Compulsory Convertible Debentures as Financial Debt?

Debentures are prima facie considered to be a financial debt as per the definition of financial debt given in the Insolvency and Bankruptcy Code, 2016 (“IBC”). However, Section 71(1) of the Companies Act, 2013 provides an option for the company to issue debentures with an option to convert the debentures into shares at the time of redemption. This gives rise to a type of debentures called compulsory convertible debentures which becomes an important point of discussion in relation to IBC.

Compulsory convertible debentures (“CCD(s)”) are a hybrid form of an instrument issued by companies at a fixed interest rate and which are mandatorily and automatically convertible into equity at a specified time, or on the happening of specified events. In relation to CCDs subscribed by non-residents, it is well-settled that such CCDs will be considered as and ‘equity instrument’ in accordance with Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.

However, one of the pertinent controversies in corporate laws surrounding CCDs is whether such convertible instruments will be considered as financial debt under IBC or not.

The analysis of the following case laws may prescribe certain guiding principles to ascertain the said controversy.

Facts

An investment agreement was entered into between the applicant (Ziasess Ventures Limited) along with Green Park Buildwell with the corporate debtor on June 23, 2010. As per the investment agreement, the applicant invested, inter alia, ₹24.99 crores towards the issuance of compulsorily convertible debentures (“CCDs”). The balance sheet of the corporate debtor had put this investment as a long-term borrowing and showed TDS as paid on interest over the debentures. At the time of submission of the claim by the applicant, the CCDs were not matured for conversion as per the terms of the issuance.

Under the investment agreement, the applicant had participation rights as well as affirmative rights in the corporate debtor. By looking at these two rights in favour of the applicant, the resolution professional rejected the applicant’s claim on April 9, 2019, treating the CCDs as equity.

Judgment 

The counsel for the resolution professional had argued that these CCDs ought to be treated as equity as the redemption of debentures has not been envisaged in the investment agreement. The National Company Law Tribunal Principal Bench, New Delhi passed an order that at the time of winding up or admission of a case under IBC, if the debentures are not matured and not convertible since the period for redemption is not complete, they shall be treated as debentures and the consequence is, it will remain as debt. Applying this principle, the tribunal directed the resolution professional to admit the claim of the applicant as a ‘Financial Debt’ as envisaged under Section 5(8) (c) of the Insolvency and Bankruptcy Code, 2016.

Facts

IFCI Limited (“IFCI”) had provided financial assistance to the corporate debtor (IVRCL Chengapalli Tollways Ltd) through compulsorily convertible debentures (“CCDs”) and agreed to subscribe to the CCDs amounting to ₹ 125,00,00,000 vide a ‘Debenture Subscription Agreement’ (“DSA”) dated 14/10/2011. IFCI's claim as a financial creditor was rejected by the resolution professional and the National Company Law Tribunal, Hyderabad Bench – II had dismissed the application filed by IFCI challenging the decision of the resolution professional pursuant to their order dated March 14, 2023 (the “Impugned Order”). As per the DSA, IFCI had a put option on IVRCL for the buy-back of the CCDs. The time for conversion of the CCDs to equity lapsed on November 9, 2017 and IFCI did not exercise its put option.

IFCI filed an appeal before the National Company Law Appellate Tribunal at Chennai under Section 61 of the Insolvency and Bankruptcy Code, 2016 (IBC) against the Impugned Order passed by the tribunal.

Judgment

The appellate tribunal placed reliance on the judgment of the Supreme Court of India in the case of Narendra Kumar Maheshwari vs. UOI and Ors. which was referred in the matter of Sahara India Real Estate Corporation Limited & Ors. vs. Securities and Exchange Board of India & Anr. reported in (2013) 1 SCC 1, wherein it was observed as follows:

“14.6.8. In Narendra Kumar Maheshwari v. Union of India [1990 Supp SCC 440], the Hon'ble Supreme Court, observed that in the various guidelines applicable to such instruments, compulsorily convertible debentures are regarded as ‘equity’ and not as a loan or debt. One of the critical considerations adopted by the Hon'ble Supreme Court of India in concluding so, is that ‘a compulsorily convertible debenture does not postulate any repayment of the principal’. The thinking of the Hon'ble Supreme Court revealed in this judgment, not only clarifies the issue, but also provides me with a touchstone to determine whether OFCDs issued by the two Companies are more in the nature of shares or debentures. SIRECL has issued three bonds viz. Abode Bond, Real Estate Bond and Nirman Bond. SHICL has also issued three bonds viz. Multiple Bond, Income Bond and Housing Bond. From a plain reading of the summary of their descriptions at Paras 9.2 and 9.3 above, it is evident that all these six bonds postulate a repayment of the principal. The repayment of the principal will be at the option of the investor. The investor holds the option, which gives her a right to determine whether she would like to get her principal back in cash or as equity shares. Hence, optionally fully convertible debentures unlike their counterpart category of compulsorily convertible debentures do not share the characteristic pointed out by the Hon'ble Supreme Court in arriving at the conclusion that compulsorily convertible debentures are more of equity than of debentures. Thus, all the six financial instruments issued by the two Companies share the defining feature of debentures in that a payment of interest to the investor and a repayment of the principal, albeit at the option of the investor, is postulated.”

