Background

On February 26, 2020, the Hon’ble Supreme Court delivered its judgment in the Jaypee matter, bringing to a close the long drawn litigation between two sets of competing creditor claims i.e. those advanced by certain creditors of Jaypee Infratech Limited (JIL) and those of its holding company, Jaiprakash Associates Limited (JAL).

In its ruling, the Supreme Court addressed two key issues:

(i) Whether the mortgage created by JIL (the JIL Mortgage) for the benefit of lenders of JAL (its holding company) (the JAL Lenders) constitutes a preferential transaction under Section 43 of the Insolvency and Bankruptcy Code, 2016 (IBC); and

(ii) Whether the JAL Lenders (in their capacity as mortgagees) could be considered as `financial creditors’ of JIL.

The dispute has its genesis in the insolvency of JIL[1],  where Mr Anuj Jain (the resolution professional of JIL) had filed an application before the National Company Law Tribunal (NCLT), Allahabad Bench seeking to set aside the JIL Mortgage on the basis that it constituted a (i) preferential transaction, (ii) an undervalued transaction as well as (iii) a fraudulent transfer, under the relevant provisions of the IBC[2].  While the NCLT agreed with these contentions[3], it was overruled by the appellate forum (NCLAT)[4], leading to the appeals which were finally decided by the Supreme Court.

In this note, we have analysed:

• Why the Supreme Court considered the JIL Mortgages to be preferential transactions;
• The court’s views on third party security not qualifying as `financial debt’ of the corporate debtor (which creates such third-party security); and
• The implications of the ruling – both in the context of ongoing insolvency proceedings as well as evaluation of new financing structures and proposals.

Why was the JIL Mortgage considered to be preferential?

At the outset, the Supreme Court has reaffirmed that Section 43 (which deals with preferential transactions) should be construed strictly[5] and that an “intent to prefer” or the “element of fraud” is irrelevant for the purposes of such an analysis[6]. Before dealing with the facts specific to the JIL Mortgage, the Supreme Court has also helpfully set out the key ingredients[7] for a transaction to be considered preferential under Section 43, namely:

1. there should have been a transfer of an asset (or an interest in such asset) of the corporate debtor to a creditor, guarantor or surety of that corporate debtor;
2. the transfer should have been for, or on account of, an ‘antecedent’ (or existing) debt or liability owed by the corporate debtor;
3. the transfer should have the effect of improving the position of the transferee (i.e. the relevant creditor, guarantor or surety) than it otherwise would have been, in a distribution of the assets of the corporate debtor under Section 53 of the IBC (the Disproportionate Recovery Rule);
4. the transfer should have occurred within the relevant ‘look-back’ period i.e. two years for a transaction with a related party[8] and one year for an un-related party; and
5. the transaction should not otherwise be exempt under Section 43(3) (the Excluded Transfers).

After considering the facts specific to this case, the Supreme Court held the JIL Mortgage to be a preferential transaction on account of the following[9]:

• the JIL Mortgage benefitted JAL, by allowing it to raise debt from the JAL Lenders
• since JAL was an existing creditor of JIL[10], such benefit to JAL was in respect of ‘antecedent debt’ owed by JIL to JAL;
• the creation of the JIL Mortgage deprived the creditors of JIL from accessing the mortgaged assets and had the effect of reducing their recovery under a Section 53 distribution of JIL’s assets;
• since the benefit (of the JIL Mortgage) flowed to JAL, a related party of JIL, the relevant back period for the JIL Mortgages was considered to be two years preceding the commencement of JIL’s insolvency; and
• the creation of the JIL Mortgage was not in JIL’s ordinary course of business (and hence was not an Excluded Transaction) given that JIL was a ‘special purpose vehicle’ established by JAL only for the purpose of the construction and operation of the Yamuna Expressway[11].

