Supreme Court’s Jaypee Ruling Casts A Shadow Over Mortgage Transactions
More than 16 lenders, including State Bank of India, Axis Bank Ltd. and ICICI Bank Ltd., that were hoping to recover their dues via Jaypee Infratech Ltd.’s insolvency resolution suffered a setback as a result of the recent Supreme Court ruling. Not only have their loan transactions to parent Jaiprakash Associates Ltd. backed by the subsidiary’s properties, been set aside, they won’t even get a seat at the committee of creditors’ table. This will benefit Jaypee Infratech’s creditors and homebuyers, experts said.
The outcome is a result of two findings by the apex court:
- First, Jaypee Infratech’s 858 acres of land that was used by it as collateral to secure the debt of its parent—Jaiprakash Associates—was a preferential transaction and has to be reversed.
- Two, a lender with a secured interest over the insolvent company’s assets would be considered only a secured creditor, and not a financial creditor. In saying so, the Supreme Court has drawn an interesting distinction between the two categories of creditors.
The second finding is worrisome, experts told BloombergQuint, adding that the logic apex court has used to deny financial creditor status to mortgage lenders can even be extended to guarantees.
Secured Vs Financial Creditors: Supreme Court Draws A Distinction
The apex court concluded that mortgaging Jaypee Infratech’s properties to secure loans given to parent Jaiprakash Associates was a preferential transaction. The natural outcome of it was lenders, who granted the loans on the back of these properties, would no longer be creditors of JIL. The order could’ve ended here but for the benefit of future cases where a transaction may not be set aside, the apex court decided to examine whether JAL’s lenders, because of creation of the mortgages, could be treated as financial creditors of JIL.
It pointed out that for a debt to become financial debt under the insolvency law, there must be a disbursal to the insolvent company. And for an entity to be categorised as a financial creditor of the insolvent company, it has to be shown that it owes a financial debt to such entity.
In this case, the debts in question are in the form of a third-party security. And so, a corporate debtor which has given its property in mortgage to secure the debts of a third party will lead to a mortgage debt. It will qualify as debt but will not take the colour of financial debt, the apex court has said.
Drawing a distinction, the Supreme Court said a secured creditor’s interest is only in realising the value of the security, while a financial creditor would also be interested in the revival of the insolvent company.
“Every secured creditor would be a creditor; and every financial creditor would also be a creditor, but every secured creditor may not be a financial creditor.”—Supreme Court Order
The apex court has pointed out that the lenders should have done diligence on JIL— they would’ve realised it may go into insolvency and the transaction might get hit by the avoidance provisions, Pooja Mahajan, managing partner, Chandhiok & Mahajan, said. But when these transactions were done, the lenders couldn’t have anticipated the insolvency law provisions. “In that sense, the outcome is unfair,” she added.
As a result of this ruling, lenders will actively check the insolvency implications in a mortgage transaction. They will look at the solvency of the entity whose security is being offered as collateral.Pooja Mahajan, Managing Partner, Chandhiok & Mahajan
The biggest beneficiaries of this ruling are JIL’s creditors and homebuyers, Mahajan pointed out.
Fate Of Mortgage Transactions And Guarantees
Lenders didn’t enter into the mortgage transactions to either extend a loan or security to JIL, or towards protecting any of its security—so the amounts won’t qualify as financial debt vis-à-vis JIL, and the lenders won’t qualify as financial creditors, the apex court has said.
A third-party mortgage becomes of limited value under IBC because its effect has been diluted, Piyush Mishra, partner at AZB & Partners, told BloombergQuint. But when viewed from the lens of credit hierarchy at the liquidation stage, lenders who have loaned on the basis of mortgage may still fare better than those who have taken guarantees.
He explained mortgage typically include a covenant to pay - the mortgager assumes the liability to pay the underlying mortgage debt. In a third party mortgage transaction, the lender will still qualify as secured creditor but a guarantee doesn’t even have that advantage.
As the apex court is making disbursal to the insolvent company a touchstone of financial debt, arguably guaranteed third party debt may not qualify as financial debt in the Insolvency of surety. Further such lender may get subordinated to ‘remaining debts’ in liquidation waterfall below statutory dues.Piyush Mishra, Partner, AZB & Partners
Mishra caveated this view and added that guarantee by nature is third party debt and is expressly covered in the definition of financial debt. Since the court does not deal with this issue directly and so arguably, guarantees can be distinguished; otherwise it will have a significant impact on financing, he added.
To avoid this interpretation issue, the apex court should’ve clarified that mortgages which come with a covenant to pay qualify as financial debt. And others, like deposit of title deeds, etc. which don’t come with the liability to pay, don’t, Mahajan said.
There are mortgages that get created where the lender has a security interest only in the property, but they can’t sue the insolvent company for payment of any remaining account. The apex court should’ve clarified that only where the corporate debtor doesn’t have the liability to pay, it won’t qualify as financial debt.Pooja Mahajan, Managing Partner, Chandhiok & Mahajan
While the fate of guarantees will need clarity, in ongoing cases where mortgage lenders have been included in creditors’ committee, they could be removed, Mahajan said.