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  • Shruti Sethi

The Third Party Security Conundrum Under IBC: Whether ‘Financial’ or Just ‘Secured

– Shruti Sethi†


Creation of security interest to secure the amounts advanced by a lender to the borrower forms an essential element of any financing transaction and in most cases, constitutes a pre-requisite for advancing debt. It has been argued by Mr. Andrew Keay that security permits credit to be obtained by a borrower and had it not been for the right to take security (and the concomitant benefits in a subsequent insolvency proceeding which the security gives) the creditor would not have granted the credit.

Gerard McCormack in his book ‘Secured Credit under English and American Law’ states that taking of security is essential for lenders because it: (a) maximizes the prospects of recovery in the event of debtor’s insolvency; (b) permits the lenders to take control of the borrower by taking control over the assets secured in favour of the lender; (c) permits the sale of the secured assets without judicial or official intervention; and (d) prevents the need for detailed financial diligence. He mentions that when a company declines into insolvency there is, by definition, insufficient money in the corporate kitty to satisfy everybody and the basic principle of insolvency law is one of ‘equality of misery’ or equality of treatment of creditors, i.e. pari passu distribution of available assets amongst creditors.

Security interest becomes relevant only in case of a default because in the best case scenario the question of recognition and enforcement (of security interest) would not arise. One may argue that a security interest which (a) is not recognized during insolvency proceedings, or (b) does not permit the beneficiary of such security interest to take control of the asset over which security interest has been created, is of no value.

Regarding security interest created by a third party (i.e., an entity other than the borrower like a group company, subsidiary or parent of the borrower) (“Security Provider”) for securing the debt advanced by a lender to the borrower, there seem to be strong arguments suggesting that recognition of the security interest in favour of a lender is of paramount importance for the lender agreeing to advance the loan to the borrower. And non-recognition of such security interest may cause an economic disincentive for international investors and potential lenders which may also cause them to refuse loans to debtors.


The insolvency process for companies and limited liability partnerships (“Corporate Persons”) in India is governed by the IBC. The IBC classifies creditors as financial creditors and operational creditors. Creditors that extend “debt along with interest, if any, disbursed against the consideration for the time value of money” are classified as financial creditors and include, inter alia, banks, bondholders, lessors of financial leases and beneficiaries of guarantees in relation to such debts.[1] Creditors that are owed a debt in respect of the provision of goods and services are classified as operational creditors and include, inter alia, employees, workmen and trade creditors. Dues to the Central Government and the State Government including for unpaid tax dues are also classified as operational debt.

During the insolvency process, categorization of a creditor as a ‘financial creditor’ of the Corporate Person under insolvency (“Corporate Debtor”) is essential because all important decisions for the Corporate Debtor like – (i) extending the insolvency resolution period; (ii) replacing the resolution professional; (iii) approving a resolution plan; (iv) raising interim finance (i.e. debt financing availed by the corporate debtor after the insolvency commencement date); and (v) initiating the liquidation process etc. are driven by the financial creditors (who constitute the committee of creditors (“CoC”)) holding 66% of the financial debt of the corporate debtor. Given the above, non-categorization of a creditor as a ‘financial creditor’ would directly impair its ability to participate in the resolution process of the Corporate Debtor and would most likely, also diminish its recovery.

An application for commencement of insolvency process of a Corporate Debtor can only be filed by (a) a financial creditor; (b) an operational creditor; or (c) the corporate debtor itself. Therefore, a beneficiary of third party security who is not classified as a ‘financial creditor’ (and by the nature of the debt cannot be classified as an operational creditor or be the corporate debtor itself) would not be able to commence insolvency proceedings against the Security Provider.

In order to understand the confusion around the status of a beneficiary of third party security in the insolvency process of a Security Provider, it is important to evaluate the following definitions under the IBC:

  1. Financial creditormeans any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to”;

 2. Financial debt “means a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes:

(a) money borrowed against the payment of interest;


(h) any counter-indemnity obligation in respect of a guarantee, indemnity, bond, documentary letter of credit or any other instrument issued by a bank or financial institution;

(i) the amount of any liability in respect of any of the guarantee or indemnity for any of the items referred to in sub-clause (a) to (h) of this clause.”

  1. Secured creditormeans a creditor in favour of whom security interest is created.”

  2. Security interest “means right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person. Provided that security interest shall not include a performance guarantee.”

This article delves into whether a beneficiary of security interest should be categorized as (a) a ‘financial creditor’ and thereby get a say in the insolvency process of the Security Provider; or (b) a ‘secured creditor’ and thereby get no say in the insolvency process of the Security Provider. There are judicial precedents that negate or diminish the priority of security interest created when the security provider is not a borrower (or is a ‘third party security provider’) in the insolvency of the security provider which has been discussed below.


In SREI Infrastructure Finance Limited v. Sterling International Enterprises Limited (“SREI Judgement”) Sterling International Enterprises Limited (the security provider) (“Sterling”) mortgaged certain immovable properties in favour of SREI Infrastructure Finance Limited (as assignee of loans from SICOM Limited) (“SREI”) for the loan availed by Unique Proteins Private Limited. The question that arose for the consideration of the National Company Law Tribunal (“NCLT”) was whether SREI could be categorized as a ‘financial creditor’ in the insolvency process of Sterling. While answering this in the affirmative the NCLT held that:

  1. Under the (Indian) Transfer of Property Act, 1882, the mortgagor binds himself to repay the mortgage money and not (i) recognizing the security interest; and (ii) categorizing SREI as a ‘financial creditor,’ would create an anomalous situation where the CoC of Sterling would approve a resolution plan for Sterling while ignoring the mortgage created in favour of SREI.

