A Paradigm Shift In Outlook Towards Third Party Security?

The recently introduced Insolvency and Bankruptcy Code, 2016 (“IBC”) has brought in its wake several judgments and orders which are changing the landscape of the financial markets in an unprecedented manner.

Continuing in the same vein, the Hon’ble National Company Law Tribunal (“NCLT“), Allahabad Bench has transformed the settled principles of third party security whilst deciding the company applications in the matter of Jaypee Infratech Limited (“JIL”).

In the said matter, JIL created a mortgage over its immovable properties admeasuring approximately 858 acres, as security for loans disbursed by several lenders to its holding company, Jaiprakash Associates Limited (“JAL“). Whilst the said mortgage was admittedly created by JIL at time when JIL was not in a position to service its lenders and had been declared a non-performing asset by some of its lenders, it appears that the provisions of IBC would be mutatis mutandis applicable to any third-party security provider.

The company applications in the said matter bring to the fore two throbbing issues which ought to be considered by the lending fraternity with severity:

  1. Whether the lenders (of the related party) be considered as “financial creditor” to the third-party mortgagor company (which has been admitted to insolvency under the IBC);
  2. whether the recovery by such lender from the third-party security could be considered to be fraudulent, preferential or undervalued.

In the present circumstances, the NCLT has summarily answered the above as follows:

  1. The Lender of the Holdco, JAL, cannot be considered to be a financial creditor of JIL (Third Party Security Provider) owing to the following reasons: (i) no monies were disbursed to/ received by JIL; (ii) there is no repayment obligation on JIL; (iii) creation of mortgage does not tantamount to undertaking repayment obligations; (iv) the creation of mortgage cannot be treated akin to a guarantee or indemnity under the provisions of Section 5(8)(i) of the Code; (v) there is no time value of money in case of a simpliciter mortgage since the debt can be realized only out of the sale proceeds of the mortgaged property but not from JIL; and (vi) the contention that the disbursement of the loan need not necessarily be to JIL, is untenable in law.
  2. The mortgage created by JIL in fact tantamounts to a preferential, fraudulent and undervalued transaction in terms of the IBC. This is in view of the fact that such transactions would result in the lenders of a related party receiving priority of payment out of the proceeds / assets of the corporate debtor to the detriment of the financial creditors of the corporate debtor. Such priority of payments to lenders of related parties who have neither disbursed funds to the corporate debtor, nor added value to the business of the corporate debtor could well be regarded as preference to such third party mortgagee and thus liable to be set aside as preferential.

Until the review of the position by the NCLAT and/or the Supreme Court, there appears to be a paradigm shift in the approach towards creation of third party security and lenders would be well advised to tread wisely in the hitherto untested waters.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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