1) Introduction:
Can a claim for failure to repay the security deposit under a contract qualify as ‘financial debt’ under the Insolvency and Bankruptcy Code, 2016 (as amended) (“Code”)? Or is the security deposit an ‘operational debt’ because it emanates from a contract for goods or services? This issue has recently been addressed by the Hon’ble Supreme Court of India (“Supreme Court”) in Global Credit Capital Limited & Anr. v. Sach Marketing Pvt. Ltd. & Anr.[1] wherein it has been elucidated that if the debt is being claimed under a written agreement / arrangement providing for rendering 'service', such debt is an operational debt only if the subject matter of the debt has some connection or correlation with the ‘service’ which is subject matter of the transaction.
2) Facts & Findings:
Sach Marketing Pvt. Ltd. (“SMPL”) and Mount Shivalik Industries Limited (“Corporate Debtor”) had entered into agreements, which were in the form of letters addressed by the Corporate Debtor, appointing SMPL as a ‘sales promoter’ to promote beer manufactured by it (“Agreements”). As per the Agreements, SMPL was to be paid a sum of INR 4,000/- per month for acting as a sales promoter for the Corporate Debtor. SMPL was further required to place a security deposit which would carry interest at 21% per annum.
In the insolvency process of the Corporate Debtor, SMPL claimed that the security deposit given was a financial debt. While the National Company Law Tribunal (“NCLT”) rejected this argument, the National Company Law Appellate Tribunal (“NCLAT”) accepted it.
Upholding the decision of the NCLAT, the Supreme Court held that the security deposit paid by SMPL to the Corporate Debtor was a ‘financial debt’ under the Code. The Supreme Court opined that a document cannot be taken for its face value, and it is imperative to ascertain the true nature of a transaction. The striking elements of the transaction and rationale culminating into this decision by the Supreme Court have been summarised below:
(a) The sine qua non for qualifying as a financial debt is that there is a debt along with interest (if any) and such debt has been disbursed against the consideration for the time value of money. Au contraire, the definition of ‘operational debt’ means a claim in respect of provision of goods or services or a debt in respect of payment of dues arising under any law for the time being in force and payable to the Central / State Government or local authority;
(b) The security deposit paid by SMPL had no correlation with performance of other terms of the Agreements or services rendered by SMPL and is therefore not a claim concerning provision of goods / services. Further, there was no clause for forfeiture of the security deposit and the Corporate Debtor was obligated to refund the same with interest after the specified period;
(c) The only amount related to the service was payment of the amount for acting as a sales promoter. Therefore, although the debt arose under a written agreement / arrangement for rendering 'service', it would be an operational debt only if the subject matter of the debt had some connection or correlation with the ‘service’ aspect of the transaction; and
(d) Section 5(8)(f) of the Code subsumes within it amounts raised under transactions which are not necessarily loan transactions, provided they have the commercial effect of a borrowing. Being an arrangement in writing for the transfer of funds to the Corporate Debtor, this was covered within the definition of ‘transaction’ under the Code. Moreover, the amounts did bear payment of interest and were treated as long-term loans and advances as well as a ‘long-term liability’ in the financial statements of the Corporate Debtor. Hence, such claim of security deposit meets the requirements of commercial effect of borrowing and would fall under Section 5(8)(f) of the Code, qualifying it as a ‘financial debt’.
3) Resonating views by NCLAT:
Not only the Supreme Court, recently, the NCLAT also had the occasion to adjudicate upon the nature of claim of security deposit paid by one party to another under a contract.
In the matter of Chintan Jhunjhunwala v. Avani Towers Private Limited & Anr.[2], the NCLAT has applied a similar test (as done by the Supreme Court) to ascertain the real nature of the transaction and the debt claimed. The corporate debtor and the financial creditor had entered into a development agreement under which the financial creditor was required to furnish a refundable security deposit of INR 120,000,000/- with the option to add another INR 30,000,000/- and this additional amount carried 18% compound interest, payable quarterly. The corporate debtor defaulted in payment of interest accrued on the additional amount. Due to such default, the financial creditor triggered the Code by filing an application under Section 7, which was admitted by the NCLT.
