Treatment of Lease Transactions under Insolvency and Bankruptcy proceedings

– Devika Agrawal and Anshit Aggrawal, Executive  (resolution@vinodkothari.com)

The determination of the nature of debt has been one of the primary tasks before a Resolution Professional/ Liquidator, and also for the stakeholders. The classification of debt is an important consideration since there exist only two types of debt under the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as “Code”), i.e., Operational Debt and Financial Debt, each with a significant set of rights and powers.

At the outset, one may think that the identification is a fairly simple job – loans and alike are financial debts, whereas those relating to supply of goods and services are operational in nature. Then, where does the confusion lie? The question of determination gains much importance for not-so-simple arrangements like lease transactions, which sit on the fence of being a financial transaction, and accordingly, the determination of financial versus operational nature will lead to consequent difference in rights and obligations.

In this article, the authors analyse the interface between the Code and lease transactions, and discuss the treatment of the leased assets or lease agreements/ transactions  under the Code.

Lease transactions in light of IBC

Leasing is very prevalent in India – A significant section of companies have an exposure to leasing transactions in one form or the other^[1]. Further, with the legal developments in India in the later half of the last decade, viz. exclusion of leased assets from liquidation estate (discussed below), allowing financial lessors to initiate recovery proceedings under SARFAESI, emergence of new sectors,^[2] have given a further boost to leasing volumes in India.

As is widely known, there are two broad classes of lease – a) Financial lease and b) Operating lease. It may be noted that in India, lease transactions do not have a dedicated statute – they are governed by the general law of contracts, and such general law does not distinguish between financial and operating lease in the public domain. Hence, whether a particular lease is financial or operational in nature, depends on intrinsic financial terms of the contract, and  neither in the language nor construct of the underlying contract.

Financial lease

As per the Indian Accounting Standards section 5(8)(f), the five tests of Financial Lease, which, though, are illustrative, are as below:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term;
2. The lessee has an option to purchase the underlying asset at a price that is expected to be sufficiently lower than the fair value at the date the option becomes exercisable for it to be reasonably certain, at the inception date, that the option will be exercised;
3. The lease term is for the major part of the economic life of the underlying asset even if the title is not transferred;
4. At the inception date, the present value of the lease payments amounts to at least substantially all of the underlying assets (generally, considered at 90%); and
5. The underlying asset is of such a specialized nature that only the lessee can use it without major modifications.

Hence, a finance lease is essentially a contract that allows the lessor, as owner, to retain legal ownership of an asset while transferring substantially all the risks and rewards of economic ownership to the lessee. In a general parlance, financial leases are considered akin to loans and as such are treated likewise^[3].

Operating lease

Technically, leases which do not satisfy any of the five tests of Financial Lease, as per the Indian Accounting Standards are classified as Operating Lease. Hence, an operating lease is a contract that allows the lessor, as owner, to retain legal ownership of an asset but allows the lessee to enjoy the economic use of the asset for a predetermined period before returning the asset to the lessor. Thus, substantial risks and rewards are not transferred to the lessee.

Treatment of Leases under IBC

As discussed above, whether a lease is a Financial Lease or an Operating Lease depends on the terms of the lease agreement entered into by the parties. The question of identification and treatment warrants further attention due to the significant differences in the rights and powers of financial creditors vs. operational creditors. Later in this article, we discuss in detail the impact of such identification.

Treatment of a Financial Lease

As per section 5(8)(d) of the Code, the definition Financial Debt includes “the amount of any liability in respect of any lease or hire purchase contract which is deemed as a finance or capital lease under Indian Accounting standards or such other accounting standard as may be prescribed” (Emphasis supplied)

Further,  section 5(7) of the Code states that a Financial Creditor means “any person to whom a financial debt is owed and includes any person to whom such debt has been legally assigned or transferred”

Therefore, a combined reading of the above definition makes it clear that a ‘financial lease’ as provided under the Indian Accounting Standards, can be considered as “Financial Debt” under the Code, and hence, the lessor, a financial creditor.

