Background
One of the significant modes of investments that have recently gained momentum in India has been fund raising by companies through debt funding from portfolio investors, financial institutions and other lenders. A typical secured debt financing/lending transaction is structured in a manner, such that the security or charge creation establishes lender’s right over specified assets of the borrower for securing the repayment of the principal amount, interest or any other special premium attached to the principal amount.
Often such borrower entity further raises debt finance by approaching another lender/creditor or a financial institution, as a result of which the entity creates a second charge over the assets of the entity in favour of the subsequent lender/creditor. Such charge stands as a subordinate security to the charge created in favour of the first lender/creditor and the enforceability of such security during the existence of the first charge-holder seems a distant possibility.
The article sets out the pragmatic difficulties and challenges faced by second/subordinate charge-holders of an asset, secured for repayment of the debt by the debtor to such lender/charge-holder and the viable solution that may be adopted and incorporated in the legal regime to foster debt financing, specially syndicate lending, where various lenders finance an entity and secure its assets.
Remedies available and the challenges
As per the Companies Act, 2013[1] the term “charge” is defined as an interest or lien created on the assets or property of a company or any of its undertakings as security and includes a mortgage.
A lender generally derives its rights under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), where a “financial institution” is entitled to enforce security interest, in addition to remedies available under the security documents. Similarly, creditor/lender, as a “financial creditor” under the Insolvency and Bankruptcy Code, 2016[2] (IBC), is entitled towards the proceeds of sale of the liquidation assets of a corporate debtor, in order of priority set out under the IBC[3]. In addition to the above laws, the lender has a right to claim specific performance and recovery of amounts due under the security documents executed in relation to the debt.
Also, so far as the claims of the first charge-holder and the second charge-holder are concerned, in the event the debts are due to both, the law stands quite clear that the claim of the first charge-holder shall prevail over the claim of the second charge-holder and the same shall be realised from the immovable property belonging to the borrower entity and the amounts due to the first charge-holder shall be repaid in priority to the second charge-holder.[4]
However, the uncertainty lies in the law regarding the remedy of a second charge-holder, in the event the borrower entity has defaulted under the security documents executed with such second charge-holder, and where, in an ongoing debt, there has been no default by the borrower entity towards the first charge-holder and payment of principal amount and interest is complied with, though there is default by the borrower in making payments towards the second charge-holder and the second charge-holder desires to enforce the security. In a typical scenario there is either an intercreditor agreement between the first charge-holder and the second charge-holder or the first charge-holder provides a no-objection certificate to the corporate debtor regarding the creation of the second charge and the same is agreed/acknowledged by the second charge-holder.
As per a standard intercreditor arrangement between the first charge-holder and the second charge-holder, the second charge-holder enforcing the security can occur only upon consent of or exit of the first charge-holder. In various cases, the first charge-holder provides a no-objection certificate to the corporate debtor to create second charge over the assets, with the condition that the security cannot be enforced by the subordinate charge-holder in the event of default without prior consent of the first charge-holder.
Therefore, in the event of any default by the borrower under the finance documents executed with the second charge-holder, the second charge-holder will be at the mercy of the first charge-holder. The first charge-holder will have a priority entitlement over the assets, even where the asset cover of the borrower is substantially higher than the amounts raised from the first and second lender, thereby making remedy of a second charge-holder redundant.
It may be noted that as a remedy, a second charge-holder will have a substantive right under the SARFAESI Act. Under the IBC, the lender may move an application seeking insolvency of the corporate debtor, though, its claim, as a secured financial creditor, will be made available to it only upon the corporate debtor being declared insolvent and thereafter in accordance with the distribution waterfall[5]. However, enforcement of security by a subordinate charge-holder will essentially be governed by the terms of contractual arrangements with the first charge-holder and the corporate debtor and there is no clear law providing for an effective remedy to the subordinate charge-holder.
My observation and conclusion
The cacophony regarding the rights of subordinate lenders in relation to enforcement of security has been a matter of significant concern for debt financing in India. Though there is a substantive right under the SARFAESI Act and the IBC available, the real challenge comes in enforcing the security in a situation where there is no default by the principal debtor towards primary lender, however, there has been a default towards the second/subordinate charge-holder. With the escalation in mezzanine and debt financing in India, there is a need for having a law regulating the debt financing, particularly group lending or syndicate financing.
I believe that following legal framework may be adopted for providing an effective remedy to subordinate charge-holders to enforce the securities and safeguarding their interests in the events discussed above:
(a) The borrower/debtor to maintain 100% asset cover, sufficient to discharge the outstanding amounts of the entire debt raised from all the lenders, vide loan or inter-corporate deposit, from the secured lenders, at all times, as is required to be maintained by the companies issuing secured/listed debentures. This will provide comfort to the first charge-holder that even if the second charge-holder is repaid for the default against it, the assets of the company are sufficient to discharge its claims.
(b) In the event of any default by a borrower against the second charge-holder, the security may be enforced, and the amounts realised from the proceeds of the sale of the charged assets to be retained in an escrow account held by and an independent escrow agent. The escrow bank account may accordingly after repayment of outstanding amounts to the subordinate lenders, utilise the remaining amount for repayment of amounts to first lender.
(c) Reserve Bank of India may address the issue by promoting syndicate and consortium lending and formulating the guidelines for enforcement of securities by subordinate lenders.
The measures set out above may provide for a greater boost and confidence to fund raising by way of further financing by subordinate lenders in India and foster greater confidence in syndicate and consortium lending.
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† Lawyer, General Corporate, M&A, Banking and Finance.
[1]S. 2(16) of the Companies Act, 2013.
[2]S. 53(1)(b)(ii) of the Insolvency and Bankruptcy Code, 2016.
[3] S. 53 of the Insolvency and Bankruptcy Code, 2016.
[4] S. 48 of the Transfer of Property Act, 1882; ICICI Bank Ltd. v. SIDCO Leathers Ltd., (2006) 10 SCC 452; Employees Provident Fund Commr. v. Official Liquidator of Esskay Pharmaceuticals Ltd., (2011) 10 SCC 727.
[5] S. 53 of the Insolvency and Bankruptcy Code, 2016.