Under Insolvency and Bankruptcy Code in respect of insolvency of Corporate Persons, the proceedings can be initiated by Financial Creditor, Operational Creditor or the Corporate Debtor himself.  The method of initiating the proceedings and processes to be followed are different for each category of Creditor.  In respect of Financial Creditor, the application for initiating Resolution Process can be made straight away without waiting for raising a claim for the money; without proving that no dispute exists for the payment under consideration.  The Financial Creditor occupies an exalted position in the scheme of things – Only Financial Creditors are entitled to be members of the Committee of Creditors and will have the right to vote in the proceedings of Committee of Creditors including approving the Resolution Applicant / Resolution Plan and such other related matters.  The classification of the Creditor into Financial Creditors or Operational Creditors therefore assumes lot of importance and is very crucial to the Resolution Process itself.

FINANCIAL CREDITORS

Para 4.3.3. of BLRC Report reads as under:

Financial contracts involve an exchange of funds between the entity and a counterparty which is a financial firm or intermediary. This can cover a broad array of types of liabilities: loan contracts secured by physical assets that can be centrally registered; loan contracts secured by floating charge on operational cash flows; loan contracts that are unsecured; debt securities that are secured by physical assets, cash flow or are unsecured

The Report at another place reads as under:

Financial creditors are those whose relationship with the entity is a pure financial contract, such as a loan or a debt security

Financial Creditors under IBC

CERTAIN IMPORTANT DEFINITIONS AND COMMENTS THEREON

In order to understand who is a Financial Creditor, we need to understand certain definition under the Act.

Section 2(10) of the Code defines a Creditor as – “Means any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree holder.”  In view of the use of words “means” in the definition only those classes of persons who have been included in the definition can be called as Creditor and no one else.

Section 2(11) of the Code defines Debt – “means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt”.  Here again due to the use of word Means in the definition only a liability or obligation in respect of claim which is due is Debt and none else.

Section 2(6) of the Code defines Claim as“means

  • A right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured or unsecured
  • Right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to right of payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured”

In this definition also the Words “Means” have been used reducing the scope of the definition to only those covered thereunder.

In the case of Pioneer Urban Land And … vs Union Of India on 9 August, 2019, the Supreme Court held as follows:

Thus, in order to be a “debt”, there ought to be a liability or obligation in respect of a “claim” which is due from any person.

Claim” then means either a right to payment or a right to payment arising out of breach of contract, and this claim can be made whether or not such right to payment is reduced to judgment. Then comes “default”, which in turn refers to non-payment of debt when whole or any part of the debt has become due and payable and is not paid by the corporate debtor. Learned counsel for the Petitioners relied upon the judgment in Union of India v. Raman Iron Foundry (1974) 2 SCC 231, and, in particular relied strongly upon the sentence reading:

 “11….Now the law is well settled that a claim for unliquidated damages does not give rise to a debt until the liability is adjudicated and damages assessed by a decree or order of a court or other adjudicatory authority.” It is precisely to do away with judgments such as Raman Iron Foundry (supra) that “claim” is defined to mean a right to payment or a right to remedy for breach of contract whether or not such right is reduced to judgment. What is clear, therefore, is that a debt is a liability or obligation in respect of a right to payment, even if it arises out of breach of contract, which is due from any person, notwithstanding that there is no adjudication of the said breach, followed by a judgment or decree or order. The expression “payment” is again an expression which is elastic enough to include “recompense”, and includes repayment. For this purpose, see Himachal Pradesh Housing and Urban Development Authority and Anr. v. Ranjit Singh Rana (2012) 4 SCC 505 (at paragraphs 13 and 14 therein), where the Webster’s Comprehensive Dictionary (International Edn.) Vol. 2 and the Law Lexicon by P. Ramanatha Aiyar (2nd Edn., Reprint) are quoted.

