From Sandboxes to Sandcastles: Supreme Court’s Stance on Guarantee Obligations in a Deed of Hypothecation

Aayush Ambasht and Param Kailash

(Penultimate Year Students, Symbiosis Law School Pune)

In the evolving regime of insolvency jurisprudence, financial instruments are considered to be the drivers of strategy and risk, with their interpretation determining key outcomes for borrower-creditor interactions. A deep dive into these interactions unravel tension amongst creditors, vying for priority over their competing security interests, with the onus placed on courts to facilitate ease in understanding the contours of debt recovery. This delicate interplay of interests was put to the test in the case of China Development Bank v. Doha Bank Q.P.S.C., bringing the intricate guarantee-hypothecation dilemma to the forefront. While clarifying several complexities in the interpretation of overlapping security arrangements, the judgment offered crucial insights into resolving intra-creditor disputes in the context of India’s insolvency regime i.e. The Insolvency and Bankruptcy Code, 2016 (IBC).

Against this background, on December 20, 2024, the Supreme Court of India, settled an affirmative stance as to whether liabilities and obligations to be discharged by effect of a covenant embedded in a Deed of Hypothecation (DoH) amounted to a guarantee and its underpinning tailwinds on recovery of financial debts within the IBC framework. This post examines an overview of the Supreme Court’s judgment and aims to discern key implications for lenders and borrowers, privy to financial transactions; underpinning tenets for security creation, risk harmonization and ease of doing business at large.

Brief Background of the Case

Ericsson India Pvt. Ltd., initiated a Corporate Insolvency Resolution Process against Reliance Infratel Ltd (Corporate Debtor), which led China Development Bank and others (Appellants) to file their claims in the capacity of financial creditors. However, the Appellants had not extended said financial facilities directly to the Corporate Debtor, but to entities falling under the broader ambit of the Reliance Communications Group (third-party entities). Despite not being a direct lender, the Appellants’ claims were founded upon the guarantee clauses present in the DoH, obligating the Corporate Debtor to cover defaults arising out of third-party entities.

Consequent to the same, Doha Bank (Respondent) moved to the National Company Law Tribunal, Mumbai (NCLT) in order to declassify the Appellants as financial creditors since it was not a direct lender. The NCLT, heard and dismissed the same, upholding the status of the Appellants as financial creditors after placing reliance on the DOH which had the effect of a guarantee. Upon an appeal to the National Company Appellate Tribunal, New Delhi (NCLAT), the NCLAT set aside NCLT’s order, pertinently upholding that a DoH cannot exist in tandem as a deed of guarantee.

Aggrieved by the same, the Appellants preferred an appeal before the Supreme Court of India.

Key Findings of the Supreme Court

To what extent does title nomenclature define the decisive nature of a document?

At the formative stage of settling precedent on guarantee clauses in a DOH, the Supreme Court shed light on the title nomenclature conundrum of a document and its triggering impact on interpreting contracts. Placing reliance on the case of C.C., C.E. and S.T. Bangalore (Adjudication) v. Northern Operating Systems Pvt. Ltd., the Court reaffirmed that as a cardinal principle of interpretation, title nomenclature shall not be decisive of the nature of a document. While tackling ensuing issues with regards to a narrower and legalistic interpretation of contracts, emphasis on Union of India v. D.N. Revri and Co. was made. It was subsequently held that only because the title of the document contains the word “hypothecation”, it cannot be concluded that guarantee is not a part of the same.

Whether obligor’s liability in a DOH constitutes as a guarantee, and thus financial debt?

Considering the aforesaid moot issue in question, the Supreme Court upon perusal of Phoenix Arc Pvt. Ltd. v. Ketulbhai Ramubhai Pate, opined that covenants to perform a promise and discharge liability under a hypothecation deed shall constitute the nature of a guarantee and its obligations thereunder. Further, the Court furnished that third-party lenders shall fall within the umbrella of financial creditors without undertaking direct lending of loan facilities to the Corporate Debtor. Diverging from the precedent set in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Ltd., the Court held that any liability intrinsic to the commercial effect of borrowing, alongside guarantees, shall amount to financial debt.