While the Supreme Court has correctly identified the elements of what constitutes a preferential transaction under Section 43 (which, in its own words is required to be construed strictly), in our view, the court has not correctly assessed if JIL Mortgage met all the requirements of a preferential transaction.  For instance:

• while it was held that JAL received a benefit on account of the JIL Mortgage (by allowing JAL to raise debt from its lenders), the court has not (in our respectful submission) sufficiently addressed how this falls foul of Disproportionate Recovery Rule i.e. how JAL’s position in a Section 53 distribution of JIL was improved on account of the JIL Mortgage (given that the JIL Mortgage did not secure any antecedent debts owed by JIL to JAL). Rather, the court seems to have arrived at its conclusion on the basis that (because of the JIL Mortgage) the position of other creditors of JIL was adversely impacted which in turn benefitted JAL (and its lenders);
• the court also seems to have been convinced that amounts owed by JIL (to JAL) coupled with the benefit (to JAL on account) of the JIL Mortgage is sufficient to constitute a transfer of interest to JAL for JIL’s ‘antecedent debt’ owed to JAL. Even though the JIL Mortgage did not secure the existing debt owed (by JIL) to JAL, the existence of such debt by itself seems to have been sufficient for the court to come to the conclusion that the JIL Mortgage was created for such existing/ antecedent debt[12] of JIL; and
• despite the fact that the mortgagees in this case were the JAL Lenders, the court was of the view that since the JIL Mortgage constituted a benefit for JAL (its related party), the relevant `look-back’ period in this case should be two years. In effect, the court has held that in case of third-party security interest, while the beneficiary of the security may be the relevant lender, the actual transfer of interest is to the third-party borrower on whose behalf such third party security is created.  Again, this seems to be an expansive interpretation of Section 43(a) of the IBC, which is not supported by the wording of the clause.

Widening the scope of `ordinary course of business’

One of the key issues before the court was whether to consider JIL Mortgage as an Excluded Transaction on account of it being in the ordinary course of business of the transferee[13] (in this case, the JAL Lenders) or a transaction that have taken place even in the ordinary course of business of JIL. While the court has correctly held that the remit of Section 43(a) of the IBC is principally directed towards the corporate debtor’s dealings[14], the Supreme Court came to the conclusion that a transfer (of assets or interest in assets of the corporate debtor) can only be said to fall under Section 43(a) if it is in the ordinary course of business of both the corporate debtor and the transferee (and not either one of them, as the wording contemplates).

Keeping in mind the spirit of the proposed exclusion (which has been correctly interpreted by the court), the better view would have been for the court to hold that for a transfer to be exempt under Section 43(a), it should at least be in the ordinary course of the corporate debtor (instead of also requiring it to be that of the transferee).  As a practical matter, since the initial determination of applicability of this exemption has to be done by the resolution professional, it remains to be seen how he determines what is in the ordinary course of business of a third party (i.e. the transferee).

Re-mortgage is a separate transaction

The JAL Lenders also took the stand that the mortgages in question were created prior to even the two-year look-back[15] and should, therefore, be outside the scope of Section 43.  This was on the basis that the mortgages (some of which were created as far back as 2012) were released and the assets subsequently re-mortaged by JIL to secure additional facilities and, therefore, should not be considered as “new” transactions entered into by JIL.

The court has technically concluded that such re-mortgages are “separate” mortgages (or transactions) for the purposes of Section 43 in so far as each such mortgage (created subsequently) had the effect of securing additional or increased credit facilities.

While the ruling in this case was limited to the facts where the mortgaged assets in question were released and subsequently re-mortgaged, the analysis is also capable of applying where the security interest over the relevant asset is not released but extended (for instance, mortgage by way of constructive delivery) to secure additional debt and each such transaction will be a separate transfer, for the purposes of an evaluation under Section 43 of the IBC.

