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Unveiling the Financial Debt Nature of Security Deposits: A Post-Global Credit Capital Analysis

The author is Rajyavardhan Singh, a second-year student at Rajiv Gandhi National University of Law, Punjab.


Introduction


A division bench of the Supreme Court in Global Credit Capital Ltd. and Anr. vs. Sach Marketing Pvt. Ltd. and Anr. (“Global Credit Capital”) dealt with the question of when a debt should be classified as a financial debt or an operational debt under the Insolvency and Bankruptcy Code, 2016 ("IBC"). The pith of the judgement’s rationale centred around the debt to have qualified as a financial debt, considering the existence of  interest against the ‘time value of money’ alongside its ‘commercial effect of borrowing’.


The dispute arose when Sach Marketing provided a security deposit, which accrued interest, to Mount Shivalik (the corporate debtor), aimed at promoting their beer. Sach Marketing contended that this deposit constituted a loan (financial debt) rather than a business expense (operational debt). Conversely, the crux of the corporate debtor’s argument rested upon the definition of an “operational creditor” under Section 5 (21) of the IBC. It was asserted that as per the original agreement, the security deposit served as a prerequisite for becoming a sales promoter and not a loan. Additionally, it was submitted that the debtor did not intend to derive any financial benefit from the deposit.


To this end, this article purposively attempts to examine the treatment of security deposits under the IBC. First, it traces three precedent-setting cases that have shaped how financial debt and security deposits are viewed under the IBC. Second, it delves into how interest separates financial debt from regular business debt (operational debt) under the IBC. Third, the article discusses the practical consequences of categorising security deposits as financial debt. Fourth, the article proposes ways forward to better the treatment of security deposits under the IBC for best practices.


Foundation Stone, Principle, and the Review in Global Credit Capital


(i) Jaypee Infratech & Pioneer Urban Land: The Genesis


In Jaypee Infratech, the Supreme Court held that for a debt to be classified as a 'financial debt' under Section 5 (8) of the IBC, it must involve disbursal against consideration for the time value of money. This requirement applies to transactions under clauses (a) to (i) of Section 5(8).


Further, the court in Pioneer Urban Land reasoned that the amounts raised with the commercial intent of temporary fund use, which include an interest component, most certainly qualify as 'financial debt' due to their commercial effect of borrowing.


Thus, the primary focus lies on the time value of money alongside the commercial substance and accounting treatment, not just the form of agreements.


(ii) Vibrus Homes: Building Block


In a similarly knit factual scenario of Vibrus Homes, the operational creditor provided a sum of Rs.32,43,000/- as an interest-free deposit toward the advance licence fee, intended as a security deposit until the licence period's conclusion. However, the project failed to materialise, leading the operational creditor to file an application under Section 9 of the IBC, which the Adjudicating Authority admitted.


National Company Law Appellate Tribunal’s (“NCLAT”) Principal Bench upon appeal upheld the Adjudicating Authority's decision, affirming that the payment made initially for the advance licence fee constituted an operational debt essentially due to the interest-free nature of the deposit. Consequently, the Adjudicating Authority's admission of the application under Section 9 for the insolvency resolution was validated.


(iii) Global Credit Capital: Final Word?


The Hon’ble Supreme Court in Global Credit Capital ruled that there cannot be a debt within the meaning of Section 3(11) of the IBC unless there is a claim within the meaning of Section 3(6).   A test to determine if a debt is a financial debt under Section 5(8) is the existence of a debt along with interest, if any, disbursed against the consideration for the time value of money.


Cases covered by categories (a) to (i) of sub-section (8) must satisfy this test. To decide whether a debt is financial or operational, it is essential to ascertain the real nature of the transaction reflected in the writing.

Where one party owes a debt to another and the creditor claims under a written agreement providing for rendering service, the debt is an operational debt only if the claim is connected with the service subject matter of the transaction.


‘Interest’ as Financial & Operational Debt under the IBC


In both Vibrius Homes and Global Credit Capital, the courts concluded that the presence of interest clearly indicates a financial debt, reflecting a loan and the time value of money. In Vibrius Homes, the absence of interest on the deposit indicated it is an operational debt, linked to the project's licensing as an advance payment rather than a loan.


Additionally, the presence of interest is a significant distinction. The term "financial debt" is defined to include interest, whereas "operational debt" does not mention interest.

Section 5(8) defines "financial debt" as "a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes (...)."


In contrast, Section 5(21) defines "operational debt" as "a claim in respect of the provision of goods or services including employment or a debt in respect of the repayment of dues arising under any law for the time being in force and payable to the Central Government, any State Government, or any local authority."


Further clarification comes from the Supreme Court’s ruling in Pioneer Urban Land, which emphasised that operational debt does not involve the time value of money. Instead, the consideration of the debt is the goods or services provided by the operational creditor.


Therefore, interest is not necessary for an operational debt, as the primary consideration is the value of the goods and services provided by the operational creditor to the corporate debtor.

Furthermore, the presence of accruing interest strengthens the case for classifying a security deposit as financial debt. As it demonstrates an expectation of financial return on the deposit, aligning it more closely with the definition of financial debt under the IBC.


Practical Consequences of Treating Security Deposits as Financial Debt under the IBC


Traditionally, unsecured creditors like depositors are at the back of the line during insolvency. By classifying security deposits as financial debt, depositors gain creditor rights, strengthening their claim on the company's assets and potentially improving their position in the queue compared to other unsecured claims. This can lead to a higher recovery rate during the process. Furthermore, because financial debt typically accrues interest, depositors would have a stronger argument for claiming interest on their security deposits alongside the principal amount during insolvency proceedings. This should also incentivise companies to handle deposits more responsibly and return them promptly, as the longer they hold onto the deposit, the more money they owe.


Moreover, all companies very ostensibly would now have to account for security deposits as financial debt in their financial statements. This increased transparency shall be necessary because it can impact their creditworthiness, especially if they have a large number of outstanding deposits, due to the higher level of debt on their books. Moreover, disputes over whether a deposit is financial or operational debt or disagreements about interest calculations, could slow down the insolvency resolution process. This can extend negotiations and delay settling claims, reviving the company, or finalising its liquidation. These delays can be costly and inconvenient for all parties involved.


Way Forward


Lessons can be learned from the UNCITRAL Model Law on Cross-Border Insolvency ("UNCITRAL Model"), which provides a legal framework for handling cross-border insolvency disputes. While the law is not directly binding on India, it has the potential to serve as a valuable resource for best practices and can inform future legal interpretations and potential legislative changes concerning security deposits within the framework of the IBC.


The UNCITRAL Model emphasises clear record-keeping of security interests, aligning with the potential for standardised security deposit agreements in India. These agreements can explicitly state the deposit's purpose, whether purely for financial security (e.g., a bank guarantee) or tied to performance guarantees (e.g., potential damage coverage in a lease). This standardisation promotes transparency and reduces disputes, allowing courts to classify deposits faster without delving into the specifics of each agreement.


Additionally, the UNCITRAL Model’s focus on the transaction's purpose especially aligns with Global Credit Capital. The courts could adopt a more functional approach, analysing the intended function of the deposit beyond the mere label of "security deposit." Deeming deposits solely linked to financial security as financial debt becomes easier with this approach.


Therefore, by embracing these lessons from the UNCITRAL Model, the IBC can evolve towards a more robust system for dealing with security deposits as debts. Therefore, it would be prudent  to adopt standardised agreements with clear purpose statements, coupled with a functional approach by courts, that can streamline classification, reduce delays, and promote fairness in insolvency proceedings.

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