Home » Between The Lines » Between The Lines | NCLT: Indemnity of obligations under an agreement is not a ‘financial debt’ under Section 5(8) of the Insolvency and Bankruptcy Code, 2016

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The National Company Law Tribunal, Mumbai Bench (“NCLT”) has in its judgement dated October 7, 2022 (“Judgement”), in the matter of Reserve Bank of India v. Reliance Capital Limited [CP. (IB) No. 1231/MB/C-I/2021] held that indemnity obligations under an agreement is not a ‘financial debt’ under Section 5(8) of the Insolvency and Bankruptcy Code, 2016 (“IBC”).

Facts

Around April 2019, Reliance Home Finance Limited (“RHFL“) proposed the issuance of commercial papers (“CPs”) to raise funds in order to meet its short-term working capital requirements. Aiming to protect its interest, Axis Bank Limited (“Applicant“) got a tripartite obligor undertaking (“Obligor Undertaking”) executed by Reliance Capital Limited (“Corporate Debtor“) and RHFL, to ensure that any dilution of the Corporate Debtor’s stake (“Stake Sale“) in Reliance Nippon Life Asset Management Limited (“Reliance Nippon“) would be utilized towards the payment due under the CPs.

The Applicant agreed to subscribe to the CPs (having a face value of INR 124 Crores) issued by RHFL and the said CPs were issued to the Applicant on April 16, 2019 by the issuing and paying agent, namely, ICICI Bank Limited.

Since the execution of the Obligor Undertaking and the subsequent issuance of the CPs, the Corporate Debtor had diluted and sold its stake in Reliance Nippon, by reducing its stake from 42.88% to 4.28%. Even after realizing an amount of INR 5,500 Crores, the Corporate Debtor failed to fulfill its payment obligations arising out of the CPs.

Consequently, the Applicant addressed various letters to the Corporate Debtor for making payments under the Obligor Undertaking, but, to no avail. The Applicant also issued a legal notice dated October 10, 2019, to the Corporate Debtor for payment of an amount of approximately INR 120 Crores pursuant to the Corporate Debtor’s obligation under the Obligor Undertaking.

Thereafter, the Corporate Debtor was admitted into Corporate Insolvency Resolution Process (“CIRP”) and Mr. Nageswara Rao Y (“Administrator”) was appointed to discharge the functions of the resolution professional.

Pursuant to the issuance of a public announcement declaring the commencement of CIRP, the Applicant submitted two Form C (Proof of Claim submitted by Financial Creditors) claims, in terms of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016, to the Administrator seeking admission into the Committee of Creditors as a ‘financial creditor’. However, both claims of the Applicant were rejected by the Administrator on the ground that the Obligor Undertaking was entered into for the purpose of utilizing money/ proceeds from the sale of Reliance Nippon shares in a certain manner and not for repayment of the financial debt of RHFL. The Corporate Debtor had not guaranteed to discharge the obligations of RHFL in case of a default.

On that account, the Applicant filed an application under Section 60(5) of the IBC, seeking admission of its claims (amounting to approximately INR 145 Crores) as a financial creditor of the Corporate Debtor (“Application”).

Issue

Whether indemnity of the obligations under an agreement constitutes a ‘financial debt’ under Section 5(8) of the IBC.

Arguments

Contentions raised by the Applicant:

1. The Obligor Undertaking is in the nature of a guarantee towards the payments under the CPs:

The Applicant claimed that the Corporate Debtor was a guarantor under the Obligor Undertaking and that Clause 2 of the said undertaking was misread by the Corporate Debtor, in as much as, it clearly states that the Corporate Debtor had an obligation to make payments due under the CPs.

The Applicant submitted that the obligation of the Corporate Debtor, to pay under the CPs had crystallized upon the occurrence of the Stake Sale.

