This article has been published by Chambers and Partners at https://chambers.com/legal-trends/indias-supreme-court-deeds-of-hypothecation-guarantees”

In their analysis of the recent Supreme Court of India judgment in China Development Bank v. Doha Bank Q.P.S.C., Vatsala Rai and Bharat Makkar, partner and senior associate, respectively, in the dispute resolution team at AZB & Partners, explore a key and complex legal question: whether obligations arising under a deed of hypothecation can be classified as a contract of guarantee under Section 126 of the Indian Contract Act, 1872. The case delves into whether such obligations qualify as “financial debt” under the Insolvency and Bankruptcy Code, 2016, thus raising important implications for both contract law and insolvency proceedings in India.

Background

The appellants in this case were creditors who had extended financial assistance to Reliance Communications and Reliance Telecom Limited and Reliance Infratel Limited (“Corporate Debtor” or CD) collectively referred to as Reliance group entities (“RCom entities”). The RCom entities had executed deeds of hypothecation (DoH) in favour of the appellants. The DoH also addressed the obligations for RCom entities to cover any shortfall that may arise in repayment by the corporate debtor.

During the corporate insolvency resolution process of the CD, the appellants were recognised as financial creditors (FC) by the resolution professional; however, such classification was challenged by Doha Bank, another FC. Doha Bank argued that the DoH did not constitute a contract of guarantee and, therefore, did not qualify as a financial debt under the Insolvency and Bankruptcy Code, 2016 (IBC).

Procedural History

The NCLT heard the application of Doha Bank and dismissed it, upholding the status of the appellants as FCs. Doha Bank then appealed this order before the NCLAT.  The NCLAT, when setting aside the NCLT order, held that the DoH was not a deed of guarantee. It determined that the sole purpose of the DoH was to create a charge on the chargors’ property and that the chargors could not be considered guarantors.

Erroneous Findings of NCLAT

The NCLAT relied on “form over substance” and made erroneous observations that clauses of DoH cannot be deemed a “covenant of guarantee” or “contract of guarantee”, and that a DoHis merely a creation of security interest which does not constitute financial debt. The NCLAT went on to state that a covenant to pay is a regular boiler plate clause in any standard draft of a “deed of hypothecation”. It asserted that such a clause – whether relating to hypothecation or guarantee – should be expressly outlined in the preamble or initial section of the agreement, rather than appearing elsewhere in the document as a provision for recouping deficiencies.

The Appeal to the Supreme Court of India (SC)

The NCLAT judgment was challenged by the appellants before the SC. They argued that the DoH was the crucial factor in determining whether RITL, or the CD, could qualify as a guarantor for the debts assignable to other RCom entities. Clause 5(iii) of the DoH specifies the event of default whereby the security trustee (for the appellants) could exercise its rights under the DoH, including repayment of the facilities advanced with interest, damages, etc, thereby giving it the characteristics of a guarantee.

The SC Order

The SC correctly interpreted the clauses of the DoH to mean that the obligation to pay by the CD in case of a shortfall in repayment after realising the assets, would constitute a guarantee under Section 126 of theIndian Contract Act, 1872 (ICA). It further held that any liability emanating from a DoH, where a non-borrowing party undertakes to cover any deficiency in repayment of debts owed by third parties, is equivalent to a contract of guarantee under Section 126 of the ICA. The judgment also states that there is no requirement that a default must occur for a debt to be classified as a financial debt under the IBC. A financial creditor can submit a claim even if no default has occurred. Consequently, a liability of this nature would also qualify as a financial debt under Section 5(8)(i) of the IBC.

The SC provided clarity on the contractual structure of the guarantee among the parties involved. RCom and RTL constitute the principal debtor, primarily liable for repayment. RITL acts as the surety providing the guarantee of repayment. The appellants are the creditors to whom the debt is owed. Relying on Phoenix ARC Pvt. Ltd. v. Ketulbhai Ramubhai Patel, (2021) 2 SCC 799, the SC underlined that a guarantee necessitates an explicit promise to discharge the liability of another, differentiating the same from standard security arrangements. Moreover, the SC highlighted that the appellants had extended financial facilities to RCom entities, thereby constituting adequate consideration for RITL’s guarantee. This was found to be in line with the requirement under Section 127 of the ICA, which provides that any promise made for the benefit of the principal-debtor qualifies as valid consideration for the surety’s obligation.

The SC went on to emphasise that financial debt involves any liability arising from a commercial effect of borrowing, inclusive of guarantees, differentiating from Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited, (2020) 8 SCC 401.

Moreover, reversing the findings of the NCLAT and rejecting the arguments made by the respondents on the agreement being a contingent contract and it becoming void after the moratorium declaration under Section 14 of the IBC, the SC stated that the moratorium imposed under Section 14(1) of the IBC does not extinguish claims; instead, it only prohibits certain actions, like the recovery or enforcement of security interests. The obligation arising from a DoH remains valid during the moratorium. Even if the claim cannot be immediately enforced due to the moratorium, the underlying debt remains.

“By interpreting the DoH as a contract of guarantee, the court has prioritised substance over form”.

The SC clarified that the title of a document, such as the DoH, cannot solely determine its nature. Relying on C.C., C.E. and S.T.Bangalore (Adjudication) & Ors. v. Northern Operating Systems Pvt. Ltd., AIR 2022 SC 2450 and B.K. Muniraju v. State of Karnataka, (2008) 4 SCC 451, the SC held that while “hypothecation” refers to using an asset as collateral for a loan, the court will consider the entire document to interpret its true nature, not just the title.

Conclusion

By interpreting the DoH as a contract of guarantee, the court has prioritised “substance over form”. It clarified that obligations to cover shortfalls in repayments fall within the ambit of financial debt. This judgment emphasises the need for careful drafting and consideration of substantive obligations in contracts, ensuring that commercial realities are not overshadowed by rigid legal formalism. It also safeguards the rights of creditors, reinforcing their ability to claim rightful status under the IBC while maintaining the integrity of the resolution process. Furthermore, the SC’s interpretation of Section 14 of the IBC ensures that the moratorium provision does not unjustly extinguish valid claims, balancing the interests of creditors and the corporate debtor. The ruling thus provides critical clarity and predictability for financial transactions, serving as a cornerstone for future insolvency and contract law disputes in India.

On the other hand, from the security provider’s perspective, the judgment will have implications for third-party security providers who at times agree to incorporate a general obligation to pay under the security documents for loans of their subsidiaries/group companies. While negotiating, third-party security providers should seek removal of clauses which require them to undertake repayment obligations if they are not looking to undertake a guarantee to repay. Another safeguard for the security provider can be to cap the repayment obligations to the realisable value of the security. This judgment will have an impact on the future structuring of ring-fenced transactions intended to provide security or contractual comfort by third parties while limiting the liability of promoters and other third parties.