Supreme Court clarifies the definition of “Financial Debt” under the Insolvency and Bankruptcy Code: Global Credit Capital vs. Sach Marketing (25 April 2024)

Introduction

Date of the Judgment: 25 April 2024

Citation: 2024 INSC 340

Judges: Abhay S. Oka, J., Pankaj Mithal, J.

What happens when a company takes a ‘security deposit’ but treats it like a loan? The Supreme Court of India recently tackled this question, focusing on whether such deposits should be considered “financial debts” under the Insolvency and Bankruptcy Code (IBC). This distinction is crucial because it determines who gets priority when a company goes bankrupt. The court examined agreements where a company received deposits in exchange for a promise of interest, deciding whether these arrangements were disguised loans or genuine service agreements. This judgment clarifies the scope of “financial debt” and protects the rights of creditors in insolvency proceedings. The judgment was authored by Justice Abhay S. Oka and Justice Pankaj Mithal concurred.

Case Background

The case revolves around M/s. Mount Shivalik Industries Limited (the corporate debtor) and Sach Marketing Pvt. Ltd. (the first respondent). The corporate debtor engaged the first respondent as a ‘Sales Promoter’ through agreements dated 1st April 2014 and 1st April 2015. These agreements stipulated that the first respondent would deposit a minimum security amount with the corporate debtor. The 2014 agreement required a deposit of Rs. 53,15,000, with the corporate debtor paying interest on Rs. 7,85,850 at 21% per annum. The 2015 agreement also required a deposit of Rs. 53,15,000, with interest paid on Rs. 32,85,850 at 21% per annum. When the corporate debtor faced insolvency, the first respondent initially claimed to be an operational creditor, later changing to a financial creditor. This claim was disputed by the Resolution Professional, leading to a legal battle over the nature of the debt.

Timeline:

Course of Proceedings

The Oriental Bank of Commerce initiated insolvency proceedings against the corporate debtor, which were admitted by the NCLT on 12th June 2018. Initially, the first respondent filed a claim as an operational creditor, but later changed it to a financial creditor on 19th September 2018. The Resolution Professional initially accepted the claim partly as operational and partly as financial but later rejected it. The NCLT rejected the first respondent’s application to be recognized as a financial creditor on 18th January 2021. On appeal, the NCLAT overturned the NCLT’s decision on 7th October 2021, ruling that the first respondent was indeed a financial creditor. The NCLT approved the resolution plan on 13th October 2021. The NCLAT’s judgment was also applied to other similar cases, which are the subject of Civil Appeal nos. 6991-6994 of 2022.

Legal Framework

The Supreme Court referred to the following provisions of the Insolvency and Bankruptcy Code, 2016 (IBC):

• ✓ 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 3(6) of the IBC defines “claim” as “(a) a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured, or unsecured; (b) right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to a right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured;”.
• ✓ Section 5(8) of the IBC 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 dematerialised 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; [Explanation. -For the purposes of this sub-clause, – (i) any amount raised from an allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing; and (ii) the expressions, “allottee” and “real estate project” shall have the meanings respectively assigned to them in clauses (d) and (zn) of section 2 of the Real Estate (Regulation and Development) Act, 2016 (16 of 2016);] (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 -clause (a) to (h) of this clause .”.
• ✓ Section 5(21) of the IBC defines “operational debt” as “a claim in respect of the provision of goods or services including employment or a debt in respect of the payment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority;”.

The court emphasized that a debt must be a liability or obligation in respect of a claim to be considered under the IBC. It also highlighted that a financial debt must involve a disbursal against the consideration for the time value of money.

Arguments

Appellants’ Arguments:

• ✓ The appellants argued that the first respondent was an operational creditor, not a financial creditor.
• ✓ They contended that the agreements were for service provision, with the security deposit being a condition for appointment as a Sales Promoter, not a financial facility.
• ✓ They submitted that there was no intention on the part of the corporate debtor to avail any financial facility from the first respondent.
• ✓ They argued that the security deposit did not constitute a “disbursal” against the time value of money, a key requirement for a financial debt.
• ✓ The appellants relied on Swiss Ribbons Private Limited and Anr. v. Union of India & Ors. [(2019) 4 SCC 17], Pioneer Urban Land and Infrastructure Ltd. & Anr. v. Union of India & Ors. [(2019) 8 SCC 416], Tuticorin Alkali Chemicals & Fertilisers Ltd., Madras v. Commissioner of Income Tax, Madras [(1997) 6 SCC 117], and Consolidated Construction Consortium Limited v. Hitro Energy Solutions Private Limited [(2022) 7 SCC 164] to support their claim that the booking of interest is not the sole criterion for a financial debt.
• ✓ They also relied on Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited & Ors. [(2020) 8 SCC 401], Phoenix ARC Private Limited v. Spade Financial Services Limited & Ors. [(2021) 3 SCC 475] and New Okhla Industrial Development Authority v. Anand Sonbhadra [(2023) 1 SCC 724] to argue that the security deposit was not a financial facility.