Section 5(7) of the Code defines FINANCIAL CREDITOR – means any person to whom financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to

Section 5(8) of the Code defines Financial Debt as means a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes

(a) money borrowed against the payment of interest;

(b) any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent;

(c) any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;

(d) the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed;

(e) receivables sold or discounted other than any receivables sold on non-recourse basis;

(f) any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of a borrowing;

Explanation. –For the purposes of this sub-clause, –

(i) any amount raised from an allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing; and

(ii) the expressions, “allottee” and “real estate project” shall have the meanings respectively assigned to them in clauses (d) and (zn) of section 2 of the Real Estate (Regulation and Development) Act, 2016 (16 of 2016);

(g) any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account;

(h) any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;

(i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clause (a) to (h) of this clause;

WHO IS A FINANCIAL CREDITOR?

On A close look at the definition of Financial Creditor under the code, we can identify that the same has two limbs:

  • means a debt along with interest, if any, which is disbursed against the consideration for the time value of money
  • and includes – the specified categories.

In the First Limb the words used are Means and hence the definition is restrictive.  Only those transactions which comply with the conditions specified in the Limb or covered and none else.

Let us analyse the first Limb of the definition.  It has two clauses. Namely:

  • debt along with interest, if any,
  • which is disbursed against the consideration for the time of value of money.

So, any debt whether interest be charged or not (as per the terms) is covered under first clause due to the use of the words, if any, after the word Interest.  Therefore, to be covered under the definition of Financial Creditor and to satisfy the first clause of the first limb there shall be debt and interest is not a mandatory condition.  The second clause of the first limb is that the debt should have been disbursed against the consideration for the time value of money.  This is the most important clause in the definition of Financial Creditor.  If the debt is disbursed against the consideration for the time value of money only then it qualifies to be a financial creditor, else NO.  

ACT OF DISBURSEMENT

Supreme Court in the case of Pioneer Urban Land And … vs Union Of India on 9 August, 2019 held as follows:

The definition of “financial debt” in Section 5(8) then goes on to state that a “debt” must be “disbursed” against the consideration for time value of money. “Disbursement” is defined in Black’s Law Dictionary (10th ed.) to mean:

“1. The act of paying out money, commonly from a fund or in settlement of a debt or account payable. 2. The money so paid; an amount of money given for a particular purpose.” In the present context, it is clear that the expression “disburse” would refer to the payment of instalments by the allottee to the real estate developer for the particular purpose of funding the real estate project in which the allottee is to be allotted a flat/apartment. The expression “disbursed” refers to money which has been paid against consideration for the “time value of money”. In short, the “disbursal” must be money and must be against consideration for the “time value of money”, meaning thereby, the fact that such money is now no longer with the lender, but is with the borrower, who then utilises the money.

Thus far, it is clear that an allottee “disburses” money in the form of advance payments made towards construction of the real estate project. We were shown the ‘Dictionary of Banking Terms’ (Second edition) by Thomas P. Fitch in which “time value for money” was defined thus:

“present value: today’s value of a payment or a stream of payment amount due and payable at  some specified future date, discounted by a compound interest rate of DISCOUNT RATE. Also called the time value of money. Today’s value of a stream of cash flows is worth less than the sum of the cash flows to be received or saved over time. Present value accounting is widely used in DISCOUNTED CASH FLOW analysis.” That this is against consideration for the time value of money is also clear as the money that is “disbursed” is no longer with the allottee, but, as has just been stated, is with the real estate developer who is legally obliged to give money’s equivalent back to the allottee, having used it in the construction of the project, and being at a discounted value so far as the allottee is concerned (in the sense of the allottee having to pay less by way of instalments than he would if he were to pay for the ultimate price of the flat/apartment).

In Dr BVS Lakshmi Vs Geometrix Laser Solutions Private Limited – Company Appeal (AT) (Insolvency) No. 38 of 2017 the NCLAT New Delhi Bench the bench dealing with the concept of disbursement held as follows:

“If the Claimant claims to be ‘Financial Creditor’ he will have to show that debt is due which he has disbursed against the ‘consideration for the time value of money’ and that the borrower has raised the amount directly or through other modes like credit facility or its de-materialized equivalent, note purchase facility or the issue of bonds, notes, debentures, loan stock or any other similar instrument.

