Supreme Court clarifies definition of financial creditor under Insolvency and Bankruptcy Code: Phoenix ARC vs. Ketulbhai Patel (2021)

Date of the Judgment: 03 February 2021

Citation: (2021) ibclaw.in 14 SC

Judges: Ashok Bhushan, J., R. Subhash Reddy, J., M.R. Shah, J.

Can a party who holds a pledge of shares be considered a ‘financial creditor’ under the Insolvency and Bankruptcy Code (IBC)? The Supreme Court of India recently addressed this question in a case involving Phoenix ARC Pvt. Ltd. and Ketulbhai Ramubhai Patel. The core issue was whether the appellant, who held pledged shares as security for a loan given to another company, could claim the status of a financial creditor in the insolvency proceedings of the company that provided the pledge. The three-judge bench, comprising Justices Ashok Bhushan, R. Subhash Reddy, and M.R. Shah, delivered the judgment.

Case Background

L&T Infrastructure Finance Company Limited (L&T) provided a financial facility of ₹40 crores to Doshion Limited on 12 May 2011. The agreement included a clause for security creation, which involved a pledge of shares of Gondwana Engineers Limited (GEL), a subsidiary of Doshion Veolia Water Solutions Private Limited (corporate debtor). On 26 July 2011, the Board of Directors of Doshion Veolia Water Solutions Private Limited passed a resolution to provide a Non-Disposal Undertaking to L&T, ensuring that their 100% shareholding in GEL would not be disposed of until the loan was repaid.

On 10 January 2012, a Pledge Agreement was executed between Doshion Veolia Water Solutions Private Limited and L&T, pledging 40,160 shares of GEL as security. A Deed of Undertaking was also executed on the same day. Later, on 30 December 2013, L&T assigned all its rights and interests in the financial facility, including the security, to Phoenix ARC Pvt. Ltd. (appellant). Doshion Limited defaulted on repayments, leading Phoenix ARC to issue a notice on 19 February 2014, recalling the financial facility. Phoenix ARC then filed a case with the Debts Recovery Tribunal, Ahmedabad, which is currently pending.

Subsequently, on 31 August 2018, Bank of Baroda initiated corporate insolvency proceedings against Doshion Veolia Water Solutions Private Limited. The respondent, Ketulbhai Ramubhai Patel, was appointed as the Interim Resolution Professional and later confirmed as the Resolution Professional. Phoenix ARC filed a claim of ₹83,49,85,667 with the respondent, asserting their status as a financial creditor. The Resolution Professional rejected this claim, stating that the corporate debtor’s liability was limited to the pledged shares. Phoenix ARC then filed an application before the National Company Law Tribunal (NCLT) seeking to be recognized as a financial creditor, which was also rejected. An appeal to the National Company Law Appellate Tribunal (NCLAT) was also dismissed, leading to the present appeal before the Supreme Court.

Timeline

Course of Proceedings

The appellant, Phoenix ARC, initially filed a Miscellaneous Application before the National Company Law Tribunal (NCLT), Mumbai Bench, seeking a direction to the Resolution Professional to admit their claim as a financial debt. The NCLT rejected this application, stating that Phoenix ARC’s status as a financial creditor was not established under Section 5(8) of the Insolvency and Bankruptcy Code, 2016. The NCLT held that the pledge of shares did not constitute a financial debt.

Aggrieved by the NCLT’s decision, Phoenix ARC appealed to the National Company Law Appellate Tribunal (NCLAT). The NCLAT also dismissed the appeal, agreeing with the NCLT that the pledge of shares did not amount to a “disbursement of any amount against the consideration for the time value of money” as required under Section 5(8) of the Code. The NCLAT held that the pledge did not fall within the ambit of a financial debt. Consequently, Phoenix ARC filed the present appeal before the Supreme Court of India.

Legal Framework

The primary legal provisions at the heart of this case are from the Insolvency and Bankruptcy Code, 2016 (IBC) and the Indian Contract Act, 1872.

