In Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Etc ¹, the Supreme Court held that a mortgagee is not a financial creditor of a corporate debtor who has merely created a mortgage to secure the loan advanced by the mortgagee to a third party. In Phoenix Arc Pvt Ltd v Ketulbhai Ramubhai Patel², the Supreme Court was called upon to decide on a similar issue- whether a pledgee would be a financial creditor of the pledgor company being the corporate debtor when the pledge was created to secure loan advanced by the pledgee to a third party. We analyse the recent judgment of the Hon’ble Supreme Court of India in this matter.

Facts:

• By and under a facility agreement dated 12^th May 2011 (“Facility Agreement”), Doshion Limited (“Borrower”) availed a financial facility from L&T Infrastructure Finance Company Limited (“Lender” / “L&T”) for an amount of Rs. 40,00,00,000/- (Rupees Forty Crores only) (“Facility”).
• In addition to the security provided by the Borrower under the Facility Agreement, Doshion Veolia Water Solutions Private Limited (“Corporate Debtor”), being the group company of the Borrower, pledged its shareholding (40,160 shares) in Gondwana Engineers Limited (“GEL”) by executing a pledge agreement in Lender’s favour dated 10^th January 2012 (“Pledge Agreement”). The Corporate Debtor also executed a non-disposal undertaking (“NDU”) in favour of L&T, thereby undertaking not to dispose of its 100% shareholding in GEL
• In 2013, the Lender assigned all its rights, title and security interest in the Facility in favour of Phoenix ARC Private Limited (“Appellant”).
• Thereafter, the Borrower failed to repay the Facility under the Facility Agreement. Resultantly, the Appellant filed an application before Debts Recovery Tribunal, Ahmedabad, after serving due notices to the Borrower for recalling the Facility.
• By an order in 2018, the company petition filed by Bank of Baroda under Section 7 of the Insolvency and Bankruptcy Code, 2016 (“Code”) to initiate the corporate insolvency resolution process against Corporate Debtor was admitted.
• Pursuant to the same, the Appellant filed its claim to recover approximately Rs. 83 Crores from Corporate Debtor.
• However, the Resolution Professional opined that the Corporate Debtor’s liability was strictly restricted to the pledge of shares and rejected the claim of the Appellant as financial creditor of the Corporate Debtor since no separate deed of guarantee had been executed between the parties.
• The Appellant’s application and appeal in the NCLT and the NCLAT for being regarded as a financial creditor of the Corporate Debtor were rejected and dismissed with both the NCLT and NCLAT holding that the Appellant was not a financial creditor of the Corporate Debtor.

Issues:

• Whether the Appellant is a Financial Creditor (as per Section 5(8) of the Code) on the strength of the Pledge Agreement executed in favour of the Lender?
• Whether the shares pledged by the Corporate Debtor under the Pledge Agreement, as a security to the Facility availed by Borrower, can be construed as a Guarantee (as per Section 126 of Indian Contract Act, 1872)?

Arguments:

It was argued on behalf of the Appellant, that since the Corporate Debtor created security interest for its parent company, in favour of the Lender, the liability of Corporate Debtor, who is a ‘surety’, shall be co-extensive to that of Borrower. It was further contended that the Corporate Debtor in effect has provided a guarantee to the Lender, whereby the Corporate Debtor has guaranteed to the Lender (now the Appellant) the debts due from the Borrower and in case of non-payment, a charge subsisted upon the 100% shareholding of GEL. The Appellant contended that the term ‘guarantee’ ought to be understood in a wider sense in order to incorporate third party security to secure repayment of a financial debt, which includes the pledging of shares as well.

It was submitted on behalf of the Resolution Professional that a separate deed of guarantee had never been executed between Corporate Debtor and the Lender in the first place; and pledge cannot, in any manner, be considered as a ‘guarantee’ under the Indian Contract Act, 1872. The Appellant had no right of recovery of any debt from the Corporate Debtor and only had a limited right of enforcing and realising the value of its security in the shape of the shares pledged with the appellant in accordance with the Pledge Agreement.

Judgment:

The Hon’ble Supreme Court of India vide its judgment dated 3^rd February 2021 dismissed the Appellant’s present appeal and upheld the decision of the Resolution Professional as approved by the NCLAT, as correct, based on the following:

1. The Corporate Debtor has not entered into any contract to ‘perform the promise’ or ‘discharge the liability’ of the Borrower in case of an event of default. The Pledge Agreement executed by the Corporate Debtor is simply limited to the pledge of 40,160 shares of GEL, extended as security. The Corporate Debtor had never promised to discharge the Borrower’s liability. Hence, Pledge Agreement and NDU do not amount to ‘guarantee’ as per the definition given under Indian Contract Act, 1872.
2. The court further observed that a person having only security interest over the assets of Corporate Debtor, by virtue of collateral security extended by the Corporate Debtor, would not be covered by the definition of ‘financial creditor’ as contained in sub-section (7) and (8) of Section 5 of the Code. Thus, the Apex Court, following its judgment in Anuj Jain, (supra), concluded that the Appellant can at best be termed as a ‘secured creditor’, but not a ‘financial creditor’. It has however been clarified that the Appellant is entitled to seek other remedies available under law to enforce the Pledge Agreement.

Thus, the principles laid down in Anuj Jain in relation to mortgages have been reiterated by this judgment for pledge of shares and this now appears to be settled law for all such third-party security.

Third party security documents often contain “covenants to pay” by which the third-party security provider covenants and promises to repay to the lender the loan advanced to the borrower. In Anuj Jain, this point was argued on behalf of one of the lenders as it was contained in their mortgage deed but appears to not have been considered by the Supreme Court. It will be interesting to see, whether such a covenant to pay, made by a third-party security provider in the security document, would allow such security document to be construed as a guarantee as such covenant contains the promise to discharge the liability of the borrower which was missing in this case. 

Footnotes

1 Civil Appeal Nos. 8512-8527 of 2019

2 Civil Appeal Nos. 5146 of 2019

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