Redefining Financial Debt: Judicial Interpretation on Zero-Coupon Instruments and maintainability of Section 7 Application under the IBC Framework
INTRODUCTION
The Insolvency and Bankruptcy Code [“Code”] has been evolving ever since its introduction, with a nascent inception of the Corporate Insolvency Resolution Process [“CIRP”], and subsequently bringing within its sweep, the Insolvency of Individuals and Partnership Firms under Part III of the Code [“Personal Insolvency”] (generally, Personal Insolvency is instituted by the Financial Creditor against the Personal Guarantors to its Corporate Debtor, with/without exhausting the CIRP). With the increasing commercialisation and the extension of credit facilities lent out in the market, the borrowers, many times, based on various factors, including financial strains in availing the working capital, transform such transactions into different profit-oriented financial instruments such as equity shares, debentures, bonds, etc., in order to sustain corporate governance and financial viability.
In the midst of such financial instruments, Debentures are the most sought-after instruments given the low risk affiliation and fixed interest payments on a periodic basis. Given, a high infusion of funds by the investors in the market through the debenture route, the Ministry of Finance vide Notification dt. 27.02.2019, allowed the Debenture Trustees to initiate Section 7 Application on behalf of the Debenture Holders. Despite the govt. machinery sanctioning the authority of the Debenture Trustees to initiate a Section 7 Application, there has been an iota of confusion as to whether any infusion of funds through the subscription of Debentures at zero coupon rates will constitute a ‘financial debt’ under Section 5(8) IBC, and thereby testing the maintainability of the Section 7 Application under IBC.
In light of the void on the aspect of Debenture Trustee qua the zero-coupon subscription and infusion of funds, the author shall pen down the judicial lineage towards the proposition that even the infusion of funds through the debenture route, which are discounted to zero-coupon arrangements, constitute the financial debt in the light of the settled law propounded in Pioneer Urban Land & Orator Marketing, which still with an uncertainty does not clear the air around the zero coupon arrangements and the affixation of the status of financial debt to such instruments.
THE JUDICIAL RAMIFICATION OF FINANCIAL DEBT QUA SECTION 5(8) IBC
In the traditional sense, the Financial Debt was only meant to refer to such kinds of commercial arrangements wherein the funds were lent out primarily with the motive of funding the working capital of a business, which further builds a nexus with the fundamental business and financial management of the Corporate Debtor, in toto, such arrangements rendering loan and upfront financial facilities. This meant that only the financial arrangements that were due and had to be repaid upon the rightful claim of the Financial Creditor can constitute a Financial Debt. However, with the transforming nature of the commercial nomenclature and the credit arrangements, the traditional sense of ‘financial debt’ was being deviated, with one such effort taken in Pioneer Urban Land & Infrastructure Ltd. v. Union of India, (2019) 8 SCC 416. The apex court in the instant case gave a broad overview on ‘Financial Debt’ under Section 5(8) IBC to hold that even if the transaction-cum-debt had the commercial effect of borrowing, meaning that in addition to the requirement of disbursal of the amount against consideration for time value of money, the borrowing had the effect of giving ‘something equivalent’ to the Financial Creditor instead of the principal consideration, the same may amount to having a commercial effect of borrowing, despite the fact that such financial facility was not a loan transaction. In the said judgment, the following observation was given by the apex court vide Para 50:
“…. in the scheme of 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 reorganization 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.”
The apex court, in similar suit, gave an observation on the term ‘Financial Debt’ in Phoenix ARC Pvt. Ltd. v. Spade Financial Services Ltd., (2021) 3 SCC 475 in which, the apex court made it clear that financial debt is a debt together with interest, if any, which is disbursed against the consideration for time value of money. In a similar pursuit, the apex court in Orator Marketing (P) Ltd. v. Samtex Desinz (P) Ltd., (2023) 3 SCC 753, made it clear that if the two essential conditions are met, i.e., Disbursal of debt against consideration for the time value of money and the commercial effect of borrowing, the same may constitute Financial Debt irrespective of whether the principal amount is laid with/without interest, meaning in effect that the financial debt includes any amount raised under any other transaction, having the commercial effect of borrowing. Some of the relevant observations of the apex court have been reproduced hereunder:
22. NCLT and NCLAT have overlooked the words “if any” which could not have been intended to be otiose. “Financial debt” means outstanding principal due in respect of a loan and would also include interest thereon, if any interest were payable thereon. If there is no interest payable on the loan, only the outstanding principal would qualify as a financial debt. Both NCLAT and NCLT have failed to notice clause (f) of Section 5(8), in terms whereof “financial debt” includes any amount raised under any other transaction, having the commercial effect of borrowing.
