Securing Payments Of Parent Company By Subsidiary Under Insolvency – Whether Preferential Transaction

The Supreme Court in its yet another landmark decision passed on 26th February 2020, in the matter of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited & Ors. – settled the disputes between the claims filed by the creditors of Jaypee Infratech Limited (JIL) and those of its holding company, Jaiprakash Associates Limited (JAL).

The Key issues addressed by the Supreme Court in this judgement are:

  • Whether the assets of JIL, mortgaged with the lenders of JAL, for the benefit of JAL, would be a preferential transaction under Section 43 of the Insolvency and Bankruptcy Code, 2016 (“IB Code”).
  • Whether the JAL lenders (as mortgagees) could be considered as Financial Creditor of JIL.

Brief Facts

The Apex Court clarified various issues with respect to preferential transactions and the nature of financial debt particularly in relation to third-party mortgages amongst others. In the aforesaid case, Mr. Anuj Jain was appointed as the Interim Resolution Professional (“IRP”) by the National Company Law Tribunal (“NCLT”), Allahabad Bench, in the Corporate Insolvency Resolution Process of JIL.

Subsequently, it came to the knowledge of the IRP that some 858 acres of unencumbered land parcels of JIL have been given as a collateral security to secure the debt of its holding company i.e. JAL, to its various lenders. The IRP filed an application before the NCLT bench at Allahabad seeking avoidance of this mortgage transaction being preferential, undervalued and fraudulent transaction under Section 43, 45, 49 and 66 of the IB Code.

The NCLT, Allahabad held that a security interest by way of a mortgage in favour of lenders counter guarantee cannot be considered to be a transaction done in the ordinary course of business and thus, a preferential transaction under sub-section 2(a) of Section 43 of the IB Code. NCLT further observed that this transfer has the effect of putting JAL, also one of the creditors of JIL, in a beneficial position that it would have been in the event of distribution of assets being made by Section 53 of the IB Code.

An appeal was filed against the order of NCLT. The National Company Law Appellate Tribunal (“NCLAT”) set aside the said NCLT Order, thereby holding that the aggrieved lenders are entitled to exercise their rights under the IB Code and that the said transactions of the Corporate Debtor i.e. JIL cannot be termed as fraudulent or undervalued under the IB Code.

Aggrieved by the NCLAT Order, the IRP filed an appeal in the Supreme Court of India.

Ingredients of a Preferential Transaction

Before dealing with the facts specific to the mortgage done by JIL, the Apex Court laid down certain key ingredients for a transaction to be squarely covered as a preferential transaction under Section 43 of the IB Code:

  • There should be a transfer of asset of the corporate debtor for the benefit of a creditor, surety or a guarantor.
  • The transfer should be for, or on account of an antecedent financial debt or operational debt or other liabilities owed by corporate debtor.
  • Such transfer of asset should put the creditor, surety or guarantor in a beneficial position as against it would have been in the event of distribution of assets being made under Section 53 of the IB Code.
  • The transfer should have occurred within the relevant ‘look-back’ period i.e. two years for a transaction with a related party and one year for an un-related party; and
  • Such transfer should not otherwise be exempt under Section 43(3) of the IB Code.

However, the Apex Court further clarified that while analysing a preferential transaction under Section 43 of the IB Code, satisfying all the key ingredients mentioned above, the intent of the parties for ascertaining fraudulent transaction is immaterial.

Apex Court’s Considerations

The Apex Court first dealt with the issue that whether the securities mortgaged by JIL to the lenders of JAL would amount to a preferential transaction under Section 43 of the IB Code.

After scrutinizing the facts of the case and the nature of transaction of JIL in favour of the lenders of JAL, the Apex Court held as under:

  • The Apex Court observed that though there had been no creditor-debtor relationship between the lender banks and JIL, however, the mortgage deeds in question, entered into by JIL to secure the debts of JAL, obviously, amounts to creation of security interest to the benefit of JAL.
  • JAL has been providing financial, technical and strategic support to JIL and moreover, is an operational creditor to JIL. Therefore, JIL owed antecedent financial debts as also operational debts and other liabilities towards JAL.
  • Considering, that JAL was an operational creditor of JIL, it would have stood much lower in priority in case JIL went into liquidation. Thus, the said transactions put JAL in an advantageous position in relation to other creditors.
  • That JAL being a related party to JIL, the relevant look back period will be that of 2 years.
  • That the said mortgage transactions were not carried out in the ordinary course of business, as at the times when such transactions were done, JIL was already under tremendous financial stress and therefore could not have been providing mortgages to secure finances of its holding company.

Therefore, the Apex Court overturned the order of NCLAT and held that the said mortgage transaction done was a preferential transaction under Section 43 of the IB Code, without considering it necessary to deal with whether these transactions are undervalued and/or fraudulent.

Status of Mortgagees

The second issue before the Apex court was whether the lenders of JAL could be considered as financial creditors in the corporate insolvency resolution process of JIL.

The Apex Court laid down certain pre-conditions for a creditor to be designated as a “financial creditor”. To sum up, a creditor to be a financial creditor, should have a direct involvement in the functional existence of the corporate debtor, acquire unique position, and one who could be then entrusted with the task of ensuring the sustenance and growth of the corporate debtor, akin to that of a guardian. In the context of insolvency, the financial creditor is entrusted to ensure that the corporate debtor is rejuvenated and gets back to its wheels with reasonable capacity of repaying its debts and to attend on its other obligations.

The Apex Court also analyzed that a creditor having only a security interest over the assets of a corporate debtor may fall within the description of a “secured creditor” by virtue of collateral security extended by the Corporate Debtor, however, the same may fall outside the definition of “financial creditor” as defined in Sub-Section (7) and (8) of Section 5 of the IB Code.

Considering these situations in the present case, the Apex Court held that the mortgage in the present transaction is neither given towards any loan, facility or advance to JIL nor towards protecting any facility or security of JIL, and thus, it cannot be said that JIL owes the lender of JAL any “financial debt”, within the meaning of Section 5(8) of the IB Code. Therefore, the lenders of JAL can only be considered to be “secured creditors” of JIL and not as “financial creditors”.

In Sum

The Apex Court has laid several key ingredients to identify what all transactions would qualify as a preferential transaction and has set out that mortgages are not automatically deemed as financial debt under the IB Code.

Though the Apex Court in this judgement has clarified that the lenders of JAL would not qualify as financial creditors of JIL, however, what will be their status with respect to their participation in the corporate insolvency resolution process of JIL is still in question on which there is no clarity.

The quality of the debt is something that needs to be considered before financial creditors automatically assume that they would be first in line with respect to the CIRP. The courts are considering all the financial aspects and are not providing a quick fix to the financial creditors. Whether or not such financial creditor will have the remedy of filing a Section 7 application under the IB Code itself is now in question.

However, this judgement has given rise to some key aspects to be considered by the stakeholders, some of them being: application of provision of Section 43 of the IB Code by resolution professionals and adjudicating authorities, exclusion of certain third party secured creditors from the committee of creditors helping the corporate debtor in faster resolution, and increased due diligence by financial institutions to ensure that the security against their loan/advance/facility is genuine and adequate.

-Lalit Munshi (Associate)

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