In the case of Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited Etc., the Supreme Court had occasion to examine (i) certain provisions relating to preferential, fraudulent and undervalued transactions contained in the Insolvency and Bankruptcy Code, 2016 (‘IBC’) and (ii) the issue pertaining to existence of a financial debt vis-à-vis creation of a mortgage to secure obligations of a third party.

Jaypee Infratech Limited (‘JIL’) is a company undergoing a corporate insolvency resolution process (‘CIRP’). JIL entered into certain transaction whereby JIL had mortgaged several parcels of land owned by it (‘Mortgage Transactions’). The Mortgage Transactions were collateral in favor of the lenders of Jaiprakash Associates Limited (‘JAL’) to secure JAL’s obligations under various loan facilities. JAL is the holding company of JIL and held approximately 71.64% equity in JIL as on the financial year ending March 2017.

With regard to issue (i) above, the interim resolution professional (‘IRP’) for JIL filed an application before the National Company Law Tribunal, Allahabad Bench (‘NCLT’) seeking setting aside of the Mortgage Transactions on the grounds that they are preferential, undervalued and fraudulent as provided for under Sections 43, 45 and 66 of the IBC respectively. The NCLT set aside six of the seven Mortgaged Transactions as being in the teeth of Sections 43, 45 and 66 inter alia on the grounds that:

a. the Mortgaged Transactions were executed by JIL at a time when it was itself under severe financial stress.

b. the Mortgaged Transactions was executed without any counter guarantee or consideration from JAL; and

c. creation of a security interest by way of mortgage in favor of lenders of a third party without any consideration could not have been treated as a transfer in the ordinary course of business.

While holding that Section 43 and 44 of the IBC must be strictly construed, the Supreme Court held that a corporate debtor shall be deemed to have given a preference if:

(i) The transaction is of transfer of the corporate debtor’s property or its interest thereof for the benefit of a creditor, surety or guarantor for an antecedent financial or operational debt or other liability.
(ii) The said transfer has an effect of putting such creditor, surety or guarantor in a beneficial position as compared to its position if Section 53 of the IBC were to apply.
(iii) Such preference is given within a period of 1 year prior to commencement of CIRP, or 2 years prior in case the beneficiary is a related party.

The Supreme Court further held that Sections 43 and 44 of the IBC create a legal fiction with a deeming effect and if any transaction shows existence of the ingredients listed above, it would create a legal fiction and such transaction would come in the teeth of Section 43 of the IBC irrespective of the intent or absence thereof unless excepted by the exceptions provided for section 43 (3) of the IBC.

Upholding the order of the NCLT, the Supreme Court held that the ultimate beneficiary of the Mortgage Transactions was JAL as the Mortgage Transactions resulted in creation of security interest to secure the obligations of JAL under various facility agreements thereby benefiting JAL, who is also a related party. The Supreme Court also observed that the requirements of Section 43 (2) (b) were fulfilled, as JAL who otherwise is an operational creditor of JIL, was in a beneficial position by virtue of the Mortgage Transactions viz., the lenders of JAL would benefit from the Mortgage Transactions and as a consequence the lenders of JIL will be put to a corresponding disadvantage because the mortgaged assets will not form part of JIL’s estate. In turn, the ultimate beneficiary would be JAL as it amounts to a corresponding reduction of the debt owed by it to its lenders.

The Supreme Court held that as far as transactions of mortgage are concerned the transferees are usually banks and financial institutions and therefore such transactions will squarely come under their ordinary course and conveniently be exempted if only the ordinary course of business of the transferee alone is looked at. Applying the principles of purposive interpretation to bring out the intent of the legislature, the Supreme Court held that the impugned transaction must fall within the ordinary course of business and financial affairs of both the corporate debtor and the transferee. Holding that the Mortgage Transactions do not fall under the ordinary course of business of JIL, the Supreme Court confirmed that the Mortgage Transactions are hit by Section 43 of the IBC and consequently the security interest created by JIL to secure the obligations of JAL stood completely discharged.

The lenders of JAL argued that the setting aside the Mortgage Transactions would have a very large impact on several such transactions and cause irreversible damage to the economy at large. Rejecting this argument, the Supreme Court held that it is incumbent on a lender to conduct due diligence qua the viability and indebtedness of the borrower and / or the third party securing the borrowers obligations. Any failure thereof, must result in consequences that the lenders will have to bear.

With regard to issue (ii) above, Certain lenders of JAL (in whose favor JIL had executed the Mortgage Transactions) sought recognition as financial creditors of JIL on the basis of the Mortgaged Transactions. On being refused such recognition by the IRP, the lenders preferred as application to the NCLT asserting their claim as financial creditors of JIL. The NCLT however, held that the lenders of JAL could not be recognized as financial creditors of JIL on the ground that the element of consideration for time value for money was absent.

The orders of the NCLT were assailed by the lenders of JAL and the National Company Law Appellate Tribunal (‘NCLAT’), while allowing the appeals held that the Mortgage Transactions did not qualify as preferential, undervalued or fraudulent and that consequently the lenders of JAL could exercise their rights as financial creditors of JIL on the grounds that the Mortgaged Transactions were made in the ordinary course of business and that the same did not attract Sections 43, 45 or 66 of the IBC. The NCLAT however, gave no reasoning with respect to the finding that the lenders of JAL are financial creditors of JIL on strength of the Mortgage Transactions.

To answer this issue, the Supreme Court undertook a detailed exposition on the meaning of the expressions ‘financial creditor’ and ‘financial debt’ as defined under Sections 5 (7) and 5 (8) the IBC. Relying on its previous decision in the case of Swiss Ribbons Pvt. Limited V. Union of India [2019 SCC OnLine SC 73], the Supreme Court observed that a financial creditor is bestowed with a critical role during the CIRP of a corporate debtor. A financial creditor is one whose interests are inherently linked with the welfare of the corporate debtor.

The Supreme Court held that the fundamental element of a financial debt is that it must be a disbursal against the consideration for time value of money. Therefore, the definition could not be read in manner so wide so as to abandon the primary requirement of disbursement against the consideration for the time value of money.

The Supreme Court held that the execution of the Mortgage Transactions by JIL to secure obligations of JAL did have an effect of creation of a security interest. However, the lenders of JAL would only be interested in realizing the value of its security under the Mortgage Transactions and not the revival of the corporate debtor. While holding that the lenders of JAL could have been secured creditors of JIL, the Supreme Court clarified that they could not have qualified as financial creditors of JIL on the strength of the Mortgage Transactions. In other words, a mortgage of assets to secure the debts of a third party may come in the ambit of the term ‘debt’ as defined under Section 3 (10) of the IBC but cannot qualify as a ‘financial debt’.

Conclusion:
This judgement has clarified beyond any doubt that a mortgage of assets by a corporate debtor securing obligations of a third party will not qualify as a financial debt and consequently, the lender of the third party cannot qualify as a financial creditor of the corporate debtor. It will be interesting to see the impact of this judgment on existing corporate insolvency resolution processes as it may result in a substantial alteration of the constitution of the committee of creditors of several corporate debtors. This judgment may also have an impact on the lending business in general as lenders may now be reluctant to accept security in the form of a mortgage of assets from a third-party company securing obligations of the borrower.

Authored by :- Mr. Nirav Shah, Partner & Mr. Ryan D’souza, Assoicate