Third party security is not `financial debt’

 After setting aside the JIL Mortgage on the basis that it constituted a preferential transaction, the Supreme Court went on to consider whether the JAL Lenders (in their capacity as mortgagees) could be treated as ‘financial creditors’ of JIL.  On this issue, the JAL Lenders advanced amongst others, the following propositions:

• that under Indian law, a mortgagor assumes the obligation to repay the ‘mortgaged debt’ and that such mortgage obligations are similar to a guarantee under Section 126 of the Indian Contract Act, 1872;
• that there were contractual repayment obligations under the relevant mortgage documents, which contemplated JIL unequivocally promising to pay the relevant JAL Lender the amounts owed by JAL (to that lender) in accordance with the terms of the relevant financing documents,

Each of which, they contended were sufficient to qualify them as ‘financial creditors’ of JIL.

However, having considered these (as well as the earlier rulings of the court in Swiss Ribbon, Essar, and Pioneer Urban), the Supreme Court (in our respectful view, incorrectly) held the JAL Lenders – in their capacity as mortgagees – could not be considered as financial creditors of JIL.  The court based its finding on a very narrow interpretation of financial debt as set out in Section 5(8) of the IBC based on which, it concluded that for a debt to be considered as ‘financial debt’, it should represent disbursement of certain amounts to the corporate debtor (against the consideration of time value of money) or at the very least, fall within one of components of financial debt set out under Section 5(8)[16].  The court has also held that while the JIL Mortgage may well constitute ‘mortgage debt’, it would not qualify as a ‘financial deb’ owed by it to the JAL Lenders[17].   This is also borne out by the observations of the court that Section 5(8) – which deals with the definition of ‘financial debt’ – does not include the term ‘mortgage’[18].

In what seems to be a circular inference, the court also concluded that since a “third party security beneficiary” does not “lend” any money to the corporate debtor (in this case, JIL), it could not be considered as being interested in the rejuvenation, revival or growth of the corporate debtor[19], which is the domain of a ‘financial creditor’ and therefore, while JAL Lenders can be considered as ‘secured creditors’ of JIL, they cannot be treated as its financial creditors[20].

Implications of the ruling

As things stand, the ruling of the Supreme Court in this matter is likely to have significant and far reaching implications – both in the context of ongoing and future insolvency proceedings as well as how financing transactions in the Indian market are structured and evaluated by the creditor community.  We have briefly dealt with both aspects below.

Impact on insolvency proceedings

• Re-evaluation of third-party security transactions: Given the reasoning of the court while invalidating the JIL Mortgage, it is likely that resolution professionals, in ongoing insolvency proceedings (with third party security) will re-assess whether the NCLT should be approached under Section 43.  It is also pertinent to note that the Supreme Court did not explain whether the JIL Mortgage was also avoidable under Sections 44 or 66 of the IBC and has kept those questions of law open[21] – thereby also leaving the window open for resolution professionals to consider whether third party security transactions ought to be considered in light of these provisions (in addition to Section 43).
• Recomposition of CoC: At the very least, this will lead to a recomposition of the committee of creditors (each, a CoC) and reclassification of the third party security beneficiaries as ‘other creditors’ of the relevant corporate debtor, resulting in a reduction in the ‘financial debt’ of the CoC and a lower (financial debt) threshold for approval by the CoC.
• Treatment of ‘third-party security’ in resolution plans: The immediate question, which is likely to come up, is whether a resolution plan can contemplate vacation of such third-party security interest. In our view, a resolution plan is unlikely to withstand judicial scrutiny if the beneficiaries of such third party security are not treated equally with other ‘secured’ financial creditors of the corporate debtor – given the court’s earlier ruling in the Essar case, which clearly recognises that “equitable treatment is to be accorded to each creditor depending upon the class to which it belongs: secured or unsecured, financial or operational”[22].

However, in cases where the ‘liquidation value’ of the third party security is higher than the payment to other ‘secured financial creditors’, it can be argued that since this value would be available  through liquidation of the corporate debtor, depriving them of the higher liquidation value in a resolution plan only on account of the third party security beneficiaries not being able to vote on a resolution plan (or not being categorised as ‘dissenting financial creditors’) is discriminatory.

