MORATORIUM UNDER INSOLVENCY & BANKRUPTCY PROCEEDINGS

Read on to understand

implications of moratorium

on lenders who have

taken certain forms of

collateral/security interest,

including security of

assets of corporate debtor

against whom insolvency

proceedings have been

initiated...

A moratorium in general parlance refers to a

delay or suspension of activity or law for a

certain period of time. In the legal context, it

may refer to the temporary suspension of a law

to allow a certain legal challenge or proceeding

to be carried out without any disruption on account of

interplay of overlapping legal processes.

Under the newly enacted Insolvency and Bankruptcy Code,

2016 ("the Code"), the National Company Law Tribunal ("the

Adjudicating Authority/NCLT") on the date of admission

of the application filed for initiating corporate insolvency

resolution process under Section 7 or Section 9 or Section

10 of the Code (called insolvency commencement date),

shall, by an order, declare a moratorium for prohibiting all

of the following, namely:

(a) institution of suits or continuation of

pending suits or proceedings against

the corporate debtor including

execution of any judgment, decree or

order in any court of law, tribunal,

arbitration panel or other authority;

(b) transferring, encumbering, alienating

or disposing of by the corporate

debtor any of its assets or any legal

right or beneficial interest therein;

(c) any action to foreclose, recover

or enforce any security interest

created by the corporate debtor in

respect of its property, including any

action under the Securitization and

Reconstruction of Financial Assets

and Enforcement of Security Interest

Act, 2002;

(d) recovery of any property by an

owner or lessor where such property

is occupied by or in the possession of the corporate

debtor¹.

An exception to the abovementioned prohibition is the

supply of essential goods and services to the corporate

debtor, which shall not be interrupted by way of the

moratorium. Further, the Central Government is authorized

to notify non-applicability of the moratorium provisions

as the Government may deem fit in consultation with

the financial services regulator. Pursuant to the powers

vested with the Central Government under the Code, the

Department of Financial Services, Government of India

has addressed its letter dated May 1, 2017 to members of

the Indian Banks' Association, seeking suggestions on the

aforesaid exclusions from Section 14 of the Code, including

cases where SARFAESI action has been initiated under

Section 13(4) and Section 14 of the SARFAESI Act.

This article aims to analyze implications of the moratorium

on lenders who have taken certain forms of collateral/

security interest, including security of assets of the

corporate debtor against whom insolvency resolution

process has been initiated, pledge of shares pertaining

to the corporate debtor, guarantee from promoters of the

corporate debtor etc. This can be better understood by the

following illustration:

Company A is a promoter of Company B. Company B

has obtained a loan from Bank X against the following

security (a) Corporate Guarantee of Company A and

(b) Pledge of Shares held by Company A in Company

B ("the Pledged Shares"). Lenders of Company

A file an application under Section 7 of the Code against

Company A. The application has been

admitted by NCLT, the moratorium

has begun and interim resolution

professional (IRP) is appointed. In these

circumstances:

i. Can Company A or IRP stop invocation

of Pledged Shares by Bank X? Will

invocation of Pledged Shares be

impacted by the moratorium?

ii. Can Bank X invoke the Corporate

Guarantee?

iii. Can Company A refuse payment to

Bank X in the event of invocation of

Corporate Guarantee?

iv. Will the invocation of Corporate

Guarantee be impacted by the

moratorium?

Analysis - As per the Code, if the

application filed against Company A is

admitted by the NCLT, the following shall

occur:

(a) a moratorium shall be declared on any action to

foreclose, recover or enforce any security interest

created by the corporate debtor in respect to its property

under Section 14(1)(c) of the Code. This may lead to

the Bank X being barred from invoking the pledge over

the Pledged Shares till such time as the moratorium

continues;

(b) the interim resolution professional ("IRP") shall

take control and custody of any asset over which the

corporate debtor has ownership rights, including

securities it holds in its subsidiaries under Section

18(1)(f) of the Code i.e. the Pledged Shares as the same

would qualify as assets of the corporate debtor; and

(c) the Committee of Creditors ("CoC") established in

relation to Company A may instruct the IRP to create

additional security on the Pledged Shares in favor of such persons as instructed by the COC under Section

28(1)(b) of the Code.