Insolvency and Bankruptcy Code, 2016:

• Section 5(7): Defines “financial creditor” as “any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to.”
• Section 5(8): Defines “financial debt” as “a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes— (a) money borrowed against the payment of interest; (b) any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent; (c) any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument; (d) the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed; (e) receivables sold or discounted other than any receivables sold on non-recourse basis; (f) any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of a borrowing; (g) any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account; (h) any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution; (i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clauses (a) to (h) of this clause.”

Indian Contract Act, 1872:

• Section 124: Defines “contract of indemnity.”
• Section 126: Defines “contract of guarantee” as “a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’.”
• Section 172: Defines “pledge” as “the bailment of goods as security for payment of a debt or performance of a promise.”

The Supreme Court’s analysis focused on whether the pledge of shares by Doshion Veolia Water Solutions Private Limited constituted a ‘financial debt’ under Section 5(8) of the IBC, particularly in light of the definitions of ‘guarantee’ and ‘pledge’ under the Indian Contract Act, 1872. The Court also considered whether the pledge could be considered a ‘guarantee’ or ‘indemnity’ under Section 5(8)(i) of the IBC.

Arguments

Appellant (Phoenix ARC Pvt. Ltd.) Arguments:

• Phoenix ARC contended that they are a financial creditor under Section 5(8)(i) of the IBC. They argued that the corporate debtor, Doshion Veolia Water Solutions Private Limited, acted as a surety, and their liability is co-extensive with that of the principal debtor, Doshion Limited.

• They submitted that the pledge of shares by the corporate debtor was essentially a guarantee for the financial debt owed by Doshion Limited to L&T Infrastructure Finance Company Limited, which was later assigned to Phoenix ARC.

• Phoenix ARC argued that the corporate debtor created a security interest in favor of L&T by pledging shares of Gondwana Engineers Limited (GEL). Since L&T assigned all its rights to Phoenix ARC, Phoenix ARC stepped into the shoes of L&T.

• They claimed that not recognizing them as a financial creditor would leave them without a remedy, as they cannot enforce the guarantee during the moratorium period, and the resolution plan would be binding without any redressal.

• Phoenix ARC argued that the term “guarantee” should not be narrowly interpreted and should include any security created by a third party to secure repayment of a financial debt, including a pledge of shares.

• They argued that the judgment in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited and others, (2020) 8 SCC 401, was distinguishable from the facts of the present case.

• The appellant argued that any security that would permit the right of action against the third party that is not the borrower, would amount to guarantee. The mere fact that corporate debtor has not borrowed money from the appellant, it cannot absolve the corporate debtor from its liability as guarantor.

Respondent (Ketulbhai Ramubhai Patel) Arguments:

• The respondent, the Resolution Professional, argued that Phoenix ARC is not a creditor of any nature to the corporate debtor. They contended that Phoenix ARC has a limited right to enforce the security by realizing the value of the pledged shares, and not a right to recover any debt from the corporate debtor.

• The respondent argued that the pledge of shares is not a guarantee under the Indian Contract Act, 1872. Section 5(8)(i) of the IBC only includes liabilities arising from a guarantee for items in sub-clauses (a) to (h), and not any other instrument in the nature of a guarantee.

• The respondent submitted that the corporate debtor did not enter into any contract of guarantee to perform the promise or discharge the liability of Doshion Limited in case of default.

• The respondent pointed out that Phoenix ARC has already initiated proceedings at the Debt Recovery Tribunal, Ahmedabad, for the realization of dues.

• The respondent argued that the pledge of shares cannot be equated with a guarantee, as both are different in terms of their implications.

• The respondent submitted that the National Company Law Tribunal (NCLT) rightly rejected the claim of the appellant as financial creditor.

• The respondent submitted that in the Code nowhere pledge is mentioned. The appellant cannot claim their pledge agreement dated 10.01.2012 as guarantee as there is no Deed of Guarantee on the record. The Code does not deal with recovery.