Whether an event of payment default must occur for a financial debt to exist?

On the aspect of whether there is a mandatory requirement of occurrence of payment default for a financial debt to be established under the IBC, it was held that an occurrence or mandatory pre-requisite of actual default suffered is not necessary. The Supreme Court clarified that the moment it is established that a financial debt is owed to any person, he/she becomes a financial creditor and has a right to initiate claims against the Corporate Debtor.

What is the treatment of contingent claims during the imposition of a moratorium?

Since institution of suits/claims against the Corporate Debtor during a moratorium period stand prohibited under the IBC, the primary issue before the Supreme Court was regarding the effectiveness of a suit for contingent claims after such period by any creditor. The Court held that the imposition of a moratorium amidst an insolvency proceeding shall not stand to extinguish any contingent claim of a creditor. In essence, it furnished that notwithstanding the restriction of enforcement of recoveries during such period, claims with regards to non-payment or default of financial debt will continue to exist and stay in effect. Even in the event that a moratorium temporarily precludes enforcement, the underlying debt shall persist and creditors can initiate claims after the moratorium period.

Analysis: Will a Lenders’ Rulebook Impact Skin in the Game for Borrowers?

Pursuant to the key takeaways mentioned above, the Supreme Court’s ruling knits a paradigm in favour of lenders (conventional, third party or syndicate), granting a wider rulebook for canvassing claims under the garb of formalized creditor classification. While settling strides on the DOH and guarantee interrelationship, clarity with regards to title salience and overall commercial substance stands cemented from a lender’s lens. The judgment also enhances the standing of third-party lenders by upholding them as financial creditors, allowing them to pursue recovery action without actual default and permitting the initiation of contingent claims post the moratorium period. These interpretations shall ensure more flexibility for lenders in relation to smoother enforcement mechanisms during insolvencies, financial restructurings and asset backed securitizations.

From a borrower's purview, the Supreme Court's interpretation of guarantee obligations embedded within a DOH presents itself with critical considerations. Given that particular clauses in hypothecation deeds may carry implications akin to guarantees, borrowers are subjected to increased assumption of liability and stricter enforcement measures accruing to events of default. Recalibrating carve-outs and cure periods for remedying special situations must be charted out, the absence of which may lead to more severe consequences, not limited to, asset seizure or bankruptcy proceedings. In addition, borrowers must now carefully consider how this ruling impacts their overall fiscal discipline, collateral lending structures, policy prudence and risk management frameworks.

While negotiating the creation, maintenance and perfection of security provisions, security providers should seek removal of clauses which require them to undertake repayment obligations if they are not looking to undertake a guarantee to discharge specific obligations. Another safeguard in this regard is to cap the repayment thresholds to the aggregate realizable value of the security provided.

By design, performance obligations arising out of security documents, must signal both worthiness and readiness for borrowers and lenders across different transactional lifecycles. In this regard, charting out the sanctity and end-use of such obligations should be paramount without muddling stakeholder governance, prolonged matter pendency or ambiguous compliance burdens. This shall help actualize more leverage and ensure the fruition of milestones spelt out in financing covenants of lending practices.  

Concluding Remarks

In conclusion, the judgment paves a definitive way forward from the lens of vetting and negotiating bespoke arrangements for assuming the creation of security interest within security documents. As a precursor to risk participation and cushioning comfort to lenders, financial transactions involving hypothecation arrangements must stand distinguished from an invariable imposition of guarantee or infructuous indemnification by borrowers. Weighing significantly over Supreme Court’s stance in relation to upholding substance over form within such an enforcement action, a “pro-creditor” regime for recoveries of financial debt stands furnished. All in all, parties undertaking financing transactions must carefully address legal considerations for both - security perfection and guarantee obligations; without deterring its distinctive commercial utility at large.