Conundrum with Treatment of ‘Indirect Secured Creditors’ during CIRP

[By Mayank Bansal & Shreya Gupta]

The author are students of Dr. B.R. Ambedkar National Law University, Sonepat.



In our insolvency & bankruptcy regime, an adequate statutory mechanism is available to protect the interest of all the relevant stakeholders, especially the creditors. Normally, a secured creditor is an entity who lends money to the corporate debtor, and some assets are pledged with him as security. Recently, the Hon’ble Supreme Court (‘SC’) in the matter of M/S Vistra ITCL (India) Ltd. & Ors. v. Mr. Dinkar Venkatasubramanian, encountered a unique class of secured creditors, i.e., ‘indirect secured creditors’ who lent money to a third party (‘borrower’). However, the corporate debtor pledged its assets to secure the loan. This type of creditor has no engagement or involvement in the affairs of the corporate debtor, and their interest is limited to selling the pledged shares in the event of default by the borrower.

In this case, an interesting question was posed before the Hon’ble SC – how such indirect secured creditors shall be treated during Corporate Insolvency Resolution Process (‘CIRP’) as no special treatment is provided to them as far as mandatory content of a resolution plan is concerned. As an answer to this question, the Hon’ble SC proposed two alternatives, namely, treating indirect secured creditors as ‘financial creditors’ of the corporate debtor or giving them rights and entitlements as provided to other secured creditors at the stage of liquidation under Section 52 of Insolvency & Bankruptcy Code, 2016 (‘IBC’).

This article seeks to critically analyze both the given alternatives since treating them as financial creditors goes against the settled definition of financial debt, and granting liquidation rights at the stage of CIRP will efface the innate difference between direct and indirect secured creditors, contrary to the spirit of the IBC.

Indirect Secured Creditors as Financial Creditors: A Legal Quandary

As per the first alternative, the Hon’ble SC proposed that indirect secured creditors shall be treated as financial creditors of the corporate debtor up to the amount of the estimated value of the pledged shares; thereby making them a member of the Committee of Creditors (‘CoC’) and giving them voting rights. However, this proposed alternative is surrounded by myriad legal issues, as discussed below:

  • No Debtor-Creditor Relation and Absence of Time Value of Money

The Hon’ble SC, while dealing with an identical legal question in the matter of Anuj Jain IRP for Jaypee Infratech Ltd. v. Axis Bank Ltd, held that for an entity to be classified as a ‘financial creditor’ in accordance with Section 5(7) of the IBC, the relation between the financial creditor and corporate debtor must exist ‘primarily’ and a financial debt must have been taken by the corporate debtor from such creditor. However, in the ongoing case, a loan has been taken by a third party, and the role of the corporate debtor is limited to pledging the shares as security with no relation to the money so lent. Thus, it would be far-fetched to bring such creditors within the ambit of financial creditors.

Further, it is well settled that financial debt must involve the essential elements of the time-value of money. This means the financial creditor must receive something extra besides the principal amount from the corporate debtor over a specific period. However, in this tripartite agreement, the corporate debtor has merely pledged its shares against the loan obtained by a third party with no additional time-related benefit owing to the creditor; therefore, no time value of money qua corporate debtor is involved.

  • A Pledge of Shares does not Constitute Financial Debt

In the present case, it was argued that since the corporate debtor has pledged its shares to secure the loan given to a third party, it shall be treated as a guarantor, and this guarantee would fall within the umbrella of financial debt under Section 5(8)(i) of IBC. This argument is completely untenable as a fundamental difference exists between pledge and a guarantee.

In Phoenix ARC Ltd. v. Ketulbhai Ramabhai Patel, the Hon’ble SC highlighted that a contract of guarantee involves two essential elements: a contract to perform the promise or discharge the liability. This pledge agreement cannot be equated with a contract of guarantee as the liability of the corporate debtor herein is restricted to the extent of the pledged shares. In the event of default by the borrower, the indirect secured creditor has a limited right to sell such shares, which does not necessitate the corporate debtor to perform a promise or discharge the liability.

