Revisiting loan documents in light of insolvency code

Revisiting loan documents in light of insolvency code

By Aditya Vikram Dua and Aniket Sawant, SNG & Partners
2 February 2019

The interests of banks, financial institutions and other lenders and recovery of loans advanced by them is at the heart of the insolvency framework introduced by the Insolvency and Bankruptcy Code, 2016 (code). Although the code has been brought into being to protect the interests of the lenders, no lender wants a transaction to enter insolvency proceedings.

There are many provisions in loan agreements that may not protect the lenders’ interest before the insolvency proceedings are initiated. The provisions under existing loan documentation need to be revisited.

Aditya Vikram Dua
SNG & Partners

Definition of financial indebtedness: The lenders prefer to keep restrictive covenants with respect to the financial indebtedness of the borrowers. However, now lenders must ensure that the definition of financial indebtedness is wide enough to cover all that is covered under the definition of financial debt in section 5(8) of the code, which includes various aspects like borrowings in general parlance, bonds, debentures, hire purchase, derivatives transactions, receivables sold on recourse basis, guarantee, indemnity obligations.

Covenant on restriction of borrowings: Borrowers tend to argue that if the lender has appropriate security then it should not be bothered with the financial indebtedness of the borrower and tend to avoid including borrowing restrictions in the documents. If a borrower is unable to service any debt, other lenders may initiate insolvency proceedings, which will impose a moratorium under which lenders will not be able to enforce the security and will be at the mercy of the decisions of the committee of creditors.

Aniket Sawant
SNG & Partners

There is a hypothetical possibility that a lender (who has a security value more than the outstanding loan) may be forced to accept a resolution plan that offers a lesser value than the security might have offered. Therefore, restriction on borrowings become very important from the lender’s perspective.

Events of default: The code allows operational creditors, which include suppliers, vendors or service providers of the borrower, to initiate corporate insolvency resolution process under section 9 of the code. However, before the initiation of such proceedings, the operational creditor has to deliver a demand notice under section 8 of the code along with an invoice demanding payment of the amount involved in the default.

The lenders should insist on incorporating a covenant in the financing document, which requires the borrower to disclose whether it has received any demand notice under section 8 and if there exists a dispute in relation to such claim they should also furnish proof of the same.

In case the borrower fails to disclose the aforesaid, or in case it discloses such notice and no prior dispute exists with respect to such claim or the borrower fails to furnish proof of existence of such dispute, then it is required to be incorporated as an event of default in the financing documents. Lenders may also take a step further and include all defaults against operational creditors as events of default.

In the past, admission of petitions for insolvency or liquidation was treated as an event of default, but in the current insolvency regime, once such a petition is admitted, a moratorium under section 14 of the code is declared in respect of the assets of the borrower and the lender is not able enforce the security until the completion of the resolution process or until after 270 days from the date of commencement of the insolvency proceedings. It is necessary therefore that the filing of an insolvency petition against the borrower itself is treated as an event of default.

Third party security provider: Where a lender has recourse to security from a third party and insolvency proceeding has commenced against the third party, the lender will not have the right to be a part of the committee of creditors as the lender is not considered a financial creditor under the code. With a view to avoiding this and safeguarding its interest, the lender shall ensure that all the aforesaid provisions with respect to restriction on borrowings and events of default as stated above should be made applicable to the security provider as well.

Guarantors: In light of Lalit Mishra and ors v Sharon Bio Medicine Ltd and ors, where it was held that personal guarantors cannot have any claims against a corporate debtor after a resolution plan is approved, it is advisable that all corporate and personal guarantees should have a clause that all the rights available to guarantors against the corporate debtor under applicable law will cease in the event that insolvency proceedings are initiated against the corporate debtor.

SNG & Partners has offices in New Delhi, Mumbai and Singapore. Aditya Vikram Dua is a senior associate and Aniket Sawant is an associate.