Third-Party Security Holders in CIRP – Between a Rock and a Hard Place

  July 26, 2021

~ By Kaustubh Sharma

In financial transactions, it is very common to see parent entities and group entities offering guarantees and securities for financing availed by a corporate borrower. That is what a third-party security is — a security created by a party over its interests or assets, for securing the loan disbursed in favour of a party other than itself.

With a series of recent developments, it is now more than evident that the fate of third-party security holders always hangs by a thread in the resolution plan approval process under the Insolvency and Bankruptcy Code, 2016 (“IBC”). Third-party security holders must be extremely cautious in how they frame their contracts and raise their claims, so that their rights do not get ignored and extinguished.

Let us start with the issue of their acceptance as a financial creditor.


1. Classification of Third-Party Security holders

The recent case of Phoenix Arc v. Ketulbhai Ramubhai Patel (“Phoenix Arc”) to a great extent settled the issue of classification of third-party security holders, where the security is in a form other than a guarantee.

The facts of the case involved a facility agreement (“Facility”) between L&T Infra Finance (“Original Lender”) and Doshion Limited (“Borrower”). As security for the facility, Doshion Velio Water Solutions Private Limited (corporate debtor/a subsidiary company of the Borrower) executed a non-disposal undertaking and a pledge. It undertook to not dispose of its 100% shareholding in Gondwana Engineers Limited (“GEL”) and also pledged 40,160 shares of GEL in favor of the Original Lender. The facility, along with any security and interest therein, was thereafter assigned in favor of an ARC (“Assignor”) under the provisions of the SARFAESI Act.

Subsequently, Corporate Insolvency Resolution Process (“CIRP”) was initiated against the corporate debtor by a financial creditor, which was admitted by the National Company Law Tribunal (“NCLT”), Mumbai. Pursuant to the commencement of the CIRP process, the Assignor filed its claims to the Resolution Professional (RP), which were rejected. On applying to the NCLT, the tribunal upheld the decision of the RP, on the grounds that the Assignor was not a ‘Financial Creditor’ under the IBC.

Similarly, the National Company Law Appellate Tribunal (“NCLAT”) also dismissed an appeal against this order of the NCLT, and held that the pledge of shares under the pledge agreement in question does not amount to “disbursement of any amount against the consideration for the time value of money” and thus, does not fall within the purview of financial debt as defined under Section 5(8)(f) of the IBC.

The matter reached the Supreme Court (“SC”), where the issue of whether the Assignor is a financial creditor within the meaning of Section 5(8) of the IBC, on the strength of the pledge agreement, was deeply examined. The Assignor argued that the act of the corporate debtor pledging shares of GEL was to give indemnity for a credit facility which was in a sense of a guarantee, and as such, the guarantee amounted to ‘financial debt’ under Section 5(8)(i) of the IBC. The SC, after studying the language of the pledge agreement, observed that it could not be said that the corporate debtor had entered into a contract to perform the promise or discharge the liability of Borrower in case of its default. The Borrower had undertaken to repay the Facility, and the pledge and undertaking provided by the corporate debtor could not be called a contract of guarantee as under Section 126 of the Indian Contract Act, 1872.

It is true that having a third-party secured creditor participate in the committee of creditors of a corporate debtor is not in sync with the object of IBC. It intends only financial creditors, invested in the rehabilitation of the corporate debtor, have a say in its insolvency process. Referring to the judgement of Swiss Ribbon vs UOI and Pioneer Urban Land v. UOI, where the term ‘financial debt’ was differentiated from other debts (such as ‘mortgaged debts’), the SC held that “a person having only security interest over the assets of the 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”. Therefore, the SC observed in Phoenix Arc that “The appellant [Assignor] at best will be secured creditor qua above security but shall not be a financial creditor” within the meaning of Section 5(7) and 5(8) of the IBC.

The moral of the story is that if the third-party security holder wishes to be recognised as a financial creditor, and not just as a secured creditor, it should draft the security document such that there is an explicit obligation on the security provider to undertake repayment of the debt owed.

However, the story does not end here — while the SC upheld the decision of the RP in not accepting the claims of the Assignor as those of a Financial Creditor, it refused to comment on the right of the Assignor to establish any of its rights in relation to the security created in its favour. This brings us to our next issue – what happens if the claim of the third-party security holder is not included in the resolution plan.


2. Treatment of Third-Party security in a resolution plan

In the case of Jaypee Kensington v. NBCC, one of the issues that the SC dealt with was the treatment of the claims of third-party security holders in the resolution plan.

In the case, around 858 acres of Jaypee Infratech Ltd (“JIL”) (corporate debtor) were mortgaged to the lenders of Jaiprakash Associates Limited (“JAL”) (holding company of the corporate debtor). In the resolution plan, the Resolution Applicant (“RA”), sought a relief that such land will continue to vest with the corporate debtor and be free from any mortgage, charge and encumbrance. From the 858 Acres of land, 758 Acres were released from mortgage, as they were classified as avoidance transactions in the Supreme Court judgment of Anuj Jain Interim Resolution vs Axis Bank Limited.

The rest of the 100-acre land (“Third party Mortgage”) continued to remain under mortgage with the lender. Even though the lender was not recognised as a financial creditor, it was recognised as a secured creditor of the corporate debtor. The lender raised an objection against the stipulations in the resolution plan, approved by the NCLT, which assumed that the effect of implementation of the plan would be that all encumbrances and charges on the property of the corporate debtor for the loans given to third-parties shall stand extinguished.

The Third-Party Mortgage was not reckoned in the CIRP, and then the resolution plan also provided that once the resolution plan had been approved, it would extinguish the lender’s right over the property.

Therefore, the Supreme Court held that the clause in the plan’s ‘reliefs and concessions’, which provided for extinguishment of security interest of the lenders, could not have been approved as it did not stand “in conformity with any principal of law for discharge of a security interest, particularly of a third party who is not included in the insolvency resolution process of a corporate debtor.” Based on the other issues of the case, consequently the entire order of the NCLT of approving the resolution plan was set aside, and revised bids were allowed from the resolution applicants.

3. Conclusion

As per the landmark judgment of the SC in Ghanshyam Mishra and Sons Pvt. Ltd. v. EARC & Ors., all claims (including claims of third-party security holders) not part of a resolution plan get extinguished on its approval. Therefore, when a third-party security fails to classify as a guarantee, the holder will not be classified as a financial creditor, but merely as a secured creditor. A secured creditor, who is not a financial creditor, will have no rights to representation in the committee of creditors (CoC). Thus, the Jaypee Kensington judgment comes as a relief in providing a strict guiding principle for the treatment of third-party security holders in a legally compliant resolution plan, and ensuring their rights are taken care of.

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