2025 (10) TMI 1163 - SC - IBC

Appeal dismissed; appellant not a financial creditor as CRPS treated as share capital under s.55 and s.3(12) IBC

EPC Constructions India Limited Through Its Liquidator - Abhijit Guhathakurta Versus M/s Matix Fertilizers And Chemicals Limited.

SC dismissed the s.7 application and the appeal, holding the appellant was not a financial creditor. The court found CRPS constitute share capital, not ... Dismissal of application of the appellant u/s 7 of the IBC, after holding that the appellant was not a financial creditor - appellant is holder of cumulative redeemable preference shares (CRPS) - commercial effect of borrowing present or not - HELD THAT:- It is well settled in Company Law that preference shares are part of the company’s share capital and the amounts paid up on them are not loans. Dividends are paid on the preference shares when company earns a profit. This is for the reason that if the dividends were paid without profits or in excess of profits made, it would amount to an illegal return of the capital. Amount paid up on preference shares not being loans, they do not qualify as a debt. To maintain a proceeding u/s 7, an application has to be filed by a financial creditor and the application has to be filed when a default has occurred. It will be noticed from the above that for a default “to kick in” there should be non-payment of debt, when whole or any part of the debt has become due and payable and is not paid. Admittedly, the CRPS had not become due and payable since the respondent had not made profits and did not have any reserve out of the profits made in the past nor did it possess any proceeds from a fresh issue of shares made for the purpose of redemption. In this admitted scenario, the question of there being any default under Section 3(12) of the IBC does not arise. Hence, the argument that the three years period mentioned in the CRPS for redemption having expired, the shares were due for redemption, does not carry the case of the appellant any further. In view of the issuance of CRPS, the earlier outstanding amount stood extinguished and the nature of relationship of the appellant with the respondent became that of a preference shareholder. There is no question of there being any underlying contrary intent as the only intent was to convert the debt into preferential shareholding. Before dealing with the term commercial effect of borrowing the opening clause of 5(8) cannot be lost sight of. It has to be first a debt and such debt would be a financial debt if it is raised under any other transaction including any forward sale or purchase agreement having the commercial effect of borrowing. As already explained the paid up amounts towards shares do not have the character of debt. The further argument that redemption was due, is also not meritorious. As required under Section 55 of the Companies Act, 2013, the shares could be redeemed only out of the profits or with any amount kept apart for dividends which is not the situation in the present case. There are no merit in this appeal. The appeal stands dismissed. ISSUES PRESENTED AND CONSIDERED 1. Whether a holder of cumulative redeemable preference shares (CRPS) can be a 'financial creditor' under Section 5(7) read with Section 5(8) of the Insolvency and Bankruptcy Code (IBC) and thereby maintain a Section 7 application when redemption is not payable due to statutory or factual constraints. 2. Whether the conversion of existing receivables into CRPS extinguishes the original debt and alters the character of the claim such that the holder becomes a creditor entitled to initiate insolvency proceedings. 3. The relevance and determinative value of accounting treatment/entries (including classification as 'unsecured loan' or 'other financial liability' in financial statements and AS-32) in characterising CRPS as financial debt. 4. The scope of Section 5(8)(f) (transactions having the 'commercial effect of borrowing') and whether the present CRPS transaction falls within that provision. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Whether CRPS holder can be a 'financial creditor' under the IBC Legal framework: Section 5(7) defines 'financial creditor' as a person to whom a financial debt is owed. Section 5(8) defines 'financial debt' as a debt disbursed against consideration for the time value of money and then lists inclusive categories (a)-(i). Sections 3(11), 3(12) and Section 7 prescribe that a default (non-payment of a debt when due) is a prerequisite for initiation under Section 7. Precedent treatment: The Court relied on prior decisions emphasising that the defining part of Section 5(8) (the 'means' part) requires a debt disbursed against time value of money; categories in the 'includes' part must satisfy that test. Authorities cited establish that shares paid up by subscription are not debts absent disbursal against consideration for time value of money. Interpretation and reasoning: Preference shares are by statutory character part of share capital (Companies Act provisions including Sections 43 and 55). Preference shareholders carry preferential rights as to dividend and repayment on winding up, but paid-up amounts on preference shares are not loans and dividends are payable only out of profits or specified proceeds. Redemption is subject to Section 55 constraints (only out of profits available for dividend or proceeds of fresh issue). The CRPS in question had not become payable because the issuer had no profits or capital reserved for redemption and had not issued fresh shares for redemption. Therefore the CRPS did not give rise to a 'debt' that is due and payable under Section 3(11) and 3(12) IBC, and the holder did not qualify as a 'financial