The Pitfalls Of Investing In Convertible Instruments From The Perspective Of The (Indian) Insolvency Regime

A decade back, investment would broadly be classified as either debt or equity. However, the rise of private credit in the last few years has witnessed the rise of convertible instruments as an extremely viable investment proposition offering investors the advantages of fixed returns as well as equity upside. The conundrum that this article seeks to highlight relates to the rights of financial creditors who are regulated by financial sector regulators and subscribe to hybrid/equity instruments in the ordinary course of their business of investing in companies and inadvertently attract the “related party” tag in terms of Section 5(24) of the Insolvency and Bankruptcy Code, 2016 (“IBC”).

Although the IBC stipulates some carve-outs to protect the legitimate interests of financial creditors who are regulated by financial sector regulators and walk-into the related party classification on account of broader financing transactions, these carve-outs are not by themselves adequate to shield legitimate interests of regulated financial creditors who routinely engage in providing financing to corporates using hybrid models.

A. General Scheme of the IBC: Primacy to the Commercial Wisdom of Financial Creditors

The scheme of the corporate insolvency resolution process (“CIRP”) in terms of the IBC recognises the commercial wisdom of financial creditors of a corporate debtor (“CD”) and provides them with certain rights in the form of: (a) the right to commence CIRP in terms of Section 7 of the IBC on the occurrence of default in debt; and (b) the right to participate in the committee of creditors (“CoC”) of the CD constituted in terms of Section 21 of the IBC, and exercise voting share calculated on the basis of the quantum of their admitted financial debt against the total financial debt admitted by the resolution professional (“RP”) of the CD.

An insolvency professional appointed to the office of an interim resolution professional/ RP of a CD cannot undertake certain actions as set out in Section 28(1) of the IBC without 66% approval of the CoC of the CD. These actions include, inter alia, changing the capital structure of the CD or recording any change in the ownership interest of the CD. More pertinently, the financial creditors forming part of the CoC have been statutorily enabled in terms of Section 30(4) of the IBC to assess the commercial viability of a resolution plan and are better placed to negotiate with a potential acquirer for an increase in recovery.

However, please note that the first proviso to Section 21 (2) of the IBC excludes any financial creditors of a CD who are also related parties of such CD from exercising any right of representation, participation or voting in a meeting of the CoC. In the event there are no unrelated financial creditors, a CoC is constituted entirely with unrelated operational creditors in terms of Regulation 16 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016. Essentially, a CoC is constituted entirely of unrelated party creditors.

B. The Related Party Disqualification and Carve-Outs for Financial Entities

A “related party” of the CD in terms of Section 5(24) of the IBC includes, inter alia, (a) a body corporate which is a holding, a subsidiary or an associate company of the CD, or a subsidiary of a holding company to which the CD is a subsidiary; (b) any person who controls more than twenty per cent. of voting rights in the CD on account of ownership or a voting agreement; and (c) any person who can control the composition of board of directors or corresponding governing body of the CD ((a), (b) and (c) are collectively referred to as “RTP Disqualifications”). Accordingly, those entities who suffer from the RTP Disqualifications are not given rights of representation, participation, or voting in a meeting of the CoC in terms of Section 21 of the IBC.

Notwithstanding the foregoing, the second proviso to Section 21(2) of the IBC carves out financial creditors regulated by a financial sector regulator (for example the Reserve Bank of India, the Securities and Exchange Board of India etcetera) (“Financial Entities”), who may be “related parties” of the CD solely on account of: (a) conversion or substitution of debt into equity shares or instruments convertible into equity shares; or (b) completion of such transactions as may be prescribed, prior to the CIRP commencement date (collectively referred to as “Carve-Outs”). Accordingly, those financial creditors who are regulated by sectoral financial regulators and fall within the ambit of any of the Carve-Outs continue to enjoy rights of representation, participation and voting in the CoC regardless of their classification as a related party of the concerned CD.