23. Furthermore, sub-clauses (a) to (i) of sub-section (8) of Section 5 IBC are apparently illustrative and not exhaustive. Legislature has the power to define a word in a statute. Such definition may either be restrictive or be extensive. Where the word is defined to include something, the definition is prima facie extensive.”
A holistic reading of the above-mentioned precedents chalks out certain parameters to ascertain whether the financial arrangement constitutes ‘financial debt’ under Section 5(8) IBC:
i. Disbursal of debt has to be against consideration for time value of money;
ii. The disbursal must be a commercial borrowing;
iii. Nexus of the Financial Creditor with the functional management of the business affairs of the Corporate Debtor; and
iv. The nature of the underlying transaction (the said parameter was even observed by the apex court in Global Credit Capital Limited v. Sach Marketing Private Limited, 2024 9 SCC 482).
IS THE DEBENTURE TRUSTEE’S CLAIM UNDER SECTION 7 QUA ZERO COUPON DEBENTURES IN THE OFFING?
While on a cursory look of the aforementioned precedents and their laid down principles, it is no more res integra that the interest free financial arrangements and the disbursement thereof will not nullify such debt from being classified as ‘Financial Debt’, NCLAT, New Delhi Bench in its striking and penning down a narrow observation, had held in Raj Singh Gehlot Director, Ambience Pvt. Ltd. v. Vistra (ITCL) India Ltd., 2022 SCC OnLine NCLAT 1431 that since owing to a subsequent Settlement Agreement, the coupon rate against the subscription of Optionally Convertible Debentures [“OCDs”] was reduced from 15% p.a. to nil, and unless the principal money is not borrowed against the payment of interest, meaning that unless the financial debt carries interest element and is disbursed against the consideration of time value of money, the disbursal of principal amount will not be a financial debt. This order, in effect, even went down to hold that an investment made with the object of profit sharing from revenue generated will also not be covered within the ambit of Section 7 of the Code. The instant NCLAT observation was in teeth of the observations as meted out in the aforementioned judgments and the incidental parameters thereon.
Similarly, the NCLAT, New Delhi Bench, in Shubham Corporation Private Limited. v. Kotoju Vasudeva Rao, 2024 SCC OnLine NCLAT 635, that when the issuance of Debentures translates into equity shares qua Debenture Subscription Agreement, changing the coupon rates to nil, then it makes it evident that there is no repayment liability, so no financial debt under Section 5(8) IBC and hence the Section 7 Application cannot be initiated. In light of such observation, NCLAT devised the test of ‘liability for repayment’ that if there is no repayment liability, the debenture is not a debt instrument.
Per contra, the NCLAT, Principal Bench in Sanjay D Kakade v. HDFC Ventures Trustee Co. Ltd., 2023 SCC OnLine NCLAT 2241 while relying upon Kotak Mahindra Bank v. A Balakrishnan, has held as hereunder:
“26. …. We have noticed above that raising of amount by the company through share subscription-cum-shareholders agreement was a commercial borrowing, since the said transaction has direct effect with the business, which was carried out by the corporate debtor, i.e., construction of building and township. We have also noticed the supplementary share subscription-cum-shareholders agreement dated July 12, 2008, where the agreement clearly noted that “the company now requires further funding to the extent of Rs. 50 in order to carry out objectives of the business plan, i.e., approval of township, and actual execution of the township as per the designs prepared by the company architects”. Thus, the raising of the amount through the above agreement has the commercial effect of borrowing, which is clearly demonstrated by the above statements contained in the supplementary agreement.
…. The expression “time value of money” encompasses in itself the concept of time value of the disbursement. We have already noticed the various clauses of amended and restated share subscription-cum-shareholders agreement dated May 14, 2008 and we have extracted the relevant clauses, where company and promoters were obliged to purchase all the shares held by the non-defaulting shareholders at a price that provides the non defaulting shareholders at an internal rate of return of 15 per cent. per annum compounded annually or the fair market value, whichever is higher. Clauses 19.1(a) and 19.6(a) as extracted above, contains clear indication that investment was with an eye to earn profits and the investment was for consideration for the time value of money.”