Bank of Baroda (Intervenor) Arguments:

• The Bank of Baroda, as an intervenor, argued that the purpose of the IBC is not for recovery of amounts and that the appellant has already moved to the Debt Recovery Tribunal, Ahmedabad.

Submissions of Parties

Issues Framed by the Supreme Court

The Supreme Court framed the following issue for consideration:

1. Whether the appellant, Phoenix ARC, is a financial creditor within the meaning of Section 5(8) of the Insolvency and Bankruptcy Code, 2016, based on the Pledge Agreement dated 10 January 2012 and the Deed of Undertaking dated 10 January 2012 entered into with L&T Infrastructure.

Treatment of the Issue by the Court

Authorities

The Supreme Court considered the following authorities:

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• The Court distinguished the judgment in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited (2020) 8 SCC 401, stating that it was rendered in a specific factual scenario and that a person having only security interest over the assets of the corporate debtor is not a financial creditor.
• The Court referred to Swiss Ribbons (P) Ltd. v. Union of India, (2019) 4 SCC 17 and Pioneer Urban Land & Infrastructure Ltd. v. Union of India, (2019) 8 SCC 416 to highlight the unique position of a financial creditor in the insolvency process.
• The Court found that Jagjivandas Jethalal and another vs. King Hamilton & Co., Indian Law Reports, Volume LV 1931, 617 was on its own facts and has no bearing on interpretation of Section 5(8)(i) with reference to Section 126 of Contract Act.
• The Court analyzed Section 5(7) and 5(8) of the Insolvency and Bankruptcy Code, 2016 to define financial creditor and financial debt, respectively.
• The Court used Section 124, 126 and 172 of the Indian Contract Act, 1872 to define and distinguish between contract of indemnity, guarantee and pledge respectively.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the interpretation of key legal provisions and the specific facts of the case. The Court emphasized that a financial debt must involve a disbursement against the consideration for the time value of money. The Court noted that the pledge agreement did not create a liability on the corporate debtor to repay the loan taken by Doshion Limited, but was merely a security interest.

The Court also focused on the definitions of “guarantee” and “pledge” under the Indian Contract Act, 1872. It held that the pledge of shares did not constitute a contract of guarantee as defined in Section 126, because the corporate debtor did not undertake to perform the promise or discharge the liability of the borrower. The Court also distinguished between a secured creditor and a financial creditor, noting that a secured creditor has an interest in realizing the value of its security, while a financial creditor has a broader interest in the revival and growth of the corporate debtor. The Court also relied on the judgement of Anuj Jain vs Axis Bank to come to the conclusion.

Fact:Law Ratio

The Court’s reasoning was primarily based on legal interpretation (70%), focusing on the definitions and distinctions between guarantee, pledge, financial debt and secured debt. The factual aspects (30%) of the case were considered to see if the facts fit into the legal framework. The Court emphasized that the core requirement for a financial debt is a disbursement against the consideration for the time value of money, which was absent in this case. The Court also noted that the pledge agreement did not create a liability on the corporate debtor to repay the loan taken by Doshion Limited, but was merely a security interest.

The Court’s reasoning was primarily based on legal interpretation (60%), focusing on the definitions and distinctions between guarantee, pledge, financial debt and secured debt. The factual aspects (40%) of the case were considered to see if the facts fit into the legal framework. The Court emphasized that the core requirement for a financial debt is a disbursement against the consideration for the time value of money, which was absent in this case.

Logical Reasoning

The Court considered whether the pledge agreement could be considered a guarantee under Section 126 of the Indian Contract Act, 1872. The Court noted that a contract of guarantee is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The Court found that the pledge agreement did not contain any such contract that the corporate debtor has contracted to perform the promise, or discharge the liability of the third person. The Court also noted that the pledge agreement is limited to pledge of 40,160 shares of GEL only.

