Treatment of interest-free loan lenders as financial creditors under the IBC: A critique

The Supreme Court may have committed an error by placing creditors who advanced interest-free loans for no consideration of ‘time value of money’ on par with financial institutions such as banks.
Treatment of interest-free loan lenders as financial creditors under the IBC: A critique
Insolvency and Bankruptcy Code

In the recent judgment passed by the Supreme Court in Orator Marketing Pvt Ltd v. Samtex Desinz Pvt Ltd, it was held that an interest-free loan given to finance business operations of a corporate body fell under the definition of ‘financial debt’ under the Insolvency and Bankruptcy Code, 2016 (IBC).

By virtue of such an inclusion, creditors that advanced interest-free loans would now be eligible to file for insolvency under Section 7 of the Code as a financial creditor in the event of a default and also participate in the Corporate Insolvency Resolution Process (CIRP). Although the Supreme Court can be credited for expanding the scope of the definition of financial debt, there may be more than what meets the eye.

Brief facts of the case

The corporate debtor was in need of additional working capital and was unable to further borrow from institutional lenders due to its pending unpaid loans. The applicant (a private limited company) agreed to lend an interest-free loan amounting to ₹1.6 crore, which was repayable within two years from the date of sanction. The corporate debtor only had to return the identical sum back to the applicant on the said date. Thereafter, the corporate debtor failed to return the amount, compelling the applicant to file for insolvency under Section 7 of the IBC as a financial creditor.

Whether such a creditor could be called a financial creditor came to be the subject matter of the dispute between the parties before the National Company Law Tribunal (NCLT) and the National Company Law Tribunal Appellate Tribunal (NCLAT). Both the NCLT and NCLAT held that such a creditor was not a financial creditor.

Reasoning of NCLT and NCLAT

The reasoning followed by the NCLT and NCLAT in this matter were as follows:

i) The mere grant of loan will not deem the applicant as a financial creditor;

ii) The onus lies on the applicant to establish that the loan was given against the consideration for time value of money, and the same was not established by the present creditor.

However, the apex court set aside the decisions passed by the NCLT and NCLAT, holding them to be patently flawed.

Reasoning of the Supreme Court

At the outset, the apex court analyzed the definition of financial debt under the IBC.

“Section 5(8) of the Insolvency and Bankruptcy Code, 2016 (IBC) defines ‘financial debt’ as a debt along with interest, if any, which is disbursed against the consideration for the time value of money.

It includes:

1. Any money borrowed against the payment of interest,

2. ……………………………………………………………………………”

On this basis, the Court reasoned as follows:

i) The mention of the words “…debt with interest, "if any" ought to be interpreted in a manner wherein the usage of "if any" indicated that a debt need not be mandatorily employed with interest.

ii) Secondly, the usage of the phrase “it includes” ought not to be interpreted in a restrictive manner where words used are of wider denotation. Hence, including interest-free loans within the ambit of the definition of financial debt is possible.

The Court lastly held that “having regard to the Aims, Objects and Scheme of the IBC, there is no discernible reason, why a term loan to meet the financial requirements of a Corporate Debtor for its operation, which obviously has the commercial effect of borrowing, should be excluded from the purview of a financial debt.”

Critical observations

1. From a bare perusal of the loan agreement, it is apparent that the agreement was structured as a ‘simpliciter interest-free loan returnable within two years’. The lender did not benefit in any conceivable commercial angle nor was the borrower under any obligation to return anything beyond the loaned amount.

2. The Court failed to examine whether such a loan arrangement was disbursed against the consideration of time value of money, which was referred to in Nikhil Mehta v. AMR Infrastructure as the “price associated with the length of time that an investor must wait until an investment matures or the related income is earned.” The Court erred by not examining whether an interest-free loan without an ‘incremental value addition in any form’ to the creditor may not fall within the definition of a financial debt, as it did not have a commercial effect of a borrowing.

3. With a creditor-in-control insolvency regime, especially post the Supreme Court’s judgment in Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta & Ors, the superiority of financial creditors as a class had been firmly established over any other creditor in the system. The reason being that, the scope of activities performed by financial institutions by advancing large scale monetary funding to corporates in order to build businesses were far superior to that of other creditors. And the failure to recover such loans directly impacted trade and economics. That being the case, the apex court may have committed an error in judgment by placing creditors who advanced interest-free loans for no consideration of ‘time value of money’ on par with financial institutions such as banks whose roles are far more crucial in terms of granting them preference towards recovery during insolvency and liquidation.

4. While it may be far-fetched, the inclusion of interest-free loan lenders as financial creditors reveals a loophole in favour of corporate debtors trying to influence the Committee of Creditors (CoC) by making known parties pump such loans into their debt system in order to block genuine institutional lenders from recovering their legitimate dues, by tilting the votes in the CoC meetings. The risk of this is especially high when corporate debtors prematurely sense a decline in the financial situation of the company.

5. Even if we were to go one step ahead and assume that the apex court was convinced that such a loan had the commercial effect of a borrowing, an alternative argument presents itself. While examining the definition of financial debt, the IBC expressly includes several illustrations. The first illustration is relevant: “1. money borrowed against the payment of interest" is a type of financial debt. Why then did the Court interpret the Section to include a debt which is patently opposite to this illustration i.e. an ‘money borrowed without the payment of interest’ OR ‘interest free loan’ into the list of illustrations, remains unexplored.

Conclusion

The Supreme Court ought to have recognised only those interest-free loans that were disbursed with the consideration of time value of money, within the definition of a financial debt. Any other simpliciter interest-free lending should have been excluded from the definition and such creditors ought not to have been placed on par with institutional financial creditors. This ruling may have made the Code vulnerable to backend deals intended to defeat legitimate claims made by financial creditors before insolvency.

Pooja Upadhya is a legal counsel for an asset reconstruction company.

Disclaimer: The views and opinions expressed in this article are those of the author's and do not necessarily reflect the views of Bar & Bench.

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