Supreme Court Clarifies Financial Creditor Status in Insolvency Cases: China Development Bank vs. Doha Bank (2024)

Introduction

Date of the Judgment: 20 December 2024
Citation: 2024 INSC 1029
Judges: Abhay S. Oka, J., Pankaj Mithal, J.
Can a company that hypothecates its assets to secure loans taken by another company be considered a guarantor and thus make the lenders ‘Financial Creditors’ under the Insolvency and Bankruptcy Code, 2016? The Supreme Court of India addressed this complex issue in a recent judgment, clarifying the scope of ‘financial debt’ and ‘Financial Creditor’ in the context of corporate insolvency. The court examined whether a Deed of Hypothecation (DoH) could create a guarantee, thereby entitling the lenders to be classified as ‘Financial Creditors’. The judgment was delivered by a two-judge bench comprising Justice Abhay S. Oka and Justice Pankaj Mithal, with the majority opinion authored by Justice Abhay S. Oka.

Case Background

The case involves several appeals against a judgment by the National Company Law Appellate Tribunal (NCLAT). The core dispute revolves around whether certain lenders, including China Development Bank, can be classified as ‘Financial Creditors’ of Reliance Infratel Limited (RITL), the Corporate Debtor, under the IBC. These lenders had provided loans to other Reliance entities (RCom and RTL), with RITL acting as a security provider through Deeds of Hypothecation (DoH). The Resolution Professional (RP) initially admitted the claims of these lenders as ‘Financial Creditors’, including them in the Committee of Creditors (CoC). However, Doha Bank, another creditor, challenged this classification, arguing that these lenders were not direct lenders to RITL and therefore, could not be considered ‘Financial Creditors’.

The NCLT initially upheld the status of the lenders as Financial Creditors, but the NCLAT reversed this decision, stating that the DoH did not constitute a guarantee. The NCLAT held that the DoH was only a charge on the property of the Chargors (RCom entities), and the Chargors could not be treated as guarantors. This led to the appeals before the Supreme Court.

Timeline

Course of Proceedings

Initially, the Resolution Professional (RP) admitted the claims of the appellants as Financial Creditors, which led to their inclusion in the Committee of Creditors (CoC). Doha Bank challenged this decision before the NCLT, arguing that the appellants were not direct lenders to the Corporate Debtor. The NCLT dismissed Doha Bank’s application, upholding the status of the appellants as Financial Creditors. However, the NCLAT reversed the NCLT’s decision, stating that the Deed of Hypothecation (DoH) did not constitute a guarantee and that the appellants could not be considered Financial Creditors. The NCLAT remanded the case back to the NCLT for consequential actions. The Supreme Court heard the appeals against the NCLAT’s decision.

Legal Framework

The Supreme Court examined the following key legal provisions:

• Section 5(7) of the Insolvency and Bankruptcy Code, 2016 (IBC): Defines “Financial Creditor” as any person to whom a financial debt is owed.
• Section 5(8) of the IBC: Defines “financial debt” as a debt disbursed against the consideration for the time value of money, including any liability in respect of a guarantee for the items mentioned in the sub-clauses. Specifically, clause (i) of Section 5(8) states that a financial debt includes “the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clause (a) to (h) of this clause.”
• Section 3(6) of the IBC: Defines “claim” as a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured, or unsecured.
• Section 3(11) of the IBC: Defines “debt” as a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt.
• Section 126 of the Indian Contract Act, 1872: Defines a “contract of guarantee” as a contract to perform the promise or discharge the liability of a third person in case of their default.
  
  “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”. A guarantee may be either oral or written.”
• Section 127 of the Indian Contract Act, 1872: States that anything done or any promise made for the benefit of the principal debtor may be sufficient consideration to the surety for giving the guarantee.
  
  “Anything done, or any promise made, for the benefit of the principal debtor, may be a sufficient consideration to the surety for giving the guarantee.”
• Section 14(1) of the IBC: Provides for a moratorium on the initiation or continuation of suits or proceedings against the corporate debtor, including the enforcement of security interests.
  
  “Subject to provisions of sub-sections (2) and (3), on the insolvency commencement date, the Adjudicating Authority shall by order declare moratorium for prohibiting all of the following, namely: (a) the institution of suits or continuation of pending suits or proceedings against the corporate debtor including execution of any judgment, decree or order in any court of law, tribunal, arbitration panel or other authority; (b) transferring, encumbering, alienating or disposing of by the corporate debtor any of its assets or any legal right or beneficial interest therein; (c) any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect of its property including any action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (54 of 2002); (d) the recovery of any property by an owner or lessor where such property is occupied by or in the possession of the corporate debtor.”

