Mortgage By A Corporate Debtor To Secure Debts Of Third Party Not 'Financial Debt' Within Meaning Of Sec 5(8) IBC : SC [Read Judgment]

The Supreme Court on Wednesday upheld the order of National Company Law Tribunal which cancelled the mortgages made by Jaypee Infratech Ltd (JIL) to secure the debts of its holding company Jaiprakash Associates Ltd (JAL).

The NCLT Ahmedabad bench had allowed the application filed by Interim Resolution Professional(appointed for JIL CIRP) seeking avoidance of these mortgage transactions, which pertained to nearly 758 acres of land, as being "preferential, undervalued and fraudulent", in terms of Sections 43, 45 and 66 of the Insolvency and Bankruptcy Code, 2016.

This order was set aside by the National Company Law Appellate Tribunal on August 1 last year in a batch of appeals filed by the corporate debtor JIL and the banks which had advanced loans to JAL.

In the Supreme Court, a bench comprising Justices A M Khanwilkar and Dinesh Maheshwari set aside the NCLAT's order and restored the original order passed by the NCLT.

When does a transfer become preferential transaction under Section 43 IBC?

The judgment authored by Justice Dinesh Maheshwari discussed the issue of 'preferential transaction' under IBC. The following questions were listed as relevant for such a determination :

1. As to whether such transfer is for the benefit of a creditor or a surety or a guarantor?
2. As to whether such transfer is for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor?
3. As to whether such transfer has the effect of putting such creditor or surety or guarantor in a beneficial position than it would have been in the event of distribution of assets being made in accordance with Section 53?
4. If such transfer had been for the benefit of a related party (other than an employee), as to whether the same was made during the period of two years preceding the insolvency commencement date; and if such transfer had been for the benefit of an unrelated party, as to whether the same was made during the period of one year preceding the insolvency commencement date?
5. As to whether such transfer is not an excluded transaction in terms of sub-section (3) of Section 43? 

The Court further explained that for a preference to become an avoidable one, it ought to have been given within the period specified in sub-section (4) of Section 43.

The extent of 'relevant time' is different with reference to the relationship of the beneficiary with the corporate debtor inasmuch as, for the persons falling within the expression 'related party' within the meaning of Section 5 (24) of the Code, such period is of two years before the insolvency commencement date whereas it is one year in relation to the person other than a related party.

It was observed :

"The scheme of IBC is to disapprove and disregard such preferential transaction which falls within the ambit of Section 43 and to ensure that any property likely to have been lost due to such transaction is brought back to the corporate debtor; and if any encumbrance is created, to remove such encumbrance so as to bring the corporate debtor back on its wheels or in other event (of liquidation), to ensure pro rata, equitable and just distribution of its assets". 

From a discussion of the facts of the case, the bench came to the conclusion that the mortgages amounted to preference given to a "related party during a relevant time".

The impugned transactions had not been in the ordinary course of business or financial affairs of JIL, held the Court. So the transactions were held to be hit by Section 43 of IBC.

Person having only security interest over property of corporate debtor not 'financial creditor'

The Court held that a person having only security interest over the property of the corporate debtor cannot be regarded its "financial creditor".

The bench observed as follows :

"A conjoint reading of the statutory provisions with the enunciation of this Court in Swiss Ribbons (supra), leaves nothing to doubt that in the scheme of the IBC, what is intended by the expression 'financial creditor' is a person who has direct engagement in the functioning of the corporate debtor; who is involved right from the beginning while assessing the viability of the corporate debtor; who would engage in restructuring of the loan as well as in reorganisation of the corporate debtor's business when there is financial stress. In other words, the financial creditor, by its own direct involvement in a functional existence of corporate debtor, acquires unique position, who could be entrusted with the task of ensuring the sustenance and growth of the corporate debtor, akin to that of a guardian."

"Keeping the objectives of the Code in view, the position and role of a person having only security interest over the assets of the corporate debtor could easily be contrasted with the role of a financial creditor because the former shall have only the interest of realising the value of its security (there being no other stakes involved and least any stake in the  corporate debtor's growth or equitable liquidation) while the latter would, apart from looking at safeguards of its own interests, would also and simultaneously be interested in rejuvenation, revival and growth of the corporate debtor.

Thus understood, it is clear that if the former i.e., a person having only security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have its say in the processes contemplated by Part II of the Code, the growth and revival of the corporate debtor may be the casualty. Such result would defeat the very objective and purpose of the Code, particularly of the provisions aimed at corporate insolvency resolution". 

Mortgage by corporate debtor to secure debts of third party not 'financial debt'

The bench further observed :

"...we have no hesitation in saying that a person having only security interest over the assets of corporate debtor (like the instant third party securities), even if falling within the  description of 'secured creditor' by virtue of collateral security extended by the corporate debtor, would nevertheless stand outside the sect of 'financial creditors' as per the definitions contained in subsections (7) and (8) of Section 5 of the Code.

Differently put, if a corporate debtor has given its property in mortgage to secure the debts of a third party, it may lead to a mortgage debt and, therefore, it may fall within the definition of 'debt' under Section 3(10) of the Code. However, it would remain a debt alone and cannot partake the character of a 'financial debt' within the meaning of Section 5(8) of the Code".

The bench observed in conclusion :

"..on the issue as to whether lenders of JAL could be treated as financial creditors, we hold that such lenders of JAL, on the strength of the mortgages in question, may fall in the category of secured creditors, but such mortgages being neither towards any loan, facility or advance to the corporate debtor nor towards protecting any facility or security of the corporate debtor, it cannot be said that the corporate debtor owes them any 'financial debt' within the meaning of Section 5(8) of the Code; and hence, such lenders of JAL do not fall in the category of the 'financial creditors' of the corporate debtor JIL."

Case Details 
Title : Anuj Jain Interim Resolution Professional for Jaypee Infratech Ltd v Axis Bank Ltd and others
Case No : Civil Appeals No. 8512-8527 of 2019
Coram    : Justices A M Khanwilkar and Dinesh Maheshwari

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