All Things Newz
Law \ Legal

Trust Theory, Security And Margin Money: The Effect Of Moratorium Under The Insolvency And Bankruptcy Code On Such Transactions – Insolvency/Bankruptcy


This write up delves upon some of the deeper underlying
aspects of ‘margin money’. It also discusses the effect of
moratorium under the Insolvency and Bankruptcy Code on such
transactions.

In general terms, a Bank Guarantee (BG) is an
instrument issued by a bank to a third party at the behest of its
client by way of assurance to pay a specified amount should the
client default. Letter of Credit (LC) is another
similar instrument of assurance of payment of the covered amount if
the contract is executed as per instructions. The difference being
that in the case of LC the issuing bank assumes primary
responsibility to pay, where as in BG the liability of the bank is
secondary and contingent on default by the client. The principles
governing these instruments have developed based on commercial
practices and contract law. They have attained status of a
‘virtual promissory note’, as readily encashable
instruments on demand. These instruments are highly relied upon and
play a critical role in facilitating domestic and international
transactions. Needless to add, any situation creating a doubt on
sanctity of such instruments could have serious implications on the
trade and commerce transactions especially international trade
transactions.

The Courts in India have consistently upheld the sanctity of
such instruments by laying down rules against injunction as regards
enforcement of such instruments. The law relating to invocation of
BG is well settled now. When during commercial dealings, an
unconditional bank guarantee is given or accepted, the beneficiary
is entitled to realize such a bank guarantee (in terms thereof)
irrespective of any pending disputes. The bank issuing the
guarantee is bound to honor it as per its terms and irrespective of
any dispute raised by its customer. The very purpose of BG would
otherwise be defeated and result in irretrievable harm or injustice
to one of the parties concerned, since, in most cases, payment of
money under such a BG would adversely affect the bank and its
customer at whose instance the guarantee is given1.

Recognizing the sanctity of BGs, it has been held that a BG is
the common mode of securing payment of money in commercial
dealings. The beneficiary, under the guarantee, is entitled to
realize the whole of the amount under that guarantee irrespective
of any pending dispute between the person on whose behalf the
guarantee was given and the beneficiary2. An
unconditional BG could be invoked by the person in whose favor the
BG was given, and the Courts would not grant any injunction
restraining the invocation. The only exception would be in the
cases of fraud or irretrievable injury3.

Issue of Margin Money

As a prudent banking practice, such BGs and LCs are issued by
banks against fee and charges and are backed by security or cash
deposits in the form of ‘cash margin’. This cash margin
enables the banks to limit their exposure and risk in such
transactions. This margin could range from 25% to 100% depending
upon type of BG/LC. A guarantee which is for an indefinite period
would usually require 100% cash margin to back it. The client does
not retain any right over this amount or exercise any control over
it till the transaction gets culminated in discharge.

The advantage of the above arrangement is twofold. BG/LC in lieu
of cash enables the client to retain the corresponding money and
utilize available cash (depending upon cash margin) for its
business operations on the other hand such cash margins work as
hedge for the issuing bank to limit its contingent liability. There
are two reasons as to why this margin amount is kept in a fixed
deposit (FD) in the name of the client and not in
the name of the bank. First, this arrangement enables the FD to
earn interest during currency of BG and second, keeping it in the
bank’s name would have exposed the issuing the bank to
additional tax obligations consequently increasing overall cost and
fee for BG. Thus, it is an efficient and effective system to meet
business obligations backed by sound legal principles.

Impact of IBC over such Margin Money

BGs are independent contracts and obligation of a third party -
namely the bank – therefore remains unaffected by insolvency of the
client. Performance guarantees have been specifically kept out of
the definition of the term ‘security
interest
‘ under section 3(31) of the Insolvency and
Bankruptcy Code, 2016 (IBC/the Code) so that the
moratorium under section 14 of the Code does not impact sanctity of
such instruments. However, in many Corporate Insolvency Resolution
Processes (CIRP), Resolution Professionals
(IRP/RP) demanded the release of such FDs (kept as
cash margin with the bank) relying upon the provisions of section
18 (f) of the Code. Section 18(f) of the Code requires the IRP
to take control and custody of any asset over which the
corporate debtor has ownership rights as recorded in the balance
sheet of the corporate debtor … including assets that may or may
not be in possession of the corporate debtor
. This gave rise
to conflict and litigations. The conflict arose on account of firm
belief of the banks that the margin money is not in the nature of a
‘security’. Rather, it is a mechanism where the client
cedes control over the margin money amount and puts the same at the
sole disposal of the bank for issuance of BG.

However, the RPs, advised by their support team, went by a
literal interpretation of the provisions mentioned above and
thought it proper to leave the issue to be decided by the Courts.
This ignored the Explanation attached to section 18 of the Code
which provided that the term “assets” shall
not include assets held under trust or under contractual
arrangements including bailment
. Initially, Tribunals
also went by these assumptions and in many cases, directions were
given to the Banks to reverse appropriation of margin money used by
them to honor bank guarantees during the moratorium
period4. Conflicting views were also expressed by the
Appellate Authority as regards true nature of margin money.

