The Supreme Court on 26th February 2020 in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Etc.Etc. 1 has decided on two main issues relating to third party security which have entirely revamped lending transactions, as security from third parties was a fairly typical manner of securing dues, until the NCLT judgments in May 2018.

Facts:

  1. Jaiprakash Associates Limited ("JAL") is a Public Listed Company and Jaypee Infratech Limited ("JIL") is its subsidiary.
  2. JAL obtained finance from a consortium of banks and financial institutions, ICICI Bank Limited, Standard Chartered Bank Limited and State Bank of India ("JAL Lenders"), the security of which inter alia comprised of mortgage created by JIL of certain lands held by it.
  3. IDBI Bank Limited, a creditor of JIL, instituted a petition under Section 7 of the Insolvency and Bankruptcy Code, 2016 ("Code") before the National Company Law Tribunal, Allahabad Bench ("NCLT") for seeking initiation of CIRP against JIL while alleging that JIL had committed a default in repayment of its dues to the tune of 526.11 crores.
  4. NCLT initiated CIRP against JIL on 9th August 2017.
  5. The NCLT on 9th May 2018 and 15th May 2018 approved the decision of the IRP of JIL rejecting the claims of the JAL Lenders to be recognized as financial creditors of the Corporate Debtor JIL on the strength of the mortgages created by Corporate Debtor JIL as collateral security of the debt of its holding company JAL.
  6. Further, the NCLT on 16th May 2018 held certain transactions by which the Corporate Debtor JIL had mortgaged its properties as collateral securities for loans and advances made by the JAL Lenders, as being preferential, undervalued and fraudulent under Section 43, 45 and 66 of the Code.
  7. The National Company Law Appellate Tribunal, New Delhi ("NCLAT") on 1st August 2019 by a common order set aside the NCLT order dated 16th May 2018 and also allowed the appeals by the Lenders of JAL to be financial creditors of Corporate Debtor JIL. However, the entire NCLAT judgement had only been in relation to the order dated 16th May 2018 passed by NCLT on the application for avoidance filed by the IRP and no reasons were given for reversing the NCLT judgments of 9th May 2018 and 15th May 2018.
  8. The appeals from the NCLAT judgement dated 1st August 2019 are addressed by the present Supreme Court judgment.

Major Issues Involved:

  1. Whether the mortgage transactions in question deserve to be avoided as being preferential, undervalued and fraudulent under Section 43, 45 and 66 of the Code?
  2. Could the JAL Lenders be recognized as financial creditors of the Corporate Debtor JIL on the strength of the mortgage created by the Corporate Debtor, as collateral security of the debt of its holding company JAL?

In this article, we examine the judgment only in relation to the issue of the third-party mortgages being preferential, undervalued and fraudulent under Section 43, 45 and 66 of the Code.

Judgment:

The Supreme Court has carefully analysed each provision of Section 43 to see whether the mortgage transactions by JIL in favour of the JAL Lenders is preferential and has identified five key requirements which need to be satisfied for a transaction to fall within its ambit.

  1. Whether such transfer is for the benefit of a creditor or a surety or a guarantor?
  1. In the present case the Supreme Court held that the creditor-debtor relationship between the banks and the corporate debtor (i.e. the parties to the transaction in question) will not be decisive of the question of ultimate beneficiary.
  2. The Court further held that as JIL owed operational debts towards JAL, JAL was an operational creditor of JIL.
  3. It was further held that the nature of mortgage created by JIL in favour of the JAL Lenders, made JAL the ultimate beneficiary as it was able to raise finance based on such mortgage.
  4. Thus, the transactions in question were made for the benefit of a creditor as the creditor was the ultimate beneficiary despite not being a party to the transaction sought to be set aside.
  1. As to whether such transfer is for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor?

In light of the facts of the matter, the Court held that corporate debtor JIL owed antecedent financial debts as also operational debts and other liabilities towards JAL.

  1. As to whether such transfer has the effect of putting such creditor or surety or guarantor in a beneficial position than it would have been in the event of distribution of assets being made in accordance with Section 53?

The Court held that JAL was obviously put in an advantageous position vis-à-vis other creditors because of the receipt of huge amount of loans by way of facilities and by way of the abovementioned transaction JAL's liability towards its creditors has been reduced in so far as the mortgaged properties is concerned. In light of these facts JAL stands clearly benefited by way of distribution of assets being made in accordance with manner other than laid down in Section 53, at the cost of exclusion of other creditors and stakeholders of corporate debtor JIL.

