Inter-Corporate Loans and Deposits: Treatment of Such Debts in Case of Default

Purpose of inter-corporate loans and deposits

Companies may give loans and guarantees, either directly or indirectly, to other companies or provide security in connection with a loan and acquire securities of any other company through subscription, purchase or otherwise. Statutorily¹, companies may give such loans, guarantees, or acquire securities up to a maximum of 60% of their paid-up share capital, securities premium account and free reserves² or 100% of their securities premium account and free reserves, whichever is more³ [collectively, inter-corporate deposits (“ICDs”)]. Such financial assistance provided inter se companies, whether in the form of a loan, guarantee or security, plays a pivotal role in offering liquidity to group or affiliated companies to address short-term financing needs. Therefore, ICDs sustain businesses and support growth and corporate operations by ensuring a steady flow of funds for various companies in need of capital. That said, while corporates with short-term surplus may place their deposits as ICDs, such loans are offered on an uncollateralised basis and as such, are unsecured borrowings, inherently at a substantial risk and therefore, come at a high-risk premium built into higher rates of interest⁴

Though common in business transactions, ICDs often present a considerable challenge to the lender company seeking to recover such borrowings (in case of default in repayment of the loan). The present article gives a brief overview of the approach adopted by courts in addressing the issue of enforceability of ICDs.

“Debts”, “deposits” and “loans” are not inter-changeable terms and therefore, not similarly enforceable

To determine the enforceability of ICDs, it is important to first recognise and evaluate, the distinction between “debts”, “deposits” and “loans”; this distinction in turn influences their enforceability in the event of a default.

At first blush, it may appear that the overarching term of ICDs would take within its sweep the whole gamut of financial transactions between companies, whether offered in the form of loans, investments, deposits, securities or guarantees. Courts, however, have adopted a view that deposits cannot be equated with loans or advances, thereby clearly demarcating between diverse kinds of financial transactions between companies.

Courts have emphasised that while terms such as “deposit” and “loan” may not be mutually exclusive, what must be considered is the intention of the parties and the circumstances behind such transactions.⁵ As an instance, in Ram Janki Devi v. Juggilal Kamlapat⁶, the Supreme Court observed that it will depend on the facts of each case whether the transaction is clothed with the character of a deposit of money. The surrounding circumstances, the relationship and character of the transaction, and the way the parties treated the transaction will throw light on the true form of the transaction.⁷ Interestingly, in Ashish Mahendrakar v. State of Maharashtra⁸, the Bombay High Court deliberated over the scope and ambit of Maharashtra Protection of Interest of Depositors (In Financial Establishments) Act, 1999 (MPID Act) vis-à-vis ICDs. The primary issue before the Court was whether ICDs procured from various investors and companies would be considered a “deposit” within the meaning of the MPID Act, and thereby would be enforceable thereunder. While ruling in the negative, the High Court observed that in offering ICDs, a company makes an informed decision after carefully evaluating the prevailing financial market conditions and therefore, it could not be permitted to take advantage under a legislation which is put in place to protect small depositors, as opposed to a body corporate.

Similarly, with reference to the provisions of Section 370 of the erstwhile Companies Act, 1956, while evaluating the distinction between a “loan” and a “deposit”, a critical observation was made by the Bombay High Court in Pennwalt India Ltd. v. Registrar of Companies⁹. The Court observed that while in both cases, there exists a creditor-debtor relationship, in the case of a deposit, it is usually made at the instance of the giver and is for the benefit of the entity making such monetary deposit and deriving benefit i.e. earning interest from the party accepting such deposits. Deposits could also take the form of a safe-custody or security for the performance of an obligation by the depositor. On the other hand, in case of a loan, it is the borrower at whose instance or need, the money is advanced. In such a case, the borrowing is primarily for the benefit of the borrower, though the lender may stand to gain in the transaction by earning interest on the loan amount. Therefore, it is deducible that typically, in case of a deposit, the initiator of the financial transaction between parties is the depositor, while in the case of a loan, it is the borrower who is the prime mover. Another crucial distinction to consider while determining the true nature and form of the financial transaction inter se companies, is the obligation of repayment of the amounts so received by the borrower. Usually, in case of a deposit, the amounts are repayable on demand, while in case of a loan, the obligation to repay the amount arises immediately on receipt of the loan.

Distinct from “deposits” and “loans”, the concept of “debt” is more comprehensive. Ordinarily, deposit of an amount creates a debt, but it need not necessarily involve a contract of loan. Whether a deposit amounts to a loan depends upon the terms of the contract pursuant to which the deposit is made.¹⁰ Therefore, while the dividing line between “deposits” and “loans” may be thin, the courts often (and on a case-to-case basis), assess the true character and form of a transaction and the way the companies treat such transaction, to determine its enforceability in law. Therefore, a review of judicial precedent seems to suggest that while the terms “deposit”, “loan” and “debt” may not be mutually exclusive, in each case, the intention of the parties, the circumstances and the contract must be closely examined to determine its true form and medium of enforcement (in case of default in repayment).

