Guarantee by Conduct: Rethinking Financial Creditor Status under IBC through the lens of China Development Bank Judgment

In the recent dictum of the Supreme Court in China Development Bank vs. Doha Bank QPSC, the quintessential question before the Court stood as - Whether lenders like China Development Bank, Export Import Bank of China, and others could be recognized as "Financial Creditors" under the IBC in the insolvency resolution of Reliance Infratel Ltd (RITL), a group company of the Reliance Communications (RCom) group?

Although these lenders had not directly disbursed funds to RITL, they argued that a guarantee-like obligation in the Deeds of Hypothecation (DoH), executed jointly by various RCom group entities, including RITL, rendered RITL a guarantor, thereby establishing their claim as financial creditors.

The Supreme Court overturned the National Company Law Appellate Tribunal’s (NCLAT) order, which had held that the appellants could not be treated as financial creditors since there was no direct lending to RITL and the DoH did not constitute a guarantee. The Supreme Court restored the National Company Law Tribunal’s (NCLT) earlier decision that had admitted these lenders’ claims as financial debts, thereby allowing their participation in the Committee of Creditors (CoC) of RITL.

The Court held that the obligations undertaken by RITL in the DoH - specifically, the obligation to pay shortfalls in recoveries from the hypothecated assets of the borrower - constituted a "contract of guarantee" within the meaning of Section 126 of the Indian Contract Act, 1872, and consequently a “financial debt” under Section 5(8)(i) of the IBC.

First, the Court clarified that a financial debt under Section 5(8) of the IBC includes any liability arising from a contract of guarantee for financial facilities, even if the facility was not availed of directly by the corporate debtor.

Second, the Court held that the definition of “financial creditor” under Section 5(7) read with Section 5(8)(i) is broad enough to include creditors who are owed a debt through such indirect arrangements, even in the absence of direct disbursement to the corporate debtor.

Third, it rejected the argument that the moratorium under Section 14 of the IBC extinguishes claims or prevents recognition of debts. The Court emphasized that while enforcement is stayed, the existence of the claim remains legally cognizable.

Fourth, the Court underlined that the commercial substance of the transaction—rather than the nomenclature of the documents (i.e., calling it a "Deed of Hypothecation")—is what governs its legal characterization.

The Supreme Court’s ruling marks a significant development in the interpretation of the IBC’s provisions concerning financial creditors. By recognizing a third-party guarantee embedded in a security deed as a basis for financial debt, the Court broadened the scope of who may participate in insolvency proceedings as financial creditors. This has far-reaching implications for both domestic and international lenders.

For the banking sector, this ruling strengthens creditor rights, particularly in group financing structures where cross-collateralization and third-party obligations are commonplace. It gives assurance to syndicated lenders that their security structures, crafted to pool assets across related entities, will be honoured in insolvency processes.

On the flip side, the ruling could open a floodgate of claims where security arrangements contain broadly worded cross-liability clauses. It becomes essential for corporate debtors and their legal advisors to be cautious while drafting such documents, lest they inadvertently create financial obligations under the IBC.

The Court distinguished this case from the Anuj Jain, IRP for Jaypee Infratech Ltd v. Axis Bank Ltd. decision, where it was held that mere creation of a security interest does not give rise to a financial debt. In Anuj Jain, the Court denied financial creditor status to banks that had security over the assets of the corporate debtor but no financial relationship with it.

In contrast, the present case involved not just a passive security interest, but an active promise by the corporate debtor to pay any deficiency arising from loan recoveries. This promise transformed the corporate debtor into a "guarantor" under Section 126 of the Contract Act, thereby creating a financial obligation.

The Court held that obligations under a Deed of Hypothecation, which includes clauses akin to guarantees, qualify the creditor as a "financial creditor" under the IBC. This interpretation means that even if a creditor has not directly lent to the corporate debtor, the presence of a guarantee-like clause in a hypothecation deed can confer financial creditor status. The Court emphasized that contingent claims based on future events like shortfalls in the realization of secured assets are legitimate financial debts if they fulfil the essential criteria under Section 5(8) of the IBC.

