The Supreme Court in its judgement dated February 26, 2020, in the case of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited, has clarified several issues including the scope and ambit for adjudication of preferential transactions, and the nature of financial debt particularly in relation to third-party mortgages amongst others.

Facts
This matter reached the Supreme Court by an appeal against an order dated August 01, 2018 passed by the National Company Law Appellate Tribunal regarding an application moved by the Interim Resolution Professional (“IRP”) of Jaypee Infratech Limited (“JIL”) seeking avoidance of certain transactions, whereby the corporate debtor (JIL) had mortgaged its properties as collateral securities for the loans and advances made by the lender banks and financial institutions to Jaiprakash Associates Limited (“JAL”), the holding company of JIL, as being preferential, undervalued and fraudulent, in terms of Sections 43, 45 and 66 of the Insolvency and Bankruptcy Code, 2016 (“IBC”). The contention of IRP, that the transactions in question were preferential, undervalued and fraudulent within the meaning of Sections 43, 45 and 66 of the IBC, were accepted in part by the NCLT, in its order dated May 16, 2018 and directions were issued for avoidance of at least six of such transactions. The transactions in question essentially create security for loans advanced to JAL from the assets (immovable property) belonging to JIL. The National Company Law Appellate Tribunal (“NCLAT”), however, took an entirely opposite view of the matter and upturned the order passed by NCLT.

Another issue was if the lenders of the JAL could be recognised as lenders of JIL for the purposes of the IBC on the strength of the mortgage created by JIL, as collateral security of the debt of its holding company, JAL. It is pertinent to note that the Committee of Creditors (“CoC”) was required by the Supreme Court to be reconstituted in view of the directions in Chitra Sharma v. Union of India (decided on November 06, 2019), and the subsequent amendments brought about in the IBC which allowed homebuyers to be part of the CoC of both JAL and JIL. This issue was raised by ICICI Bank Limited and Axis Bank Limited, which challenged the decision of the IRP of rejecting their claims to be recognized as financial creditors of JIL on account of the securities provided by JIL for the facilities granted by them to JAL.

Issues
Broadly, the following issues were discussed by the Supreme Court:
(i) Whether impugned transactions are preferential, falling within Section 43(2) of the IBC. In order to better understand the issue, it can be further categorised in the following manner:

• Extent of the look back period in terms of Section 43(4) of the IBC.
• Meaning and scope of ordinary course of business or financial affairs.
• Duties and responsibilities of resolution professional in CIRP as per Section 25 with respect to Section 43 of the IBC.

(ii) Whether lenders of JAL could be categorised as financial creditors of JIL.

Arguments
Issue (i):
Regarding the issue pertaining to the avoidance application, the counsel for the IRP argued that transactions have the effect of putting JAL, which is an equity shareholder and an operational creditor (for an amount of INR 261.77 crores) of JIL, in a beneficial position than it would have been in the event of distribution of assets under Section 53 (liquidation waterfall) of the IBC vis-à-vis other creditors; and that if the transactions are held to be valid, the liability of JAL towards its own creditors gets secured and becomes realisable from the value of the mortgaged properties whereby, JAL’s liabilities are reduced and JAL gets benefitted in exclusion of creditors of JIL.

It was further contended that the assets in question were released from the earlier mortgages and fresh mortgages were created during the look back period with increased/enhanced amount of facilities as provided under each individual transaction. The said so-called re-mortgage essentially amounts to a fresh mortgage within the relevant time of two years before the date of commencement of CIRP and was not done in the ordinary course of business of JIL and hence, is hit by Section 43 of the IBC.

It was further argued that Section 43 of the IBC ought to be read keeping in mind the intention of the legislature in introducing such provision, which had been to protect the creditors against siphoning away of corporate assets by the management of the company, who have special knowledge of the company’s financial troubles by virtue of its position, and that the true economic effect of the transaction must be put under the scanner.

Ordinary Course of Business:
Further, it was contended that mortgages could not have been made in the “ordinary course of business” of JIL, as it is difficult to fathom why a subsidiary would furnish security to its parent company in the ordinary course and, on the contrary, it is the parent company which at times furnishes security on behalf of its subsidiary since it derives economic value from the subsidiary. Since JIL was itself reeling under financial stress, why it would routinely undertake to secure the indebtedness of JAL by furnishing such high valued securities and that too when the amount of debt secured by way of mortgaging the assets of the corporate debtor increased from INR 3,000 crores to approximately INR 24,000 crores. Even though creation of third party security is a normal practice, the creation of every third party security cannot always deemed to have been done in the ordinary course of business; that such ‘ordinary course’ has to be determined under the circumstances when such transactions were entered into.

Relevant Period/ Lookback Period:
It was contended that the term ‘transaction’ under the IBC includes an agreement or arrangement in writing for the transfer of assets, or funds, goods or services from or to the corporate debtor. The use of the word ‘include’ would signify its natural import and is to be given a wide interpretation.