Treatment of ICDs under the Insolvency and Bankruptcy Code, 2016 (“Code”): Whether a loan or an investment?

ICDs may present a complex legal situation in relation to its enforceability, especially when evaluated through the prism of financial debts under the Code. As is widely known and understood, a financial creditor means any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred.¹¹ Moreover, the Code defines a financial debt to mean a debt along with interest (if any), which is disbursed against consideration for the time value of money and includes money borrowed against the payment of interest.¹²

Whether monetary sums provided inter se companies under ICDs would constitute a financial debt for maintainability of an application under Section 7¹³ of the Code was considered by the National Company Law Appellate Tribunal (NCLAT) in a few cases. In Narendra Kumar Agarwal v. Monotrone Leasing (P) Ltd.¹⁴, the NCLAT considered the issue whether an ICD would fall within the ambit of a financial debt under Section 5(8) of the Code. In this case, the applicant had extended an inter-corporate loan of INR 25 lakhs for 90 days to the corporate debtor, which was repayable with 15% interest p.a. The applicant remitted the said amount by transferring funds to the corporate debtor, which was also acknowledged by the corporate debtor. While certain part (re)payments were made, the corporate debtor failed to pay the total outstanding loan amount. Thereupon, the applicant/financial creditor raised a demand. The applicant contended that the corporate debtor had committed default in repayment of the ICD including both, the principal amount and the interest thereon. Upon initiation of corporate insolvency resolution process by the applicant/financial creditor under Section 7 of the Code, NCLT Kolkata¹⁵ admitted the petition holding that if an ICD was issued for a certain period, with the intention of paying back the loan amount along with interest, such transaction would fall within the ambit of “financial debt”. In an appeal before the NCLAT against the order of admission, the appellant contended that the transaction may be treated as an ICD, but it could not be treated as a financial debt. However, the NCLAT observed that in case the ICD is granted for a certain period, which was to be repaid with interest, the ICD would fall within the definition of a “financial debt”. It was further observed that the interest is the product of the instant transaction, which is undoubtedly “time value of money”. In other words, it was held that such transaction of inter-corporate deposit was fully covered by the definition of “financial debt” as provided under Section 5(8) of the Code. Moreover, having considered the financial contract executed between the parties, the NCLAT observed that the written contract could not be treated as the only essential element to prove the existence of a financial debt, if the transaction’s nature was proved otherwise.

As opposed to the above, in Ansal Housing Ltd. v. Samyak Projects (P) Ltd.¹⁶, the NCLAT held that the financial assistance given by Ansal Housing Limited (A) to Samyak Projects Private Limited (S) by way of an ICD under a joint venture agreement, did not amount to a financial debt under Section 5(8) of the Code. In this case, certain financial assistance was extended by A to S through an ICD. This was for the purpose of buying land for a real estate project, to be jointly developed under the joint venture agreement executed between the parties. The NCLAT held that the transaction was an investment for profit and did not amount to a disbursement for time value of money and as such, would not be treated as a financial debt under Section 5(8) of the Code. It was thus held that A was not a financial creditor under Section 5(7) of the Code and the application filed by A under Section 7 was not maintainable (and was rightly rejected by the NCLT). On appeal to the Supreme Court , the Court refused to interfere with the NCLAT’s judgment and dismissed the appeal.

A careful examination of the reasoning given by the NCLAT shows that it gives primacy to the intent and object of the Code viz. resolution of a corporate debtor as opposed to recovery of debts of creditors. In the context of Ansal Housing case¹⁷, amounts disbursed by the developer of a real estate project to a landowner under an inter-corporate deposit agreement, to be adjusted against future profits, was viewed as an investment, and with respect, rightly so. Treatment of such loans as a financial debt would have resulted in reading down the Code as a tool for recovery. The same view was reiterated in Realpro Realty Solutions (P) Ltd. v. Sanskar Projects and Housing Ltd.¹⁸, where the NCLAT noted that there was common participation and sharing of profits and losses in the construction and development of a real estate project. However, in the latter case, what was under consideration was a “profit-sharing loan agreement”, as opposed to a standard inter-corporate loan agreement.

Therefore, where a company offers loans or deposits under joint venture or profit-sharing (loan) agreements, they cannot claim the status of a financial creditor under Section 5(7) of the Code. Said differently, where the terms of the agreement lay the foundation of a legal and binding relationship between companies, with mutual financial obligations, the transaction would be an investment for profit and not disbursement for time value of money and as such, would not be treated as a financial debt under Section 5(8) of the Code. In such circumstances, to determine if an ICD would be accorded the treatment of a financial debt under the Code, would largely depend on the nature of the contract and true form and character of the transaction between the companies. In the absence of its treatment as a financial debt, the remedy available to the creditor company will be to initiate civil proceedings for breach of contract and recovery of money.