NCLAT Rules Fully Convertible Debentures Are Equity, Not Financial Debt Under Section 5(8) IBC

The NCLAT upheld the Resolution Professional's rejection of the claim, ruling that the fully convertible debentures (CCDs) constitute equity instruments, not financial debt under Section 5(8) of the IBC. The agreements between parties consistently treated the CCDs as equity, with no provisions altering their nature upon any event. Interest payable by the sponsor on default does not convert CCDs into financial debt. The Corporate Debtor was prohibited from incurring further debt without lender consent, which was not obtained. The claim was also dismissed due to delay in challenging the rejection, filed four months late after the claim was denied. With the Resolution Plan approved by the CoC, the appeal was dismissed, affirming the CCDs' classification as equity, not financial debt.

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ISSUES:

Whether Compulsorily Convertible Debentures (CCDs) subscribed by a financial creditor constitute 'financial debt' under Section 5(8) of the Insolvency and Bankruptcy Code, 2016 (the Code) or are to be treated as 'equity instruments'.Whether the occurrence of default or any other event can change the nature of CCDs from equity to debt absent contractual provisions to that effect.Whether a CCD holder whose CCDs have matured for conversion prior to initiation of Corporate Insolvency Resolution Process (CIRP) is entitled to be treated as a financial creditor and included in the Committee of Creditors (CoC).Whether reliance on RBI Master Directions on Foreign Direct Investment (FDI) is appropriate for determining the nature of CCDs in domestic transactions.Whether the delay in challenging the rejection of claim by the Resolution Professional (RP) can be condoned under the Code.

RULINGS / HOLDINGS:

CCDs which are fully, compulsorily and mandatorily convertible are to be treated as "equity instruments" and not as "financial debt" under the Code, as they do not postulate any repayment of principal. The Court held that "a compulsory Convertible 'Debenture does not postulate any repayment of the principle" and thus "does not constitute a 'debenture' in its classic sense".The occurrence of default or any other event, unless expressly provided in the contract or subsequently agreed upon, cannot change the nature of CCDs from equity to debt. The Court stated: "occurrence of default or any other happening, unless it is a part of the conditions of the contract/ agreement or later on agreed between the parties... cannot change its very nature from equity to debt".A CCD holder whose CCDs have matured before admission into CIRP is not entitled to be treated as a financial creditor or included in the CoC if the CCDs are equity instruments as per the contractual terms and applicable law. The Court observed that "the CCDs had already matured on 09.11.2017 and therefore stood automatically converted to equity".RBI Master Directions on FDI, though issued in a different context, provide relevant guiding principles for classifying CCDs as equity instruments, and reliance on these directions was held appropriate. The Court noted that "Debentures which are fully, compulsorily and mandatorily convertible shall be treated as 'Equity Instruments'" as per RBI guidelines.The delay of more than three months in challenging the rejection of the claim by the RP is not condoned under the Code, given the time-bound nature of insolvency proceedings. The Court held that "any delay in challenging the rejection of the claims cannot be condoned as a matter of routine".

RATIONALE:

The Court applied the definition of "financial debt" under Section 5(8) of the Code, which requires the debt to be disbursed against consideration for the time value of money, and noted that CCDs do not satisfy this criterion as the principal repayment is not contemplated and interest payment obligations lie with the sponsor company, not the corporate debtor.The Court relied on the Supreme Court precedent in Narendra Kumar Maheshwari v. Union of India, which clarified that compulsorily convertible debentures are equity instruments because they do not involve repayment of principal and only convert into shares, distinguishing them from classic debentures.The contractual documents including the Concession Agreement, Debenture Subscription Agreement (DSA), Share Pledge Agreement, and Share Buy Back Agreement consistently treated the CCDs as equity instruments with no provision for conversion to debt upon default or other events, and the Court emphasized that no such term was brought to its notice.The Court considered the RBI Master Directions on FDI as providing authoritative guidance on the classification of CCDs, despite their issuance in the context of foreign investments, and found their principles applicable to the present domestic dispute.The Court rejected the contention that financial statements recording CCDs as "Other Financial Liabilities" automatically classify them as financial debt, recognizing that accounting treatment alone does not determine legal classification under the Code.The Court noted that the sponsor company's obligation to pay interest on CCDs and the absence of any obligation on the corporate debtor to pay interest negate the presence of "time value of money" consideration, a key element of financial debt.The Court underscored the importance of adhering to the time-bound framework of the Code and refused to condone the appellant's delay in challenging the rejection of its claim, especially since the Resolution Plan had already been approved with 100% voting share of the CoC.

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