To show that there is a debt due which was disbursed against the ‘consideration for the time value of money’, it is not necessary to show that an amount has been disbursed to the ‘Corporate Debtor’. A person can show that the disbursement has been made against the ‘consideration for the time value of money’ through any instrument.  Any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction for which only the market value of such transaction shall be taken into account, it is not necessary to show that amount has been disbursed. The disbursement against the ‘consideration for the time value of money’ is the main factor.”

In Company Appeal (AT) (Insolvency) No. 142 of 2017 – Neeraj Bhatia Vs Devandra Ahluwalia and others, the NCLAT Delhi Bench – The guarantors of a loan to Banks have paid monies towards the guarantee they have provided for the advances obtained by the Corporate Debtor.  On the non-payment of these balances by the Corporate Debtor the guarantors have invoked IBC as Financial Creditors.  The NCLAT held thus: 

The amount of Rs. 1.05 Crores, if paid by the contesting respondents, they have so paid to the Bank (Financial Creditor), as ‘personal guarantor’ as defined in sub-section (22) of Section 5 and such ‘personal guarantor’ cannot claim to be a ‘Financial Creditor’ as defined under sub-section (7) read with sub-section (8) of Section 5 of the I & B Code till it is shown that debt amount has been disbursed against the consideration for time value of money. 

There is nothing on record to suggest that the amount has been ‘disbursed’ in favour of ‘Corporate Debtor’ against ‘consideration for the time value of money’. The contesting respondents have also failed to bring on record any evidence to suggest that the money was borrowed or raised by the Corporate Debtor’ under any other transactions including sale or purchase or other mode having commercial effect of borrowing.”

Based on the above reasoning, the NCLAT stuck down the plea of the defendants that they be treated as Financial Creditors.  From this, it can be inferred that the amount has to be disbursed to the Corporate Director directly or at his instance to a third party.  Otherwise such disbursement will be not covered as disbursement to be a Financial Creditor.

However, with due respect to NCLAT, the NCLAT has not considered the position of a guarantor who has fulfilled his obligation under a contract of guarantee.  For this we need to refer to the provisions of Contract Act.  The relevant sections of the Contract Act, 1872 are reproduced below:

140. Rights of surety on payment or performance –

Where a guaranteed debt has become due, or default of the principal debtor to perform a guaranteed duty has taken place, the surety upon payment or performance of all that he is liable for, is invested with all the rights which the creditor had against the principal debtor.

141. Surety’s right to benefit of creditor’s securities

A surety is entitled to the benefit of every security which the creditor has against the principal debtor at the time when the contract of suretyship entered into, whether the surety knows of the existence of such security or not; and if the creditor loses, or without the consent of the existence of such security or not; and if the creditor loses, or without the consent of the surety, parts with such security, the surety, the surety is discharged to the extent of the value of the security.

Based on the principle of Subrogation, the Surety will step into the place of Principal Creditor and all rights and securities of the Principal Creditor will vest with the Surety.  In the instant case, the Surety having fulfilled his obligations under the Contract of Guarantee will be so placed in the position of the Bank and will have rights and securities as available to the Banker.

Further the definition of Financial Creditor also has the clause “includes any person to whom such debt has been legally assigned or transferred”

Hence the Surety should have been considered as Financial Creditor.  To this extent, in my view the NCLAT has erred in its conclusion.

TIME VALUE OF MONEY

Again this word has not been defined under Code and hence we have to revert to the Dictionary meaning or the meaning of the phrase as generally understood.

The time value of money concept states that cash received today is more valuable than cash received at some point in the future. The reason is that someone who agrees to receive payment at a later date foregoes the ability to invest that cash right now. The only way for someone to agree to a delayed payment is to pay them for the privilege, which is known as interest income.

