Insolvency Law: Pledge Holders Are Not Financial Creditors, Supreme Court Says

In an important judgment, the Supreme Court has held that a beneficiary of pledged shares will not be considered a financial creditor under the Insolvency Code.

A three-judge bench led by Justice Ashok Bhushan observed that a pledge cannot be equated with a guarantee. As such, on receiving a pledge in its favour, a person will only become a secured but not a financial creditor. And so, it cannot form part of the creditor’s committee, the court said.

Sushmita Gandhi, partner at IndusLaw, said the judgment will result in two key changes. First, it may lead to revisions in existing pledge and facility agreements and two, creditors will now be more prudent in sanctioning loans which are backed merely by pledged securities.

Pledge Lacks Attributes of Financial Debt Or Guarantee: Supreme Court

The case relates to a facility agreement of Rs 40 crore between Doshion Ltd. and L&T Infrastructure Finance. The borrower’s subsidiary — Doshion Veolia — pledged its holding in another company as a security against the loan taken by its parent. L&T later assigned its rights as a creditor in favour of Phoenix ARC, which initiated recovery proceedings against the parent entity.

Separately, Doshion Veolia defaulted on its loans which prompted one of its lenders — Bank of Baroda — to initiate insolvency proceedings. The resolution professional refused to classify Phoenix ARC as a financial creditor, which prompted it to move court.

Phoenix ARC argued that any security created by a third party to secure repayment of debt is a guarantee. As such, the ARC became a financial creditor on account of the assignment of pledged shares by L&T in its favour.

Reading into the scheme of IBC and the Indian Contract Act, the apex court dismissed this argument and ruled in favour of the CoC. It found that the pledge agreement between L&T and the borrower did not contain any promise to repay the loan taken by its holding company.

Agreeing with the apex court’s conclusion, Gandhi said the concept of ‘guarantee’ is much wider than ‘pledge’.

The very essence of the ‘guarantee’ and ‘indemnity’ is to step into the shoes of a third party, while a pledge only identifies the right to retain the goods and sell it when there is a default.

Sushmita Gandhi, partner, IndusLaw

Ramakant Rai, partner at Trilegal explained that many existing pledge agreements may not contain a separate guarantee clause.

Explaining the reason behind this, he said that promoters currently are reluctant to extend a separate guarantee against a loan as they want to limit the lender’s recourse only to the extent of pledged shares.

While a lender may want maximum security, competition in the debt market means that a lender may offer more favorable terms to a promoter as compared to others. In such instances, they may do away with the requirement of a guarantee altogether. But lenders still insist on a guarantee where they feel a necessity to do so.

Ramakant Rai, partner, Trilegal

The judgment will also cover transactions which involve mortgage, hypothecation or a charge, Ajay Shaw, partner at DSK Legal, said. Lenders who wish to make a claim as a financial creditor must also ensure that any security is coupled with a guarantee, he said.

This can be achieved through a separate contract of guarantee or by incorporating a clause in the security agreement which qualifies as a guarantee under the Section 128 of the Indian Contract Act, Shaw said.