The Carve-Outs as set out above, if read strictly, provide a financial entity which is regulated by a financial sector regulator an exemption from: (a) holding equity shares/instruments convertible into equity shares on account of conversion/ substitution of debt prior to CIRP commencement date; and (b) completion of such transactions which still have to be notified by the Central Government prior to the commencement of CIRP. Accordingly, currently only two exemptions have been strictly crystallised, that is, a Financial Entity holding equity on account of substitution/ conversion of debt prior to CIRP commencement or if such Financial Entity holds instruments convertible into equity shares on account of substitution/conversion of debt prior to commencement of CIRP. Accordingly, if a Financial Entity qualifies as a related party of the CD solely on account of the situations identified by the Carve Outs, its rights to participate in the CoC and exercise voting share proportionate to its admitted financial debt will remain unaffected.

However, the Carve-Outs do not explicitly cover a situation where traditional equity instruments such as compulsorily convertible debentures (“CCDs”) have been converted into equity prior to CIRP commencement, as upon such conversion, the Financial Entity is no longer a related party on account of instruments convertible into equity but is a related party on account of equity shares converted from such CCDs. The Carve-Outs also do not cover a situation where an investor would have, in the first instance, invested in equity shares of the CD (whether by way of primary or secondary transaction) as part of a broader financing transaction. Essentially, neither conversion of CCDs (or other equity instruments) nor subscription to equity instruments prior to CIRP commencement date are covered by the Carve-Outs and such transactions may levy a Related Party Disqualification on a Financial Entity. Please see below an illustrative table summarising the gap in the protection afforded by the Carve-Outs if interpreted strictly.

C. Liberal Interpretation of the Carve-Outs Adopted by the Adjudicating Authorities

In the CIRP of Gati Infrastructure Bhasmey Power Private Limited (“Gati”), IFCI Limited had filed its claim as a financial creditor to the extent of the amounts due under the loan agreements entered into with Gati and also held 38.73% equity shareholding in Gati. However, the RP had denied IFCI Limited participation in the CoC of Gati on account of its shareholding which attracted one of the Related Party Disqualifications stating that subscription to equity shares is not one of the identified Carve-Outs. Subsequently, IFCI Limited had filed an interlocutory application [IA 1477/2023] before the Hon’ble National Company Law Tribunal, Hyderabad Bench (“NCLT-Hyderabad Bench”) praying for the re-constitution of the CoC such that IFCI Limited can participate to the extent of its admitted financial debt.

The NCLT-Hyderabad Bench, vide an order dated 06 February 2024 allowed IFCI Limited’s application and observed that the inclusion of “completion of such transactions as may be prescribed prior to the CIRP commencement date” as one of the Carve-Outs in the second proviso to Section 21(2) of the IBC by the legislature covers those transactions which “create compelling circumstances to financial creditors to continue as equity holder and thus reluctantly inviting the tag of related party to corporate debtor though they do not intend to continue as equity holder of the corporate debtor”. In the facts of the case, IFCI had also exercised its contractual put option prior to insolvency commencement to exit its equity investment but was unsuccessful in doing so due to non-cooperation of the obligors. However, in our considered view, the power to “prescribe transactions” lies with the Central Government and an interpretation by NCLT-Hyderabad Bench to include IFCI’s scenario within “prescribed transactions” without any notification from the Central Government to that effect may not be envisaged in the scheme of IBC.

Notwithstanding the peculiar facts in Gati’s case, the Insolvency Law Committee Report dated February 2020 had recorded the insufficiency of the current Carve-Outs to capture all situations in which a financial creditor regulated by a financial sector regulator may be deemed to be a related party of an otherwise unrelated CD. Accordingly, the Committee had recommended that the scope of the Carve-Outs should be broadened by enabling the Central Government to prescribe additional transactions solely by completion of which a financial creditor which, is regulated by a financial sector regulator and not otherwise related to the corporate debtor, should not be considered as a “related party” of the CD. However, such transactions have not yet been notified by the Central Government.

