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The authors are Anaya Nandish Shah and Pulkit Rajmohan Agarwal, third year students at Gujarat National Law University.
Introduction
Owing to the ever-evolving landscape of Insolvency and Bankruptcy laws, numerous intricacies await resolution. Among these complexities, a significant challenge revolves around the protection of secured creditors' rights – particularly those who do not fall within the categorization of financial or operational creditors.
Understanding the issue - It is common practice nowadays for a pledgor, to pledge assets to a creditor, to avail debt for its sister concern or a subsidiary. In M/s Vistra Itcl (India) Limited v. Dinkar Venkatasubramanian (“Amtek Auto”), a company named Amtek Auto Limited, pledged certain shares with Vistra Itcl (India) Limited to avail credit for two of its group companies, Brassco Engineers Ltd and WLD Investments Pvt. Ltd. However, Amtek Auto faced insolvency proceedings as per the provisions of the Insolvency and Bankruptcy Code, 2016 (“IBC”). The legal conundrum that arose herein was whether Vistra Itcl (secured creditor) could enforce its rights over the pledged shares amidst the insolvency proceedings of Amtek Auto (corporate debtor), owing to the fact that the debt was not raised for the corporate debtor itself, but for its subsidiaries. Moreover, ascertaining whether secured creditors could be classified as financial creditors also becomes crucial.
In light of this, the article seeks to analyse the implications of judicial pronouncements surrounding this matter and propose potential pathways towards a balanced resolution.
The judicial transition – from the past to the present
The challenge of enforcing the security interest of a third party under IBC laws unfurled for the first time before the Supreme Court in Anuj Jain v. Axis Bank Limited (“Jaypee Infratech”). The Court, in this case, held that the security interest created through such an arrangement of pledging could not be classified as a financial debt under Section 5(8) of the IBC, since no funds were directly transferred to the corporate debtor. Further, the Court emphasized the fact that the role of financial creditors is not only to retrieve the funds but also to revive the company, as opposed to the sole objective of secured creditors to recover the sum. As a result, these secured creditors were not identified as financial creditors, thus preventing them from being included in the Committee of Creditors (“CoC”). The justification for differentiating between financial and such secured creditors was reaffirmed by a larger bench in the Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel (“Phoenix ARC”) case.
Nevertheless, in Amtek Auto the Court analysed the situation from a different perspective, considering the adverse consequences that the third-party secured creditors had encountered owing to these judgments. The Court duly acknowledged that, as a result of previous judgements, the secured creditors were neither classified as financial nor as operational creditors. Hence, they were denied the statutory protections afforded to operational and dissenting financial creditors under Section 30(2) of IBC. Not only this, the rights originally provided to the secured creditors under Section 52 of IBC could be availed only in cases of liquidation and not Corporate Insolvency Resolution Process (“CIRP”). Consequentially, the secured creditors fared much worse as compared to operational and dissenting financial creditors.
In order to protect these secured creditors from such a treatment, the Apex Court proposed two amicable solutions that vary according to the stage of advancement of the insolvency proceeding. While the CIRP was underway, it was suggested that the secured creditors be reclassified as financial creditors and thus be entitled to the estimated value of the pledged shares. Post the completion of CIRP, the secured creditors shall be entitled to retain their security interest and receive the proceeds thereof in accordance with Section 52 and Section 53 of IBC.
Analysis of the proposed solutions
The recent judgment of the Apex Court offers respite to institutions involved in financing through pledges and it represents a significant stride in its approach towards interpreting laws to offer commercially feasible resolutions. Nevertheless, the decision is not devoid of legal complications. Analysis of the proposed solutions are as follows:
Solution I:
The first solution provided by the court essentially gave secured creditors a right to vote in the insolvency proceedings to the extent of recovering their interest from the assets of the corporate debtor. The method of financing in the industry, as used in the current case, has become a common practice, and a step to recognize such creditors was essential for safeguarding their interests. Implementation of the first solution implies that the secured creditor would be a part of the CoC and would have a say in the insolvency process.