The Applicant further submitted that the definition of ‘obligor’ under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) reads as “a person liable to the originator, whether under a contract or otherwise, to pay a financial asset or to discharge any obligation in respect of a financial asset, whether existing, future, conditional or contingent and includes the borrower.” Further, a ‘financial asset’ under the SARFAESI Act is defined as “debt or receivables and includes (1) a claim to any debt or receivables or part thereof, whether secured or unsecured; or….

The Applicant contended that since CPs are unsecured money market instruments issued in the form of a promissory note, they should be classified as a financial debt under Section 5(8) of the IBC and the Corporate Debtor has a contingent obligation to pay the debt, either in whole or in part, depending on the value of the Stake Sale.

Responding to the Administrator’s contention that there is no promise on part of the Corporate Debtor to perform or pay in case of default by RHFL, the Applicant cited Clause 2 of the Obligor Undertaking, which provided that the Stake Sale in Reliance Nippon is only a trigger event for ascertaining the due date for payment and does not absolve the Corporate Debtor from the liability to pay on account of default by RHFL.

The Applicant argued that upon materialization of the Stake Sale, the Corporate Debtor had an obligation to pay the financial debt pursuant to the Obligor Undertaking. Therefore, the Applicant should be classified as a financial creditor.

2. Due amount under the CPs is a financial debt under Section 5(8)(i) and (f) of the IBC:

The Applicant contended that the Obligor Undertaking provided for an indemnity clause, wherein the Corporate Debtor was to indemnify the Applicant against any breach of any of the terms of the Obligor Undertaking by the Corporate Debtor or RHFL. The Applicant further submitted that since RHFL has not paid any amounts under the CPs, the obligation of the Corporate Debtor to indemnify the Applicant had arisen, considering that the Obligor Undertaking had been breached. Therefore, the obligation of the Corporate Debtor classifies as a financial debt under Clause 5(8)(i) of the IBC, which reads as “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.”.

Contentions raised by the Corporate Debtor:

1. The Obligor Undertaking is not a guarantee that attracts the definition of ‘financial debt’ under Section 5(8) of the IBC:

The Corporate Debtor contended that Section 126 of the Indian Contract Act, 1872 postulates that a ‘guarantee’ must possess the following twin essential attributes:

  • First, there must be a contract to perform or discharge the liability of a third party; and
  • This contract to perform a third party’s promise must be in case of that third party’s default.

The basic ingredient of a ‘guarantee’, being a promise to perform in the event of a default by a third party is lacking in the instant case. Under the Obligor Undertaking, the Corporate Debtor had not promised to perform RHFL’S obligation to pay under the CPs or to discharge RHFL’S liability, in the event of RHGL’S default. Thus, the Obligor Undertaking is not a guarantee and therefore, does not attract the definition of ‘financial debt’ under Section 5(8) of the IBC.

The Corporate Debtor further submitted that the Obligor Undertaking was merely a contingent contract, under which the Corporate Debtor had undertaken that upon the sale of its or its affiliate shares in Reliance Nippon it would use the proceeds to either (i) purchase the CPs from the Applicant; or (ii) infuse funds into RHFL to redeem the CPs issued by RHFL. The Corporate Debtor’s undertaking was not premised on RHFL’S default in serving the CPs, and thus could not be classified as a ‘guarantee’.

2. The Applicant is not owed a ‘financial debt’ under Section 5(8) of the IBC:

The Corporate Debtor submitted that the Applicant’s contention that the Obligor Undertaking and the issuance of CPs construed together is a ‘financial debt’ in terms of Section 5(8) of the IBC, is not legally sustainable for the following reasons:

  • The Applicant itself commercially understood that the Obligor Undertaking does not have the commercial effect of a borrowing; and
  • In the Applicant’s Form C (Proof of Claim submitted by Financial Creditors) claims, it specifically took the plea that RHFL was the principal borrower, and the Corporate Debtor was only a ‘guarantor’.

The Corporate Debtor contended that the Applicant communicated its own commercial understanding that the Corporate Debtor was not the borrower but had acted as an assurer/security provider.