NASDAQ Glossary of Financial Terms defines Time Value of Money as:” The idea that a dollar today is worth more than a dollar in the future, because the dollar received today can earn interest up until the time the future dollar is received.

In ‘Nikhil Mehta and Sons vs. AMR Infrastructure Ltd. – Company Appeal (AT) (Insolvency) No. 07 of 2017, has dealt with the issue of interpretation of the phrase “time of value of money” as follows:

“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 for over a period of time in a single or series of payments in future. It may also be a sum of money invested today to be repaid over a period of time in a single or series of instalments to be paid in future. In Black’s Law Dictionary (9th edition) the expression Time Value’ has been defined to mean “the price associated with the length of time that an investor must wait until an investment matures or the related income is earned”. In both the cases, the inflows and outflows are distanced by time and there is a compensation for time value of money”.

WHETHER HOME BUYERS ARE FINANCIAL CREDITORS

Nikhil Mehta & Sons (HUF) v. AMR Infrastructure Limited [C.A. (I.B.) No. 543/KB/2017 arising out of C.P. (I.B.)/170/KB/2017 the NCLAT held the payment by the homebuyers under an assured returns scheme by the Developer will get covered under the definition of Financial Creditor under the Code.  The NCLAT viewed the committed returns by the Developers as a means of financing done by the Developers and will be covered as debt given by the Homebuyers against consideration for time value of money and hence is classifiable as Financial Creditors.  This was subsequently followed in other cases notably:

Neelam Singh v Megasoft Infrastructure [(2017) SCC Online NCLT 10612],

Anubhuti Aggarwal v DPL Builders Pvt. Ltd [(2017) SCC Online NCLT 12672],

Pawan Dubey v J.B.K. Developers [(2018) SCC Online NCLT 794].

All these cases were decided prior to the amendment Act 2018.  The Amendment Act has modified the definition of the term Financial Creditor by including an explanation  to Section 5 (8)(f) as follows:

Explanation. -For the purposes of this sub-clause, –

(i) any amount raised from an allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing; and

(ii) the expressions, “allottee” and “real estate project” shall have the meanings respectively assigned to them in clauses (d) and (zn) of section 2 of the Real Estate (Regulation and Development) Act, 2016 (16 of 2016);]

Since the insertion of explanation was by way of clarification, it was interpreted by the Supreme Court in Pioneer Urban Land And … vs Union Of India that it is applicable retrospectively.

However, while the amendment clarifies the amounts raised from allottees as borrowings the basic question whether the borrowings were disbursed against consideration for time value of money has not been addressed.  Hence even with the amendment act 2018 the amounts raised from allottees by the developers will have failed the test of financial creditor if they are not disbursed as consideration for time value of money.

The issue has been clarified by the Supreme Court in Pioneer Urban Land And … vs Union Of India by looking at the provisions of Real Estate (Regulation and Development) Act, 2016 (RERA).

In the case of Pioneer Urban Land And … vs Union Of India on 9 August, 2019, the Supreme Court had occasion to deal with the matter whether Home Buyers are Financial Creditors and also whether the Insolvency Code (Second Amendment) Act, 2018 including Home Buyers are Financial Creditors is constitutionally valid. While coming to the conclusions, as it did, the Supreme Court held as follows:

what is unique to real estate developers vis-à-vis operational debts, is the fact that, in operational debts generally, when a person supplies goods and services, such person is the creditor and the person who has to pay for such goods and services is the debtor. In the case of real estate developers, the developer who is the supplier of the flat/apartment is the debtor inasmuch as the home buyer/allottee funds his own apartment by paying amounts in advance to the developer for construction of the building in which his apartment is to be found. Another vital difference between operational debts and allottees of real estate projects is that an operational creditor has no interest in or stake in the corporate debtor, unlike the case of an allottee of a real estate project, who is vitally concerned with the financial health of the corporate debtor, for otherwise, the real estate project may not be brought to fruition. Also, in such event, no compensation, nor refund together with interest, which is the other option, will be recoverable from the corporate debtor. One other important distinction is that in an operational debt, there is no consideration for the time value of money – the consideration of the debt is the goods or services that are either sold or availed of from the operational creditor. Payments made in advance for goods and services are not made to fund manufacture of such goods or provision of such services. Examples given of advance payments being made for turnkey projects and capital goods, where customisation and uniqueness of such goods are important by reason of which advance payments are made, are wholly inapposite as examples vis-à-vis advance payments made by allottees. In real estate projects, money is raised from the allottee, being raised against consideration for the time value of money.