However, permitting such a classification could potentially grant creditors the ability to prioritize their interests over fulfilling the primary objective of the IBC , which is the revival and resurgence of a business. As per the Jaypee Infratech case, financial creditors are akin to the guardians of the corporate debtors and are entrusted with the duty of their revitalization. However, the secured creditors have no direct nexus with the business of the corporate debtor and thus would be driven by the sole objective of recovering their money. This would contradict the purpose of IBC, which aims to ensure that the corporate debtor continues as a going concern. Thus, opting for an immediate and unrestricted classification as a financial creditor may not offer the optimal solution. Rather, a system of checks and balances upon the inclusion of secured creditors in the insolvency proceedings should be introduced.
An analogy can be drawn to the categorization of homebuyers within IBC. Initially, the legislative amendments and judicial pronouncements identified the homebuyers as the financial creditors. However, the 2020 Amendment Act introduced a minimum requirement of 100 or 10% of the total homebuyers involved in the project, in order to initiate CIRP. On similar lines, while categorizing the secured creditors as financial creditors, restrictions as to their involvement in the CoC under Section 21 can be imposed. Nonetheless, the secured creditors should be given the same protection as accorded to the financial creditors under Section 30(2). This would secure the position of the secured creditor and simultaneously shield the corporate debtor from the exclusive pursuit by creditors.
Solution II:
In the present case, the rights of the secured creditor over the collateral had been extinguished. To address this, the Court resorted to Section 52 and Section 53 of IBC. These sections primarily pertain to the rights of a secured creditor during the process of liquidation. As per the facts of the case, the CIRP had successfully concluded leaving no scope for liquidation. Despite this, the court enabled the secured creditors under the aforesaid sections to either claim their interest over the security or in case of relinquishment, claim the proceeds arising from the sales thereof. It becomes pertinent to note that in a CIRP proceeding, all the categories of creditors incur heavy haircuts over their claims. Even when a financial creditor has an exclusive right over a particular asset, any proceeds from its sale would be distributed among the other creditors in accordance with the proportion of their claims as outlined in the plan. However, as discussed in Essar Steel v. Satish Kumar Gupta, the application of liquidation payment priorities to a Corporate Debtor, which is a going concern, would unfairly favour secured creditors causing a detrimental impact on the interests of the operational creditors.
Such a differential treatment of the secured creditors vis-à-vis other creditors should only be permitted when there exist compelling grounds to do so. This necessity arises because consistently allowing secured creditors to fully recover their security interest, while subjecting other creditors to substantial haircuts as a result of the CIRP process, could be inequitable. Thus, the implementation of this remedy should be contingent upon the circumstances, facts and figures of each case.
Underscoring this, the National Company Law Appellate Tribunal in Edelweiss Asset Reconstruction Company Limited v. Anuj Jain Company held that the Amtek Auto case was not a declaration of law under Article 141 of the Constitution of India, since the judgment was rendered to discharge justice within the context of that particular set of circumstances. Hence, the solution offered by the Apex Court cannot be claimed as a blanket rule.
Conclusion
The present legal regime pertaining to the security interests of third-party secured creditors arising through the arrangement of pledges is governed by judicial interpretations. Contrasting interpretations of the same have led to complex issues that still require clarifications.As mentioned previously, the ratio in Amtek Auto is not a declaration of law and thus not binding upon the courts. Resultantly, the secured creditors remain unprotected, with the precedents Jaypee Infratech and Phoenix Arc still holding relevance. Therefore, institutions dealing in such a financial arrangement are left without any recourse potentially deterring them from future lending owing to the legal uncertainties. This reinstates the vulnerable position of the secured creditors, calling for legislative amendments to address this matter and bring legal certainty to significant business transactions ensuring safeguards for all the concerned parties.
In conjunction with the aforementioned recommendations, till the legal conundrum is settled, a relief in the form of an amendment to Section 30(2) can be provided to ensure protection for secured creditors who are not recognised as financial creditors. This adjustment would guarantee protection for secured creditors, ensuring that their treatment, although not identical to that of financial creditors, remains equitable and does not undermine their security rights. This proactive step by the legislature would contribute to rectifying the existing imbalance and bolstering the legal framework to accommodate the complexities surrounding third-party secured creditors and pledges within the IBC.