SECURED CREDITOR, FINANCIAL CREDITOR AND SECURED FINANCIAL CREDITOR: A LEGAL CONUNDRUM

The ‘equitable treatment of similarly placed creditors’ is a well-established principle in insolvency laws. The legislative guide of the United Nations Commission on International Trade Law (“ UNCITRAL”) clearly states that “ The insolvency law should specify that all similarly ranked creditors, regardless of whether they are domestic or foreign creditors, are to be treated equally with respect to the submission and processing of their claims. ”[1]

The terms ‘financial debt’ and ‘financial creditors’ have been defined in Part II of the Insolvency and Bankruptcy Code, 2016 (the “Code”), whereas the term ‘secured creditor’ and ‘security interest’ have been defined in Part I of the Code. Does this mean that the legislature intended to make a clear distinction between a ‘financial creditor’ and a ‘secured creditor’. While a ‘financial creditor’ in most of the cases would be a ‘secured creditor’, the question whether a ‘secured creditor’ is also a financial creditor has lead to a legal conundrum in the recent times.

To understand this legal conundrum, it is suitable to take note of the relevant statutory provisions under the Code. The Code defines the terms ‘corporate debtor’, ‘creditor’ and ‘debt’ respectively, as follows:

‘corporate debtor’ means a corporate person who owes a debt to any person;

‘creditor’ means any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree-holder;

‘debt’ means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt;

The Code defines the terms ‘claim’ as follows:

‘claim’ means

(a)           a right to payment, whether or not such right is reduced to judgment, fixed, disputed, undisputed, legal, equitable, secured or unsecured;

(b)           right to remedy for breach of contract under any law for the time being in force, if such breach gives rise to a right to payment, whether or not such right is reduced to judgment, fixed, matured, unmatured, disputed, undisputed, secured or unsecured;

The Code defines the terms ‘secured creditors’ and ‘security interest’ respectively as follows:

‘secured creditor’ means a creditor in favour of whom security interest is created;

‘security interest’ means right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person:

Provided that security interest shall not include a performance guarantee;

The Code defines the terms 'financial creditor’ and ‘financial debt’ respectively as follows:

‘financial creditor’ means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to;

‘financial debt’ means a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes –

(a)           money borrowed against the payment of interest;

(b)           any amount raised by acceptance under any acceptance credit facility or its de-materialised equivalent;

(c)            any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument;

(d)           the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under the Indian Accounting Standards or such other accounting standards as may be prescribed;

(e)            receivables sold or discounted other than any receivables sold on non-recourse basis;

(f)             any amount raised under any other transaction, including any forward sale or purchase agreement, having the commercial effect of a borrowing;

Explanation. -For the purposes of this sub-clause,

(i)             any amount raised from an allottee under a real estate project shall be deemed to be an amount having the commercial effect of a borrowing; and

(ii)           the expressions, “allottee” and “real estate project” shall have the meanings respectively assigned to them in clauses (d) and (zn) of section 2 of the Real Estate (Regulation and Development) Act, 2016 (16 of 2016);

(g)           any derivative transaction entered into in connection with protection against or benefit from fluctuation in any rate or price and for calculating the value of any derivative transaction, only the market value of such transaction shall be taken into account;

(h)           any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;

(i)             the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clause (a) to (h) of this clause;

The Code defines the terms ‘secured creditor’ and ‘financial creditor’ separately. While the term ‘financial creditor’ has been defined as “any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to” , the term ‘secured creditor’ has been defined as “a creditor in favour of whom security interest is created” . Further, the definition of the term ‘creditor’ in the Code recognizes both ‘financial creditor’ as well as ‘secured creditor’, as the term ‘creditor’ is defined as meaning “ any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree-holder”. From the above, it is not clear whether a secured creditor would also qualify as a financial creditor of a corporate debtor and vice versa.

Therefore, it is important to look at the judicial pronouncements in order to ascertain the yardsticks that have been employed to determine whether a creditor who is a financial creditor can also be a secured creditor and vice versa.

In Swiss Ribbons Private Limited vs. Union of India [2] , the Hon’ble Supreme Court observed that:           

“23. A perusal of the definition of ‘financial creditor’ and ‘financial debt’ makes it clear that a financial debt is a debt together with interest, if any, which is disbursed against the consideration for time value of money. It may further be money that is borrowed or raised in any of the manners prescribed in Section 5(8) or otherwise, as Section 5(8) is an inclusive definition. On the other hand, an ‘operational debt’ would include a claim in respect of the provision of goods or services, including employment, or a debt in respect of payment of dues arising under any law and payable to the Government or any local authority.”[Emphasis Supplied]

In Anuj Jain vs . Axis Bank Limited and Ors., [3] the Hon’ble Supreme Court observed that:

“39.3. The most important feature, as this Court has said, is that a financial creditor is, from the very beginning, involved in assessing the viability of the corporate debtor who can, and indeed, engage in restructuring of the loan as well as reorganisation of the corporate debtor's business when there is financial stress. Hence, a financial creditor is not only about in terrorem clauses for repayment of dues; it has the unique parental and nursing roles too. In short, the financial creditor is the one whose stakes are intrinsically inter-woven with the well-being of the corporate debtor.”

