[The following guest post is contributed by Aditya Swarup, who is an Assistant Professor at the Jindal Global Law School]
In the seemingly complex world of corporate finance, creditors often face questions on the kind of security that ought to be taken by the them to support the loan to the borrower, answers to which depend on the relationship between debt and equity of the company. A further question arises on the kind of remedy available to the creditor if the borrower defaults in repayment of the loan – whether the remedy is personal or proprietary in nature? This question is significant especially in light of the introduction of the Insolvency and Bankruptcy Code, 2016 (“Insolvency Code”) and the recent amendments to the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (“SARFAESI Act”) (as amended on 12 August 2016) (“SARFAESI Amendments”).
In their simplest terms, personal (or contractual) remedies are remedies that attach to the “person”, while proprietary remedies attach to the property irrespective of the person in possession of the property (save for a bona fide purchaser). The distinction gains significance in a situation where the borrower is insolvent: a creditor with proprietary rights gains priority over the general class of unsecured creditors, while a creditor with personal remedies is in the same class as unsecured creditors. For instance, X, acting in the capacity of a trustee, fraudulently transfers Rs. 10 crore belonging to A to company B, and B later becomes insolvent. At the time of insolvency, B’s assets and liabilities are in the ratio of 1:4. In this case, if A wants to exercise a personal remedy, A will only be entitled to recover of a proportion of the liability owed to it, i.e. Rs. 2.5 crore. However, A can also avail of a proprietary remedy claiming that since the money was transferred fraudulently, A retained a beneficial interest in such money and therefore can lay claim to the entire Rs. 10 crore and get it out of the asset pool to the exclusion of all other creditors of B.
Kinds of absolute interests
In this sense, one of the main drawbacks of personal remedies is that these remedies merely entitle a creditor to prove the debt in liquidation of the insolvent debtor, which generally result in recovery of little or none of the outstanding debt. In contrast, a creditor who has a proprietary remedy can avail of the remedy either outside liquidation altogether or at least in priority to the claims of most other creditors. Proprietary remedies can arise out of either absolute (or quasi security) or security interests. If the creditor has an absolute interest, it is or becomes the absolute owner of the asset. A security interest merely secures the creditor with the obligation to repay. The creditor does not get title to the asset but can only sell the asset to recover its payments. Examples of absolute interests include finance leases, receivables financing, retention of title agreements and Quistclose trusts. Examples of security interests include charges, pledges, mortgages and liens. Some of these absolute interests are explained below:
(a) Finance leases
A lease typically involves the transfer of a right to enjoy property. In practice however, the ownership of the property remains with the lessor and all that is transferred is a right to enjoy the property. In the case of a finance lease, the creditor (lessor) retains ownership in the assets for the duration of the lease during which time the borrower (lessee) makes payments in installments towards the enjoyment of the property. Once the duration of the lease is determined, the ownership in the assets is transferred to the borrower. This is in contrast to an operating lease where, upon determination of the lease, the ownership is still retained by the creditor. Finance leases are a very common form of corporate finance, especially in the aviation industry.
As regards treatment of finance leases by the Indian Courts, while they were acknowledged as a form of financing and considered different from ordinary leases, in Association of Leasing and Financing Companies v. Union of India, (2011) 2 SCC 352, the Supreme Court has held that in view of the accounting standards, finance leases are required to be shown as assets in the books of the lessee and not the lessor. This decision may create some confusion in understanding who owns title to the asset when the borrower is insolvent. I believe this was one of the questions in Mumbai International Airport Limited v. Commissioner of Service Tax, WP 3013/2014, but has not yet been adjudicated by the Hon’ble Bombay High Court.
(b) Receivables financing
Receivables financing is usually achieved by transferring the title in the receivables to the creditor (being the assignee) with the borrower (the assignor) collecting the revenues arising from the receivables and holding the money in trust for the creditor. However, since the title in the receivables is held with the creditor, the credit risk is transferred to the borrower. Types of this arrangement are also referred to as factoring and, as of 2009, the amount of sales through factoring was over 6 billion euros (both domestic and international). In 2011, the Government introduced the Factoring Regulation Act, 2011, which sought to, for the first time, regulate receivables financing in India.
(c) Retention of Title
Though prevalent in many forms, the most common example of retention of title transactions are where the buyer acquires raw materials from a seller, and the seller also extends credit to the buyer which can be paid after the buyer disposes off the raw material or finished goods. In such a situation, since the seller is exposed to a considerable credit risk, he or she agrees to retain title to the raw materials/goods, even though they are in the possession of the buyer.