  1. If such transfer had been for the benefit of a related party (other than an employee), as to whether the same was made during the period of two years preceding the insolvency commencement date; and if such transfer had been for the benefit of an unrelated party, as to whether the same was made during the period of one year preceding the insolvency commencement date?

Coming to the look-back period and contention of Section 43 and 44 having only prospective effect, the bench was of the view that both the sections came into operation as the comprehensive scheme of corporate insolvency resolution and liquidation from the date of being effective, and merely because the look-back period is envisaged for the purpose of relevant time, it cannot be said that the provision itself is retrospective in operation. Further, the contentions urged on behalf of the respondents would result in postponing the effective date of operation Section 43(4) for a period of 2 years in case of related parties and one year in the case of unrelated party, and thereby, effectively postponing the application of entire Section 43 for a period of two years which was never the intention of legislature and thus such contentions were rejected.

Thus, the look-back period is 2 years preceding the insolvency commencement date i.e. 9th August 2017. Therefore, transactions commencing from 10th August 2015 until date of insolvency shall fall under the scanner. The flow of mortgages provided by corporate debtor JIL are as follows:

  • In relation to the first and second transaction in question, the initial mortgage deed dated 24th February 2015 for the mortgage in favour of some of the JAL Lenders, was released and re-mortgaged on 15th September 2015 as well as on 29th December 2016, changing the facility amount from 3250 Crores to 24109 Crores and from 24109 Crores to 23491 Crores respectively.
  • In relation to the third transaction, the initial mortgage deed dated 12th May 2014 in favour of ICICI Bank Limited was released in three transactions vide release deeds dated 30th December 2015, 24th June 2016 and 7th March 2017 and thereafter was subsequently re-mortgaged on 7th March 2017.
  • In relation to the fourth transaction, the initial mortgage deed dated 12th May 2014 in favour of ICICI Bank Limited was released and re-mortgaged on 7th March 2017.
  • In relation to the fifth transaction, the initial mortgage deed dated 24th June 2009 in favour of Standard Chartered Bank Limited was extended to secure the increased facility amount from 900 Crores to 1300 Crores by mortgage deed dated 27th November 2012. Further additional land was added to increase the facility amount from 1300 Crores to 1750 Crores by mortgage deed dated 23rd March 2013. Subsequently the mortgage deed dated 23rd March 2013 was released on 4th November 2015 and re-mortgaged on 24th May 2016.
  • In relation to the sixth transaction, mortgage deed dated 4th March 2016 was entered in favour of State Bank of India.

In relation to the "re-mortgages", the bench was of the view that on release by the mortgagee the mortgage ceases to exist and thus in all its legal effects and connotations such mortgages can only be regarded as fresh mortgages. Further, these "re-mortgages" were also made in some cases to secure an increased facility amount in some transactions, thereby extending unwarranted advantage to JAL at the cost of the estate of corporate debtor JIL. Thus, all the six transactions identified by the IRP fell within the look back period.

  1. As to whether such transfer is not an excluded transaction in terms of sub-section (3) of Section 43?

Section 43(3) of the Code excludes certain transactions which would otherwise be considered preferential transactions. These exclusions are as follows:

(a) transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee;

(b) any transfer creating a security interest in property acquired by the corporate debtor to the extent that –

  1. such security interest secures new value and was given at the time of or after the signing of a security agreement that contains a description of such property as security interest, and was used by corporate debtor to acquire such property; and
  2. such transfer was registered with an information utility on or before thirty days after the corporate debtor receives possession of such property:

Provided that any transfer made in pursuance of the order of a court shall not, preclude such transfer to be deemed as giving of preference by the corporate debtor.

On the point of ordinary course of business, the JAL Lenders forcefully argued that they being the transferees executed the transactions in the ordinary course of business of providing financial support with loans and advances and therefore these transactions should not be considered preferential under Section 43(2). The Bench however accepted the contention of the IRP that the use of the word 'or' in Section 43(3) is required to be read as 'and' so as to be conjunctive and covering only the transactions in the ordinary course of business or financial affairs of both the corporate debtor and the transferee.