While in the case of Indian Overseas Bank it
was held that the ‘margin money’ is not a
security …. “The ‘margin money’ is the contribution
on the part of the borrower who seeks ‘Bank Guarantee’. The
said margin money remains with the Bank, as long as the Bank
Guarantee is alive
5.” On the other
hand in the case of C & C Construction Ltd.
Vs. Power Grid Corporation of India
Ltd
6, it was held that ……
keeping in minds the provisions of Section 14 (1)
(C) r/w Section 14 (3) (b), if any, such bank guarantee is
liquidated, it can be restricted to the full value of the guarantee
minus margin money provided by corporate debtor to the banker for
taking that bank guarantee and accordingly, banks can release the
fund to the extent of full value of the bank guarantee minus margin
money provided by the corporate debtor to the banker for the bank
guarantee
.”

The Principal Bench of National Company Law Tribunal, Delhi
examined the issue in the right earnest in the case of
Phoenix ARC Pvt. Ltd. vs. Anush Finleash &
Construction Pvt. Ltd
7 in light of
judgment of the Bombay High Court in the case of Reserve Bank of
India vs. Bank of Credit And Commerce (1993 78 Comp Cas 207 Bom)
and laid down that the “FDRs are given towards
margin money against the bank guarantees given to the beneficiary,
not as FDRs to be realized by the Corporate Debtor as and when it
wishes. …….. margin money is construed as substratum of a Trust
created to pay to the beneficiary to whom Bank Guarantee is given.
Once any asset goes into trust by documentation for the benefit of
beneficiary, the original owner will not have any right over the
said asset unless is it is free from the trust.”

Thus, strengthening the Trust Theory in the context of margin
money.

While based on the “Trust Theory” the
legal position around the bank guarantee margin money issue seems
to be settling down, the issue of margin money in the context of LC
came to be examined by the Appellate Authority in the case of
Punjab National Bank Vs Supriyo Kumar Chaudhuri Resolution
Professional, JVL Agro Industries Ltd
8. The
Appellate Authority in this case reiterated the legal position that
margin money is construed as substratum of the trust towards the
beneficiary to whom BG is given. Once any asset goes into trust by
documentation for the benefit of beneficiary, the original owner
will not have any right over the said asset unless it is has lived
up to its commitment . … it cannot be said to be an asset of the
‘Corporate Debtor’. The provision of Section 14(3)(b)
specifically excludes the Application of Section 14 to a
‘surety’ in a contract of Guarantee to a ‘Corporate
Debtor’.

As regards the LC, the Appellate Authority held that
it is basically akin to a contract of Guarantee,
as it is a contingent liability of the ‘Corporate Debtor’
which gets crystallized on the happening of a future e margin money
can in no manner be said to be a ‘Security Interest’ as
defined under Section 3(31) of the IBC. Section 14(1)(c) prohibits
any action to foreclose, recover or ensure any ‘Security
Interest’ created by the ‘Corporate Debtor’ in respect
of its property. As we hold that no ‘Security Interest’ was
created by the ‘Corporate Debtor’ with respect to the
margin money that was deposited by the ‘Corporate Debtor
Company’ towards the opening of the LC in the Appellant Bank,
we are of the considered view that the Banks having appropriated
this money during the period of Moratorium is justified as we hold
that the amount is not an asset of the ‘Corporate
Debtor’
.”

The legal position as reiterated by the Appellate Authority
reinforces and restores the sanctity of BG and LC as trusted
instruments of executing business transactions. This is reassuring
for businesses especially in the case of overseas dealings.

Footnotes

1 Civil Appeal No. 15357 of 1961, decided on December 4,
1996 [(1997) 1 Supreme Court Cases 568]

2 Hindustan Construction v. State of Bihar (1999) 8 SCC
436

3 Svenska Handeisbanken v. Indian Charge Chrome: AIR 1994
S C 626.

Larsen & Toubro Ltd. v. Maharashtra State Electricity
Board: An IR 1996 S C 334.

Hindustan S teel Works Construction Ltd. v. G.S. Atwal
& Co. (Engineers) (P) Ltd.: An IR 1996 S C 131.

National Thermal Power Corporation Ltd. v. Flowmeore (P)
Ltd.: AIR 1996 SC 445.

State of Maharashtra v. National Construction Co.: [1996]
1 SCR 293.

Hindustan S teel Works Construction Ltd. v. Tarapore
& Co: AIR 1996 SC 2268

U.P. State S ug a r Corporation v. Sumac International
Ltd.: AIR 1997 S C 1644

4 Company Appeal (AT)(Insolvency) No. 635 of
2019

5 Indian Overseas Bank’ Vs. ‘Arvind Kumar’,
Comp. App. (AT) (Ins.) No. 558/2020, dated 28.09.2020

6 Company Appeal (AT) (Insolvency) No. 781 of
2019

7 (IB)-1705(PB)/2018

8 Company Appeal (AT) (Insolvency) No 657 of
2020

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



Source link

Related posts

Asia Employment Law: Mid-Year Review – 2022 H1 – Employee Rights/ Labour Relations

US Fundraising For Foreign Charities – Directors and Officers

Work From Home No More? – Employee Rights/ Labour Relations