After China Development Bank ruling: Has the treatment of third-party security changed under the IBC?

The distinction between a secured creditor and a financial creditor is a defining feature of India’s insolvency framework. While a secured creditor may or may not be a financial creditor, it is only financial creditors who participate in the committee of creditors (CoC) and exercise voting rights during the corporate insolvency resolution process (CIRP) of a corporate debtor. Whether a creditor qualifies as a financial creditor can, therefore, have a significant bearing on the outcome of a CIRP.

The National Company Law Appellate Tribunal’s (NCLAT) recent decision in J C Flowers Asset Reconstruction Private Limited v Vithal M. Dahake¹ (JC Flowers) has provided a new interpretation of security documents on the basis of obligations contained in them. The NCLAT recognised a creditor holding an English mortgage executed by a third-party security provider as a financial creditor under Section 5(8) of the Insolvency and Bankruptcy Code, 2016 (IBC). At first glance, the ruling appears to depart from the Supreme Court’s decision in Anuj Jain Interim Resolution Professional, Jaypee Infratech Limited v Axis Bank Limited² (Jaypee Infratech), which held that a creditor does not become a financial creditor merely by virtue of the security provided by the security provider.

A closer reading, however, suggests that JC Flowers does not overturn Jaypee Infratech. Instead, it follows the Supreme Court’s subsequent decision in China Development Bank v Doha Bank Q.P.S.C. & Ors³ (China Development Bank).

It is important to understand how the law has evolved from Jaypee Infratech to China Development Bank and whether JC Flowers marks a genuine departure from settled law or simply applies the principles laid down by the Supreme Court in a different factual setting.

The Supreme Court first considered the status of third-party security providers in Jaypee Infratech. The case arose during the CIRP of Jaypee Infratech Limited (JIL), which had mortgaged its land as collateral security for loans advanced not to JIL itself but to its holding company, Jaiprakash Associates Limited (JAL). The lenders of JAL argued that the mortgage constituted a financial debt under Section 5(8) of the IBC, entitling them to be treated as financial creditors of JIL.

The Supreme Court rejected this argument. It drew a clear distinction between a secured creditor and a financial creditor, observing that while a mortgage creates a security interest in favour of a creditor, it does not, by itself, create a financial debt owed by the corporate debtor.

For a creditor to qualify as a financial creditor under Section 5(8) of the IBC, there must be a debt disbursed against consideration for the time value of money that is owed by the corporate debtor. Since no loan had been advanced to JIL, the lenders could not claim the status of financial creditors merely because JIL had provided collateral security. The Court, therefore, held that the lenders were secured creditors with rights against the mortgaged property, but not financial creditors entitled to participate in the CoC and exercise voting rights in JIL’s CIRP.

The Supreme Court reaffirmed this approach in Phoenix ARC Private Limited v Ketulbhai Ramubhai Patel⁴ (Phoenix ARC). In that case, the corporate debtor had pledged its shares to secure borrowings of its holding company. The lenders of the holding company argued that the pledge should be treated as a guarantee and, therefore, constitute a financial debt.

The Court disagreed. Referring to Section 126 of the Indian Contract Act, 1872 (Contract Act), the Supreme Court emphasised that a ‘contract of guarantee’ requires an undertaking to discharge the liability of another person upon default. The pledge agreement before the Court merely created a security interest and contained no promise by the pledgor to repay the borrower’s debt. In the absence of such an undertaking to repay, the lender remained only a secured creditor and could not be recognised as a financial creditor under Section 5(8) of the IBC.

Jaypee Infratech and Phoenix ARC established an important principle. The mere creation of third-party security, whether through a mortgage, pledge or similar arrangement, does not, without anything more, create a financial debt. The creditor may enforce the security but does not automatically become financial creditor in the CIRP of the security provider.

The legal position became more nuanced with the Supreme Court’s decision in China Development Bank. Rather than departing from Jaypee Infratech, the Court refined the inquiry by examining not merely the existence of third-party security, but the nature of the obligations assumed by the security provider.

The dispute arose from a deed of hypothecation executed by Reliance Infratel Limited (RITL) to secure loan facilities extended to other Reliance group entities. When insolvency proceedings were initiated against RITL, the lender, China Development Bank claimed to be its financial creditor on the basis of the deed of hypothecation.

Unlike the mortgage considered in Jaypee Infratech, the deed of hypothecation did more than merely create a security interest. It contained an express undertaking by RITL to repay the secured debt, together with interest, costs and other amounts due under the financing documents. The deed also required RITL to make good any shortfall remaining after the security interest in the secured assets had been enforced.

The Supreme Court held that these obligations fundamentally altered the character of the obligation from security creation to repayment of debt. Although the document was named as a deed of hypothecation, its substantive terms showed that RITL had undertaken to discharge the borrower’s liability in the event of default. In effect, the document operated as a contract of guarantee within the meaning of Section 126 of the Contract Act.