Even the total consideration agreed at a time when the flat/apartment is non-existent or incomplete, is significantly less than the price the buyer would have to pay for a ready/complete flat/apartment, and therefore, he gains the time value of money.

Likewise, the developer who benefits from the amounts disbursed also gains from the time value of money. The fact that the allottee makes such payments in instalments which are co-terminus with phases of completion of the real estate project does not any the less make such payments as payments involving “exchange”, i.e. advances paid only in order to obtain a flat/apartment. What is predominant, insofar as the real estate developer is concerned, is the fact that such instalment payments are used as a means of finance qua the real estate project. One other vital difference with operational debts is the fact that the documentary evidence for amounts being due and payable by the real estate developer is there in the form of the information provided by the real estate developer compulsorily under RERA. This information, like the information from information utilities under the Code, makes it easy for home buyers/allottees to approach the NCLT under Section 7 of the Code to trigger the Code on the real estate developer’s own information given on its webpage as to delay in construction, etc. It is these fundamental differences between the real estate developer and the supplier of goods and services that the legislature has focused upon and included real estate developers as financial debtors. This being the case, it is clear that there cannot be said to be any infraction of equal protection of the laws.”

While coming to the conclusion, the Court has surveyed the provisions of RERA more particular Sections 18 and 19 and held as follows:

“Importantly, under Section 18, if the promoter fails to complete or is unable to give possession of an apartment, plot or building in accordance with the terms of the agreement for sale, he must return the amount received by him in respect of such apartment etc. with such interest as may be prescribed and must, in addition, compensate the allottee in case of any loss caused to him. Under Section 19, the allottee shall be entitled to claim possession of the apartment, plot or building, as the case may be, or refund of amount paid along with interest in accordance with the terms of the agreement for sale. In addition, all allottees are to be responsible for making necessary payments in instalments within the time specified in the agreement for sale and shall be liable to pay interest at such rate as may be prescribed for any delay in such payment”

Thus, in allowing the category of Home Buyers as Financial Creditors, one of the reasons  was that the Supreme Court has drawn from the provisions of RERA which provide for payment of interest and considered that the amounts paid by the Home Buyers are for time value of money.

Let us look at the definition of operational creditor and operation debt under the Code.

Section 5(20) of the Code defines an Operational Creditor means a person to whom an operational debt is owed and includes any person to whom such debt has been legally assigned or transferred

Section 5(21) of the Code defines Operational Debt means a claim in respect of the provision of goods or services including employment or a debt in respect of the 1[payment] of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority.

A Careful analysis of the definition of Operational Creditor and Operational Debt will indicate a debt which is against the provision of goods or services including employment or debt in respect of payment of dues to Government is operational Debt.  The words “Goods” has not been defined under the Code.  However, Section 2(37) of the Code specifies as follows:

“words and expressions used but not defined in this Code but defined in the Indian Contract Act, 1872(9 of 1872), the Indian Partnership Act, 1932 (9 of 1932), the Securities Contact (Regulation) Act, 1956 (42 of 1956), the Securities Exchange Board of India Act, 1992 (15 of 1992), the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993), the Limited Liability Partnership Act, 2008 (6 of 2009) and the Companies Act, 2013 (18 of 2013), shall have the meanings respectively assigned to them in those Acts.”