“43. Applying the aforementioned fundamental principles to the definition occurring in Section 5(8) of the Code, we have not an iota of doubt that for a debt to become 'financial debt' for the purpose of Part II of the Code, the basic elements are that it ought to be a disbursal against the consideration for time value of money. It may include any of the methods for raising money or incurring liability by the modes prescribed in Sub-clauses (a) to (f) of Section 5(8); it may also include any derivative transaction or counter-indemnity obligation as per Sub-clauses (g) and (h) of Section 5(8); and it may also be the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in Sub-clauses (a) to (h). The requirement of existence of a debt, which is disbursed against the consideration for the time value of money, in our view, remains an essential part even in respect of any of the transactions/dealings stated in Sub-clauses (a) to (i) of Section 5(8), even if it is not necessarily stated therein. In any case, the definition, by its very frame, cannot be read so expansive, rather infinitely wide, that the root requirements of 'disbursement' against 'the consideration for the time value of money' could be forsaken in the manner that any transaction could stand alone to become a financial debt. In other words, any of the transactions stated in the said Sub-clauses (a) to (i) of Section 5(8) would be falling within the ambit of 'financial debt' only if it carries the essential elements stated in the principal Clause or at least has the features which could be traced to such essential elements in the principal clause.” [Emphasis Supplied]

“44. As noticed, the root requirement for a creditor to become financial creditor for the purpose of Part II of the Code, there must be a financial debt which is owed to that person. He may be the principal creditor to whom the financial debt is owed or he may be an assignee in terms of extended meaning of this definition but, and nevertheless, the requirement of existence of a debt being owed is not forsaken.”

From the above understanding as expounded by the Hon’ble Supreme Court, it is clear that for a creditor to be a financial creditor, there has to be an essential element of disbursal, and that too against the consideration for time value of money. Also, such disbursal needs to be found in the genesis of any debt before it may be treated as 'financial debt' within the meaning of Section 5(8) of the Code.

In Anuj Jain vs. Axis Bank Limited and Ors., [4] case the Hon’ble Supreme Court while dealing with the definition of ‘secured creditor’ observed that:

“46.1 A “secured creditor” in terms of Section 3(30) means a creditor in whose favour a security interest is created; and “security interest”, in terms of Section 3(31), means a right, title or interest or claim of property created in favour of or provided for a secured creditor by a transaction which secures payment for the purpose of an obligation and it includes, amongst others, a mortgage. Thus, any mortgage created in favour of a creditor leads to a security interest being created and thereby, the creditor becomes a secured creditor.”

The Hon’ble Supreme Court in the instant case also analyzed the distinction between secured creditors who are directly engaged in advancing credit to the corporate debtor as against the secured creditors who are indirect creditors for having extended any loan or facility to a third party but had taken a security from the corporate debtor. While drawing a distinction between a financial creditor and a secured creditor the court observed the following:

“47.1. Keeping the objectives of the Code in view, the position and role of a person having only security interest over the assets of the corporate debtor could easily be contrasted with the role of a financial creditor because the former shall have only the interest of realising the value of its security (there being no other stakes involved and least any stake in the corporate debtor's growth or equitable liquidation) while the latter would, apart from looking at safeguards of its own interests, would also and simultaneously be interested in rejuvenation, revival and growth of the corporate debtor.”[Emphasis supplied]

The Hon’ble Supreme Court further observed that:

“47.2 Therefore, we have no hesitation in saying that a person having only security interest over the assets of corporate debtor (like the instant third party securities), even if falling within the description of 'secured creditor' by virtue of collateral security extended by the corporate debtor, would nevertheless stand outside the sect of 'financial creditors' as per the definitions contained in Sub-sections (7) and (8) of Section 5 of the Code .” [Emphasis supplied]

“50.4. We may usefully elaborate a little. On a contextual reading of the expositions in Essar Steel and Swiss Ribbons, it is but clear that the Court had examined the status of direct secured creditor of the corporate debtor and there had not been any occasion to examine the features related with an indirect secured creditor, who is neither involved in assessing the viability of the corporate debtor nor in lending finances to the corporate debtor for setting up the business. As noticed, the prime, rather only, area of interest of such indirect secured creditor is in recovery of its debt and not in reorganization of the corporate debtor's business. Thus understood, it is absolutely clear that the class of secured creditors indicated by this Court in Essar Steel and Swiss Ribbons, as being subsumed in financial creditors, is only that of such secured creditors who are directly engaged in advancing credit to the corporate debtor and not the indirect creditors who had extended any loan or facility to a third party but had taken a security from the corporate debtor, whose resolution is under consideration.” [Emphasis supplied]

From the above observations of the Hon’ble Supreme Court, the following can be inferred in relation to a secured creditor who can also be considered as a financial creditor of the Corporate Debtor and thus a ‘secured financial creditor’:

(a)            The debt should have been disbursed against the consideration for the time value of money.

(b)           The debt should have been extended to the Corporate Debtor.

(c)            The debt should have been secured by a security interest, in favour of the secured creditor by any person.