The Court also considered the argument that the corporate debtor was a direct and real beneficiary of the loan advanced by the Assignor to the parent Company of the corporate debtor. The Court held that the present is also a case where only security was created by the corporate debtor in 40,160 shares of GEL, there was no liability to repay the loan taken by the borrower on the corporate debtor in the present case.

The Court also considered the judgment of this Court in Jaypee Infratech Limited vs. Axis Bank Limited (supra). The Court 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.

The Court also considered the argument that the term “guarantee” should not be narrowly interpreted and should include any security created by a third party to secure repayment of a financial debt, including a pledge of shares. The Court held that the pledge agreement and undertaking given, entered between Assignor and corporate debtor cannot be termed as contract of guarantee within the meaning of Section 126.

The Court also considered the argument that the judgment in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited and others, (2020) 8 SCC 401, was distinguishable from the facts of the present case. The Court held that the above judgment has been rendered in the specific facts scenario which does not apply to the present case at all. The Court held that the present is also a case where only security was created by the corporate debtor in 40,160 shares of GEL, there was no liability to repay the loan taken by the borrower on the corporate debtor in the present case.

The Supreme Court quoted the followingprovisions of the Code:

Section 5(7) defines “financial creditor” as: “any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to”.

Section 5(8) defines “financial debt” as: “a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes— (a) money borrowed against the payment of interest; (b) any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent; (c) any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument; (d) the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed; (e) receivables sold or discounted other than any receivables sold on non-recourse basis; (f) any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of a borrowing; (g) any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account; (h) any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution; (i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clauses (a) to (h) of this clause.”

The Supreme Court quoted the following provisions of the Indian Contract Act, 1872:

Section 124 defines “contract of indemnity” as: “A contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person, is called a “contract of indemnity”.”

Section 126 defines “contract of guarantee” as: “A “contract of guarantee” is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the “surety”; the person in respect of whose default the guarantee is given is called the “principal debtor”, and the person to whom the guarantee is given is called the “creditor”.”

Section 172 defines “pledge” as: “The bailment of goods as security for payment of a debt or performance of a promise is called “pledge”. The bailor is in this case called the “pawnor”. The bailee is called the “pawnee”.”

Ratio Decidendi

The ratio decidendi of the case is that a party holding a pledge of shares as security for a loan does not automatically qualify as a financial creditor under Section 5(8) of the Insolvency and Bankruptcy Code, 2016. The pledge of shares does not constitute a guarantee, indemnity or a financial debt as defined in the Code. The Court held that the pledge of shares is not a financial debt as it does not involve a disbursement against the consideration for the time value of money.

Obiter Dicta

The Supreme Court made the following observations that are not essential to the decision:

• The Court emphasized the distinction between a secured creditor and a financial creditor under the IBC, noting that a secured creditor has an interest in realizing the value of its security, while a financial creditor has a broader interest in the revival and growth of the corporate debtor.
• The Court highlighted that the IBC is not primarily a mechanism for debt recovery, but rather a mechanism for the resolution of corporate insolvency.

Conclusion

The Supreme Court’s judgment in Phoenix ARC Pvt. Ltd. vs. Ketulbhai Ramubhai Patel clarified the definition of a financial creditor under the Insolvency and Bankruptcy Code, 2016. The Court held that a pledge of shares does not automatically qualify a party as a financial creditor. The Court emphasized that a financial debt must involve a disbursement against the consideration for the time value of money and that a pledge of shares is merely a security interest and not a financial debt. This judgment provides important guidance for creditors and resolution professionals in insolvency proceedings and clarifies the scope of financial debt and financial creditor under the IBC.

The Supreme Court’s decision reinforces the principle that not all creditors are financial creditors under the IBC. The Court highlighted that the IBC is not a mechanism for recovery of debt, but for the resolution of corporate insolvency. The judgment also clarifies that a pledge of shares is a security interest and not a financial debt. This has significant implications for creditors who hold pledges as security, as it clarifies that they do not have the same rights as financial creditors in insolvency proceedings.