[Aayush and Param are students at Symbiosis Law School, Pune.]
According to Section 2(n) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2000, hypothecation means a charge in or upon any movable property, existing or future, created by a borrower in favour of a secured creditor without delivery of possession of the movable property to such creditor, as a security for financial assistance and includes floating charge and crystallization of such charge into fixed charge on movable property. A deed of hypothecation (DoH) is a security instrument that enables creditors to lay down proof of their claims, allowing them to retain the title and possession of the collateral movable asset, to the extent of the secured nature of the debt exposures extended to borrowers. In this context, by providing the lender enforceable rights over a borrower’s assets, instruments like a DoH are widely employed for creating and enforcing security interest during actual or potential events of default on behalf of the borrower.
Against this background, on 20 December 2024, the Supreme Court of India in China Development Bank v. Doha Bank QPSC and Others settled an affirmative stance as to whether liabilities and obligations to be discharged by effect of a covenant embedded in a DoH amounted to a guarantee and its underpinning tailwinds on recovery of financial debts. This post examines an overview of the Supreme Court’s judgment and aims to discern key implications for lenders and borrowers, privy to financial transactions; underpinning tenets for security creation, risk harmonization and ease of doing business at large.
Brief Background of the Case
Ericsson India Private Limited, initiated a corporate insolvency resolution process against Reliance Infratel Limited (Corporate Debtor), which led China Development Bank and others (Appellants) to file their claims in the capacity of financial creditors. However, the Appellants had not extended said financial facilities directly to the Corporate Debtor, but to entities falling under the broader ambit of the Reliance Communications Group (Third-Party Entities). Despite not being a direct lender, the Appellants’ claims were founded upon the guarantee clauses present in the DoH, obligating the Corporate Debtor to cover defaults arising out of Third-Party Entities.
Consequent to the same, Doha Bank moved to the National Company Law Tribunal, Mumbai (NCLT) in order to declassify the Appellants as financial creditors since it was not a direct lender. The NCLT, heard and dismissed the same, upholding the status of the Appellants as financial creditors after placing reliance on the DOH which had the effect of a guarantee. Upon an appeal to the National Company Appellate Tribunal, New Delhi (NCLAT), the NCLAT set aside NCLT’s order, pertinently upholding that a DoH cannot exist in tandem as a deed of guarantee.
Aggrieved by the same, the Appellants preferred an appeal before the Supreme Court of India.
Key Findings of the Supreme Court
Considering in primacy whether an obligor’s liability in a DOH constitutes as a guarantee, the Supreme Court, upon perusal of Phoenix Arc Private Limited v. Ketulbhai Ramubhai Pate, opined that covenants to perform a promise and discharge liability under a hypothecation deed shall constitute the nature of a guarantee and its obligations thereunder. Further, the court furnished that third-party lenders shall fall within the umbrella of financial creditors without undertaking direct lending of loan facilities to the corporate debtor. Diverging from the precedent set in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited, the court held that any liability intrinsic to the commercial effect of borrowing, alongside guarantees, shall amount to financial debt.
Secondly, on whether an event of ‘payment default’ must occur for a financial debt to exist, the Supreme Court ruled that it is not necessary for an actual default to occur before a financial creditor can submit claims for recovery of financial debts. The court clarified that once a financial debt is established as owed to a person, that person becomes a financial creditor with the right to initiate claims.
Finally, with respect to the treatment of contingent claims during the imposition of a moratorium, the court has determined that imposing a moratorium during insolvency proceedings does not extinguish a creditor's contingent claim. Claims related to non-payment or default of financial debt remain valid, even with restrictions on enforcing rights during a moratorium. The underlying debt continues to exist, even if enforcement is temporarily prevented by a moratorium.
Analysis: Will a Lenders’ Rulebook Impact Skin in the Game for Borrowers?
Pursuant to the key takeaways mentioned above, the Supreme Court’s ruling knits a paradigm in favour of lenders (conventional, third party or syndicate), granting a wider rulebook for canvassing claims under the garb of formalized creditor classification. While settling strides on the DOH and guarantee interrelationship, clarity with regards to title salience and overall commercial substance stands cemented from a lender’s lens. In this regard, the Supreme Court reaffirmed that as a cardinal principle of interpretation, title nomenclature shall not be decisive of the nature of a document. While tackling ensuing issues with regards to interpretation of contracts, emphasis was made on the adoption of a common-sense approach in this regard, as opposed to a more narrow, pedantic and legalistic interpretation. This broad scope of interpretation shall ensure that commercial contractual considerations for a lender do not stand diminished or compromised in any manner. The judgment also enhances the standing of third party lenders, upholding them as financial creditors and allowing them to pursue recovery action without actual default and permits the initiation of contingent claims post the moratorium period. These interpretations shall ensure more flexibility for lenders in relation to smoother enforcement mechanisms during insolvencies, financial restructurings and asset backed securitizations.
From a borrower's purview, the Supreme Court's interpretation of guarantee obligations embedded within a DOH presents itself with critical considerations. Borrowers must now recognize that commercial implications under a hypothecation arrangement extend beyond merely creating security interest for a loan, resulting in increased assumption of liability and stricter enforcement measures accruing to events of default. As a result, borrowers should closely examine existing deeds of hypothecation and assess any potential undertones to guarantees arising from the rationale of this significant judgment. Recalibrating carve-out and cure periods for remedying special situations must be charted out, the absence of which may lead to more severe consequences. These consequences shall include accelerated debt recovery actions by lenders, personal guarantee enforcement, asset seizure or sale at distressed valuations, and a far-reaching restriction on future credit access. In addition, borrowers must now carefully consider how this ruling impacts their overall fiscal discipline, policy prudence and risk management practices. Given that particular clauses in hypothecation deeds may now carry implications akin to guarantees, borrowers should reassess their collateral lending arrangements and ensure they have adequate liquidity against security interest provided.
While negotiating the creation, maintenance and perfection of security provisions, security providers should seek removal of clauses which require them to undertake repayment obligations if they are not looking to undertake a guarantee to repay. Another safeguard in this regard is to cap the repayment obligations to the aggregate realizable value of the security provided.
By design, performance obligations arising out of security documents, must signal both worthiness and readiness for borrowers and lenders across different transactional lifecycles. In this regard, charting out the sanctity and end-use of such obligations should be paramount without muddling stakeholder governance, prolonged matter pendency or burden of ambiguous compliances.
Overall, the judgement has ushered a pro-creditor regime in India’s insolvency landscape. With greater control over resolution proceedings, creditors are empowered with a more disciplined and predictable insolvency process. By clearing debtor-friendly biases in the code, a more robust credit environment is guaranteed, instilling confidence amongst investors and financial institutions in the debt recovery framework, while positively impacting the broader scales of the economy.
Concluding Remarks
In conclusion, the judgment paves a definitive way forward from the lens of vetting and negotiating bespoke arrangements for assuming the creation of security interest within security documents. As a precursor to risk participation and cushioning comfort to lenders, financial transactions involving hypothecation arrangements must stand distinguished from an invariable imposition of guarantee or infructuous indemnification by borrowers. Significantly, this judgment aligns with the Supreme Court's preference for looking at the substance of a claim enforcement insolvency process over its literal form; supporting a pro-creditor playbook that extends a runway for creditors in recovering financial debts and stimulating overall economic activity for borrowers. All in all, parties undertaking financing transactions must carefully address legal considerations for both - security perfection and guarantee obligations, without deterring its distinctive commercial utility at large.
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