusion

The China Development Bank judgment clarifies the scope of “financial debt” under IBC, expanding its interpretation to include obligations tied to corporate guarantees, even in the absence of direct lending relationships. By emphasizing the importance of contingent liabilities and the role of security interests in the resolution process, the Court reinforces the need for flexibility in classifying creditors. This decision ensures equitable treatment of creditors in insolvency proceedings, highlighting the evolving nature of financial debt definitions and its implications for insolvency resolution practices.

[1] https://api.sci.gov.in/supremecourt/2022/31997/31997_2022_5_1501_58144_Judgement_20-Dec-2024.pdf.

[2] Kotak Mahindra Bank Limited v. A. Balakrishnan, (2022) 9 SCC 186.

[3] Orator Marketing Pvt. Ltd. v. Samtex Desinz Pvt. Ltd., (2023) 3 SCC 753.

[4] Essar Steel Ltd. v. Gramercy Emerging Market Fund, 2002 SCC OnLine Guj 319.

[5] Vistra ITCL (India) Ltd. & Ors. v. Dinkar Venkatasubramanian, (2023) 7 SCC 324.

[6] Phoenix ARC Pvt. Ltd. v. Ketulbhai Ramubhai Patel, (2021) 2 SCC 799.

[7] Western Coalfields Limited & Anr. v. Rajesh s/o Nandlal Biyani, 2011 SCC OnLine Bom 1217.

[8] Essar Steel Ltd. v. Gramercy Emerging Market Fund, 2002 SCC OnLine Guj 319.

[9] Nikhil Mehta and Sons (HUF) v. AMR Infrastructure Ltd., (AT) (Insolvency) No. 07 of 2017.

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