The word Goods has neither been defined under any of the Act specified under Section 2(37) of the Code nor has it been defined under General Clauses Act.  In the absence of definition of Goods, we need to consider the definition of Goods generally.  In South Bihar Sugar Mills Ltd Vs Union of India AIR 1968 SC 922, it was held that” as the Act does not define goods, the Legislature must be taken to have used the words in its ordinary dictionary meaning.  The dictionary meaning is that to become goods it must be something which can ordinarily come to the market to be bought and sold and known to the market.

In the General parlance, usage, Goods have a different meaning and Immovable Property has a different meaning.  Immovable Property transactions are covered under the Transfer of Property Act buildings / apartments purchased by the Home Buyers are covered under the Transfer of Property Act whereas the Goods purchase is covered under the Sale of Goods Act.  From this perspective, the purchase of apartments by Home Buyers cannot be termed as purchase of Goods it is not generally understood in the Trade as Goods.  Further, in view of the different enactments which deal with the transfer of Goods and Property, the Homebuyers purchase of Houses are not goods.  Hence even without referring to the RERA or the amendment made by the IBC (Amendment) Act, 2018 Home Buyers are covered under Financial Creditors and cannot be covered under Operational Creditors.

LOANS / BORROWINGS FROM PROMOTERS / RELATIVES OF PROMOTERS WITHOUT INTEREST – WHETHER CATEGORISED AS FINANCIAL DEBT

In the case of Shailesh Sangani Vs Joel Cardoso and another Company Appeal (AT) (Insolvency) No. 616 of 2018 the NCLAT Delhi Bench had an occasion to deal with such an instance.

The Factual Matrix in this case is as follows: A shareholder has granted unsecured loans  payable on demand from time to time to the Company and some of which has been repaid and in respect of outstanding balance, the Shareholder has moved the NCLT as Financial Creditor under IBC. Corporate Debtor raised the plea before the learned Adjudicating Authority that there were cross holdings inter-se the respondents in various companies and the amounts so arrived at was a settlement amount which had not ended in compliance of mutual obligations between the parties. The Corporate Debtor further stated that the unsecured loan of Rs.1,45,36,475/- was a part of overall settlement and it was ready to settle the cross holding of shares and loans inter-se the respondents. Respondent further contended that none of the loans under the quasi partnership arrangement inter-se the Respondents had any term for repayment or interest. The learned Adjudicating Authority found that the contention raised on behalf of Corporate Debtor was not plausible as the factum of amount advanced as loan by Respondent no.1 to Corporate Debtor was admitted and reflected in the accounts and confirmed by the Corporate Debtor. Learned Adjudicating Authority was of the view that the said amount was arrived at after the parties mutually agreed and the same was reflected in the books of the Corporate Debtor under the head ‘long term borrowings’, the amount of debt fell within the purview of ‘financial debt’ notwithstanding the fact that no interest was payable.

While concluding that the amounts provided by the Shareholders to the Company though without interest are still financial debts, the NCLAT has specified that the important point to be considered is whether the transaction has been disbursed against consideration for time value of money and not necessarily there shall be any interest payment.  While doing so, the following reasoning has been adopted by NCLAT:

“Para 5 – It is manifestly clear that the liability or obligation to pay must arise out of a claim due from a debtor/ borrower. The nature of obligation and from where it springs is immaterial.

Para 6 – The amount disbursed as debt against the consideration for time value of money may or may not be interest bearing. What is material is that the disbursement of debt should be against consideration for the time value of money. Clauses (a) to (i) of Section 5(8) embody the nature of transactions which are included in the definition of ‘financial debt’. It includes money borrowed against the payment of interest. Clause (f) of Section 5(8) specifically deals with amount raised under any other transaction having the commercial effect of a borrowing which also includes a forward sale or purchase agreement. It is manifestly clear that money advanced by a Promoter, Director or a Shareholder of the Corporate Debtor as a stakeholder to improve financial health of the Company and boost its economic prospects, would have the commercial effect of borrowing on the part of Corporate Debtor notwithstanding the fact that no provision is made for interest thereon. Due to fluctuations in market and the risks to which it is exposed, a Company may at times feel the heat of resource crunch and the stakeholders like Promoter, Director or a Shareholder may, in order to protect their legitimate interests be called upon to respond to the crisis and in order to save the company they may infuse funds without claiming interest. In such situation such funds may be treated as long term borrowings. Once it is so, it cannot be said that the debt has not been disbursed against the consideration for the time value of the money