This broad interpretation has implications for the classification of creditors and their rights in insolvency proceedings. Creditors who were previously considered as holding only security interests may now be classified as financial creditors, granting them a seat at the table in the Committee of Creditors (CoC) and influence over the resolution process

The banking sector's response to the judgment has been mixed. Some stakeholders appreciate the clarity provided regarding the treatment of contingent liabilities and the recognition of various financial obligations under the IBC. However, others express concern over the divergent and radical changes brought in by this dictum. The judgment's reliance on specific clauses within hypothecation deeds to confer financial creditor status raises questions about the interpretation of similar clauses in other financial instruments.

Critics argue that the judgment introduces unfairness by potentially elevating the status of certain creditors based on ambiguous contractual clauses. In the case at hand, the Supreme Court relied on a specific clause in the hypothecation deed that obligated the chargor to cover any shortfall after the sale of hypothecated assets. The Court interpreted this as a guarantee, thereby granting the creditor financial creditor status. However, this interpretation has been challenged for not considering the deed in its entirety and for potentially conflicting with previous judgments, such as Jaypee Infratech, where the Court held that a mortgage by a third-party security provider does not constitute a guarantee without a separate deed of guarantee.

This broadened definition has several repercussions:

1. Increased Litigation and Uncertainty: Banks may face more disputes over creditor classifications, leading to prolonged insolvency proceedings. The reliance on specific clauses within financial instruments to determine creditor status can result in inconsistent interpretations and legal challenges.

2. Disruption of Established Practices: Traditional understandings of security interests and guarantees are being questioned. Banks that have structured their financial instruments based on previous interpretations may now find themselves at a disadvantage, facing unforeseen obligations or reduced influence in insolvency proceedings.

3. Potential for Strategic Misuse: Creditors might structure agreements to include clauses that could elevate their status in insolvency proceedings, potentially at the expense of other stakeholders. This could lead to an imbalance in the resolution process, where certain creditors have disproportionate influence.

Furthermore, the judgment's broad interpretation could inadvertently open avenues for fraudulent activities. Entities might design financial instruments with embedded clauses that, while appearing as standard security arrangements, effectively function as guarantees. This could be used to manipulate creditor status in insolvency proceedings, allowing certain creditors undue influence in the Committee of Creditors (CoC) without transparent disclosure. Such practices undermine the integrity of the insolvency resolution process and could disadvantage genuine creditors.

4. Tax Evasive Manoeuvres: The recharacterization of DoHs as guarantees may have tax implications. Guarantees often attract different tax treatments compared to security arrangements. If financial institutions have historically treated DoHs as non-guarantee instruments for tax purposes, this reinterpretation could expose them to retrospective tax liabilities, penalties, and interest. Moreover, the lack of clarity might be exploited to structure transactions in a manner that minimizes tax obligations, bordering on tax evasion.

5. Possible conflicts with regulatory and legal compliance: The interpretation propounded by the apex court may conflict with existing regulatory frameworks established by the Reserve Bank of India (RBI) and the Indian Contract Act, 1872.

Under Section 126 of the Indian Contract Act, a contract of guarantee involves a clear and unequivocal promise to discharge the liability of a third party in case of default. By interpreting certain clauses within a DoH as constituting a guarantee, the judgment potentially blurs the distinction between security arrangements and guarantees, leading to ambiguity in regulatory compliance.

This shift in interpretation may disrupt established expectations and contractual arrangements within the banking sector. Stakeholders who have relied on the traditional understanding of security interests and guarantees may find themselves at a disadvantage, facing unforeseen obligations or reduced influence in insolvency proceedings.

The Supreme Court’s decision in China Development Bank v. Doha Bank QPSC is both bold and commercially progressive. By reading the contractual promise of a third-party obligor into the definition of financial debt, the Court has championed a substance-over-form approach that aligns Indian insolvency law with global practices. The judgment secures the rights of institutional lenders while balancing them with principles of contractual integrity and commercial fairness.

At the same time, it leaves open certain areas for regulatory or legislative refinement, particularly in managing potential overlaps between financial creditors and secured creditors, and the treatment of contingent or group liabilities. However, its broad interpretation of hypothecation deeds as conferring financial creditor status introduces complexities and perceived unfairness for stakeholders in the banking sector. The decision underscores the need for clear contractual drafting and may prompt a re-evaluation of existing financial arrangements to align with the evolving legal landscape.

About the authors: Sumant Nayak is a Senior Partner at Desai & Diwanji.

Nishikant Nayak is an Advocate and aspiring Solicitor in UK.

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

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