The court interpreted these provisions within the framework of the IBC, emphasizing the inclusive nature of the definition of ‘financial debt’ and the importance of recognizing guarantees within the context of corporate insolvency.

Arguments

Submissions of the Appellants:

• The appellants argued that the Deeds of Hypothecation (DoH) created a guarantee, making them ‘Financial Creditors’ of the Corporate Debtor. They contended that the Corporate Debtor, as a Chargor, had undertaken to pay any shortfall in the recovery of amounts due to the appellants, which is akin to a guarantee under Section 126 of the Contract Act.
• They highlighted that the Corporate Debtor had covenanted to pay the amounts due under the facilities availed by other RCom entities and had created a charge over its assets to secure these obligations. Specifically, clause 5(iii) of the DoH was cited, where the Corporate Debtor agreed to pay any shortfall in the realization of outstanding debt.
• The appellants emphasized that the definition of ‘financial debt’ under Section 5(8) of the IBC is inclusive and not exhaustive. They argued that the debt need not be directly disbursed to the Corporate Debtor. The Security Trustee, under the DoH, acts for the benefit of the secured lenders, who are the direct and intended beneficiaries.
• The appellants also pointed out that the entire CIRP had proceeded on the basis that they were Financial Creditors and they had participated and voted as such.
• In the alternative, the appellants argued that even if not considered Financial Creditors, they were entitled to receive a payout commensurate to their security interest as secured creditors. They emphasized that the security interest of the appellants cannot be extinguished during the CIRP.

Submissions of the Respondents (Doha Bank & Ors.):

• The respondents contended that the DoH was merely a document hypothecating properties and did not create a guarantee. They argued that a guarantee requires three parties: a guarantor, a principal debtor, and a creditor, which were not present in the DoH.
• They argued that clause 5(iii) of the DoH only contained the process of enforcement of security by the Security Trustee and that the Corporate Debtor had not promised to discharge the liability of any borrower.
• The respondents submitted that the clause 5(iii) of the DoH was a contingent contract under Section 32 of the Contract Act, which ceased to exist when the moratorium was declared under Section 14 of the IBC. They argued that since the hypothecated property could not be sold after the moratorium, there was no question of a shortfall.
• They argued that the appellants were contract lenders of the three RCom entities and not the Corporate Debtor, as the Corporate Debtor had not availed any loans or facilities from the appellants. They further contended that the Corporate Debtor had not treated the DoH as a guarantee in its financial statements.
• The respondents argued that the appellants voted and approved the Resolution Plan, which extinguished their security, and they could not now turn back and rewrite the plan. They also argued that the IBC cannot be used for recovery, and the appellants were attempting to use the CIRP as a mode of recovery of their loans from the RCom entities.

Submissions Table

Issues Framed by the Supreme Court

The Supreme Court addressed the following issues:

1. Whether the appellants can be classified as ‘Financial Creditors’ within the meaning of sub-section (7) of Section 5 of the Insolvency and Bankruptcy Code, 2016 (IBC).
2. Whether the appellants can be classified as ‘Secured Creditors’ and paid commensurate to their security interest if they are not classified as ‘Financial Creditors’.

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 relied on several authorities to support its reasoning:

• Kotak Mahindra Bank Limited v. A. Balakrishnan [CITATION]: The Court followed this case to support the inclusive definition of ‘financial debt’.
• Orator Marketing Pvt. Ltd. v. Samtex Desinz Pvt. Ltd [CITATION]: The Court followed this case to support that the debt need not be directly disbursed to the Corporate Debtor.
• Maitreya Doshi v. Anand Rathi Global Finance Ltd. & Ors [CITATION], M.C. Chacko v. State Bank of Travancore [CITATION], and Essar Steel Ltd. v. Gramercy Emerging Market Fund [CITATION]: The Court followed these cases to support that the Security Trustee acted for the benefit of the secured lenders, who are the direct and intended beneficiaries.
• Vistra ITCL (India) Ltd. & Ors. v. Dinkar Venkatasubramanian [CITATION]: The Court referred to this case to acknowledge the rights of secured creditors, although it did not delve into this aspect as it held that the appellants were Financial Creditors.
• B.K. Muniraju v. State of Karnataka & Ors. [CITATION], Union of India v. D.N. Revri & Co. and Ors. [CITATION], and Maharashtra State Electricity Distribution Company Limited v. Maharashtra Electricity Regulatory Commission & Ors. [CITATION]: The Court relied on these cases to interpret the contract, stating that the nomenclature of a contract is not decisive of its nature.
• Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta & Ors [CITATION]: The Court referred to this case to highlight that the IBC ensures a fresh start for the Corporate Debtor.
• Phoenix ARC Pvt. Ltd. v. Ketulbhai Ramubhai Patel [CITATION]: The Court distinguished this case, as in the present case, the Corporate Debtor had undertaken to discharge the liability of the borrowers.
• Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited & Ors [CITATION]: The Court distinguished this case, stating that in the present case, there was a guarantee, not just a security interest.
• C.C., C.E. and S.T. Bangalore (Adjudication) & Ors. v. Northern Operating Systems Pvt. Ltd. [CITATION], State of Orissa v. Titaghur Paper Mills Co. Ltd. [CITATION], and Prakash Roadlines (P) Ltd. v. Oriental Fire & General Insurance Co. Ltd. [CITATION]: The Court relied on these cases to emphasize that the nomenclature of a contract is not decisive of its nature.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the interpretation of clause 5(iii) of the Deed of Hypothecation (DoH) and the definition of ‘financial debt’ under the IBC. The Court emphasized that the Corporate Debtor’s undertaking to pay any shortfall in the recovery of amounts due to the appellants, as outlined in clause 5(iii), constituted a guarantee under Section 126 of the Contract Act. This was a crucial factor in determining that the appellants qualified as ‘Financial Creditors’. The Court also highlighted the inclusive nature of the definition of ‘financial debt’ under Section 5(8) of the IBC, which does not require the debt to be directly disbursed to the Corporate Debtor. The Court also rejected the argument that the moratorium under Section 14 of the IBC extinguished the claim, emphasizing that the moratorium only bars enforcement, not the existence of the claim. The Court also considered the fact that the Security Trustee was acting on behalf of the lenders, thus satisfying the three-party requirement for a guarantee.

Decision

The Supreme Court set aside the judgment of the NCLAT and restored the order of the NCLT. The Court held that the appellants are ‘Financial Creditors’ of the Corporate Debtor and are entitled to participate in the Committee of Creditors (CoC). The Court also clarified that the moratorium under Section 14 of the IBC does not extinguish the claim of the creditor. The Court emphasized that the purpose of the IBC is not just recovery, but also resolution. The Court’s decision clarifies the scope of ‘financial debt’ and ‘Financial Creditor’ under the IBC, particularly in cases where security is provided through Deeds of Hypothecation. The decision provides a clear interpretation of the law and gives guidance to the Resolution Professionals and the Adjudicating Authority on how to deal with similar cases in the future.

Ratio Decidendi

The ratio decidendi of the case is that a Deed of Hypothecation (DoH) can create a guarantee if it includes a clause where the Chargor undertakes to pay any shortfall in the recovery of amounts due to the lender. Such a guarantee qualifies the lender as a ‘Financial Creditor’ under the Insolvency and Bankruptcy Code, 2016 (IBC). The Court clarified that the definition of ‘financial debt’ under Section 5(8) of the IBC is inclusive and not exhaustive, and the debt need not be directly disbursed to the Corporate Debtor. The Court emphasized that the moratorium under Section 14 of the IBC does not extinguish the claim of the creditor, but only bars its enforcement.

Flowchart

Implications

This judgment has significant implications for future insolvency cases, particularly those involving Deeds of Hypothecation. It clarifies that a DoH can create a guarantee, making the lenders ‘Financial Creditors’ under the IBC. This will impact how Resolution Professionals and Adjudicating Authorities classify creditors in corporate insolvency resolution processes. The judgment also reinforces the inclusive nature of the definition of ‘financial debt’ under the IBC, emphasizing that the debt need not be directly disbursed to the Corporate Debtor. This will help in recognizing the rights of lenders who have provided loans to other entities, where the Corporate Debtor has acted as a guarantor or security provider. The judgment will also have implications for the interpretation of contracts and the enforcement of security interests under the IBC. It is likely to lead to a more consistent approach in classifying creditors and ensure that creditors who have a legitimate claim are not excluded from the Committee of Creditors.