The NCLAT it is respectfully submitted had not distinguished the difference between Equity contributions and Loan Contributions by the Promoters.  Every loan given by the Promoters need not necessarily be treated as Financial Debt just because the Promoter is finally benefitted by the improvement in performance of the Company, increase in share value etc.  These are incidents of Equity Holding and hence in such cases, the contributions shall be Equated as Equity Contributions and not as Debt Contributions. A debtor is not interested in the performance of the company nor the changes that may be reflected in the financial position of the Company on account of infusion of funds by him.  The Debtor is only interested in the interest and repayment of debt and interest.  Thus, to attribute to the increase in profits etc as motives to the Debtor and specify that these are incidences of his debt and hence will be treated as factors for consideration of disbursement against time value of money may not be correct, in the absence of a written agreement to the contrary.

There is definitely difference between Equity Contribution and Loan Contribution. Only an equity shareholder is interested in the incidences which are attributed by the NCLAT in this case i.e. increase in profitability, raise in share price etc.  because these are the factors he will be considering as a return – the equity shareholder is interested in his value of the firm and not for the interest on the funds provided by him..  Ind AS 31 defines An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.  Thus an equity contributor is interested in the residual value i.e. derived on account of profits, profitability etc whereas a Debt contributor is purely interested in the repayment of interest and principal.  This is the prime difference between these two contributions and this difference, in my view, the NCLAT has failed to recognise in this case.

In the case of NIKHIL MEHTA AND SONS (HUF) Vs. AMR INFRASTRUCTURES LTD the NCLAT Delhi Bench has made the following observation which is pertinent:

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 has been implied by the opening words of Section 5(8) of the IBC.

Thus, if the contribution is in the nature of Equity it cannot be equated to Debt.

For example, while sanctioning Financial Limits, Banks and Financial Institutions, specify that the promoters should contribute through loans (as their share) certain portion of the finance and such amounts (contributed either by the promoters/their relatives) shall not be repaid / prepaid during the currency of the facilities which were sanctioned by the Banks / FIs.  Such contributions by the Promoters are in the nature of Equity Contributions and cannot be termed as Loans / Borrowings and should not be classified under Section 5(8)(f) because there is no specific consideration against Time Value of Money.

In view of the above discussion, in my view, Loans / Borrowings by Promoters without any appropriate Agreement for Interest cannot be equated as Financial Borrowings under IBC.

PUTTABLE INSTRUMENTS HOLDERS – WHETHER FINANCIAL CREDITORS

The NCLAT Delhi Bench in the case of Pushpa Shah & Anr Vs IL&FS Financial Services Limited & Anr. Company Appeal (AT) (Insolvency) No. 521 of 2018 had occasion to deal with the issue.

The Factual matrix of the case is as follows:

Prior to 20th August, 2009, the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) was holding approximately 5% of the equity shares of ‘MCX’. Pursuant to a negotiation, it was agreed between the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) and the ‘MCX’ Group that (i) the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) would exit MCX; (ii) the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) investment in ‘MCX’ would be transferred to another investor viz IFCI; (iii) part of the proceeds realized therefrom would be used by the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) to purchase from ‘MCX’ 4,42,00,000 equity shares in ‘MCX-SX’ representing 2.46% of its equity share capital; and (iv) the ‘La-Fin Financial Services Pvt. Ltd.’- (‘Corporate Debtor’), as a condition to the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) purchasing the aforesaid shares of ‘MCX-SX’, would offer to buy or cause to be bought from the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) the said Shares at an agreed price within a pre-determined period.

