Supreme Court: 'Creditor' Will Not Become 'Financial Creditor' If Corporate Debtor Only Gives Security by Pledging Shares without Undertaking To Discharge Borrower

Supreme Court: 'Creditor' Will Not Become 'Financial Creditor' If Corporate Debtor Only Gives Security by Pledging Shares without Undertaking To Discharge Borrower

On 3 February, 2021, a bench of the Supreme Court of India (SC) 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 Section 5(7) and (8)."

A Three-Judge Bench of the SC comprising Justices Ashok Bhushan, R Subhash Reddy and MR Shah, in the case of Phoenix Arc Pvt. Ltd. (Appellant) v. Ketulbhai Ramubhai Patel (Respondent), held, "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 Bench put its reliance on the cases Swiss Ribbons (P) Ltd. v. Union of India, (2019) 4 SCC 17 and Pioneer Urban Land & Infrastructure Ltd. v. Union of India, (2019) 8 SCC 416 wherein the judgments contained elaborate discussion regarding the essentials of "financial debt" and "financial creditor".

In this case, the appellant was the assignee of a loan of Rs. 40 crore advanced by a creditor to the parent company of the corporate debtor. As a security to that loan, the corporate debtor (Doshion Veolia Water Solutions Private Limited) had executed a pledge agreement with the creditor, pledging certain shareholdings in another company.

An appeal was filed by the appellant challenging the orders of the National Company Law Tribunal (NCLT) and the National Company Law Appellant Tribunal (NCLAT).

The Tribunal rejected the plea of the appellant and it held that theappellant is not the financial creditor of the corporate debtor, Doshion Veolia Water Solutions Private Limited.

Issues before the SC

Whether the appellant can be a 'financial creditor' solely based on the pledge agreement?

On behalf of the appellant the senior Advocate KV Vishwanathan argued that it would be a 'financial creditor' according to Section 5(8)(i) of the IBC, which deals with the liability arising out of 'guarantee or indemnity'.

On behalf of the respondent, it was submitted that the appellant would not be a creditor as it has no right of recovery of any debt from the corporate debtor. It has a limited right of enforcing and realizing the value of its security held by the corporate debtor in its subsidiary. Hence, the pledge is not a guarantee under the Contract Act.

The Bench observed that the pledge agreement would not be considered as a 'guarantee' as defined under Section 126 of the Contract Act, 1872. The Court reasoned that it would not be a 'guarantee' as it did not contain an undertaking by the corporate debtor to discharge the liability of the borrower.

The Court pointed out while explaining the ambit of Section 126 of the Contract Act, "A contract of guarantee contains a guarantee "to perform the promise or discharge the liability of a third person in case of his default". Thus, keywords 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 Top Court stated, "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 the borrower."

The Court further observed and stated, "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."

It was further noted by the Apex Court that, "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 crore is undertaken by the corporate debtor.

It was the borrower who had promised to repay the loan of Rs.40 crore in Facility Agreement dated 12.05.2011 and it was a borrower who had undertaken to discharge the liability towards the lender."

The SC further pointed out that the Pledge Agreement does not contain any contract that the corporate debtor has contracted to perform the promise or discharge the liability of the third person. The Pledge Agreement is limited to pledge of 40,160 shares of GEL only."

The Court stated that the appellant cannot be considered as a 'financial creditor' but could be termed as a 'secured creditor'. The SC upheld the orders of the NCLAT of refusal of the interim resolution professional to allow its participation in the resolution process of a corporate debtor.

The Court held, "A person having only security interest over the assets of the corporate debtor, even if falling within the description of 'secured creditor' by 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 SC 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.