Mutual Debts – Right of Set-off & Banker’s Lien in IBC

Facts of the case – Bank (FC) filed the claim for the full amount of Bank Guarantee (BG), without adjusting the margin amount (held in the shape of FDR). Thereafter during CIRP, the BG was invoked (being performance guarantee) and paid in full by the bank. The bank did not adjust the FDR and thereafter refused to release it. After payment of the BG as above, there is no other BG for which margin was required. The claim for the full value of BG has already been made. During the liquidation process, the bank wants to claim the FDR as margin and adjust it against the claim amount of BG.

Issues:

1. Whether the bank (FC) can set-off the amount of FDR with its claim, after the invocation of BG during CIRP.
2. Whether the bank can withhold the FDR, during the CIRP.
3. Whether the bank can adjust (set-off) the amount of FDR in the claim amount during the Liquidation process.
4. Whether the bank can enforce security interest over such FDR under section 52.

1. Whether the bank (FC) can set-off the amount of FDR with its claim, after the invocation of BG during CIRP.

Contractual set-off

Parties sometimes agree to a contractual right of set-off, for example, when they have an ongoing business relationship; alternatively, they may agree to exclude set-off rights. 

What Is a Set-Off Clause?

A set-off clause is a legal clause that gives a lender the authority to seize a debtor’s deposits when they default on a loan. A set-off clause can also refer to a settlement of mutual debt between a creditor and a debtor through offsetting transaction claims. This allows creditors to collect a greater amount than they usually could under bankruptcy proceedings.

Key Takeaways

• Set-off clauses are written into legal agreements to protect the lender.
• A set-off clause allows the lender to seize assets belonging to the borrower, such as bank accounts, in the event of a default.
• Set-off clauses are also used by manufacturers and other sellers of goods to protect them from a default by a buyer.

How a Set-Off Clause Works

Set-off clauses give the lender the right of setoff – the legal right to seize funds from the debtor or a guarantor of the debt. They are part of many lending agreements and can be structured in various ways. Lenders may elect to include a set-off clause in the agreement to ensure that, in the event of default, they will receive a greater percentage of the amount that’s owed them than they might otherwise. If a debtor is unable to meet an obligation to the bank, the bank can seize the assets detailed in the clause.

Set-off clauses are most commonly used in loan agreements between lenders, such as banks, and their borrowers. They may also be used in other kinds of transactions where one party faces a risk of payment default, such as a contract between a manufacturer and a buyer of its goods.

Examples of Set-Off Clauses

A lending set-off clause is often included in a loan agreement between a borrower and the bank where they hold other assets, such as money in a checking, savings, or money market account, or a certificate of deposit. The borrower agrees to make those assets available to the lender in the case of default. If assets are held at that lender, they can be more easily accessed by the lender to cover a defaulted payment. But a set-off clause may also include rights to assets held at other institutions. While those assets are not as readily accessible to the lender, the set-off clause does give the lender contractual consent to seize them if a borrower defaults.

A set-off clause might also be part of a supplier agreement between the supplier, such as a manufacturer, and a buyer, such as a retailer. This type of clause can be used in place of a letter of credit from a bank and gives the supplier access to deposit accounts or other assets held at the buyer’s financial institution if the buyer fails to pay. With a set-off clause, the seller can obtain payment equivalent to the amount that’s owed them under the supplier agreement.

Benefits of Set-Off Clauses

Set-off clauses are used for the benefit of the party at risk of a payment default. They give the creditor legal access to a debtor’s assets at either the lender’s financial institution or another one where the debtor has accounts. Before signing a contract with a set-off clause, borrowers should be aware that it may result in the loss of assets they would have been able to retain through other means of debt settlement, such as bankruptcy.

Right of Set-off (Mutual credits) in IBC.

Though nothing is mentioned in the Code & CIRP Regulations, NCLT Mumbai (01.05.2019) in Bharti Airtel Ltd. vs. Vijaykumar V. Iyer (MA 230/2019 in CP No. 302/IBC/NCLT/MB/MAH/2018) permitted set-off of mutual debts during insolvency proceedings. The question before the Tribunal was, whether the set-off is allowable under Insolvency Proceedings. Tribunal observed as under;

• “…the Bench is of the view that the applicant is legally entitled under the insolvency code to set off the amount of Rs 112 crore while making a payment of the amount retained out of the total consideration settled as per Spectrum Trading Agreement…this Application deserves to be allowed,”

However, NCLAT (13.07.2020) in Vijay Kumar V Iyer vs. Bharti Airtel Ltd & Ors [Company Appeal (AT) (Ins) No.530 & 700 of 2019] ruled that set-off of mutual debts are not allowed during insolvency proceedings.

