Section 7 of Insolvency and Bankruptcy Code (IBC) enables a Financial Creditor (FC) to initiate Corporate Insolvency Resolution Process (CIRP) against a Corporate Debtor when a default on a debt has occurred. There is plenty of jurisprudence on what constitutes as financial debt for the purposes of this Act. Similarly, a question can arise in the minds of the lenders whether a debt (loan) which has been converted into equity by the borrower can be said to be financial debt under the Act and hence, can CIRP be started against such a borrower.
The author in this article seeks to answer this question by referring to the provisions of the IBC, provisions under company law and the judicial decisions on so far.
What is a Financial Debt under IBC?
Section 5(8) of IBC defines Financial Debt as debt along with interest (if any) which is disbursed against the consideration for time value of money and includes items referred to in sub-clauses (a) to (i).
The observations made by NCLAT Delhi in Utsav Securities Private Limited v. Timeline Buidlcon Private Limited on the meaning of Financial Debt is helpful for the present discussion.
The court in its judgment at para 14 observed as follows:
“Therefore, the first essential requirement of financial debt has to be met viz. that the debt is disbursed against the consideration for the time value of money and which many include the events enumerated in various sub-clauses. A financial creditor is a person who has right to a financial debt. The key feature of financial transaction as postulated by Section 5(8) is its consideration for time value of money. In other words, the legislature has included such financial transactions in the definition of ‘Financial Debt’ which are usually for a sum of money received today to be paid over a period of time in a single or series of payments in future.”
The court further noted (para 14):
“It is significant to notice that in order to satisfy the requirement of this provision, the financial transaction should be in the nature of debt and no equity is to be implied by the opening words of Section 5(8) of the IBC.”
Thus, according to the court’s interpretation, equity doesn’t come under the ambit of Financial Debt under the Act.
Conversion of Debt into Equity under Companies Act, 2013
Debt-Equity swap is a restructuring process in which a borrower company converts its loan amount to shares of equity or stocks. These stocks/shares are held by the lenders in lieu of their original loan. The benefit of this transaction is that it enables the company as well as the lender to improve its balance sheet without going any cash exchange.
In India, Section 62(3) of the Companies Act (“The Act”) provides for the conversion of loan into equity shares by the company.
The provision is reproduced hereunder:
“Nothing in this section shall apply to the increase of the subscribed capital of a company caused by the exercise of an option as a term attached to the debentures issued or loan raised by the company to convert such debentures or loans into shares in the company.
Provided that the terms of issue of such debentures or loan containing such an option have been approved before the issue of such debentures or the raising of loan by a special resolution passed by the company in general meeting.”
It can be deduced that only those loans which contain a clause for conversion of the said loan into equity or debenture can be converted into equity as per the Act. Other loans which do not contain this option cannot be converted into equity unless some arrangements are made by the company with the lender to modify the terms of the loan and include the option for conversion. Secondly, before the conversion can take place, it is mandatory that a special resolution is passed by the company in the general meeting (of the creditors, debenture holders) to approve the said conversion. Once, the conversion is completed, the lender acquires an ownership in the company and the company is released from its legal obligation to repay the loan.
Ruling of Courts in India
In this case, the FC had disbursed a loan to the Corporate Debtor (“CD”) which was recorded as unsecured loan from the director in the CD’s book of accounts. The board resolved to convert this loan into equity shares and an AGM was called for the same. The agenda of the AGM was shared with the FC beforehand. On the day of the AGM, no objections were received from the FC on this issue and the loan was successfully converted into equity shares.
The FC however demanded refund of the said loan and filed Section 7 petition for same. The court however dismissed the FC’s petition on the grounds that once a debt i.e., loan given to corporate debtor has been converted into equity shares, there is no debt in existence in the books of corporate debtor. Hence insolvency cannot be initiated against corporate debtor.
2. Canara Bank Vs. IVRCL Ltd. (NCLT Hyderabad)
In this case, Canara Bank had sanctioned open credit facilities to IVRCL Ltd. worth Rs. 1,121 crores, part of which was later converted into equity as part of Corporate Debt Restructuring (CDR) Process. The CDR process couldn’t be completed in time and CIRP was started against the company by one of the lenders. Accordingly, Canara Bank filed its claim before the Interim Resolution Professional (IRP) for debt converted into equity and uninvoked bank guarantees arguing that such debt are claims under section 5(8) of the code. But these claims were rejcted by the IRP, aggrieved by which, Canara Bank approached the NCLT. It argued that the conversion of debt of IVRCL into equity is only an arrangement to attract a strategic buyer and that the dues retain the nature of debt.
The NCLT accepted the IRP’s argument that once a debt is converted into equity cannot be included in claims, but uninvoked bank guarantees can be treated as debt and is a valid financial creditors’ claim.
3. Rita Kapur Vs. Invest Care Real Estate LLP (NCLAT Delhi)
In the instant case, the application was filed under Section 7 IBC which was dismissed on the ground that the loan advanced by the appellant was converted into equity by her own act and conduct and as such it does not fall within the definition of financial debt which is due and payable. Aggrieved by the same, an appeal was preferred before the Hon’ble NCLAT and the same was upheld. The appellant thereafter preferred a Civil Appeal before the Hon’ble Supreme Court, where the appeal was allowed. The matter was remanded back to the NCLAT for fresh disposal. The issue that arose consideration before the Hon’ble NCLAT was whether the amount of loan is debt or has the same been converted into capital.
The Hon’ble NCLAT held that the loan advanced by the appellant that has been converted into capital contribution without her consent cannot be treated as a capital contribution in order to dismiss the application filed by her under Section 7 of the Code. Accordingly, the matter was remanded back to Hon’ble NCLT for further proceedings after admitting the Petition filed under Section 7 of the Code.
From the above discussion a few things can be concluded. First is that once a debt has been successfully converted into equity, it ceases to be ‘Financial Debt’ under the provisions of IBC and hence, such claims shall not be maintainable. Section 62 (3) of Companies Act in this regard provides the framework for lawful conversion of debt into equity. Second, it is to be noted that the Companies Act provides for conversion of only those loans which contain the conversion clause and not others. Third, from the NCLAT’s ruling in Rita Kapur Vs. Invest Care Real Estate LLP, it is clear that where conversion of loan takes place without the permission or participation of the lender in the general meeting, such a conversion would not be valid and the lender would continue to have the legal right to repayment and hence, such a debt would amount to Financial Debt under IBC.
To sum up, a debt converted into equity would cease to be ‘Financial Debt’ under IBC as long as all the procedures and caveats discussed above are taken care of.