The appellate tribunal further noted that it has been held by the Hon’ble apex court that any Instrument which is fully, compulsorily convertible into shares is regarded as ‘Equity’, and not a ‘Loan’ or ‘Debt’. Further, the appellate tribunal stated that it was conscious of the fact that CCDs in the present case had matured before admission into CIRP.

The appellate tribunal dismissed the appeal for the aforesaid reasons and concluded that in the facts of the case, the CCDs were in the nature of ‘Equity Instruments’ and did not fall within the definition of ‘Financial Debt’ as defined under Section 5(8) of the Code.

Facts  

The applicant (Agritrade Power Holding Mauritius Limited) held 38,05,576 compulsory convertible debentures (“CCDs”) of the corporate debtor (SKS Power Generation (Chattisgarh) Limited) having face value of ₹1,000 each carrying interest at the rate of 11.5% per annum.  Relying on the SGM Webtech Pvt. Ltd. vs. Boulevard Projects Pvt. Ltd, the applicant filed a claim for a financial debt under the said CCDs and accrued interest. The claim was rejected by the resolution professional stating that the CCDs were mentioned as ‘Other Equity’ and not as debt in the books of accounts of the corporate debtor, indicating that the same has been considered as an equity or quasi-equity instrument and not as a debt instrument.

The applicant filed an application in the National Company Law Tribunal, Mumbai Bench-IV against the rejection of its claim by the resolution professional of the corporate debtor.

The terms of CCDs noted that it was mandatorily convertible on the mandatory conversion date which is stated as the earlier of:

(a) expiry of period of 10 years from the date of the debenture certificate; or

(b) in the case of any winding up, liquidation or dissolution of the corporate debtor (or any analogous event) the last date permitted under applicable laws for the conversion of the investor’s CCDs; or

(c) in the case of happening of any initial public offering, the last date permitted under applicable laws for the conversion of the investor CCDs.

Judgment

The tribunal observed that as per the terms of the CCD, mandatory conversion date arises on the winding up, dissolution or liquidation of the company (or any analogous event). The tribunal opined that the resolution process contemplated under IBC is an analogous event. Accordingly, the mandatory conversion date arises on the date of commencement of resolution process. In view of mandatory conversion date occurring on an analogous event, the tribunal stated that the obligation of the corporate debtor towards principal component of CCDs ceases to exist on that day and accordingly, no debt to the extent of principal amounts of CCDs can be said to exist at the commencement of CIRP.

The tribunal further stated that since the terms and conditions of the CCDs contemplated compulsory conversion of only principal amount, interest accrued thereupon till the date of conversion is certainly an obligation or liability of the corporate debtor. Since the interest on debt is also a financial debt, the tribunal held that the amount of accrued interest till the mandatory conversion date of CCDs (that is, the CIRP commencement date) is a financial debt and deserves to be admitted as such.

The tribunal allowed accrued interest to be classified as financial debt and rejected the principal amounts as financial debt.

In view of the above said judgements, it can be concluded that the treatment of CCDs and accrued interests as financial debt in IBC is to be determined on the facts of each case. However, it is to be noted that the timing of the conversion event is an important factor while deciding the nature of the obligations of the corporate debtor.

In our view, if the CIRP is commenced prior to the conversion event of the CCDs, then it is likely that the CCDs may be construed as financial debt under the IBC and in cases where the conversion event of the CCDs has expired on the date on commencement of the CIRP and the CCDs were not converted into equity shares, then it is likely that the CCDs may not be construed as financial debt under the IBC.

It is to be noted that the Supreme Court of India is yet to assess this issue in connection with the IBC and until then, the classification of CCDs as financial debt in IBC will remain uncertain.

About the author: Rahul Chauhan is a Partner and Mudit Nijesh Shah is an Associate at Desai & Diwanji.