Similarly, NCLAT, Principal Bench in Adhunik Corporation Limited v. Shivam India Limited, 2025 SCC OnLine NCLAT 408, while deciding whether the sale commission in consideration of the infusion of upfront financial facilities can constitute the financial debt. In support of the aforementioned parameters, the NCLAT has held as hereunder:
“16. The nature of the underlying transaction is therefore a determinative factor in deciding whether infusion of funds can be classified as financial debt or not.
26. …. Even the funds provided for purchase of raw material at prevailing market prices was towards operationalization of the Corporate Debtor. The right of the Appellant to enjoy sales commission was also a form of return for the amount financed. From the judgment of the Hon’ble Supreme Court in Pioneer judgment supra the ratio is clear that even if transactions are not necessarily loan transactions, they still attract Section 5(8) of the IBC as long as the transactions have the commercial effect of a borrowing. The essential condition which needs to be fulfilled is disbursement against the consideration for time value of money. Since in the present case, the infusion of funds was a transaction which has direct bearing on the business carried out by the Corporate Debtor, raising of the amount through the above agreement has the commercial effect of borrowing. The clauses of the MoA contain clear indication that the infusion of funds was being done with the intent of earning profits and the investments was therefore for consideration for the time value of money.”
Furthermore, NCLT New Delhi Bench II in Glorify Advisors Pvt. Ltd. v. Microgreen Electronics Pvt. Ltd. ((IB)-149/ND/2025) has held that since the since OCDs were redeemable at the option of the holder, with 30 days notice and also carried penal interest at 18% p.a. in case of default, so the penal interest constituted a debt disbursed against th consideration for time value of money, and hence a financial debt.
Henceforth, the inconsistent approach of the Adjudicatory Authorities towards the consideration of zero-coupon debentures as Financial Debt under Section 5(8) IBC has shrouded the Debenture Trustees in uncertainty, thereby setting the stage for such financial custodians in limbos. It would, in conclusion, not be out of context to mention that such an ambiguity distort the credit framework and shall frown upon the Debenture Trustees as FCs to pursue their legitimate claims on behalf of the Debenture Holders qua such Share Subscription and Shareholders’ Agreements.
CONCLUSION
The judicial landscape surrounding the maintainability of a Section 7 Application under the Code framework by Debenture Trustees acting on behalf of Debenture Holders has been marked by a discernible, albeit gradual, shift towards consistency. While the Adjudicatory Authorities initially displayed an inconsistent approach in classifying funds infused through zero-coupon led subscriptions of debentures as a financial debt under Section 5(8) IBC, the growing reliance on the foundational principles established in Pioneer Urban Land and Orator Marketing is paramount. These precedents underscore the essential requirements of disbursal of debt against consideration for the time value of money and the presence of a commercial effect of borrowing, irrespective of whether the transaction carries an explicit interest element.
The initial narrow observations, which often led to the rejection of claims by holding that the absence of a coupon rate or the potential for conversion into equity negated the existence of a financial debt, placed Debenture Trustees in a state of uncertainty and limbo. Such ambiguity risked distorting the credit framework. However, the emerging judicial wisdom, emphasizing the substance of the transaction, specifically, the commercial effect of borrowing and the inherent nexus with the functional management of the business affairs of the Corporate Debtor, is reinforcing the authority granted by the Ministry of Finance to Debenture Trustees to initiate proceedings as Financial Creditors. This trend suggests a greater coherence in recognizing these instruments, even those discounted to zero-coupon arrangements, as financial debt.
This move towards greater judicial consistency on the issue of Debenture Trustees acting on their legitimate claims, even when faced with financial arrangements where they are frowned upon at zero-coupon led subscriptions of debentures, is a critical step. Such uniformity and affirmation will provide much-needed certainty for the creditors’ community. Ultimately, ensuring the rights of these financial custodians to pursue claims on behalf of Debenture Holders is vital to maintaining the perennial flow of credit and safeguarding the overall commercial viability within the economy, thereby fulfilling the core objectives of the IBC.
Author Bio
