Deed of Hypothecation as a Guarantee under the Insolvency and Bankruptcy Code: Implications of SC Ruling

The legal landscape of insolvency in India has been significantly shaped by judicial interpretations, particularly concerning the classification of financial instruments under the Insolvency and Bankruptcy Code, 2016 (IBC). A landmark decision in this context is the Supreme Court’s ruling in China Development Bank v. Doha Bank Q.P.S.C., which addressed the pivotal question of whether a Deed of Hypothecation (DoH) can be construed as a guarantee under Section 5(8) of the IBC. This article delves into the intricacies of this judgment and explores its far-reaching implications for creditors and debtors involved in insolvency proceedings.

The dispute originated from financial transactions involving the Reliance Group entities, specifically Reliance Communications (RCom), Reliance Telecom Limited (RTL), and Reliance Infratel Limited (RITL). The appellants, including China Development Bank, had extended financial assistance to RCom and RTL. To secure these loans, RITL executed a Deed of Hypothecation in favor of the appellants, creating a charge over its assets. Notably, RITL was not a direct borrower but provided security for the loans advanced to its associate companies.

During the Corporate Insolvency Resolution Process (CIRP) of RITL, the appellants were recognized as financial creditors by the Resolution Professional. However, this classification was contested by Doha Bank, another financial creditor, which argued that the DoH did not constitute a contract of guarantee and, therefore, the appellants should not be considered financial creditors under the IBC.

The National Company Law Tribunal (NCLT) initially upheld the appellants’ status as financial creditors. Dissatisfied with this decision, Doha Bank appealed to the National Company Law Appellate Tribunal (NCLAT). The NCLAT reversed the NCLT’s ruling, holding that the DoH was merely a security document and did not amount to a guarantee. It emphasized that the DoH’s primary purpose was to create a charge on the charger’s property and that RITL could not be deemed a guarantor in the absence of an explicit guarantee agreement.

Challenging the NCLAT’s decision, the appellants approached the Supreme Court. They contended that the DoH contained clauses that effectively obligated RITL to discharge the debt in case of default by the principal borrowers, thereby constituting a guarantee under Section 126 of the Indian Contract Act, 1872.

Supreme Court’s Analysis and Judgment

The Supreme Court meticulously examined the provisions of the DoH, particularly Clause 5(iii), which stipulated that upon the occurrence of an event of default, the security trustee had the right to enforce the security and apply the proceeds towards the repayment of the secured obligations. Crucially, the clause also provided that if the realized amounts were insufficient to discharge the secured obligations, RITL was liable to pay the shortfall, thereby undertaking to cover any deficiency in repayment.

The Court held that this undertaking by RITL to pay any shortfall amounted to a contract of guarantee as defined under Section 126 of the Indian Contract Act. It reasoned that RITL, by committing to cover the deficiency, assumed the role of a surety, promising to discharge the liability of a third party (RCom and RTL) in case of their default.

Furthermore, the Supreme Court addressed the definition of “financial debt” under Section 5(8) of the IBC, which includes “any counter-indemnity obligation in respect of a guarantee.” The Court clarified that the term “financial debt” encompasses obligations arising from guarantees, even if such guarantees are embedded within other security documents like a DoH. It emphasized that the substance of the transaction should prevail over its form, and the presence of a guarantee obligation within a DoH brings it within the ambit of financial debt under the IBC.

Comparative Analysis with Previous Judicial Precedents

The China Development Bank ruling can be contrasted with the Supreme Court’s earlier decision in Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited (2020). In the Jaypee Infratech case, the Court dealt with the issue of whether a mortgage created by a third-party security provider to secure a borrower’s loan could be treated as a guarantee. The Court concluded that a mortgage created by a third-party security provider to secure a borrower’s loan cannot be treated as a guarantee without a separate deed of guarantee. The Court concluded that a creditor cannot be classified as a financial creditor under the IBC relying only on a mortgage deed—a person who has a security interest over only the assets of a corporate debtor is not a financial creditor of such corporate debtor under the IBC. In contrast, the China Development Bank case involved a DoH that explicitly included a clause obligating the security provider to cover any shortfall in the event of default by the principal borrower. The Supreme Court recognized this obligation as a guarantee, thereby classifying the appellants as financial creditors under the IBC. Hence, the Supreme Court’s Ruling in China Development Bank Creates Further Confusion on Third-Party Securities and creates a necessity for a settled position in this matter.

Implications for Creditors

The Supreme Court’s ruling has profound implications for creditors in insolvency proceedings. By recognizing that a DoH can constitute a guarantee, the Court has broadened the scope of what constitutes financial debt under the IBC. This expansion allows creditors holding security documents with embedded guarantee clauses to assert their status as financial creditors, thereby granting them a significant role in the CIRP, including participation in the Committee of Creditors (CoC) and voting rights. Creditors can now rely on the guarantee obligations within security documents like DoHs to enforce their claims more effectively. In the event of a default, they can pursue the guarantor (even if not a direct borrower) for the shortfall, thereby enhancing their prospects of debt recovery. The judgment encourages creditors to structure their security arrangements thoughtfully, ensuring that guarantee obligations are explicitly incorporated within security documents. This strategic structuring can provide additional layers of security and strengthen the creditors’ position in insolvency proceedings.

Implications for Debtors

For debtors, particularly those providing security for loans advanced to third parties, the ruling carries significant consequences. Entities that offer their assets as security through instruments like DoHs may now find themselves classified as guarantors, thereby exposing them to direct liability for the debts of third parties. This increased liability necessitates careful consideration before extending such guarantees. As guarantors classified as financial creditors, these entities may face claims from other creditors during their own CIRP. The recognition of guarantee obligations as financial debt means that such liabilities will be factored into the resolution process, potentially affecting the outcome for the debtor. Debtors must ensure that the terms of their security documents are clear and unambiguous. If the intention is not to assume the role of a guarantor, this should be explicitly stated to avoid unintended liabilities.

Conclusion

The Supreme Court’s decision in China Development Bank v. Doha Bank Q.P.S.C. marks a watershed moment in the interpretation of financial instruments under the IBC. By holding that a Deed of Hypothecation can amount to a guarantee, the Court has underscored the importance of the substantive obligations contained within security documents over their formal titles. This ruling not only broadens the definition of financial debt but also reshapes the dynamics between creditors and debtors in insolvency proceedings. Creditors are now better positioned to enforce their claims, while debtors must exercise heightened diligence in their contractual engagements to manage potential liabilities effectively.