The respondents, particularly the lenders of JAL stated that the transactions in question are not preferential and do not fall under Section 43 of the IBC and submitted that they, being bankers and financial institutions, are regularly engaged in the business of extending loans and other facilities which form the backbone of economic growth, since Section 43(3)(a) carves out exception for the transactions made in the ordinary course of business. It was stated that taking of such securities, including third party security, is one of the normal and ordinary features of their business and dealings, particularly that of corporate money lending. They stated that if at all such third party securities are avoided on the allegation of being preferential, it is likely to have a devastating effect on the entire economy because the bankers and financial institutions would then be left high and dry and for future dealings, they shall have no alternative but to restrict their activities only to the direct party securities which would, in turn, result in retardation and regression.

A creditor of JAL, Axis Bank, further contended that the land parcels were mortgaged on February 24, 2015, which is beyond even the two years formulation, the relevant time being from August 10, 2015 to August 09, 2017 as the lookback period for related party transactions is two years. The subsequent re-execution of the mortgage deeds on September 15, 2015 and then again on December 29, 2016 cannot be considered a substantive event since the nature and identity of the security remained the same and no fresh encumbrances were created and the same was done merely to reflect the increase in the facilities and members of the consortium.

Standard Chartered Bank, another creditor of JAL, argued in furtherance of the arguments earlier advanced regarding the fact that the transactions were made in the ordinary course of business by pointing out that in the annual reports of JIL the mortgaged properties were disclosed as ‘inventories’ for the corporate debtor being a real estate company; and hence, dealing with the ‘inventories’/‘stock-in-trade’ is in the ordinary course of business. It was also argued that for the purpose of Section 43 of the IBC, the relationship between the respondent-lenders and JIL ought to be looked into rather than assuming JAL to be the primary transferee.

JAL, while pointing out previous transactions such as cash infusions, bank guarantees and pledges of shares by JAL on behalf of JIL demonstrated that transactions between the two entities were in their ordinary course of business and further argued that the mortgage of land in favour of the lenders of JAL was authorised in the manner provided in Section 186 of the Companies Act, 2013.

Issue (ii):
The central question was if the lenders of JAL could be recognised as financial creditors of JIL for the purposes of the IBC. It was pointed out that in the present case, the corporate debtor has created a mortgage of its property in favour of third party without any consideration for time value of money, therefore, the basic ingredient of ‘financial debt’ was not made, since the lenders of JAL having not disbursed any debt against the consideration for the time value of money to JIL, thus, there is no money owed by JIL to the lenders. It was also argued that holding security interest would not automatically make an entity a financial creditor, and that ‘mortgage’ was not covered under the definition of financial debt under the IBC.

The lenders of JAL argued that the nature and character of a ‘mortgage’ is such that it secures a debt; and in the present case, the mortgage in question, as made by JIL, had been to secure the debt obligations of its holding company, JAL. The learned counsel has also referred to an order in the case of SREI Infrastructure Finance Limited v. Sterling International Enterprises Limited, (decided on March 13, 2019), wherein it is held that a third party mortgagor, who mortgages the property to secure the financial obligation of another party, stands in the position of a guarantor; and the mortgagee is a financial creditor of the third party mortgagor. It was further argued that as per the mortgage deeds/loan documents entered into between the parties, JIL had unequivocally promised to pay to the debts/liabilities owed by JAL in accordance with the terms and conditions of the secured financing documents executed.

Observations of the Supreme Court
The Supreme Court first analysed the historical background, objects, scheme and structure of the relevant parts of the IBC, after which it proceeded to address the issues framed by it.

Issue (i):
It was observed that there has been no creditor-debtor relationship between the lender banks and JIL, but that will not be decisive of the question of the ultimate beneficiary of these transactions. The mortgage deeds in question, entered by JIL to secure the debts of JAL, amount to creation of security interest to the benefit of JAL. It was also held that the transactions put JAL in such capacity that it is a related party to JIL and is a creditor as also surety of JIL. In other words, JIL owed antecedent financial debts as also operational debts and other liabilities towards JAL therefore, the requirement of Section 43(2)(a) was met. Further, it was observed that JAL, as an operational creditor would not be given priority in repayment as per the liquidation waterfall provided for in Section 53 of the IBC. Therefore, it was observed that the requirement under Section 43(2)(b) was met. Thus, it was concluded that JIL has given a preference in the manner laid down in Section 43(2) of the IBC.

With regard to the lookback period, it was held that the argument of the respondents that the impugned transactions were not of creation of any new encumbrance by JIL and in fact, most of the properties in question had already been under mortgage with the respective lenders much before the lookback period commenced and that the re-mortgages could not be counted as separate ‘transactions’, cannot be accepted. It was held that so-called remortgage, on all its legal effects and connotations, could only be regarded as a fresh mortgage.

With regard to whether the transactions were made in the ordinary course of business affairs, it was observed that Section 43(a)(3) of the IBC calls for purposive interpretation so as to ensure that the provision operates in sync with the intention of legislature and achieves the avowed objectives therefore, the word ‘or’ should be read as ‘and’, thus, the provision should read as; ‘transfer made in the ordinary course of the business or financial affairs of the corporate debtor and the transferee’.