First Respondent’s Arguments:

• ✓ The first respondent argued that the agreements’ true nature was to raise finance, not to provide services.
• ✓ They pointed out that the corporate debtor acknowledged the liability of paying interest on the security deposit and deducted TDS on it.
• ✓ They contended that the transaction satisfied the criteria of disbursal, time value of money, and commercial effect of borrowing.
• ✓ They relied on Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited & Ors. [(2020) 8 SCC 401] to argue that the money was repayable after a fixed tenure with interest, indicating a financial debt.
• ✓ They argued that clause (f) of Section 5(8) of the IBC is a “catch-all” provision that includes transactions with the commercial effect of borrowing, citing Pioneer Urban Land and Infrastructure Ltd. & Anr. v. Union of India & Ors. [(2019) 8 SCC 416].
• ✓ They also relied on V.E.A. Annamalai Chettiar & Ors. v. S.V.V.S. Veerappa Chettiar & Ors. [AIR 1956 SC 12] to argue that the true effect of the transaction should be considered.

Resolution Professional’s Arguments:

• ✓ The Resolution Professional supported the appellants, arguing that the security deposit was not a financial debt.
• ✓ They contended that the security deposit was meant to ensure the performance of the agreements, not to reorganize the corporate debtor’s debts.
• ✓ They argued that accounting treatment cannot override the law and the definition of “operational debt” under the IBC.
• ✓ They submitted that none of the ingredients of clauses (a) to (f) of Section 5(8) of the IBC were present.
• ✓ They pointed out that the first respondent was categorized as an operational creditor in a previous NCLAT judgment.

Innovativeness of the argument: The first respondent’s argument that the agreements were a tool for raising finance, rather than genuine service agreements, was innovative. They highlighted the corporate debtor’s practice of using security deposits as a means of borrowing, which was not immediately apparent from the face of the agreements.

Issues Framed by the Supreme Court

The Supreme Court framed the following issues for consideration:

1. Whether the first respondent is a financial creditor within the meaning of sub-section (7) of Section 5 of the Insolvency and Bankruptcy Code, 2016 (IBC).
2. Whether the 1st to 4th respondents in Civil Appeal nos.6991-6994 of 2022 are financial creditors of the same corporate debtor – M/s. Mount Shivalik Industries Limited.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues:

Authorities

The Supreme Court considered the following authorities:

On the definition of “financial debt”:

• ✓ Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited & Ors. [(2020) 8 SCC 401] – The Court referred to this case to emphasize that a financial debt must involve a disbursal against the consideration for the time value of money. It highlighted that the essential element of disbursal against the consideration for time value of money needs to be found in the genesis of any debt before it may be treated as a “financial debt”.
• ✓ Phoenix ARC Private Limited v. Spade Financial Services Limited & Ors. [(2021) 3 SCC 475] – The Court referred to this case to discuss the meaning of “disburse” and “time value of money” in the context of Section 5(8) of the IBC. It reiterated that the disbursal must be against consideration for the time value of money.
• ✓ Pioneer Urban Land and Infrastructure Ltd. & Anr. v. Union of India & Ors. [(2019) 8 SCC 416] – The Court referred to this case to explain that the expression “borrow” is wide enough to include an advance given by homebuyers to a real estate developer for temporary use and that clause (f) of Section 5(8) of the IBC covers transactions with the commercial effect of borrowing.

On the interpretation of agreements:

• ✓ V.E.A. Annamalai Chettiar & Ors. v. S.V.V.S. Veerappa Chettiar & Ors. [AIR 1956 SC 12] – The Court referred to this case to emphasize that the true effect of a transaction should be considered, not just the face value of the document.

On the definition of “operational debt”:

• ✓ Section 5(21) of the IBC – The Court examined the definition of “operational debt” to determine if the claim of the first respondent could be categorized as such. It concluded that the claim was not related to the provision of goods or services.

Other Cases:

• ✓ Swiss Ribbons Private Limited and Anr. v. Union of India & Ors. [(2019) 4 SCC 17] – The Court referred to this case to understand the definitions of “financial creditor” and “financial debt”.
• ✓ Tuticorin Alkali Chemicals & Fertilisers Ltd., Madras v. Commissioner of Income Tax, Madras [(1997) 6 SCC 117] – The Court referred to this case to emphasize that booking or payment of interest is not the only criterion for ascertaining whether the debt is a financial debt.
• ✓ Consolidated Construction Consortium Limited v. Hitro Energy Solutions Private Limited [(2022) 7 SCC 164] – The Court referred to this case to emphasize that booking or payment of interest is not the only criterion for ascertaining whether the debt is a financial debt.
• ✓ New Okhla Industrial Development Authority v. Anand Sonbhadra [(2023) 1 SCC 724] – The Court referred to this case in the context of the arguments made by the appellants.

Judgment

The Supreme Court upheld the NCLAT’s decision, ruling that the security deposits under the agreements constituted a financial debt. The court reasoned that the deposits, along with the interest, met the criteria of a financial debt as defined under Section 5(8) of the IBC.