Treatment of an Operating Lease

As discussed, in an operating lease, the risks and rewards arising from the ownership of an asset are retained by the lessor himself, unlike the case in financial lease. In an operating lease the ownership of the underlying asset is not transferred to the lessee – the intent of the operating lease is to hire out an asset.

Going by the argument above, one may state that any lease which is not a financial lease is an operating lease. However, it is also essential to note that the Code defines ‘Operational Debt’ as a “claim in respect of the provision of goods or services including employment or a debt in respect of the payment of dues arising under any law for the time being in force and payable to the Central Government, any State Government or any local authority.^[4]” Hence, simply falling out of the basket of financial leases may not suffice – the terms and consideration of the contract should be in the nature of claims defined above.

In this context, a question which is often raised is whether or not lease and rental dues can be treated as operational debt^[5]. It is very clear that any lease transaction, whether financial or operating, has an element of supply of service. In the case of financial lease when the asset is transferred, it also becomes a supply of goods. However, in the case of operating leases, since the ownership of assets always remains with the lessor, it is only a supply of services. As such, one may say that a lease always connotes a supply of service which naturally falls within the ambit of operational debt. Hence, it is most generally presumed that all operating leases can be defined as operational debt under the code. However, interestingly in the matter of “Jindal Steel & power Ltd. v. DCM International Ltd.^[6]”, the Hon’ble NCLAT held that lease rentals by landlords do not qualify as operational debt for the purpose of the code. The Hon’ble NCLAT observed that:

“Admittedly, the Appellant is a tenant of Respondent- ‘Corporate Debtor’. Even if it is accepted that a Memorandum of Understanding has been entered between the parties in regard to the premises in question, the Appellant being a tenant, having not made any claim in respect of the provisions of the goods or services and the debt in respect of the repayment of dues does not arise under any law for the time being in force payable to the Central Government or State Government, we hold that the Appellant tenant do not come within the meaning of ‘Operational Creditor’ as defined under sub-section (20) read with sub-Section (21) of Section 5 of the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to ‘I&B Code’) for triggering Insolvency and Bankruptcy Process under Section 9 of the ‘I&B Code.”

Relying on the aforementioned judgment of NCLAT, the NCLT, Mumbai Bench, in Citicare Super Speciality Hospital v. Vighnaharta Health Visionaries Pvt. Ltd, dismissed the petition which was in relation to arrears of license fee. Further, relying on Jindal Steel (supra) and Citicare (supra), NCLT Hyderabad also, in the case of Manjeera Retail Holdings Pvt. Ltd. v. Blue Tree Hospitality Pvt. Ltd.^[7], held that the petitioner claiming default in payment of rent of the premises leased out cannot be treated as an operational creditor, and the amount involved cannot be treated as an operational debt.

At this juncture, it must be noted that in view of the divergent views of the Appellate Tribunal and recommendations made in the BLRC Report^[8], the matter is currently pending before the Hon’ble Supreme Court in the matter of Promila Taneja v. Surendri Design Private Limited^[9] and is currently sub-judice.

In this pretext, it may so be the case that a lease transaction may fall in neither of the two categories and as such may have to file the claim as ‘other creditors’. Categorisation as such would lead to a significant loss of rights as such creditors fall in the lower rank, with negligible participation and/ or recovery in the process.

Significance of Treatment

As already discussed, the classification of lease as financial or operating depends on intrinsic financial terms of the contract, and  neither in the language nor construct of the underlying contract. Where a lease contract is one which qualifies to be a financial debt, the lessor becomes a financial creditor of the corporate debtor. Such identification shall impact the lessor’s right in several ways, inter-alia

• Right of representation in the CoC

Section 21(2) of the Code states that, “The committee of creditors shall comprise the financial creditors..”

