[By Dhruv Kohli]
The author is a student of Gujarat National Law University.
Introduction
In its judgment dated 9th September, 2022, the principal bench of NCLAT has held that a “Deed of Hypothecation” executed in favour of a third-party creditor is not to be construed as a “financial debt” under the IBC. As a corollary, the bench noted that such a third-party secured creditor shall not be eligible to file its claims as a “financial creditor” and hence neither file an application to initiate CIRP nor be a part of the Committee of Creditors. Interestingly, the bench came to this conclusion on the basis that the deed did not carry an explicit clause to the effect that it is a “guarantee” and hence cannot be construed as a “financial debt”. The author in this article makes an attempt to argue that the judgement of NCLAT is flawed and suffers from non-application of mind.
Facts
The Appellant (Doha Bank) in the present case had extended a loan facility to Reliance Infratel (Corporate Debtor/CD). The CD along with Reliance Communications Infrastructure (RCIL), Reliance Communications (RCom) and Reliance Telecom (RTL) (collectively who were referred to as “RCom entities”) had further availed loan facilities from various other lenders (referred to as the “indirect lenders”). As a part of the latter facility, all the RCom entities had pooled in all of their assets and created a first pari passu charge over them. In order to create the same, RCom entities had executed a “Deed of Hypothecation (DOH)”. Upon initiation of CIRP against the CD in 2017, the indirect lenders had filed their claim with the RP who accepted their claims and the same were categorized as “financial creditors”. However, this categorization was objected by the Appellant on the ground that the indirect lenders had not extended any “direct loan” to the CD and that DOH was extended only as a part of normal contractual practice and the same cannot be construed as a deed of guarantee. The RP rejected the contention of the appellant, holding that upon a combined reading of the entire DOH, it emerges that there is a covenant to pay upon occurrence of any shortfall or deficiency and the same is to be construed as a contract of guarantee. In appeal, the NCLT too rejected the appellant’s contention by upholding the argument as given by the RP.
NCLAT’s Judgment
In appeal, the principal bench came to the conclusion that the DOH that has been executed by the CD in favour of the indirect lenders while it does create a security interest, the same cannot be construed as a financial debt under IBC. While coming to this decision, the NCLAT held that section 5(8) of the IBC provides for an “exhaustive list” of what can be construed as “financial debt” and that the DOH does not fall within this ambit. Secondly, the NCLAT also held that to construe an instrument as a contract of guarantee, is to be specifically specified in the initial part or object of the agreement or preamble and not somewhere some wordings are mentioned in the agreement. The bench observed that a clause within the agreement stating that the deficiency will be recouped, cannot be the basis to claim that there exists a contract of guarantee. By upholding this, the NCLAT reversed the judgment of NCLT.
Analysis
A guarantee as defined under the Indian Contract Act means “a contract to perform the promise, or discharge the liability, of a third person in case of his default”. Therefore, the essential element herein is that there ought to be an obligation to fulfil the obligations of a third party. In the present case, the NCLAT erred in holding that the DOH is not a guarantee under Indian Contract Act. Clause 2 of the DOH specifically provided that each of the chargor(s) had covenanted to pay all the amount that is repayable under the loan facilities. Further clause 5(iii) of the DOH provided that in case there is any shortfall or deficiency even after the sale of the hypothecated assets, all of the chargor(s) specifically agreed to provide for amount to cover this deficiency. What appears from these two clauses is that the CD had not merely created a charge on its assets; instead it had specifically undertaken to pay the amount taken under the facility as well as any shortfall/deficiency that arises. As a general rule, the liability of the surety is co- extensive with that of the principal debtor unless otherwise provided by the contract. Clause 2 and 5(iii) of the DOH prima facie imposed an obligation upon the CD to pay even on behalf of other RCom entities. This transforms the DOH from a mere security interest into a contract of guarantee.
In Intesa Sanpaola v. Videocon Industries, the Bombay HC had opined that an undertaking to pay is a guarantee. Further, in the case of IL&FS Infrastructure Debt Fund v. Mcleod Russel India, the NCLT categorically came to the conclusion that a ‘shortfall undertaking’ executed by the parent company of the CD can be construed as a guarantee and the same can be further construed as a financial debt under IBC. Interestingly, the NCLT in Mcleod Russel rejected the argument that since the instrument did not carry the term ‘guarantee’ the same cannot be construed as one. Deriving from the same, in the present case the CD had undertaken to pay under the facility. Even if the facility was not directly taken by the CD, its undertaking to pay under the DOH transformed the document directly into a guarantee.
The NCLAT also failed to take into consideration the observation as made by the Insolvency Law Committee report of 2020, wherein, it was categorically mentioned that “by creating a security interest in favour of the creditor, the security provider undertakes to repay the debt owed to the creditor to the extent of the security interest, in the event that the borrower fails to do so. Therefore, just like the borrower, the security provider should also be considered as a debtor of the creditor”. The report went onto observe that such a creditor should be accorded the status of financial/operational creditor vis-à-vis both the principal debtor and the security provider and merely because the creditor did not disburse a debt directly to the security provider, it would not preclude the creditor from acquiring the status of a financial/operational creditor. The decision erroneously negated the report without even considering the same.
Further, holding that since there is no explicit covenant in the instrument, the instrument cannot be construed as a guarantee goes against the canons of construction of a contract. By coming to this decision, the NCLAT has gone against the ratio as laid down by the apex court in the landmark case of Associated Hotels of India Limited v. R.N. Kapoor, which while interpreting a licensing agreement as a lease deed had categorically come to the conclusion that “the nomenclature used in a document is not decisive or conclusive and the nature of a transaction is to be determined on the basis of the substance of the document as a whole rather than the labels used therein”. The same was again reiterated in Assam Small Scale Industrial Development Corporation v. J.D. Pharmaceuticals.
Conclusion
The classification of a third-party security holder as a financial/operational creditor has always been a contentious position and has been subject to considerable litigation. A DOH is a standard form of security that is commonly executed between parties, especially in commercial transaction(s) to raise capital. In the author’s opinion, the present decision has further complicated matters for third-party security holder, especially by holding that there ought to be a specific covenant of guarantee in an instrument to construe it as one. The disregard of the insolvency law committee report on the same aspect further goes onto show a non-application of mind on behalf of the adjudicating authority. The ramifications of this decision would further be seen on the banking sector wherein lenders often acquire such third party security in order to provide credit facilities. As a result of this decision, lenders would now have to specifically include covenants of guarantee in their security document(s) to secure their interests, which otherwise could become difficult as borrowers or their associates may not actually intend to enter into a contract of guarantee and undertake the obligations that flow from the same. The decision also increases possibility of further litigation on interpretation of a third-party secured creditor and their allied rights as seemingly different opinions have emerged which invariably would lead to large scale subjectivity on as to how such creditors are to be treated under IBC.