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September 06, 2017

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MORATORIUM UNDER INSOLVENCY & BANKRUPTCY PROCEEDINGS


- Santosh B. Parab, General Counsel and Head - Legal [ IDFC Bank Limited ]

santoshbparab

Read on to understand implications of moratorium on lenders who have taken certain forms of collateral/security interest, including security of assets of corporate debtor against whom insolvency proceedings have been initiated...

A moratorium in general parlance refers to a delay or suspension of activity or law for a certain period of time. In the legal context, it may refer to the temporary suspension of a law to allow a certain legal challenge or proceeding to be carried out without any disruption on account of interplay of overlapping legal processes.

Under the newly enacted Insolvency and Bankruptcy Code, 2016 (“the Code”), the National Company Law Tribunal (“the Adjudicating Authority/NCLT”) on the date of admission of the application filed for initiating corporate insolvency resolution process under Section 7 or Section 9 or Section 10 of the Code (called insolvency commencement date), shall, by an order, declare a moratorium for prohibiting all of the following, namely:

(a) institution of suits or continuation of pending suits or proceedings against the corporate debtor including execution of any judgment, decree or order in any court of law, tribunal, arbitration panel or other authority;

(b) transferring, encumbering, alienating or disposing of by the corporate debtor any of its assets or any legal right or beneficial interest therein;

(c) any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect of its property, including any action under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

(d) recovery of any property by an owner or lessor where such property is occupied by or in the possession of the corporate debtor1.

An exception to the abovementioned prohibition is the supply of essential goods and services to the corporate debtor, which shall not be interrupted by way of the moratorium. Further, the Central Government is authorized to notify non-applicability of the moratorium provisions as the Government may deem fit in consultation with the financial services regulator. Pursuant to the powers vested with the Central Government under the Code, the Department of Financial Services, Government of India has addressed its letter dated May 1, 2017 to members of the Indian Banks’ Association, seeking suggestions on the aforesaid exclusions from Section 14 of the Code, including cases where SARFAESI action has been initiated under Section 13(4) and Section 14 of the SARFAESI Act.

This article aims to analyze implications of the moratorium on lenders who have taken certain forms of collateral/ security interest, including security of assets of the corporate debtor against whom insolvency resolution process has been initiated, pledge of shares pertaining to the corporate debtor, guarantee from promoters of the corporate debtor etc. This can be better understood by the following illustration:

Company A is a promoter of Company B. Company B has obtained a loan from Bank X against the following security (a) Corporate Guarantee of Company A and (b) Pledge of Shares held by Company A in Company B (“the Pledged Shares”). Lenders of Company A file an application under Section 7 of the Code against Company A. The application has been admitted by NCLT, the moratorium has begun and interim resolution professional (IRP) is appointed. In these circumstances:

i. Can Company A or IRP stop invocation of Pledged Shares by Bank X? Will invocation of Pledged Shares be impacted by the moratorium?

ii. Can Bank X invoke the Corporate Guarantee?

iii. Can Company A refuse payment to Bank X in the event of invocation of Corporate Guarantee?

iv. Will the invocation of Corporate Guarantee be impacted by the moratorium?

Analysis - As per the Code, if the application filed against Company A is admitted by the NCLT, the following shall occur:

(a) a moratorium shall be declared on any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect to its property under Section 14(1)(c) of the Code. This may lead to the Bank X being barred from invoking the pledge over the Pledged Shares till such time as the moratorium continues;

(b) the interim resolution professional (“IRP”) shall take control and custody of any asset over which the corporate debtor has ownership rights, including securities it holds in its subsidiaries under Section 18(1)(f) of the Code i.e. the Pledged Shares as the same would qualify as assets of the corporate debtor; and

(c) the Committee of Creditors (“CoC”) established in relation to Company A may instruct the IRP to create additional security on the Pledged Shares in favor of such persons as instructed by the COC under Section 28(1)(b) of the Code.