On appeal, the NCLAT analysed the clauses of the development agreement and observed the differential treatment given to the amounts i.e., INR 120,000,000/- was a security deposit and INR 30,000,000/- was an advance (which although was part of the security deposit but carried interest). Basis this analysis, the NCLAT held that payment of interest on the additional amount was not related to the amount given as security deposit. The NCLAT further concluded that payment of 18% compound interest indicates the time value of money, and the development agreement was a transaction having the commercial effect of borrowing. Additionally, in the notes of financial statements of the corporate debtor, there was an acknowledgment of the additional amount as an unsecured loan on which interest was payable. In view thereof, the NCLAT upheld the admission order passed by the NCLT and noted that default in payment of interest on an advance, which was paid as part of security deposit, was a ‘financial debt’ under the Code. Interestingly, while the financial creditor had categorised the entire security deposit with accrued interest as inventory in its books, the NCLAT held that such categorisation would not change the nature of the transaction.
In another decision in the matter of Carestream Health India Private Limited v. Seaview Mercantile LLP[3], the NCLAT concluded that the scope of operational debt under the Code does not include security deposit which is unrelated to any immediate service rendered. This also aligns with the principles explained in Global Credit (supra) to determine if a debt claimed would constitute an ‘operational debt’.
In this case, an application was filed under Section 9 of the Code basis default in refunding the security deposit paid by the creditor under a ‘Without Prejudice Letter of Intent’ (“Letter of Intent”) signed for leasing a unit. However, after due diligence it was found that the unit leased was not eligible for IT/ITES/STPI registration. Therefore, the creditor sought to terminate the Letter of Intent and demanded refund of the security deposit paid. It was contended by the creditor that the security deposit would be an operational debt since it is an advance payment for supply of goods and services.
The NCLAT analysed the Letter of Intent and observed that the claim for refund of security deposit was linked to a conditional contractual arrangement and not to actual provision of goods / services. Further, while it is settled that claim towards unpaid license fees for an immovable property would be an operational debt, a security deposit cannot be termed as a form of license fee; rather in this case, it was liable to be forfeited on account of non-performance of the obligation. The NCLAT accordingly dismissed the appeal and upheld the decision of the NCLT.
4) Paving the way ahead:
While these decisions appear to be simple application of elements of what constitutes ‘financial’ and ‘operational’ debt, they are significant and do add value to the existing (albeit developing) jurisprudence under the Code. The Supreme Court has laid great emphasis on the need to determine the true nature of the transaction and application of judicial mind to crystallise the nature of debt claimed. Needless to state, not all claims for security deposit would be classified as financial debts under the Code and this would entail careful analysis and consideration of the terms of the underlying agreement / arrangement. Nonetheless, the test laid down by the Supreme Court in Global Credit (supra) can also be beneficial to other instances involving deposits or monies paid under commercial transactions, which do not exactly have any connection with the goods / services which is the subject matter of the transaction.
Concurrently, it can be inferred that a claim for failure to refund security deposit need not ipso facto or necessarily be construed as an operational debt because it arises under an agreement / arrangement for goods or services, unless the subject matter of the security deposit has some connection or correlation with the ‘service’ which is the subject matter of the transaction. Besides this, parties negotiating commercial agreements may want to assess and mould the clauses, bearing in mind the ingredients of what constitutes ‘financial’ v. ‘operational’ debt under the Code.
Whether this will open a pandoras box making admission of insolvency applications more intricate or whether this would create an anomaly where creditors split their debt and file separate applications based on the nature of debt, only time will tell!
[1] Civil Appeal No. 1143 of 2022
[2] Company Appeal (AT) (Ins.) No. 769 of 2024
[3] Company Appeal (AT) (Ins.) No. 579 of 2023