It was observed that an activity could be regarded as ‘business’ if there is a course of dealings, which are either actually continued or contemplated to be continued with a profit motive. Therefore, even if transferees submit that such transfers had been in the ordinary course of their business, the question would still remain if the transfers were made in the ordinary course of business or financial affairs of JIL so as to fall within the exception provided in the IBC.

The decision of the High Court of Australia in the case of Downs Distributing Company Pty Limited v. Associated Blue Star Stores Pty Limited (in liq.) ((1948) 76 CLR 463) was referred to, where it was held that ordinary course of business would mean: “that the transaction must fall into place as part of the undistinguished common flow of business done, that it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation.”

The Supreme Court therefore, held that even if the transactions in question were entered in the ordinary course of business of bankers and financial institutions like the present respondents but on the given set of facts, there is not an iota of doubt that the impugned transactions do not fall within the ordinary course of business of JIL, which had been promoter as a special purpose vehicle floated by JAL for the purpose of construction and operation of Yamuna Expressway and for development of the parcels of land along with the expressway for residential, commercial and other uses. Therefore, the Supreme Court concluded that providing mortgages to secure the loans of JAL, at the cost of its own financial health could not be construed to be in the ‘ordinary course of business of JIL.

It was further held that since the lenders, as a part of their due diligence are required to study the viability of the enterprise that it is lending to in order to ensure, inter alia, that the security against such loan/advance/facility is genuine and adequate and that the lenders should have assessed if the security provided to them was prudent and viable. It was also observed that since several of the lenders of JIL were also lenders of JAL, they could not plead ignorance about the financial position of either party and should have been aware of the risk involved.

After holding that the transactions were hit by Section 43 of the IBC, the Supreme Court further went on to express how it expected resolution professionals to apply the provisions.

Issue (ii):
Firstly, the determination of Issue (i) was reiterated, and it was held that the security interests created by JIL over the properties in question stand discharged in whole. However, the Supreme Court saw it fit to answer the question raised on basis of the law in order to create a lasting precedent. It was observed that the IBC confers upon financial creditors with a pivotal role in the corporate insolvency resolution process due to the fact that financial creditors are, 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.

The Supreme Court further went on to hold that there was not an iota of doubt that for a debt to become ‘financial debt’ for the purpose of Part II of the IBC, the basic element is that it ought to be a disbursal against the consideration for time value of money and that for a person to be designated as a financial creditor of a corporate debtor, it has to be shown that the corporate debtor owes a financial debt to such person. Understood this way, it becomes clear that a third party to whom the corporate debtor does not owe a financial debt cannot become its financial creditor for the purpose of Part II of the IBC.

It was further observed that 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, apart from looking at safeguards of its own interests, would also simultaneously be interested in rejuvenation, revival and growth of the corporate debtor. Thus understood, it is clear that if the former, that is, a person having only security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have its say in the processes contemplated by Part II of the IBC, the growth and revival of the corporate debtor may be the casualty.

Therefore, it was held that if a corporate debtor has given its property in mortgage to secure the debts of a third party, it may lead to a mortgage debt and, therefore, it may fall within the definition of ‘debt’ under Section 3(10) of the IBC. However, it would remain a debt alone and cannot partake the character of a ‘financial debt’ within the meaning of Section 5(8) of the IBC. Thus, it was concluded that the lenders of JAL, on the strength of the mortgages in question, may fall in the category of secured creditors, but such mortgages being neither towards any loan, facility or advance to the corporate debtor nor towards protecting any facility or security of the corporate debtor, it cannot be said that the corporate debtor owes them any ‘financial debt’ within the meaning of Section 5(8) of the IBC; and hence, such lenders of JAL do not fall in the category of the ‘financial creditors’ of JIL.

Decision of the Supreme Court
The Supreme Court held that the transactions were hit by Section 43 (preferential transactions and relevant time) of the IBC, and the NCLT had correctly passed directions as per Section 44 (orders in case of preferential transactions) of the IBC.

Vaish Associates Advocates View
This landmark judgement of the Supreme Court cleared the air on many issues. Firstly, it was elucidated by the Supreme Court as to what actually was a preferential transaction and further, it laid down the steps that should be taken by a resolution professional in order to determine the same. It clarified the law with regard to the operation of the look back period under the IBC.

However, the status of third party mortgagees has not been clarified except for stating that they will not be reckoned as ‘financial creditors’ which means they would not be a part of the committee of creditors and would not be able to vote on issues. This has essentially created a new class of creditors, namely creditors to other entities such as sister concerns/ subsidiaries/ holding companies.

It was also observed that such lenders should be conducting thorough due diligence and analysis with regard to the entity which is actually providing the security and to determine if the security so provided is prudent and viable. Further, by an extension of the reasoning provided herein, other securities provided on behalf of third parties, which is a common occurrence in India, would not constitute ‘financial debt’ in relation to a corporate debtor.

For more information please write to Mr. Bomi Daruwala at [email protected]

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