The Corporate Debtor invoked on the principle laid down in the case of Anuj Jain v. Axis Bank Limited and Others [2020 8 SCC 401] (“Anuj Jain Case”), wherein the Hon’ble Supreme Court (“SC”) held that there must be a disbursal of money against time value vis-à-vis the corporate debtor in order to constitute a ‘financial debt’. However, in the present case, it was an admitted position that there was no such disbursal to the corporate debtor for consideration against the time value of money.

The Corporate Debtor also relied on Pioneer Urban Land and Infrastructure Limited and Another v. Union of India and Others [Writ Petition (Civil) No. 43 of 2019], wherein the Hon’ble SC held that for a transaction to have a commercial effect of a borrowing, money must be lent and/or received by the corporate debtor for temporary use with ‘profit as the main aim’.

Observations of the NCLT

The NCLT affirmed the view of the Corporate Debtor and observed that since the Applicant had not established that the money was disbursed to the Corporate Debtor, the question of default on the part of the Corporate Debtor does not arise.

The NCLT also applied the principles enunciated in the Anuj Jain Case and observed that no ‘financial debt’ is owed to the Applicant under Section 5(8) of the IBC, for the following reasons;

  • There has been no disbursal to the Corporate Debtor against consideration for the time value of money;
  • Disbursal has been made to an independent juristic person, namely RHFL under the CPs;
  • There has been no borrowing by the Corporate Debtor.
  • RHFL had a ‘commercial interest’ in the CPs since the same was subscribed by the Applicant. The Corporate Debtor did not have a ‘commercial interest’ in the same.

The NCLT further observed that the Applicant’s reliance on the indemnity clause of the Obligor Undertaking is also misplaced, because the said indemnity related to a breach of the Obligor Undertaking itself, and was not an indemnity issued against the CPs issued by RHFL. Plainly, it was not an indemnity that would constitute ‘financial debt’ under Section 5(8) of the IBC.

Decision of the NCLT

The NCLT relied on the case of Dr. B.V.S Laxmi v. Geometrix Laser Solution Private Limited [Company Appeal (AT) (Insolvency) No. 38 of 2017], wherein the Hon’ble National Company Law Appellate Tribunal stated that “In the present case, the Appellant has failed to bring on record any evidence to suggest that disbursed money has been made against ‘consideration for the time value of money’. There is nothing on the record to suggest that the Respondents borrowed the money. In absence of such evidence, the Appellant cannot claim that the loan if any given by the Appellant comes within the meaning of ‘financial debt’ in terms of sub-section (8)(a) of Section 5 of the ‘I & B Code…”.

Since the Applicant had failed to establish that the money was disbursed to the Corporate Debtor, the question of default on the part of the Corporate Debtor did not arise. The NCLT opined that disbursement is a sine qua non for any debt to fall within the ambit of the definition of financial debt under Section 5(8) of the IBC.

Further, the indemnity provided by the Corporate Debtor to the Applicant, under the Obligor Undertaking did not constitute ‘financial debt’ under Section 5(8) of the IBC.

Accordingly, the NCLT rejected and disposed of the Application.

VA View:

The NCLT through this Judgement has reaffirmed the well settled principle that for a transaction to acquire a status of a ‘financial debt’, money should be disbursed and that such disbursement should be made against the ‘consideration for the time value of money’, which is a substantive ingredient to fulfill requirements of the expression ‘financial debt’. Without proof of disbursement, an amount cannot be claimed as financial debt, as a disbursement is a sine qua non for any debt to fall within the ambit of the definition of financial debt.

The NCLT has also correctly observed that Applicant’s reliance on the indemnity clause of the Obligor Undertaking was misplaced, considering that the said indemnity clause was regarding a breach of the Obligor Undertaking itself, not an indemnity issued in respect of the CPs issued by RHFL. Therefore, it was not an indemnity that would constitute ‘financial debt’ under Section 5(8) of the IBC.

For any query, please write to Mr. Bomi Daruwala at [email protected]

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