On plain reading of the abovementioned sections of Code, it appears that security created in the form of pledge over Pledged Shares cannot be enforced till expiry of the moratorium period. Though the IRP can theoretically take control of Pledged Shares, under the existing depository system established under the Depositories Act, 1996 read along with the bye-laws issued by the National Securities Depository Limited (NSDL)3, there is no provision for any third party to take charge or control of the already Pledged Shares. Unless, Bank X consents to the release of the pledge on Pledged Shares, neither IRP will be able to take control or deal with in any manner, or create additional pledge over Pledged Shares nor COC can instruct creation of additional pledge over Pledged Shares in favor of lenders of Company A. The Code does not give any power to either the IRP or COC to invalidate or cancel the pledge validly created in favor of Bank X on Pledged Shares in terms of the procedure prescribed under the Depositories Act, 1996. Therefore, the pledge created in favor of Bank X will not be impacted except that during the moratorium period, Bank X may not be able to invoke and sell Pledged Shares. After expiry of the moratorium period, Bank X will have no restriction for invoking or selling Pledged Shares.

Though the IRP can theoretically take control of Pledged Shares, under the existing depository system established under the Depositories Act, 1996, there is no provision for any third party to take charge or control of the already Pledged Shares

As regards the Corporate Guarantee, Bank X may not be able to invoke it during the moratorium period, however, there would be no restriction on sending demand notice to the Company A, asking it to make payment under the Corporate Guarantee. Further, upon non-payment by Company A under the said Guarantee, Bank X will be at liberty to initiate appropriate legal proceedings against Company A before Debt Recovery Tribunals and/or under the Code, in its capacity as a financial creditor of Company A in terms of the Code.

Now let’s reverse the above illustration:

Company A is a promoter of Company B. Company B has obtained a loan from Bank X against the following security (a) Corporate Guarantee of Company A and (b) Pledge of Shares held by Company A in Company B (“the Pledged Shares”). Some other lenders of Company B file an application under Section 7 of the Code against Company B. The application has been admitted by NCLT, the moratorium has begun, and IP is appointed. In these circumstances:

i. Can Company A or IRP stop invocation of Pledged Shares by Bank X? Will invocation of Pledged Shares be impacted by the moratorium?

ii. Can Bank X invoke Corporate Guarantee?

iii. Can Company A refuse payment to Bank X in the event of invocation of Corporate Guarantee?

iv. Will invocation of Corporate Guarantee be impacted by the moratorium?

In this case, neither invocation of Corporate Guarantee nor Pledged Shares shall be impacted by declaration of moratorium. The COC can even, as part of the resolution plan, decide on invocation of Corporate Guarantee and Pledged Shares.

It may thus be noted that it is important that moratorium provisions are interpreted to be restricted to the assets of the corporate debtor and must not be used as a tool by third-party security providers to evade their liability under security documents executed with the lenders.

The recent judgment given by NCLT, Mumbai, in case of M/s Schweitzer Systematic India Private Limited vs. Phoenix ARC Limited2, is an illustrative judgment on this aspect, where the tribunal ruled that ‘ moratorium has no application on properties beyond the ownership of the corporate debtor .’

It was further ruled that (a) moratorium shall commence on the corporate debtor; (b) property not owned by corporate debtor does not fall within the ambit of moratorium; (c) order of CMM directing the court commissioner to take over possession of properties shall not fall into the clutches of moratorium; (d) further clarified that any action under SARFAESI Act shall come within the ambit of moratorium if an action is to foreclose or recover or create any interest in respect of the property belonged to or owned by a corporate debtor, otherwise not.

Footnote:
1. Section 14 of the Insolvency and Bankruptcy Code, 2016.
2. Order dated July 3, 2013 in TCP No. 1059/I&BP/NCLT/MB/MAH.
3. In terms of the Depositories Act, 1996 read along with the Bye-Law 9.9.9 issued by NSDL (as amended till June, 2017); the entry of pledge or hypothecation made in respect of any securities shall be cancelled by the Depository Participant when the Client redeems the pledge or hypothecation and makes a request, with the concurrence of the pledgee.

Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.

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