In lending transactions, standard practice is to obtain shortfall undertakings, that is meeting any shortfall in the repayment of the underlying facility from holding companies of the borrower or financially strong companies in the group.

The form of such undertakings varies between lenders. Some lenders require that any shortfall in the repayment of the facility be provided through a separate fund; others want direct payment. The basis of such undertakings is indemnity. The definition of financial debt in the Insolvency and Bankruptcy Code, 2016 (IBC), includes “the amount of any liability in respect of any guarantee or indemnity”. It has long been a matter of argument whether such liability in respect of a guarantee or indemnity falls within the list of items in the IBC defined as financial debt, a term that usually relates to borrowing monies.

This question recently came before the National Company Law Tribunal (NCLT) in IL&FS Infrastructure Debt Fund v McLeod Russel India Limited. The NCLT held that a shortfall undertaking can indeed be a financial debt under the IBC.

IL&FS Infrastructure Debt Fund, the financial creditor, initiated a corporate insolvency resolution process (CIRP) in respect of McLeod Russel India Limited, the corporate debtor. The debtor had executed a shortfall undertaking in favour of the creditor in consideration of non-convertible debentures issued for an amount of INR1.5 billion (USD18.2 million) by Babcock Borsig Limited and Williamson Magor & Company Limited (borrowers). The undertaking provided for maintenance of the debt service reserve account (DSRA), an indemnity against any losses, expenses, claims and liabilities incurred or suffered by the creditor and the issue of post-dated cheques (PDCs) for the payment of the principal and interest over the following year.

The debtor issued the PDCs in favour of the creditor together with a letter of comfort to the debenture trustee acting for the creditor. When the borrowers defaulted, the creditor demanded the debtor maintain the DSRA and fulfil its obligations under the undertaking. The debtor failed to do so and the financial creditor applied to the NCLT to initiate the CIRP under section 7 of the IBC.

The key issues were whether a letter of comfort, an indemnity bond or a shortfall undertaking for the payment of debenture securities could be a financial debt under the IBC and whether the PDCs issued by the corporate debtor together with the other instruments reflected an intention by the debtor to create security for repayment.

The NCLT held that the execution by the debtor of the instruments, including the shortfall undertaking, to protect the interests of the creditor in subscribing to the debentures issued by the borrowers, together with the issue of the PDCs, clearly showed an intention by the debtor to repay. The NCLT further found that the debtor did not fulfil its obligations under the letter of comfort and the indemnity bond and failed to maintain the DSRA as the undertaking required. The shortfall undertaking, the letter of comfort and the PCDs were thus instruments of guarantee for the repayment of the debentures. They therefore qualified as financial debt under section 5(8)(i) of the IBC. The tribunal admitted the section 7 application for the initiation of the CIRP.

The judgment not only recognised the instruments of guarantee as financial debt under the IBC, but also adopted a broader interpretation of financial debt and financial creditors. Any failure to fulfil obligations under indemnities or guarantees for a financial debt under the IBC is a financial debt itself and may lead to IBC insolvency resolution proceedings. The judgment emphasised the importance of intention and substance as shown in the instruments, rather than the form of a transaction.

The NCLT rejected the debtor’s argument that a shortfall undertaking was not by itself a guarantee under the Contract Act, 1872, but only a way of maintaining funds in the DSRA on the borrower’s default. The tribunal adopted an expansive interpretive approach to prevent recovery of the stakeholder’s debt being thwarted by obsolete technicalities. It did so by finding an intention to repay the debt, evidenced by instruments such as the shortfall undertaking, the letter of comfort, an indemnity bond and even the post-dated or undated cheques.