[By Varuni Agarwal]
The author is a student at the National Law University, Odisha.
INTRODUCTION
Section 7 of the Insolvency Bankruptcy Code (“IBC”) empowers a financial creditor to initiate a Corporate Insolvency Resolution Process against the Corporate Debtor on account of default. As per Section 5(7) of IBC, a financial creditor means a creditor against whom the Corporate Debtor owes a financial debt. Section 5(8), defining financial debt, has a principal term stating “a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes”, and sub-clauses (a) to (i) stating some credit situations.
In July 2021, in the case of Orator Marketing v. Samtex Desinz (“Orator judgment”), the Supreme Court discussed the legal issue of whether a secured creditor, giving an interest-free loan, would qualify as a financial creditor. The article critically analyzes the core findings of the Court and its contradiction with the established judicial precedents.
UNDERSTANDING THE JUDGEMENT
M/sSameer Sales Pvt. Ltd. advanced a term loan of Rs. 1.60 crores to M/s Samtex Desinz Pvt. Ltd., the Corporate Debtor, without any interest for a period of two years from the date of execution of the Loan agreement to meet its working capital requirement. The creditor went on to initiate the Corporate Insolvency Resolution process through Section 7 of IBC. The NCLT and NCLAT held that the creditor is not a financial creditor. However, the Hon’ble Apex Court held that Hon’ble NCLAT and NCLT have misconstrued the definition of ‘Financial Debt’ and have read it in isolation and analyzed the definition of ‘Financial Debt’.
CRITICAL ANALYSIS OF THE JUDGEMENT
- FLAWED ANALYSIS OF TIME VALUE OF MONEY
The bench has based its decision on 2 findings. Firstly, while interpreting the terms ‘means and included’, it determined that Section 5(8) of IBC has 2 separate categories that are qualified to be called ‘financial debt’. The first one is ‘disbursed against consideration of time value of money, and the second includes those situations that are mentioned in sub-clauses (a) to (i) of the sub-section. Secondly,it had particularly covered the case-at-hand as a transaction under Section 5(8)(f), due to the transaction having “commercial effect of borrowing”, and interpreting the meaning of the phrase.
With respect to the first finding, the bench does not seem to have followed the 2020 Supreme Court judgment inAnuj Jainvs. Axis Bank Limited (“Anuj Jain judgment”). The Anuj Jain judgment had categorically held and clarified that “any of the transactions stated in the said sub-clauses (a) to (i) of Section 5(8) would be falling within the ambit of ‘financial debt’ only if it carries the essential elements stated in the principal Clause or at least has the features which could be traced to such essential elements in the principal clause”. This means that while the nature of the transaction may be of any kind, including those as mentioned in sub-section (a) to (i), the same must have an element of the time value of money, mentioned in the principal part of the sub-section. Thus, this deviation from the settled principle of law seems uncalled for.
While establishing the first finding, the Court went on to classify the present case as having “commercial effect of borrowing”. It relied on the fact that the loan was taken for fulfilling CD’s working capital requirements, thus having a commercial effect. However, the Court in Pioneer Urban Land and Infrastructure Limited v. Union of India construed the meaning of ‘commercial’ as transactions having profit as their main aim. Further, Explanation 1 of Section 5(8) classifies the real estate projects as having “commercial effect of borrowing” on the pretext that the real estate developer profits on the sale of the apartment, and the flat/apartment purchasers profits by the sale of the apartment. The essence of the argument is that in the case of a loan, the ‘commercial interest’ would exist only when the creditor receives something in return that puts them in a beneficial position than before.
Examining the present case, the creditor neither had a security interest over the Corporate Debtor’s property nor was receiving any interest. Thus, the creditor was essentially not receiving any additional amount which would have financially put them in a beneficial position than before giving the loan. On the contrary, without having a provision of the time value of money and mandating payment of interest of the repayment, the lender is essentially being put at an adverse level than before, due to general depreciation in the value of money during that loan period. Hence, the “commercial effect of borrowing” clearly did not exist in this case, and reading the provision independent of the principal condition of “disbursed against consideration of time value of money”is a wrong construction.
- CONTRADICTING FEBRUARY 2021 JUDGMENT ON SIMILAR LEGAL ISSUE
On February 3, 2021, the Supreme Court pronounced its judgment in Phoenix Arc Ltd. v. KetulBhai (“Phoenix judgment”), explicitly holding that the secured creditor, having given a loan without interest, will not fall under the definition of financial creditor under Section 5(8). With the Court holding that interest-free loans will also qualify as financial debt, the Orator judgment seems to go in total contradiction of the Phoenix judgment. Interestingly, having been pronounced prior to, and discussing the similar legal issue as, the Orator judgment, the Court had not referred and discussed the Phoenix judgment in the present case, let alone follow the same.
Further, the creditors in the Phoenix judgment specifically argued that their case falls under Section 5(8)(b) dealing with credit facility, independent of the concept of time value of money. However, the Court rejected the submission, holding that the loan must have an essence of the principal terms, in order to be qualified as “financial debt”, whereas, the Orator judgment specifically opposed this position. Consequently, since the Phoenix judgment is not even explicitly overruled, this gives in confusion as to what the position of the law stands for Section 5(8) of IBC.
- CAN WORKING CAPITAL BE USED AS A LOOPHOLE?
Working capital is the money used to cover a company’s short-term expenses, including inventory, payments on short-term debt, and day-to-day expenses. Due to the loan being taken to fulfill the working capital requirements of the Corporate Debtor, the Court observed the existence of a ‘commercial interest’ and categorized the transaction as having “commercial effect of borrowing”.
Unarguably, since the start of COVID, a heavy percentage of funds are being raised for the sole objective of fulfilling the working capital requirement. Thus, the Orator judgment opens doors for creditors of such nature, to qualify as a financial creditor and initiate Corporate Insolvency Resolution Process under IBC through Section 7.
CONCLUSION
Loans for working capital requirements being considered as a financial debt might be recognized as a loophole in the system to avail Section 7 route, especially after COVID. The gap in judicial interpretations would result in more confusion. As the agreements are entered into after keeping an eye on recent developments on the issue, reliance on the Orator judgment might prove misleading and increase the number of litigations in the future.