  • Unique Status of Financial Creditor Cannot be Extended to Indirect Secured Creditor

The Hon’ble SC in Swiss Ribbon v. Union of India held that in the scheme of IBC, the financial creditors enjoy a unique status owing to their involvement from the very initial stages with the corporate debtor. Akin to a guardian, they are entrusted with the vital task of assessing the viability and restructuring of corporate debtors while exercising their commercial wisdom.

In complete contrast to the above, the interest of indirect secured creditors is limited to realizing the security interest and recovering money from the corporate debtor. The Hon’ble SC in Anuj Jain (Supra) observed that the indirect secured creditors have a remote connection with the corporate debtor, bereft of any long-term objective of revival and growth, and they shall not be accorded the unique status of the financial creditor.

Equal Treatment of Unequal: Conferring Liquidation Rights to Indirect Secured Creditors during CIRP

As per the second alternative suggested by the Hon’ble SC, the indirect secured creditor shall be allowed to retain the security interest in the pledged shares even post CIRP; subsequently, it will be vested with all the rights and obligations as given to a secured creditor at the stage of liquidation under Section 52 and Section 53 of the IBC. During liquidation, the secured creditor can either sell the pledged security outside the liquidation framework or relinquish its security interest and claim its dues under the waterfall mechanism. In the authors’ opinion, the above alternative is very uncharacteristic and has opened Pandora’s box, raising many convoluted questions.

Firstly, the scheme of IBC does not envisage special protection for such indirect secured creditors at the stage of CIRP. The Hon’ble SC in Essar Steel v. Satish Kumar Gupta observed that the secured creditor as a class is included within the broad class of financial creditor, and ample protection is available to it For indirect secured creditors who do not fall within the ambit of financial creditors owing to their limited interest in the affairs of corporate debtors, it would be highly incongruous to ensure such an enhanced level of protection.

Secondly, even at the stage of liquidation, the special treatment given to secured creditors to either realize or relinquish their security interest under Section 52 must be limited to direct secured creditors as the legislature never intended to accord such preferential treatment to a class of creditors, which is not instrumental in the resolution of the corporate debtor. The UNCITRAL Legislative Guide on Insolvency Law (Page 11) also stresses the principle that equitable treatment shall be given to similarly situated creditors. The Hon’ble Apex Court in Anuj Jain (Supra) clearly highlighted the innate difference between direct and indirect secured creditors and pointed out that the former set of secured creditors is intrinsically linked with the interest of the corporate debtor, whereas the latter is neither involved in assessing the viability nor lent any money to the corporate debtor; therefore, putting them on an equal pedestal would do more harm than good.

Thirdly, allowing the indirect secured creditor to retain the security interest post-approval of the resolution plan contravenes the settled ‘clean slate theory’, which advocates that no past claim would survive once a resolution plan is approved. The corporate debtor shall start its operation afresh. Lastly, as per the pledge agreement, the principal liability to repay the money was of the borrower, and the pledged shares could only be invoked in the event of default. So, the Court failed to clarify that once the creditor recovers the amount from the sale of pledged shares, how the corporate debtor will receive this money from the borrower? This may result in another round of litigation.

Conclusion and Way Forward

Undoubtedly, the Hon’ble SC, while resolving this legal quandary, propounded unique alternatives to grant enhanced protection to indirect secured creditors, which the Code does not envisage. The Court failed to distinguish the inherent and structural differences between the direct and indirect secured creditors.

Still, considering the limited involvement of indirect secured creditors in the affairs of the corporate debtors, the plausible solution would be to direct them to submit their dues in ‘Form F’ under which claims of ‘Other Creditors’ (excluding financial and operational) are entertained; subsequently, their treatment during CIRP shall be subject be the commercial wisdom of CoC which does not warrant any judicial protection. Further, to ensure complete justice, they shall be allowed to recover the balance amount from the borrower outside the framework of IBC.


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