Distinguishing Financial Debt from Operational Debt Under the IBC Framework
The Insolvency and Bankruptcy Code, 2016 (IBC), segments debt into two distinct categories: Financial Debt and Operational Debt. This classification determines the rights, roles, and remedies available to creditors within the Corporate Insolvency Resolution Process (CIRP).
A recent judgment by the Supreme Court of India in Global Credit Capital Limited vs. Sach Marketing Pvt. Ltd., 2024 SCC OnLine SC 649, addresses this critical classification, offering clarity on how certain transactions—such as a security deposit under a service agreement—may be treated under the IBC.
The case underscores a foundational principle in insolvency law: it is not the label but the substance of the transaction that dictates its legal nature.
Brief Factual Matrix
One Mount Shivalik Industries Limited (Corporate Debtor, or CD) entered into a Sales Promoter Agreement with Sach Marketing Pvt. Ltd. (Sach).
As part of this agreement, Sach deposited a security amount with the CD, with the understanding that it would earn interest.
Following the initiation of CIRP against CD, Sach filed a claim as a financial creditor, which was rejected by the Interim Resolution Professional (IRP).
A Resolution Plan was approved by the NCLT, but Sach’s application to have its claim recognized as financial debt was denied by the tribunal.
The NCLAT overruled this decision, holding Sach to be a financial creditor.
The matter was escalated to the Supreme Court, centering on whether the deposit constituted financial or operational debt.
Key Legal Arguments
Submissions by the Successful Resolution Applicant (SRA)
The SRA asserted that since the agreement was a service contract, any monetary claim arising out of it should be classified as operational debt under Section 5(21) of the IBC.
It emphasized that the security deposit was a condition precedent for appointment and not a financial accommodation.
Receipt of interest or acknowledgment of security in financial statements, they argued, does not transform a service-based deposit into a financial debt.
Submissions by Sach Marketing Pvt. Ltd.
Sach maintained that the transaction satisfied the three core ingredients of financial debt:
Disbursal of funds
Consideration for time value of money
Commercial effect of borrowing
They noted that interest payments were made and TDS deducted, supporting the financial nature of the transaction.
No actual services were rendered in return for the deposit, indicating that the transaction's essence was not operational, but financial.
Observations by the Supreme Court
The Supreme Court examined the broader nature and intent of the transaction, moving beyond its contractual form. The key principles outlined include:
Functional Test Over Formal Labels:
The mere presence of a service agreement does not restrict the deposit to being operational debt. What matters is whether the underlying economic effect resembles borrowing.Applicability of Section 5(8) of IBC:
Referring to Anuj Jain v. Axis Bank (2020) and Phoenix ARC v. Spade Financial Services (2021), the Court reaffirmed that a financial debt requires disbursal against time value of money. In this case, the deposit met that standard.Exclusionary Clause Under Section 5(8)(f):
Drawing from Pioneer Urban Land v. Union of India (2019), the Court stated that Section 5(8)(f) applies only when the transaction is not covered under other sub-clauses (a) to (e) but still involves a commercial borrowing effect.True Nature of Debt:
It was ruled that examining the agreement alone is insufficient. The entire transaction, conduct, and economic outcome must be evaluated to determine the real nature of the debt.
The Ruling
The Supreme Court upheld NCLAT's decision, declaring that the deposit fulfilled the legal and functional tests of financial debt under Section 5(8) of the IBC. Since the deposit was not linked to any actual service rendered, and it had an inbuilt interest mechanism, the Court categorized it as financial debt.
Sach, therefore, was to be treated as a financial creditor and not merely an operational participant.
Broader Implications Under Corporate & Commercial Law
This decision reiterates a vital interpretative standard under corporate and commercial law: substance prevails over form. Especially in insolvency matters, courts are not bound by contractual nomenclature. Instead, they evaluate the transaction’s purpose, effect, and financial architecture.
It also clarifies that security deposits, when carrying interest and not tied to actual operational performance, may be seen as financial accommodations, making the depositors financial creditors under IBC.
Conclusion
The Supreme Court’s decision in Global Credit Capital Ltd. v. Sach Marketing Pvt. Ltd. offers more than just a ruling on creditor classification. It establishes a transactional clarity test rooted in function over form—essential for understanding how debt is defined under Indian insolvency law.
For stakeholders engaged in corporate and commercial transactions, the judgment offers guidance on how commercial arrangements may be interpreted in insolvency proceedings. Security arrangements, interest payments, and service performance terms can all shift the legal nature of a debt—from operational to financial.
Understanding such distinctions is not merely academic—it is pivotal in determining stakeholder rights, voting powers in CoC, and distribution priorities in resolution plans.
Comments
Post a Comment