A “Share Purchase Agreement” (in short “SPA”) dated 20th August, 2009 was executed between the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’), ‘MCX’ and ‘MCX-SX’. As per ‘SPA’, the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) purchased 4.42 Cr. equity shares of ‘MCX-SX’ which was 2.46% of the equity share capital of ‘MCXSX’. Side by side a ‘Letter of Undertaking’ (‘LOU’) was executed on 20th August, 2009 by the ‘La-Fin Financial Services Pvt. Ltd.’- (‘Corporate Debtor’) to purchase the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) share in ‘MCX-SX’ any time after a period of one year but not later than three years from the date of ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) investment pursuant to said ‘SPA’.

A premium or a price was also indicated that the purchase price of the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) share would be higher of (i) the price that would give the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) an internal rate of return of 15% on its investment; or (ii) the price at which the most recent transaction of ‘MCX-SX’s equity shares was carried out by the ‘MCX Group’. Further, as per the “Letter of Undertaking” dated 20th August, 2009 the ‘La-Fin Financial Services Pvt. Ltd.’- (‘Corporate Debtor’) without the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) written consent forbidden to issue ‘MCX-SX’ share to any person(s) at a price below Rs.35/- per equity share. The ‘IL&FS Financial Services Limited’- (‘Financial Creditor’), therefore, purchased the share of ‘MCX’ on 20th August, 2009 at Rs. 36/- per share for total consideration of Rs. 159,12,00,000/- (Rupees One Hundred Fifty-Nine Crore Twelve Lakh Only)”

Based on the above factual matrix, the NCLAT has come to the following conclusion:

On careful reading of the agreement such as ‘SPA’ and ‘La-Fin LoU’, we find that the ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) has disbursed the amount and the ‘Corporate Debtor’ has raised the amount with an object of having economic gain or commercial effect of borrowing. The clauses of ‘SPA’ if read along with the ‘LoU’, we find that the terms of transaction involved not only the purchase of shares but it shows the date by which the amount of transaction was to be repaid by the ‘Corporate Debtor’ which had fallen due on 19th August, 2012. There was an element of ‘time value of money’, particularly, when one of the conditions related to ‘internal rate of return of 15%’ on the transaction, therefore, the time value of money having already shown, we hold that the amount disbursed by ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) and the ‘Corporate Debtor’ had agreed to reverse the transaction by purchasing the shares within a specified time along with the payment of 15% accrual on 20th August, 2009. We hold that the amount if disbursed by ‘IL&FS Financial Services Limited’- (‘Financial Creditor’) “.

The principles of checking whether an arrangement in a put option is a Financing Option (Liability option) or an Equity Option are specified in the Ind AS 32 – Presentation of Financial Instruments. The process to be followed in that case is as follows:

  • If the Instrument contains an obligation to deliver Cash or another Financial Asset – It is a Financial Liability
  • If the Instrument is a non-derivative and the entity has an obligation to deliver variable number of its own equity instruments – It is a Financial Liability
  • If the instrument is a non-derivative which is settled by the entity exchanging fixed amount of cash or other financial asset for fixed number of its equity instruments (Fixed to Fixed) – It is a Equity
  • If the instrument is a non-derivative which is settled in an obligation to deliver fixed number of its own equity instruments – It is an Equity Instrument
  • If the instrument is a non-derivative which is settled other than by the entity exchanging fixed amount of cash or other financial asset for fixed number of its equity instruments – It is a Liability

Judging from the above, the compensation to be paid to ILFS was in the nature of amount of purchase price fixed per share with an insured internal IRR and hence cannot be treated as Equity Instrument. The NCLAT also has held the liability as a Financial Liability.  Further, an operation credit, as we have discussed in the definition elsewhere, is a claim in respect of the provision of goods or services including employment and the definition of goods does not include shares and hence even in terms of the Code the transaction cannot be held as Operational Debt.

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