Further Section 21(4) of the Code states that, “Where a person is financial creditor as well as an operational creditor, –

• such person shall be a financial creditor to the extent of the financial debt owed by the corporate debtor, and shall be included in the committee of creditors, with voting share proportionate to the extent of financial debt owed by such creditor;”

It is evident from a bare reading of the provisions of the Code that only Financial creditors have a right of representation in the meeting of committee of creditors (‘CoC’). The Operational creditors do not have any right of representation in the CoC except for in the event where the corporate debtor does not have any financial creditors.

As a result of this basic distinction, financial lessors have the right to form part of the CoC and make representation. At this juncture, it must be noted that an operational lessor, if classified as an operational debtor, may also be entitled to be attend the meeting of the CoC if its dues are equal to or more than 10% of the total debt – however, even in such cases, such operational lessors shall not have the right to represent at such meetings.

• Right to vote on the Resolution Plan

Unarguably, the most important right bestowed upon the financial creditors is the right to vote on the resolution plan. Hence, by virtue of the identification as FCs or OCs, lessors will or will not get the right to vote. Needless to say, the right to vote is very crucial as it decides the fate of recoveries that the creditors shall make from the resolution process.

In this context, identification as FC have an additional benefit – even if the FCs do not give their consent to the resolution plan, they will make recoveries on priority basis, in the capacity of ‘dissenting financial creditors’

Regulation 38 of the Insolvency and Bankruptcy Board of India (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 (‘CIRP Regulation’) provides that –

“(1). The amount payable under resolution plan –

• to the operational creditors shall be paid in priority over financial creditors; and
• to the financial creditors, who have a right to vote under sub-section (2) of section 21 and did not vote in favour of the resolution plan, shall be paid in priority over financial creditors who voted in favour of the plan. “

(Emphasis supplied)  

• Filing of Claim

Depending on the identification on the grounds stated above, the financial and operating lessor would have to file their claim as a financial creditor and operational creditor, respectively.  However, an open thread in this regard is whether such claims shall be in the capacity of a secured creditor. While in the following paragraphs, we discuss the same at length in the context of liquidation, the question remains relevant at the stage of cirp also.

By virtue of section 14 of the Code, it is understood that the right of disposal or selling off of a leased asset, cannot be exercised during the tenure of corporate insolvency resolution process because the moratorium restricts exercise of any such power. Hence, during the pendency of CIRP, the lessor may not claim ownership of the asset. However, the lessor may, at the time of filing its claim, indicate whether or not they intend to pull out the asset from the CD’s pool. This information shall be material for the incumbent resolution applicant also – who shall formulate the plan including/ excluding such asset, depending on the decision of the lessor.

• Outcome of a Resolution Plan

The outcome of an approved resolution plan may differ depending on the decision of the lessor to relinquish its asset –

• Where the financial lessor decides to relinquish the asset for the CD’s pool, it shall be entitled to participate in the resolution plan. In such cases, if the lessor votes against an approved plan, it will assume the status of a dissenting financial creditor, and as such, be entitled to receive its share prior to the other financial creditors.
• Where such lessor intends to hold on its asset, the same may be indicated in the claim form. In such cases, such assets, even though not alienated during CIRP, shall not be made available to the resolution applicant, and shall be returned to the lessor upon completion of the moratorium. It must be noted that in such cases, the lessor shall not be entitled to receive anything from the resolution applicant (RA), except in case of termination payments, which exist due to terms of the lease – such claims essentially become unsecured claims.

Is a Financial Lessor a Secured Creditor?

While considering the rights of a lessor who qualifies as a financial creditor, an important question that arises is whether such financial lessor is also a secured creditor for the purpose of the Code. While considering the question it is pertinent to look into the definition of secured creditor and security interest as under –

Section 3(30) of the Code provides that, “secured creditor means a creditor in favour of whom security interest is created”

Further, section 3(31) of the Code provides that, “security interest means rights, title or interest or a claim to property, created in favour of, or provided for a secured creditor by a transaction which secures payment or performance of an obligation and include mortgage, charge, hypothecation, assignment and encumbrance or any other agreement or arrangement securing payment or performance of any obligation of any person..”