On plain reading of the abovementioned sections of Code,

it appears that security created in the form of pledge

over Pledged Shares cannot be enforced till expiry of the

moratorium period. Though the IRP can theoretically take

control of Pledged Shares, under the existing depository

system established under the Depositories Act, 1996 read

along with the bye-laws issued by the National Securities

Depository Limited (NSDL)³, there is no provision for any

third party to take charge or control of the already Pledged

Shares. Unless, Bank X consents to the release of the pledge

on Pledged Shares, neither IRP will be able to take control

or deal with in any manner, or create additional pledge over

Pledged Shares nor COC can instruct creation of additional

pledge over Pledged Shares in favor of lenders of Company

A. The Code does not give any power to either the IRP or

COC to invalidate or cancel the pledge validly created in

favor of Bank X on Pledged Shares in terms of the procedure

prescribed under the Depositories Act, 1996. Therefore, the

pledge created in favor of Bank X will not be impacted

except that during the moratorium period, Bank X may not

be able to invoke and sell Pledged Shares. After expiry of

the moratorium period, Bank X will have no restriction for

invoking or selling Pledged Shares.

As regards the Corporate Guarantee, Bank X may not be

able to invoke it during the moratorium period, however,

there would be no restriction on sending demand notice

to the Company A, asking it to make payment under the

Corporate Guarantee. Further, upon non-payment by

Company A under the said Guarantee, Bank X will be at

liberty to initiate appropriate legal proceedings against

Company A before Debt Recovery Tribunals and/or under

the Code, in its capacity as a financial creditor of Company

A in terms of the Code.

Now let's reverse the above illustration:

Company A is a promoter of Company B. Company B

has obtained a loan from Bank X against the following

security (a) Corporate Guarantee of Company A and (b)

Pledge of Shares held by Company A in Company B ("the

Pledged Shares"). Some other lenders of Company B file an

application under Section 7 of the Code against Company B.

The application has been admitted by NCLT, the moratorium

has begun, and IP is appointed. In these circumstances:

i.

Can Company A or IRP stop invocation of Pledged

Shares by Bank X? Will invocation of Pledged Shares be

impacted by the moratorium?

ii.

Can Bank X invoke Corporate Guarantee?

iii.

Can Company A refuse payment to Bank X in the event

of invocation of Corporate Guarantee?

iv.

Will invocation of Corporate Guarantee be impacted by

the moratorium?

In this case, neither invocation of Corporate Guarantee

nor Pledged Shares shall be impacted by declaration of

moratorium. The COC can even, as part of the resolution

plan, decide on invocation of Corporate Guarantee and

Pledged Shares.

It may thus be noted that it is important that moratorium

provisions are interpreted to be restricted to the assets of

the corporate debtor and must not be used as a tool by

third-party security providers to evade their liability under

security documents executed with the lenders.

The recent judgment given by NCLT, Mumbai, in case of

M/s Schweitzer Systematic India Private Limited vs.

Phoenix ARC Limited², is an illustrative judgment on this

aspect, where the tribunal ruled that '

moratorium has no

application on properties beyond the ownership of the

corporate debtor

.'

It was further ruled that (a) moratorium shall commence on

the corporate debtor; (b) property not owned by corporate

debtor does not fall within the ambit of moratorium; (c)

order of CMM directing the court commissioner to take over

possession of properties shall not fall into the clutches of

moratorium; (d) further clarified that any action under

SARFAESI Act shall come within the ambit of moratorium if

an action is to foreclose or recover or create any interest in

respect of the property belonged to or owned by a corporate

debtor, otherwise not.

Footnote:
1. Section 14 of the Insolvency and Bankruptcy Code, 2016.

2. Order dated July 3, 2013 in TCP No. 1059/I&BP/NCLT/MB/MAH.

3. In terms of the Depositories Act, 1996 read along with the Bye-Law 9.9.9 issued by NSDL (as

amended till June, 2017); the entry of pledge or hypothecation made in respect of any securities shall be cancelled by the Depository Participant when the Client

redeems the pledge or hypothecation and makes a request, with the concurrence of the pledgee.

Disclaimer

– The views expressed in this article are the personal views of the author and are purely informative in nature.