Accordingly, the Financial Entities who, as part of broader financing transactions, may also subscribe to equity shares/ securities convertible into equity beyond identified thresholds or seek to obtain control rights over the board of the borrower through contractual provisions and do not fall under any of the Carve Outs, may have to approach the jurisdictional adjudicating authority for adequate protection of their rights in case CIRP against their borrower has commenced.

D. Treatment of Amounts Due under CCDs in the CIRP of a Corporate Debtor

If a Financial Entity has also subscribed to CCDs as part of financing the CD, the paid-up amounts in relation to the CCD subscription may not qualify as debt depending on the terms of the subscription. In IFCI Limited v. Sutanu Sinha [Civil Appeal No. 4929 of 2023], the Hon’ble Supreme Court had observed that the CCDs held by IFCI Limited did not amount to “financial debt” against the CD as all obligations including coupon payments in relation to such CCDs were of the parent company of the CD and not the CD itself. The Court while examining the terms of the CCD subscription had observed that amounts due as coupon on the CCDs issued by the CD were to be paid by the sponsor company and not the CD itself and accordingly IFCI Limited, the concerned Financial Entity, could not claim to be a creditor of the CD.

However, in the matter of Indian Renewable Energy Development Agency Limited v. Waaree Energies Limited [Company Appeal (AT)(Insolvency) No. 1380 of 2024], the Chairperson’s court of the Hon’ble National Company Law Appellate Tribunal (“NCLAT”) observed that the terms of the subscription would determine whether amounts payable under a CCD arrangement can be classified as “financial debt” in terms of the IBC. NCLAT, relying on the terms of the CCD subscription agreement, which included an interest stipulation upon the occurrence of an event of default, observed that the transaction had a component of time value of money and came under the ambit of Section 5(8) of the IBC. Sutanu Sinha (supra) was only relied upon to establish whether or not amounts under debenture subscription agreements fall under the ambit of financial debt in terms of the IBC would depend on the terms of such arrangement.

In this regard, the National Company Law Tribunal, Mumbai bench in L&T Finance Limited v. Tikona Infinet Private Limited [CP(IB) No. 694/MB/2024] had taken a view, based on the terms of the concerned agreement, that although paid-up amounts in relation to CCDs would amount as equity, the interest component/ coupon amount would qualify as financial debt in terms of Section 5(8) of the IBC. The Tribunal went on to observe that the observations of the Hon’ble Supreme Court in Sutanu Sinha (supra) would be restricted to a case where the CD is not obligated to pay interest in terms of the CCD subscription. The Tribunal also observed that coupon rights of CCD subscribers are solely tied to ensuring that they achieve their agreed IRR, which has a component of time value of money and accordingly amounts in relation to coupon rights would be considered ‘financial debt’ under law.

The foregoing would imply that in an event a Financial Entity is being disqualified from participating in a CoC due to an inadvertently attracted related party disqualification, for example, on account of CCDs having been converted into equity exceeding identified thresholds prior to the commencement of CIRP, such Financial Entity may have to approach the adjudicating authority for a determination based on the terms of subscription of such agreement to assess whether the CCDs, prior to conversion, amounted to ‘financial debt’. Accordingly, if the adjudicating authority observes such CCDs were financial debt prior to conversion into equity shares, the Financial Entity may be eligible for the benefit of a Carve-Out as it is holding equity shares on account of conversion/substitution of debt prior to CIRP commencement date.

E. Concluding Remarks

In conclusion, it is likely that should an investor choose to invest in the form of CCDs or equity shares, such investment may bring the investor within the purview of related party and inadvertently prejudice their debt investment to the extent of disentitling them from voting/representation in the CoC in the CIRP of a CD. However, the judiciary has progressively moved towards a “substance over form” approach recognising that commerce has evolved and the documents forming the base of commerce have also evolved and created a hybrid nature of instruments (Sutanu Sinha (supra)). Accordingly, the judiciary is also conscious towards upholding the commercial ends sought to be achieved by such hybrid nature of instrument. That said, a timely and commercially informed notification from the Central Government expanding the ambit of the Carve Outs would go a long way in protecting the bona fide commercial interests of Financial Entities.

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