  2. This would further complicate the situation because SREI may then be able to argue (and possibly litigate arguing) that it should be permitted to deal with the immovable properties (charged in its favour) outside the insolvency process since it has vested interest on such properties; and

  3. Not permitting SREI to have a seat on the CoC while dealing with assets charged in its favour would also amount to a violation of natural justice.

While all of these seem to be valid arguments, the judiciary after this judgement seemed to have taken a U-turn from this approach.

In the case of Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel, the Resolution Professional of Doshion Water Solutions Private Limited, (“Phoenix ARC Judgement”) Doshion Water Solutions Private Limited (“Doshion”) had pledged certain shares of Gondwana Engineers Limited held by them in favour of Phoenix ARC Private Limited (as the assignee of the loan) (“Phoenix”) for the loan advanced to Doshion Limited. In this case, the National Company Law Appellate Tribunal (“NCLAT”) held that pledge of shares would not tantamount to “disbursement of any amount against the consideration for the time value of money” (as required under the definition of financial debt under IBC) and therefore, Phoenix could not be categorized as a ‘financial creditor’ of Doshion. A similar stance was also taken by the judiciary in a few other cases.

However, after the conflicting case laws on this subject, the Insolvency Law Committee (“ILC”) (constituted by the Government of India to recommend amendments to the IBC) in its report dated February 20, 2020, in relation to status of a creditor in the insolvency process of a Security Provider stated that: (a) ‘Security interest’ is provided for securing the due performance or payment of an obligation and is therefore, inextricably linked to the underlying debt or obligation; (b) debt is an essential element of a security interest and it subsists within a security interest; and (c) by creating a security interest in favour of the creditor, the Security Provider undertakes to repay the debt owed by the borrower to the creditor to the extent of the security interest, in the event that the borrower is unable to do so. And therefore, just like the borrower, the lender should also be considered as a ‘financial creditor’ of the Security Provider.

However, disregarding the arguments advanced and recommendations made by the ILC, the Supreme Court in Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited (“Jaypee Judgement”) while overturning the SREI Judgement held that beneficiaries of security interest cannot be categorized as a ‘financial creditor’ in the insolvency process of the Security Provider.

In this matter, Jaypee Infratech Limited (“JIL”) had mortgaged its properties for the loans and advances made by certain lenders (“Lenders”) to Jaiprakash Associates Limited (the holding company of JIL). The Supreme Court provided the following justification for its decision:

  1. Definition of “financial debt” under IBC uses the terms ‘means and includes.’ Therefore, for a debt to become ‘financial debt’, it needs to be (i) disbursed against the consideration for time value of money; and (ii) may include any of the methods for raising money or incurring liability by the modes prescribed in sub-clauses (a) to (i) of the definition of ‘financial debt’ (please see para B (2) above). Since no debt was advanced by the lenders to JIL, the essential element of ‘disbursal against the consideration for time value of money’ could not be fulfilled and therefore, the debt could not be treated as ‘financial debt.’

  2. However, such a creditor can be categorized as a ‘secured creditor’ by virtue of collateral security extended by the corporate debtor.

  3. While discussing the judgement in the matter of Swiss Ribbons Private Limited v. Union of India (“Swiss Ribbons Judgement”) the Court stated that a beneficiary of a third party security cannot be considered as a ‘financial creditor’ because financial creditors are creditors who are from the very beginning, involved in assessing the viability of the corporate debtor and engaged in restructuring of the loan as well as reorganization of the corporate debtor’s business when there is a financial stress. A financial creditor has the unique parental and nursing roles.

Thereafter, in the case of Phoenix ARC Private Limited v. Ketulbhai Ramubhai Patel (which arose as an appeal from the Phoenix ARC Judgement) (“Phoenix ARC Appeal Judgement”), the Supreme Court while upholding the decision in the Jaypee Judgement stated that a beneficiary of a pledge can only be categorized as ‘secured creditor’ and not ‘financial creditor’ in the insolvency process of the Security Provider. They relied upon the fact that the pledge was created on a certain number of shares and did not have a contract that the security provider would perform the promise, or discharge the liability of the borrower.

In line with the abovementioned judgements, the Insolvency and Bankruptcy Board of India (“IBBI”) amended the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 vide an amendment dated March 15, 2021 (“CIRP Amendment Regulations”), and provided that claims as ‘financial creditor’ can only be submitted by (a) direct lenders to the Corporate Debtor; or (b) beneficiaries of a guarantee from the Corporate Debtor; or (c) beneficiaries of obligations under para B(2)(h) and (i) above. Prima-facie, this would imply that creditors who benefit from security interest would:

  1. not be able to file their claims as ‘financial creditors’ irrespective of the terms of the contractual agreement between the creditor and the Security Provider; and

  2. need to file their claims in the format provided for other creditors (i.e. creditors other than financial creditors and operational creditors), who do not have any say in the resolution process and are generally wiped off in resolution plans.

† Shruti Sethi is a senior associate at AZB & Partners, Mumbai.

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