creditor' for Section 7 purposes. Ratio vs. Obiter: Ratio - Preference shareholding, including CRPS, does not convert its holder into a financial creditor absent the foundational elements of 'debt' as defined in the IBC; redemption contingent on statutory conditions does not create an immediately payable financial debt. Obiter - Observations on policy considerations and the conceptual distinction between debt and equity (citing academic commentary) serve explanatory purpose. Conclusions: The holder of CRPS is not a financial creditor under the IBC where redemption is not payable in law or fact; Section 7 application by such holder is not maintainable. Issue 2 - Effect of conversion of receivables into CRPS on the original debt Legal framework: Companies Act provisions and general company law principle that conversion of receivables into shares extinguishes the prior liability; Section 55 limits redemption mechanics. IBC requires a 'debt' and a 'default' for Section 7. Precedent treatment: Cited authorities hold that conversion of a creditor's claim into shares extinguishes the original liability and that unredeemed preference shareholders do not become creditors merely because redemption is not effected. Interpretation and reasoning: The Board resolution and allotment documents show an express, consensual conversion of receivables into CRPS with terms explained and accepted. Once conversion occurred, the earlier outstanding amounts were extinguished and the relationship became that of shareholder and issuing company. The Court rejects attempts to 'unscramble' the transaction by looking behind its operative documents where parties knowingly elected the conversion route. Ratio vs. Obiter: Ratio - A bona fide conversion of receivables into preference share capital extinguishes the earlier debt; the converted instrument must be assessed by its legal character post-conversion. Obiter - Analogies to tax/other civil law authorities illustrating extinguishment of liability reinforce the point. Conclusions: The conversion extinguished the original receivable; the appellant's status became that of a preference shareholder and not a creditor for purposes of Section 7. Issue 3 - Relevance of accounting entries and accounting standards to characterisation Legal framework: Accounting Standards (e.g., AS-32) may prescribe classification for financial reporting; however, statutory definitions in Companies Act and IBC govern legal characterisation for insolvency processes. Prior jurisprudence holds accounting treatment is not determinative of legal character. Precedent treatment: Authorities cited establish that book entries and accounting classifications are evidentiary but not conclusive; true nature of the transaction is determined from contractual and statutory matrix. Interpretation and reasoning: Treatment of CRPS as 'unsecured loan' or 'other financial liability' in financial statements does not override the statutory scheme that treats preference share capital as share capital and subjects redemption to Section 55 conditions. The IBC's prerequisites (existence of a debt and default) cannot be satisfied merely by accounting entries; the substance and legal form (documents, statutory regime) govern. Ratio vs. Obiter: Ratio - Accounting entries are not determinative of whether an instrument is a financial debt under Section 5(8); the statutory tests in IBC/Companies Act must be satisfied. Obiter - Discussion on limitations of accounting standards in altering legal character. Conclusions: Accounting classification in books cannot convert CRPS into a financial debt for IBC purposes; such entries do not render a Section 7 petition maintainable. Issue 4 - Applicability of Section 5(8)(f): 'commercial effect of borrowing' Legal framework: Section 5(8)(f) covers amounts raised under transactions having the commercial effect of a borrowing, but the opening clause of Section 5(8) (the 'means' part) continues to require a debt disbursed against consideration for time value of money. Precedent treatment: Authorities emphasize that sub-clauses (a)-(i) must be read subject to the principal requirement of disbursal against consideration for time value of money; not every commercial arrangement will satisfy that threshold. Interpretation and reasoning: The CRPS transaction involved conversion of receivables into share capital to facilitate the issuer's leverage; however, the paid-up sum represented share capital and not an advance disbursed against time value of money. The statutory redemption constraint (Section 55) and absence of profits/fresh issue proceeds meant redemption was not a legally enforceable debt. Therefore the commercial effect test is not met in substance. Ratio vs. Obiter: Ratio - Sub-clause (f) cannot be invoked to characterise a paid-up preference share instrument as financial debt unless the transaction meets the core requirement of disbursal against the consideration for the time value of money and otherwise satisfies the commercial-effect test in substance. Obiter - Commentary distinguishing fact patterns where commercial effect may suffice. Conclusions: Section 5(8)(f) is inapplicable to the CRPS transaction on the facts; the instrument did not have the requisite commercial effect of borrowing to constitute a financial debt. OVERALL CONCLUSION The Court upholds the tribunals' conclusions: the CRPS holder was a preference shareholder and not a financial creditor under the IBC; the original receivables were extinguished by conversion into CRPS; no debt had become due and payable (no default) because redemption was contingent on statutory and factual prerequisites; therefore a Section 7 petition was not maintainable. These holdings constitute the operative ratio.