Thus, any person who creates a security interest in the property of the lessee is a secured creditor. However, in a financial lease, the legal ownership of an asset remains with the lessor throughout the tenure of lease – only the right to use the asset is transferred to the lessee. Also, it is only at the end of the tenure of lease that the lessee has an option to effectuate the transfer of ownership of the leased asset. Hence it cannot be said that a security interest is created on the asset in favor of the leassor. Therefore, a financial lessor cannot be said to be a secured creditor in essence.

Additionally, the Code mandatorily requires that a secured creditor, while filing its claim as such, must produce evidence of registration of charge with the registrar of companies^[10]. In this context, given that a lease transaction is not technically a security interest, and as such has no charge registered, it becomes difficult to argue that the lessor is a secured creditor.

Once we argue that a lessor may not necessarily be classified as a ‘secured creditor’ the next question would be whether such lessors at all have the right of relinquishment as per section 52. In this context, it must be noted that in most cases, a leased asset does not form part of the liquidation estate (see discussion below). Hence, the question of relinquishment may not arise at all. On the contrary, where such lessor succeeds in establishing claim as a secured creditor, and choses to relinquish the asset to the liquidation asset, the lessor shall be treated as a secured creditor for the value equivalent to that of the asset, and for the remainder value, as an unsecured financial/ operational creditor, as the case may be.

Inclusion of leased asset in the Liquidation estate

The focal point of the entire liquidation process is realisation of assets for distribution of proceeds therefrom, to the creditors. Hence, it is important to identify what are the assets that the liquidator can go on to sell. This pool of assets which can be realised is referred to as the “liquidation estate”, which the liquidator holds as a fiduciary for the benefit of the creditors.

Prima facie, the liquidation estate includes all properties that the corporate debtor ‘owns’. This gives rise to the question whether leased assets form a part of the liquidation estate. For the purpose of answering this question, it is pertinent to look into the section 36(4) of the Code – Section 36(4)(a)(iv) states that assets which are owned by the third party but are in possession of the corporate debtor including “other contractual agreements which do not stipulate transfer of title but only use of asset” shall not form a part of the Liquidation estate.

This clearly implies that any lease agreement which stipulates a predetermined, automatic and willing transfer of leased assets after a period of time to the lessee, will form a part of the liquidation estate. On the other hand, where such transfer is not automatic or deemed obvious, and the lessee only has the right to use, the asset shall be excluded from the liquidation estate. In other words, if it has been pre-determined at the time of execution of the lease agreement that the title of ownership is to change hands at the end of the tenure of the lease, then the property covered under the lease agreement will form a part of the liquidation estate. Leased assets which do not stipulate automatic transfer of title but only right to use is transferred, shall be excluded from the liquidation estate of the lessee^[11].

Fate of Lease Contracts where the leased asset is “essential” to business

One of the most common events leading to termination of commercial contracts is commencement of the insolvency process of any party. Does it imply that upon commencement of any and every insolvency process, agreements can be terminated? Similarly, could lease arrangements also be terminated on grounds on commencement of insolvency proceedings.

Attention must be drawn towards the moratorium that becomes effective from commencement of CIRP as well the overarching objective of the Code to continue the going concern nature of the corporate debtor. Hence, to argue that commencement of insolvency should lead to termination of all commercial arrangements would be counter-intuitive to the objectives of the Code.

At this juncture, a brief discussion on ipso facto clauses vis-a-vis the Rule of Anti-deprivation^[12] becomes crucial. This rule arises from the classic conflict between the autonomy of parties in entering into contracts and the objective of corporate rescue.^[13]

The Hon’ble Supreme Court in the case of Gujarat Urja Vikas Nigam Limited v. Mr. Amit Gupta^[14], observed that during the CIRP, a conditional stay on the ipso facto clauses might be enforced on the condition that the Committee of Creditors agrees to the supplier’s continuous payment for its services during the CIRP period. In the case of other commodities, a balance must be struck between contract autonomy while avoiding forcing any party into a financially unviable contract and guaranteeing the ‘going concern’ aspect of the business to settle and restructure bad debts.

