Introduction
The Hon’ble Supreme Court of India has, in the case of China Development Bank v. Doha Bank Q.P.S.C[i]., examined the legal complexities surrounding the classification of appellants as financial creditors (‘FCs’) under the Insolvency and Bankruptcy Code, 2016 (‘IBC’), specifically concerning a Deed of Hypothecation (‘DoH’) executed by the corporate debtor (‘CD’). The Supreme Court delves into the definition of financial debt. It evaluates the interplay between IBC and the Indian Contract Act, 1872 (‘Act’) to decide whether the DoH amounted to a guarantee, thus qualifying the creditors/appellants as FCs.
Background
The appellants, including China Development Bank, had extended financial facilities to Reliance Communications Ltd. (‘Rcom’) and Reliance Telecom Ltd. (‘RTL’).
To secure these facilities, a DoH was executed by RCom entities, and one of the sub-clauses of the DoH mentioned that if, after the sale of the hypothecated assets, there is a shortfall in the discharge of the liabilities of RCom or RTL (‘Parties’), the CD would be under an obligation to pay for such shortfall or deficiency, i.e., Reliance Infratel Limited (RITL), the CD, agreed to discharge the liability of the Parties to the appellants in case they defaulted.
RITL entered the Corporate Insolvency Resolution Process (‘CIRP’), during which China Development Bank claimed to be an FC, citing RITL’s obligation under the DoH. Such a claim was admitted by the Resolution Professional (‘RP’).
The Doha Bank, the Respondent, opposed the aforementioned submission. It argued that firstly, the China Development Bank was not a direct lender to RITL, and secondly, the DoH was only a security arrangement, not a guarantee.
During the pendency of the aforementioned dispute, the resolution plan was approved by the Committee of Creditors (‘CoC’) and the National Company Law Tribunal (‘’NCLT’), subsequently raising further debate. The National Company Law Appellate Tribunal (‘NCLAT’), however, reversed the order passed by the NCLT and concluded that the DoH merely created a security interest and did not constitute any guarantee.
Aggrieved by NCLAT’s order, the China Development Bank filed the present appeal before the Supreme Court, challenging the NCLAT’s decision.
Issue
Whether the DoH executed by the CD constituted a financial debt under s. 5(8) of the IBC, thereby making the appellants FCs?
Held
The Supreme Court set aside the NCLAT’s decision. It reinstated the NCLT's order while holding that the appellants, including China Development Bank, qualified as the FCs under the IBC based on the following reasoning:
Financial debt is defined under s. 5(8) of the IBC inclusively, covering liabilities arising from guarantees of financial obligations. The Court emphasized that the absence of explicit terminology such as ‘guarantee’ in the DoH does not preclude its classification as financial debt.
Cl. 5(iii) of the DoH explicitly obligated the CD to discharge liabilities in the event of default by the principal borrowers, i.e., RCom and RTL. The Court interpreted this clause as a contractual guarantee under s. 126 of the Act, as it imposed a liability on the CD to fulfil the obligations of a third party in case of default.
Despite the DoH being labelled as a security document, its substantive terms indicated that the CD assumed the liability of third-party borrowers. The legal effect of any document is not determined by its nomenclature, especially in the present case wherein the DoH contained the elements of a guarantee; it ought to have been treated as on.
The Supreme Court further clarified that s. 5(8) of the IBC does not require a financial debt to be contingent upon a default for a claim to be submitted during CIRP. A financial debt exists the moment a liability arises, even if no payment default has occurred.
The moratorium imposed under s. 14 of the IBC does not extinguish claims or liabilities but merely stays enforcement actions during the CIRP. Therefore, the CD’s contingent obligation under the DoH remained valid and enforceable.
The Court reaffirmed the inclusive participation of all creditors in the CIRP and highlighted the appellants’ active role as FCs in the Committee of Creditors. The appellants’ claims were correctly admitted by the RP and the NCLT, as their rights arose from enforceable obligations under the DoH.
The NCLAT erroneously relied upon the absence of any direct lending agreement between the appellants and the CD to deny FC status. The Court clarified that direct lending is not a prerequisite under s. 5(8) of the IBC when the debt arises from a valid guarantee.
Thus, the Court held that the appellants, having enforceable claims under the DoH, are FCs under the IBC. The NCLAT’s judgment was quashed, and the NCLT’s ruling was restored.
Our Analysis
The Supreme Court’s judgment reinstates the NCLT’s decision, recognizing China Development Bank and others as FCs in the CIRP of RITL.
The Court identified cl. 5(iii) of the DoH as a contractual guarantee under the Indian Contract Act, creating enforceable obligations for RITL to discharge the debt of the Parties in case of default. It rejected the argument that the DoH’s designation as a security document negates its substantive effect as a guarantee. Moreover, the Court clarified that financial debt need not depend on a default for claims to arise; liability exists upon execution of such an obligation.
The Court emphasized that financial debt encompasses liabilities arising from guarantees, even if the term ‘guarantee’ is not explicitly used in the underlying document, thus emphasizing the importance of interpreting financial instruments based on their substantive content rather than their nomenclature. The judgment reaffirms the inclusive approach of the IBC, ensuring that creditors with enforceable claims participate in CIRP, irrespective of any direct lending relationships. By quashing the NCLAT’s ruling, the Court underscored that nomenclature does not override the substance of a financial arrangement.
End Note
[i] 2024 SCC OnLine SC 3829 dated 20.12.2024.
Authored by Sweta Singh, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinions.