Creditor Will Not Become 'Financial Creditor' Under IBC If A Corporate Debtor Has Only Given Security By Pledging Shares, Without Undertaking To Discharge Borrower's Liability: Supreme Court

The Supreme Court has held that if a corporate debtor has only offered security by pledging shares, without undertaking to discharge the borrower's liability, then the creditor in such a case will not become 'financial creditor' as defined under the Insolvency and Bankruptcy Code(IBC).

The Court held that such a creditor could be a secured creditor but will not be a financial creditor under the IBC entitled to take part in the insolvency resolution process.

Referring to precedents, a bench headed by Justice Ashok Bhushan held that "a person having only security interest over the assets of corporate debtor, even if falling within the description of 'secured creditor' by virtue of collateral security extended by the corporate debtor, would not be covered by the financial creditors as per definitions contained in sub-section (7) and (8) of Section 5".

The top court was hearing an appeal filed by Phoenix Arc Pvt Ltd challenging the orders of NCLT and NCLAT which upheld the refusal of the interim resolution professional to allow its participation in the resolution process of a corporate debtor named, Doshion Veolia Water Solutions Private Limited.

Phoenix Arc was the assignee of a loan of Rs 40 crores advanced by a creditor to the parent company of the corporate debtor. As a security to that loan, the corporate debtor had executed a pledge agreement with the creditor, pledging certain shareholdings in another company.

The question before the top court was whether the appellant can be a "financial creditor" solely on the basis of this pledge agreement.

Senior Advocate KV Vishwanathan, appearing for the appellant, argued that the appellant will become a "financial creditor" by virtue of Section 5(8)(i) of the IBC, which mentions liability arising out of 'guarantee or indemnity'.

Ms. Ami Jain, counsel appearing for the respondent(IRP), submitted that the appellant is not a creditor as it has no right of recovery of any debt from the corporate debtor and has a limited right of enforcing and realising the value of its security in the shape of the shares held by the corporate debtor in its subsidiary. The pledge is not, in any manner, a guarantee under the Contract Act, it was argued.

The Court noted that the pledge agreement in the instant case did not amount to a 'guarantee' as defined under Section 126 of the Contract Act, 1872, since it did not contain an undertaking by the corporate debtor to discharge the liability of the borrower.

"'The present is not a case where the corporate debtor has entered into a contract to perform the promise, or discharge the liability of borrower in case of his default. The Pledge Agreement is limited to pledge 40,160 shares as security. The corporate debtor has never promised to discharge the liability of borrower.

The Facility Agreement under which the borrower was bound by the terms and conditions and containing his obligation to repay the loan security for performance are all contained in the Facility Agreement.

A contract of guarantee contains a guarantee "to perform the promise or discharge the liability of third person in case of his default". Thus, key words in Section 126 are contract "to perform the promise", or "discharge the liability", of a third person.

Both the expressions"perform the promise" or "discharge the liability"relate to "a third person". The Pledge Agreement dated 10.01.2012 does not contain any contract that the promise which was made by the borrower in the Facility Agreement dated 12.05.2011 to discharge the liability of debt of Rs.40 crores is undertaken by the corporate debtor. It was the borrower who had promised to repay the loan of Rs.40 crores in Facility Agreement dated 12.05.2011 and it was borrower who had undertaken to discharge the liability towards lender. The Pledge Agreement dated10.01.2012 does not contain any contract that corporate debtor has contracted to perform the promise, or discharge the liability of the third person. The Pledge Agreement is limited to pledge of40,160 shares of GEL only".

The Court observed that the appellant can at best be termed a "secured creditor".

"The present is also a case where only security was created by the corporate debtor in 40,160 shares of GEL, there was no liability to repay the loan taken by the borrower on the corporate debtor in the present case. At best the Pledge Agreement and Agreement of undertaking executed on10.01.2012, that is, subsequent to Facility Agreement, is security in favour of Lender-Assignor who at best will be secured creditor qua corporate debtor and not the financial creditor qua corporate debtor"

"This Court held that a person having only security interest over the assets of corporate debtor, even if falling within the description of 'secured creditor' by virtue of collateral security extended by the corporate debtor, would not be covered by the financial creditors as per definitions contained in sub-section (7) and (8) of Section 5.What has been held by this Court as noted above is fully attracted in the present case where corporate debtor has only extended a security by pledging 40,160 shares of GEL. The appellant at best will be secured debtor qua above security but shall not be a financial creditor within the meaning of Section 5sub-sections (7) and (8)".

Though the Court held that the appellant was not a 'financial creditor' under IBC, it clarified that it was entitled to seek other remedies available under law to enforce the pledge agreement.

Case : Phoenix Arc Pvt Ltd v Ketulbhai Ramubhai Patel

Bench : Justices Ashok Bhushan, R Subhash Reddy and MR Shah

Citation : LL 2021 SC 60

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