In this landmark case, while the Apex Court remained silent on the validity on ipso-facto clause vis-a-vis the Code, it clarified with enough emphasis that where termination of a contract, solely due to commencement of insolvency, leads to the death of corporate debtor, such termination shall not be allowed. Hence, the Hon’ble SC prioritised the going-concern nature over ipso-facto clauses.

Thus, whether or not a lessor is entitled to terminate the contract, solely on grounds of commencement of lease, is subject importance of such an agreement for the sustenance of the corporate debtor.

Conclusion

From the discussions above, it can be rightly said that the rights of a lessor and the feasibility of a collective process rather than an individual action, shall significantly depend on such lessor’s classification as financial or operating. Hence, an understanding of these rights would be crucial while entering into lease arrangements in future, as the terms agreed upon at the time of entering into such lease arrangements would decide the fate and rights of the lessor, should the lessee go into insolvency or liquidation.

On a closing note, the foregoing discussion makes it clear that unless the existing gaps in the Code, vis-a-vis lease transactions, their treatment as secured creditors, right to relinquishment, and other factors discussed above, are resolved, the true devil would lie in the strategical drafting of lease agreements, as they could essentially make or break the rights available to the lessor.

^[1] As per the World Leading Report, 2022, contributed by Vinod Kothari & Consultants Private Limited, the new leasing volumes including new disbursement by IRFC was Rs. 306.64 billion

^[2] Evaluation of Leasing in India, March, 2019 by International Financial Corporation, contributed by Vinod Kothari, Nidhi Bothra and Abhirup Ghosh of Vinod Kothari Consultants Private Limited

^[3] In the case of Association of Leasing and Financial Services Company v. Union of India, the Hon’ble Supreme Court of India clearly stated that financial leasing and hire purchase transactions are a mode of long term funding (See Para 20 and 21). See also, Asea Brown Boveri Ltd v. Industrial Finance Corporation of India wherein the Apex Court observed that “According to Lease Financing & Hire Purchase by Vinod Kothari (Second Edition, 1986, at pp. 6 & 7), a finance lease, also called a capital lease, is nothing but a loan in disguise.”

^[4] Section 5 (21)

^[5] Whether Landlord is an Operational Creditor under IBC

^[6]https://ibbi.gov.in/webadmin/pdf/order/2017/Dec/28th%20Nov%202017%20in%20the%20matter%20of%20Jindal%20Steel%20&%20Power%20Ltd.%20Vs.%20DCM%20International%20Ltd.%20CA%20(AT)%20(Insolvency)%20No.%20288-2017_2017-12-07%2011:25:54.pdf

^[7]2019 SCC OnLine NCLT 18433

^[8] https://ibbi.gov.in/BLRCReportVol1_04112015.pdf

^[9] Civil Appeal No(s).4237/2020

^[10] Section 77 (3) of the Companies Act, 2013

^[11] See detailed discussion in our article Inclusion of assets taken on lease in the liquidation estate of the lessee authored by Ms. Anita Baid

^[12] The Anti-deprivation rule is aimed at preventing decrease in the value of assets in the liquidation estate which could in turn lead to reduction in distribution to the creditors of the corporate debtor

^[13] Vinod Kothari & Sikha Bansal, Contractual Freedom Vs.  Corporate Rescue: Taking Anti- Deprivation Rule beyond Gujarat Urja ruling – https://ibbi.gov.in/uploads/whatsnew/dc8b0d64dc2980fe0e27fa3ba576b4c7.pdf (Pg. 261-277)

^[14] SCC Online SC 194