Further, the whole of conspectus of sub-section (3) is that only if any transfer is found to have been made by the corporate debtor, either in the ordinary course of its business or financial affairs or in the process of acquiring any enhancement in its value or worth, that might be considered as having been done without any tinge of favour to any person in preference to others and thus, might stand excluded from the purview of being preferential, subject to fulfilment of other requirements of sub-section (3) of Section 43. If the transfers are examined with reference to ordinary course of business of transferee alone, all such transactions may conveniently get excluded from the rigour of Section 43(2), which was never the intention of the legislature.

The Supreme Court agreed that the ordinary course of business or financial affairs of the corporate debtor JIL cannot be that of providing mortgages to secure loans and facilities obtained by its holding company, that too at the cost of its own financial health and thus the transactions were neither in the ordinary course of business or financial affairs of corporate debtor JIL nor did they secure new value in the property acquired by corporate debtor JIL and hence are not excluded transactions under Section 43(3).

The Supreme Court thus noted that all the requirements of Section 43 were satisfied in the present case and the transactions were hit by Section 43 and the IRP was correct in issuing directions for release and discharge of the mortgages under Section 44.

The Supreme Court did not elaborate on whether the transactions were also undervalued and fraudulent as they had already been decided as preferential and their avoidance was approved. However, the Supreme Court noted that in the present case the NCLT recorded combined findings on the transactions being preferential, undervalued and fraudulent without making requisite enquiries to find out whether the transactions were indeed undervalued or fraudulent. The Bench therefore remarked that in the future it would be appropriate to deal with each question and issue separately and distinctly as the scope of enquiry to determine whether a transaction is undervalued is entirely different from determining whether it is fraudulent and/or preferential.

The Bench has further laid down a checklist to be followed by a resolution professional in order to identify and avoid preferential transactions under Section 43 of the Code. Thus, a transaction involving security provided by a third party does not automatically fall under the category of "preferential transaction" and these steps are required to be performed by the resolution professional to determine whether such transaction falls within the ambit of Section 43:

a) Organizing all the transactions backwards from the date of commencement of insolvency to the preceding two years and identify the person involved and categorize them as related parties and others;

b) Bifurcate the identified transactions into two sub-sets and the transactions involving non-related parties are to be further trimmed to include transaction of the preceding one year from the date of commencement of insolvency;

c) Examine the sub-sets to find (i) as to whether the transaction is of transfer of property or an interest thereof of the corporate debtor; and (ii) whether the beneficiary involved in the transaction stands in the capacity of creditor or surety or guarantor qua the corporate debtor. This would lead to shortlisting those transaction which seem to be preferential;

d) Scrutinize the transaction to find if the transfer is made on account of antecedent financial or operational debt or other liability owed by corporate debtor;

e) Scrutinize whether the transfer in question has the effect of putting such creditor, guarantor or surety in a beneficial position than it would have been in the event of distribution of assets as per Section 53 of the Code; if affirmative the transaction is a preferential transaction entered into in relevant time;

f) The last filtration is to make the transaction pass through clauses (a) and (b) of Section 43(3);

g) After the analysis, the IRP is required to apply to the Adjudicating Authority for necessary transactions that had passed through all the positive tests of sub-section (2) and (4) and also the negative test under sub-section (3).

While rejecting the argument that this judgment would have far reaching ramifications across the financing sector, as a large number of transactions become liable to be set aside as preferential, the Supreme Court has noted that bankers or financial institutions are supposed to, and they indeed, take up 'due diligence' so as to study inter alia, that the security against their loan/advance/facility is genuine and adequate. If they are at all entering into a transaction whereby a third party security, including that of a subsidiary company, is to be taken as collateral, they are obliged to undertake further due diligence so as to ensure that such third party security is a prudent and viable one and is not likely to be hit by any law. In that sequence, they remain under obligation to assure themselves that such third party whose security is being taken, is not already indebted or in red and is not likely to fail in dealing with its own indebtedness. In the context of IBC, such requirement is moreover imperative on a bare look at the provisions contained in Part II thereof. To conclude, if despite the knowledge that the security provider is itself in a precarious financial position, the lenders choose to take the business risk of accepting security from such third party and that too, for securing the loans/advances/facilities of a related party, they themselves remain responsible for present legal consequences.

Footnotes

1 Civil Appeal Nos. 8512-8527 of 2019

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