How each authority was viewed by the Court:

• ✓ Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited & Ors. [(2020) 8 SCC 401]: The Court used this case to reinforce the essential elements of a financial debt, emphasizing the requirement of disbursal against the consideration for the time value of money.
• ✓ Phoenix ARC Private Limited v. Spade Financial Services Limited & Ors. [(2021) 3 SCC 475]: This case was used to interpret the terms “disburse” and “time value of money,” further clarifying the requirements for a financial debt.
• ✓ Pioneer Urban Land and Infrastructure Ltd. & Anr. v. Union of India & Ors. [(2019) 8 SCC 416]: The Court relied on this case to support the view that the term “borrow” includes advances and that clause (f) of Section 5(8) covers transactions with the commercial effect of borrowing.
• ✓ V.E.A. Annamalai Chettiar & Ors. v. S.V.V.S. Veerappa Chettiar & Ors. [AIR 1956 SC 12]: This case was used to emphasize the importance of considering the true effect of a transaction, rather than just the face value of the documents.
• ✓ Section 5(21) of the IBC: The Court examined this provision to determine if the claim could be categorized as an operational debt, ultimately concluding that it could not.
• ✓ Swiss Ribbons Private Limited and Anr. v. Union of India & Ors. [(2019) 4 SCC 17]: This case was used to understand the definitions of “financial creditor” and “financial debt”.
• ✓ Tuticorin Alkali Chemicals & Fertilisers Ltd., Madras v. Commissioner of Income Tax, Madras [(1997) 6 SCC 117]: The Court referred to this case to emphasize that booking or payment of interest is not the only criterion for ascertaining whether the debt is a financial debt.
• ✓ Consolidated Construction Consortium Limited v. Hitro Energy Solutions Private Limited [(2022) 7 SCC 164]: The Court referred to this case to emphasize that booking or payment of interest is not the only criterion for ascertaining whether the debt is a financial debt.
• ✓ New Okhla Industrial Development Authority v. Anand Sonbhadra [(2023) 1 SCC 724]: The Court referred to this case in the context of the arguments made by the appellants.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the following factors:

• ✓ Nature of the Transaction: The court looked beyond the label of “security deposit” and examined the true nature of the transaction. It found that the deposit was essentially a loan, given the obligation to repay with interest.
• ✓ Commercial Effect of Borrowing: The court emphasized that the transaction had the commercial effect of borrowing, as the corporate debtor treated the amount as a liability and paid interest on it.
• ✓ Lack of Correlation with Services: The court noted that the deposit was not directly linked to the services provided by the first respondent, further supporting its characterization as a financial debt.
• ✓ Time Value of Money: The provision for interest payment was seen as consideration for the time value of money, a key element of a financial debt.
• ✓ Accounting Treatment: The court considered the corporate debtor’s financial statements, which treated the deposits as long-term liabilities, as evidence of the transaction’s true nature.

Fact:Law Ratio

The court’s reasoning was a blend of factual analysis and legal interpretation. While the factual aspects of the agreements and the corporate debtor’s accounting practices were important, the court’s application of the legal definitions and principles of the IBC was decisive.

Logical Reasoning:

Implications

This judgment has significant implications for the interpretation of “financial debt” under the IBC. It clarifies that:

• ✓ The true nature of a transaction must be examined, not just its label.
• ✓ A security deposit can be considered a financial debt if it has the commercial effect of borrowing and involves a disbursal against the time value of money.
• ✓ The accounting treatment of a transaction can be used as evidence of its true nature.
• ✓ The judgment will have a significant impact on future insolvency proceedings, particularly in cases where security deposits are treated as loans.

Impact on Future Cases:

• ✓ This judgment will serve as a precedent for similar cases involving security deposits and their classification under the IBC.
• ✓ It will likely lead to more scrutiny of agreements that involve security deposits, to determine if they are disguised loans.
• ✓ It will provide greater clarity to creditors regarding their rights in insolvency proceedings.
• ✓ The judgment will encourage a more substantive approach to the definition of “financial debt”, moving beyond mere labels.

Potential for Conflict:

• ✓ There could be potential conflicts in cases where the agreements are ambiguous or where the accounting treatment is inconsistent with the true nature of the transaction.
• ✓ There may be challenges in determining the commercial effect of borrowing in complex transactions.
• ✓ There could be disputes regarding the interpretation of “disbursal against the time value of money” in different contexts.

Conclusion

The Supreme Court’s judgment in Global Credit Capital Limited & Anr. vs. Sach Marketing Pvt. Ltd. & Anr. provides a crucial clarification on the definition of “financial debt” under the IBC. By looking beyond the label of “security deposit” and focusing on the true nature of the transaction, the court has ensured that creditors are not deprived of their rights in insolvency proceedings. This judgment emphasizes the importance of examining the commercial effect of transactions and the need for a substantive approach to the definition of “financial debt.” It also highlights the significance of accounting treatment as evidence of the true nature of a transaction. The judgment will have a lasting impact on insolvency law and will likely shape the interpretation of “financial debt” in future cases.

Key Takeaways:

• ✓ Security deposits can be treated as financial debts if they meet certain criteria.
• ✓ The commercial effect of a transaction is a key factor in determining its nature.
• ✓ Accounting treatment can be used as evidence of a transaction’s true nature.
• ✓ The judgment provides greater clarity and protection for creditors in insolvency proceedings.