The Court, therefore, emphasised that the legal character of a document depends on the obligations it creates rather than the nomenclature attached to it. A document that merely creates security remains a security document. However, where the security provider also assumes a direct and enforceable obligation to repay the underlying debt, the arrangement may acquire the character of a guarantee and consequently give rise to a financial debt under Section 5(8) of the IBC.

Importantly, the judgment did not hold that every third-party security creates a financial debt. It also did not dilute the principle laid down in Jaypee Infratech that the creation of security alone is insufficient for classification as a financial creditor. Instead, it introduced an important qualification: where the security document contains an independent covenant requiring the security provider to discharge the borrower’s liability, the creditor’s rights may extend beyond those of a secured creditor and bring them within the umbrella of financial creditor.

Courts/Tribunals must therefore examine whether the contractual obligations undertaken by the security provider are, in substance, equivalent to those of a guarantor.

This shift has important implications for financing transactions. Security documents that were traditionally viewed as creating only proprietary rights over assets may also create personal repayment obligations depending on their drafting. As a result, determining whether a creditor qualifies as a financial creditor now requires a closer examination of the specific covenants contained in the relevant security document rather than simply identifying its legal form.

One may view the NCLAT’s decision in JC Flowers as a departure from Jaypee Infratech. However, as indicated earlier, the decision is better understood as an application of the principles laid down in China Development Bank.

The dispute arose from loan facilities extended by YES Bank to Sumer Radius Realty Private Limited (SRRPL). To secure these facilities, Radius Estate Projects Private Limited (REPPL), which was not the borrower, executed English deeds of mortgage over its properties. Following commencement of REPPL’s CIRP, J C Flowers, as the assignee of YES Bank’s debt, sought recognition as a financial creditor based on these mortgage deeds.

The resolution professional rejected J C Flowers’ claim, relying on Jaypee Infratech. It was argued that REPPL had merely provided third-party security for another entity’s borrowings, without receiving any loan itself. Accordingly, J C Flowers could, at best, qualify as a secured creditor and not a financial creditor under Section 5(8) of the IBC.

The NCLAT approached the issue differently. Following the reasoning adopted by the Supreme Court in China Development Bank, it looked beyond the title of the document and examined the obligations undertaken by REPPL under the mortgage deeds.

The NCLAT found that the deeds did more than creating a security interest over REPPL’s assets. They contained an express covenant requiring REPPL to repay the secured debt upon default by SRRPL. This obligation imposed a personal liability on the mortgagor that extended beyond the mere provision of security.

The NCLAT also attached significance to the fact that the mortgages were structured as English mortgages under Section 58(e) of the Transfer of Property Act, 1882. Unlike certain other forms of mortgage, an English mortgage inherently carries a personal covenant by the mortgagor to repay the mortgage debt. While the express repayment obligations contained in the deeds were sufficient to support the Tribunal’s conclusion, the nature of an English mortgage further reinforced that REPPL had assumed obligations akin to those of a guarantor.

On this basis, the obligation contained in a ‘covenant to pay’ clause gave rise to a financial debt under Section 5(8) of the IBC. Consequently, J C Flowers was recognised as a financial creditor in REPPL’s CIRP.

The NCLAT distinguished the nature of obligations in Jaypee Infratech from the one in JC Flowers as the latter contained a ‘covenant to pay’ clause.

Both China Development Bank and JC Flowers involved security documents that imposed direct repayment obligations on the security provider. Those obligations enabled the courts to characterise the arrangements as contracts of guarantee in substance, regardless of the nomenclature of the documents.

The decisions therefore establish an important distinction. A security document that merely creates a proprietary interest in favour of the lender continues to be governed by the principles in Jaypee Infratech. However, where the document also contains an express or inherent obligation requiring the security provider to discharge the borrower’s liability, it may give rise to a financial debt, bringing the lender within the ambit of a financial creditor.

The combined effect of Jaypee Infratech, China Development Bank and JC Flowers is that the treatment of third-party security under IBC depends less on the label attached to the security document and more on the obligations it creates. The critical question is no longer whether the corporate debtor has provided a mortgage, pledge or hypothecation, but whether it has also undertaken an independent obligation to repay the underlying debt.

This evolution is likely to influence how financing transactions are structured and documented. Lenders may seek to incorporate express repayment covenants or other guarantee-like obligations into security documents to strengthen their position in the event of the security provider’s insolvency. Conversely, entities providing third-party security will need to carefully consider whether the proposed documentation inadvertently exposes them to liabilities extending beyond the creation of security over their assets. This is a much-awaited respite for lenders who advanced loans based on the economic viability of the “third party” offering securities (including the assets offered as securities) for loans not directly disbursed to them. It has not only given them a seat in the CoC but also its share of the pie in the CIRP as a financial creditor.

The decisions also underscore the importance of careful drafting. Similar security arrangements may produce different outcomes under IBC depending on the language used in the underlying documents. The precise allocation of rights and obligations may determine not only the enforceability of the security but also whether a creditor is entitled to participate in the insolvency process as a financial creditor. Resolution professionals and adjudicating authorities must therefore undertake a closer examination of the rights and obligations created by each instrument, rather than relying solely on its title or form.