 Considerations for new financings and debt restructuring

 In addition to its findings on the two key issues, this ruling of the court is also instructive in that it sheds light on how the court has considered the role and obligations of lenders while evaluating financing proposals.  Some of the key takeaways are as follows:

• In particular, to mitigate against the position that third party security by itself does not constitute financial debt (of the third party security provider) and given the weightage which the court has given to the scope of financial debt as defined under Section 5(8) of the IBC, it would be preferable for such lenders to also insist on the corporate debtor issuing a corporate guarantee such that the obligations of the corporate debtor (in respect of such a guarantee) can also be secured by its assets. It should, however, be borne in mind that issuance of such a guarantee (along with the security) will not by itself, mitigate against or rule out the possibility of such a transaction being challenged as either preferential, undervalued or a fraudulent transfer, which will in each case, be fact specific and depend on the circumstances surrounding the transaction.

The default by JIL  and its account being classified as a ‘non-performing asset’ have been considered as material factors by the court in this case. This also lends context to the court’s observations[23] of lenders (who accept third party security) having to undertake due diligence to assure themselves  that the corporate debtor (providing such security) is not already in (or facing imminent) default.  In the context of the JIL Mortgage, in fact, the court has observed that the JAL Lenders (being fully aware of JIL’s default at the time of creation of the JIL Mortgage) chose to accept the risk of it being set aside.

• These observations are relevant for not only new financing transactions but also in the context of restructuring of existing debt – where it is common for a defaulting borrower to offer new or additional security over its assets to some of its lenders. While evaluating such proposals, lenders should be mindful that as part of debt restructuring (pre-insolvency), a bilateral transaction which has the effect of either (a) elevating that creditor from an unsecured status to that of a secured creditor; or (b) including the provision of additional security (which was previously unavailable to it), especially without the consent of the other competing creditors, may be vulnerable to being challenged if the borrower enters insolvency within a period of at least one year of such a restructuring.

Conclusion

This ruling has given rise to some key aspects for stakeholders to consider.  Key amongst these are:

• how resolution professionals and the ‘adjudication authority’ apply the provisions of Section 43 of the IBC to evaluate preferential transactions (including for third party security) and in particular, how they consider the Disproportionate Recovery Rule (which, in our view, was not met in the context of the JIL Mortgage);
• a CoC will exclude certain secured creditors (i.e. the third party secured creditors) and accordingly a smaller number of financial creditors will be in control of corporate insolvency processes. However, if distribution of proceeds to such third party secured creditors is linked to their liquidation value or is not otherwise discriminatory, this may, in fact, result in faster resolution processes with smaller creditors’ committees (both in terms of number of members as well as financial debt); and
• increased diligence and assessment by lenders while evaluating financing proposals – in particular, structured financing proposals which involve collaterals being provided by group companies (of the borrower) or involve other forms of cross-collateralisation.

[1]               Which is currently undergoing its second insolvency process under the IBC

[2]               Under Sections 43, 45 and 66 of the IBC respectively

[3]               Vide order dated 16 May 2018

[4]               Vide common order dated 01 August 2018

[5]               Paragraph 18 of the order

[6]               Paragraph 17.4 of the order

[7]               Paragraph 20 of the order

[8]               As defined under Section 5(24) of the IBC

[9]               See paragraphs 22 to 25 of the order

[10]             JIL owed both financial as well as operational debt to JAL (as recorded in paragraph 22.2.2 of the order)

[11]             See paragraphs 25.6 and 25.7 of the order

[12]             See paragraph 22.2 of the order

[13]             Section 43(a) of the IBC

[14]             See paragraph 25.2.1 of the order

[15]             See paragraph 24 of the order

[16]             See paragraph 43 of the order

[17]             See paragraph 47.1 of the order

[18]             See paragraph 51 of the order

[19]             See paragraph 47.1 of the order

[20]             See paragraph 54 of the order

[21]             Though helpfully observing that the ingredients of each of these provisions are separate and must be dealt with on merits, with reference to requirements specific to those provisions

[22]             See paragraph 57 of the Essar order

[23]             See paragraph 26 of the order