Financial Debt and Financial Creditor: Section 5(7) and 5(8)

Financial creditors are the decision makers of the corporate insolvency process. Only they sit and vote on the committee of creditors, and they may initiate insolvency on a default owed to any financial creditor. Whether a creditor is financial or operational therefore decides its influence over the fate of the debtor. This note examines the definitions of financial creditor and financial debt, the essential test of disbursal against time value of money, each head of financial debt, the leading cases, and the position of financial creditors in the process.

1. The Definitions

• Financial creditor, section 5(7). Any person to whom a financial debt is owed, including a person to whom such debt has been legally assigned or transferred.
• Financial debt, section 5(8). A debt along with interest, if any, which is disbursed against the consideration for the time value of money, and includes the nine kinds of transactions listed in clauses (a) to (i)
• Assignees. Asset reconstruction companies and other assignees step into the shoes of the original lender and are financial creditors to the same extent.

2. The Essential Test

• Disbursal. Money must have been paid out by the creditor to the corporate debtor or for its benefit; in Anuj Jain v Axis Bank (2020), the Supreme Court held that disbursal against time value of money must be found in the genesis of the debt before it can be treated as financial debt.
• Time value of money. The creditor is compensated, or expects to be compensated, for parting with money over time, usually by interest; it distinguishes lending from the supply of goods or services.
• Interest not essential. In Orator Marketing v Samtex Desinz (2021), the Court held that an interest-free term loan given to meet working capital needs is a financial debt; the words if any in section 5(8) show that interest is not indispensable.

Figure 1: Is it a financial debt?

3. The Nine Heads of Financial Debt

Figure 2: Clauses (a) to (i) of section 5(8)

• (a) Money borrowed against interest. Term loans, working capital facilities and inter-corporate deposits.
• (b) and (c) Market instruments. Acceptance credit facilities, note purchase facilities, bonds, notes, debentures and loan stock; debenture holders are financial creditors, usually represented by a debenture trustee.
• (d) Finance leases. The liability under a lease or hire purchase contract deemed a finance or capital lease under the Indian Accounting Standards or other prescribed standards.
• (e) Receivables. Receivables sold or discounted other than on a non-recourse basis; where the buyer has recourse to the seller, the transaction is in substance a loan.
• (f) Commercial effect of borrowing. Any amount raised under any other transaction, including a forward sale or purchase agreement, having the commercial effect of a borrowing; its Explanation deems amounts raised from allottees of real estate projects to fall within it (Topic 8)
• (g) Derivatives. Derivative transactions entered into to protect against or benefit from fluctuation in a rate or price, valued at their market value.
• (h) Counter-indemnity. A counter-indemnity obligation for a guarantee, indemnity, bond or documentary letter of credit issued by a bank or financial institution; when a bank guarantee is invoked and paid, the bank becomes a financial creditor of the customer.
• (i) Guarantees. The liability under any guarantee or indemnity for any of the items in (a) to (h), which makes the guarantor's creditor a financial creditor of a corporate guarantor (Laxmi Pat Surana v Union Bank of India, 2021)

4. Leading Cases

Figure 3: Cases on financial debt

• Anuj Jain v Axis Bank, 2020. Jaypee Infratech had mortgaged its land to secure loans given by banks to its parent, Jaiprakash Associates; since nothing had been disbursed to Jaypee Infratech, the banks were secured creditors of it but not its financial creditors, and the mortgages were also set aside as preferential transactions (Topic 48)
• Phoenix ARC v Spade Financial Services, 2021. Transactions that were collusive and designed to give the promoters a voice on the CoC were not genuine financial debt; and an entity that was a related party when it acquired the debt, and ceased to be one only to evade the bar, may still be excluded from the CoC.
• Equity contrasted. Share capital and share application money are not debts, because a shareholder bears the risk of the business rather than lending for time value; convertible instruments are classified according to their terms.

5. Financial Creditors in the Process

• Initiation. A financial creditor, alone or jointly, may apply under section 7 on a default in respect of a financial debt owed to it or to any other financial creditor (Topic 11)
• Committee of creditors. All financial creditors form the CoC (section 21(2)), and each votes in proportion to its share of financial debt (section 5(28))
• Related parties excluded. A financial creditor that is a related party of the corporate debtor has no right of representation, participation or voting in the CoC; this does not apply to a regulated financial creditor that became a related party only by converting debt into equity (Topic 26)
• Classes of creditors. Financial debt owed to a class, such as debenture holders, fixed deposit holders or allottees, is represented by an authorised representative (section 21(6A)), who votes as the majority of the class directs (Topic 27)
• Plan and liquidation. A dissenting financial creditor must receive the statutory minimum under section 30(2)(b), which after the 2026 Amendment is the lower of its liquidation share and its share under the section 53(1) order (Topic 41); in liquidation, a secured financial creditor may realise its security or relinquish it (section 52), and unsecured financial creditors rank fourth in the waterfall (section 53)

6. Frequently Asked Questions

Is a bank that issued a bank guarantee a financial creditor?

Once the guarantee is invoked and paid, the bank's claim against its customer under the counter-indemnity is a financial debt under section 5(8)(h). Before invocation, the bank holds only a contingent claim, which it may still submit in the process.

Can a promoter who lent money to the company vote in the CoC?

No. A promoter is ordinarily a related party, and the first proviso to section 21(2) bars related party financial creditors from representation, participation and voting in the committee of creditors.

Is a loan without interest a financial debt?

Yes, if it was disbursed against the consideration for the time value of money, such as a term loan for working capital. The Supreme Court so held in Orator Marketing (2021).

7. Related Topics

• Topic 8: Real Estate Allottees as Financial Creditors. The Explanation to section 5(8)(f)
• Topic 9: Operational Debt and Operational Creditors. The other class of creditors.
• Topic 25: Committee of Creditors. Constitution and voting.