Debt Deconstructed: Analysis Of Supreme Court's Judgment On Determining The Nature Of Debt

This conundrum has been settled by the Supreme Court in Global Credit Capital Limited & Anr. v Sach marketing Pvt. Ltd.^[2], (Judgment) where it has provided with the yardstick for determining whether a debt is financial or operational debt under Sections 5(8) and 5(21) of IBC, respectively.

Brief Facts on the Matter

The dispute arises out of two agreements (Agreements) executed between Mount Shivalik Industries Limited (Corporate Debtor) and Sach Marketing Pvt. Ltd (Sach Marketing). Under the Agreements, Sach Marketing was appointed as a sales manager and was required to deposit a minimum security over which the Corporate Debtor was to pay 21% interest per annum to Sach Marketing. Subsequently, corporate insolvency resolution process was initiated against the Corporate Debtor. Sach Marketing filed a claim with the resolution professional (RP) as a financial creditor. The RP rejected the claim and categorized Sach Marketing as an operational creditor. Sach Marketing filed an application before the National Company Law Tribunal challenging the decision of the RP. The application was rejected on the ground that the security deposit was given as part of the Agreements by Sach Marketing to provide its services to Corporate Debtor. Aggrieved, Sach Marketing approached the National Company Law Appellate Tribunal (NCLAT) which held that Sach Marketing was a financial creditor as the security deposit paid to Corporate Debtor had no correlation with any other clause under the Agreements. The order of the NCLAT was challenged before the Supreme Court, where the Supreme Court dealt with the following issues: as to what constitutes a debt, what liability or an obligation of a corporate debtor gives rise to a claim; and under what circumstances can a debt be classified either as financial or operational debt.

Existence of claim, a pre requisite for any amount to be classified as Debt

In order to determine the nature of debt as financial or operation, the Supreme Court firstly examined the ingredients of 'debt' under IBC. On perusing the meaning of 'debt' under Section 3(11) of IBC, the Supreme Court observed that a debt is a liability or an obligation in relation to a claim which is due from any person, including financial and operational debt. IBC inter alia defines claim as a right to receive payment, in other words, liability of a corporate debtor to make payment. Accordingly, a liability or an obligation cannot be categorized as a debt (financial or operational), unless it is a claim, i.e., having the right to payment, covered by Section 3(6) of IBC.

Thereafter, the Supreme Court dwelled into the question whether in the instant case the security deposit could be considered as debt. The security deposit was paid to the Corporate Debtor without any provision of its forfeiture and the security deposit had no correlation with the performance of other conditions of the Agreements. In fact, the Corporate Debtor was liable to refund the security deposit after a specific period with interest to Sach Marketing. In light of these facts, the Supreme Court upheld NCLAT's view that since the security deposit had no correlation with any clause under the Agreements, it is to be considered as 'debt' under Sections 3 (11) of IBC. This was held as the security deposit was not given to the Corporate Debtor for the purposes or in relation to the services provided by Sach Marketing to Corporate Debtor under the Agreements. Thus, the Supreme Court held that the right to seek refund of the security deposit along with interest is a claim within the meaning of Section 3 (6) of IBC.

What Amounts to a Debt as Financial or Operational

The Supreme Court held that in order to determine the issue of whether a debt is financial or operational debt, the real nature of transaction must be ascertained. The Supreme Court analyzed the provision under Section 5(8) of IBC which defines 'financial debt'. It held that the categories provided under Section 5(8) must satisfy the twin test to qualify as financial debt i.e., (i) existence of a debt; and (ii) the debt must be disbursed against consideration for the time value of money. The Supreme Court relied upon its previous judgments in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v Axis Bank Limited & Ors (Jaypee Infratech) and Phoenix ARC Private Limited v Space Financial Services Limited & Ors., (Phoenix ARC) where it had dealt with the concept of time value of money and the contours of financial debt.

Pertinently, in Phoenix ARC, the Supreme Court had discussed the expression 'disbursed' under Section 5(8) of IBC. It held that the term 'disbursed' refers to the money paid against consideration for time value of money. The Supreme Court also referred to the report of the Insolvency Law Committee dated March 26, 2018, where the term 'time value of money' was interpreted as: “compensation or the price paid for the length of time for which the money has been disbursed. This may be in the form of interest paid on the money or factoring of a discount in the payment.” Applying the principles to the fact of the case, the Supreme Court held that that the security interest provided by Sach Marketing had the provision for payment of interest, showing that there was consideration for the time value of money under the Agreements.

As regards to the argument that the security deposit is an operational debt, Supreme Court held that where a creditor claims debt under an agreement pertaining to rendering of services, such debt is only an operational debt if the subject matter of the claim has some connection to the service to be rendered, as per Section 5(21) of IBC. In light of the terms of the Agreements, the Supreme Court held that the security deposit was not provided to the Corporate Debtor in connection the service to be rendered by Sach Marketing. There was no correlation between the services and the security amount. Thus, the security deposit could not have been said to have relation to the purported services provided by Sach Marketing.

The transaction involving financial debt to have commercial effect of borrowing under Section 5(8)(f) of IBC

To supplement the above observation, the Supreme Court relied on Section 5(8)(f) of the IBC which covers all those transactions qualifying as financial debt which are not covered by Sections 5(8)(a)-(e). However, the Supreme Court clarified that for applicability of any transaction laid down under Section 5(8) of IBC, the conditions under the twin test must be satisfied.

The condition for applicability of Section 5(8)(f) of IBC is that any amount to be considered as financial debt under the transaction must have commercial effect of borrowing. Section 3(33) of IBC defines transaction to include agreements in writing for transfer of funds to corporate debtor. The Supreme Court held that Sach Marketing and the Corporate Debtor had a written arrangement for transfer of funds to the Corporate Debtor. Further, the financial statement of the Corporate Debtor treated the security deposit as long term loan, and the financial statement of Sach Marketing considered the interest on the security deposit as a revenue. On this basis, the Supreme Court held that the security deposit under the Agreements had the commercial effect of borrowing.

Analysis of the Judgment

In this landmark judgment, the Supreme Court has expanded the understanding of the definition of 'financial debt' by including debts which may arise from transactions which do not conform strictly to the standards of a financial agreement. It held that the determinative factor to ascertain the nature of debt is to understand the nature of the transaction provided in the agreement. If the debt is not related to the service to be or rendered in the agreement, such debt cannot be classified as operational debt. However, for such debt to be categorized as financial debt, a creditor must satisfy the twin test laid down under section 5(8) of IBC.

In its earlier judgment viz., Consolidated Construction Consortium Limited v Hitro Energy Solutions Private Limited^[3], the Supreme Court had considered the issue whether an advance amount paid by recipient of service under an agreement could be considered as an operational debt. While deciding the issue, the Supreme Court replied upon the same principle as applied under the Judgment i.e., the claim must bear co-relation or nexus with the provision of goods or services, without specifying who is to the supplier or receiver. Thus, the Judgment establishes and settles the law on determining the nature of debt.

In addition, the reliance placed by the Supreme Court on the financial statements of Corporate Debtor and Sach Marketing to ascertain the commercial effect of the transaction finds relevance under Regulation 8 of Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 which gives options to financial creditors to reply upon documents to prove the existence of debt.

Indubitably, the Judgment will be a forerunner in determining the scope of the claims of financial and operational creditors and must be followed by RPs and adjudicating/appellate authorities while determining the true nature of the transactions which form basis of the debt.

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