(d) Quistclose trust
As stated in Twinsectra v. Yardley,  2 AC 164, where a creditor makes it clear that money is lent for a specific purpose, and the purpose fails, the power of the borrower to use the money disappears and the money is held by the borrower on resulting trust for the creditor. Such a kind of trust amounts to a quasi-security interest since the creditor then is entitled to a proprietary remedy and the money held on trust is said to be outside the asset pool of the borrower in case of insolvency. The trust was first recognized in Barclays Bank v. Quistclose Investments Ltd.,  AC 567, and hence the name “Quistclose trust”. Quistclose trusts are recognized as resulting trusts and enforceable in India (See also Canbank Financial Services Ltd. v. Custodian, (2004) 8 SCC 355 making reference to the principle).
The current status of “absolute interests” in India
In theory, and at least on paper before 2016, absolute interests were altogether considered to out of the asset pool of a debtor and hence outside the purview of winding up and insolvency in India. The definitions of “property” and “transfer of property” under the Presidency Towns Insolvency Act, 1909 did not specifically cover absolute interests and there is little evidence to show that they were enforced as such. Similarly, the original un-amended SARFAESI Act defined “security interest” as follows:
“(zf) ‘security interest’ means right, title and interest of any kind whatsoever upon property, created in favour of any secured creditor and includes any mortgage, charge, hypothecation, assignment other than those specified in section 31”.
Section 31 of the SARFAESI Act specifically excluded creation of security on any aircraft and “any contract in which no security interest has been created”. However, it is submitted that the enactment of the Factoring Regulation Act, 2011, the SARFAESI Amendments and the Insolvency Code have sounded the death knell of absolute interests in India. The relevant provisions in the SARFAESI Amendments and Insolvency Code read as follows:
Clause (zf) of section 2 of the SARFAESI Act now reads:
“(zf) ‘security interest’ means right, title or interest of any kind whatsoever upon property created in favour of any secured creditor and includes-
(i) any mortgage, charge, hypothecation, assignment or any right, title or interest of any kind, on tangible property, retained by the secured creditor as an owner of the property, given on hire or financial lease or conditional sale or under any contract which secured the obligation to pay any unpaid portion of the purchase price of the asset or any obligation incurred or credit provided to enable the borrower to acquire the intangible property; or…”
Section 3(27) of the Insolvency Code states:
“(27) ‘property’ includes money, goods, actionable claims, land and every description of property situated in India or outside India and every description of interest including present or future or vested or contingent interest arising out of, or incidental to, property;”
Section 3(31) of the Insolvency Code states:
“(31) ‘security interest’ means right, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and includes mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person”
Section 3(34) of the Insolvency Code states:
“‘transfer of property’ means transfer of any property and includes a transfer of any interest in the property and creation of any charge upon the property”
Analysing these provisions, it could be argued that the absolute interests enumerated above have no further relevance in law and are treated on par with security interests. Surprisingly, the notes and clauses and the Joint Parliamentary Committee Reports to either of these legislation do not mention why there was a need to bring out such a change in the definition of security interests. Hence, today, if a company becomes insolvent, all the assets of the company, irrespective of whether or not they are owned by the company, will be considered as part of the asset pool and distributed in accordance with section 53 of the Insolvency Code. If absolute interests were excluded, then the holder of these absolute interests would not have had to account for deductions such as the insolvency resolution costs, liquidation costs and workmen’s dues.
That being said, there is still room for the enforceability of Quistclose trusts in India and taking property which is the subject matter of such a trust away from the asset pool. This could be because Quistclose trusts (and trusts in general) involve the bifurcation of legal and beneficial ownership unlike absolute interests. The legal ownership of the property is with the borrower but the beneficial ownership is with the creditor. It is for this reason Quistclose trusts are also called quasi-security interests. The definitions of the two legislations do not deal with it, and doing so may also be inconsistent with the Indian Trusts Act, 1882.
The road ahead
The seeming abolition of absolute interests in India is problematic because there doesn’t seem to be any debate in the formal legislative aids as to why such amendments were passed. A “seeming abolition” because even though it could be argued that the Insolvency Code and SARFAESI Act only refuse to recognise such interests and they could still be enforced in property and trust law (when the borrower is not insolvent), the difference in the remedies in enforceability would most times come about when the borrower is insolvent. As stated earlier, the advantages of proprietary remedies are the priority they give to the creditor in the event of the borrower’s insolvency and the remedy is meaningless if the interest is not recognised in law. There is a movement in some common law countries (New Zealand, Canada and Australia) to outline provisions for registration and perfecting absolute and quasi-security interests so as to identify all the assets of the company. The reasons and the need for such a scheme seem to be clearly elucidated in those jurisdictions. Further, the need for proprietary rights and remedies has been acknowledged as well. Surprisingly, the required sophistication of analysis in order to clarify issues of absolute and quasi-security interests seems woefully absent during the insolvency reform process in India. The consequences of the recent amendments and the status of proprietary remedies in India are yet to be seen, and are sure to exercise the minds of lawyers and courts in the near future.
- Aditya Swarup