• # 14. We have also observed that Accounting Conventions cannot supersede any express provisions of the laid down provisions of the specific law on the subject. The I&B Code, 2016 provides the mechanism of Moratorium during the CIRP till the Resolution Plan is approved or Liquidation order is passed. The I&B Code has a provision to override other laws as enunciated above. Hence, even if there are some such provisions in any other law, the I&B Code 2016 will prevail over that.

# 15. Accordingly, we allow the present appeal and set aside the order dated 01.05.2019 passed by NCLT, Mumbai Bench, and direct the Respondent No.1 & 2 to pay the amount whatever has been set off by them to the Aircel Entities.

Though, I personally do not agree with the decision of the Appellate Court, based on the detailed arguments mentioned in the order of NCLT dated 01.05.2019, the ruling of the Appellate Court (NCLAT) will prevail, till such time the same is deliberated upon by the Hon’ble SCI.

In the present case, despite the bank having contractual rights of set-off, it can not adjust the amount of FDR in its claim amount of BG, in light of the ruling of NCLAT dated 13.07.2020.

2. Whether the bank (FC) can withhold the FDR, during the CIRP / Liquidation process.

Though under section 171, 172 &173 of “The Indian Contract Act, 1872, the bank can retain the possession of the security (FDR), under the provisions of section 18(f) read with section 238 of IBC, IRP / RP is required to take control and custody of assets over which the corporate debtor has ownership rights. Thus the bank can not withhold the possession of FDR, during the CIRP / Liquidation process.

The Indian Contract Act, 1872

Section 171. The general lien of bankers, factors, wharfingers, attorneys, and policy-brokers.  – Bankers, factors, wharfingers, attorneys of a High Court and policy-brokers may, in the absence of a contract to the contrary, retain as security for a general balance of the account, any goods bailed to them; but no other persons have a right to retain, as a security for such balance, goods bailed to them unless there is an express contract to that effect.

Section 172. “Pledge” “pawnor”, and “pawnee” defined. – The bailment of goods as security for payment of a debt or performance of a promise is called “pledge”. The bailor is in this case called the “pawnor”. The bailee is called the “pawnee”.

Section 173. Pawnee’s right of retainer. – The pawnee may retain the goods pledged, not only for payment of the debt or the performance of the promise, but for the interest of the debt, and all necessary expenses incurred by him in respect of the possession or for the preservation of the goods pledged.

I&B Code, 2016

Section 18. Duties of the interim resolution professional. –

The interim resolution professional shall perform the following duties, namely: –

(f) 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, or with information utility or the depository of securities or any other registry that records the ownership of assets including –

(i) assets over which the corporate debtor has ownership rights which may be located in a foreign country;

(ii) assets that may or may not be in possession of the corporate debtor;

(iii) tangible assets, whether movable or immovable;

(iv) intangible assets including intellectual property;

(v) securities including shares held in any subsidiary of the corporate debtor, financial instruments, insurance policies;

(vi) assets subject to the determination of ownership by a court or authority;

Section 238. Provisions of this Code to override other laws. –

The provisions of this Code shall have an effect, notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law.

Case Law;

“NCLAT” (2019.05.14)  in Encore Asset Reconstruction Company Pvt. Ltd vs. Ms. Charu Sandeep Desai & Ors. [Company Appeal (AT) (Insolvency) No. 719 of 2018] held that a secured lender which has taken physical possession of the mortgaged property prior to admission of insolvency proceedings must hand over custody of the same to the Interim Resolution Professional (“IRP”) as section 18 of the Insolvency and Bankruptcy Code, 2016 (“IBC”) will prevail over Section 13(4) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (“SARFAESI Act”).

However, IRP/RP is to keep in mind the following provisions of the Code in respect of the encumbered property of the CD. In the present case, the FDR in question is encumbered property, with the bank having security interest over the same. As such IRP/RP can take possession & custody of the said FDR (encumbered asset of CD), but can not utilize the same towards IRPC ( Insolvency Resolution Process Cost), in terms of regulation 29(1) of Insolvency Resolution Process Regulations.

IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016.

Regulation 29. Sale of assets outside the ordinary course of business.

(1) The resolution professional may sell an unencumbered asset(s) of the corporate debtor, other than in the ordinary course of business if he is of the opinion that such a sale is necessary for a better realization of value under the facts and circumstances of the case:

Provided that the book value of all assets sold during the corporate insolvency resolution process period in aggregate under this sub-regulation shall not exceed ten percent of the total claims admitted by the interim resolution professional.

3. Whether the bank (FC) can adjust the amount of FDR in the claim amount during the Liquidation process.

In the present case, the bank can set-off the amount of FDR in the claim amount. Here regulation 29 of Liquidation Process Regulations comes handy.

# Regulation 29. Mutual credits and set-off.

Where there are mutual dealings between the corporate debtor and another party, the sums due from one party shall be set off against the sums due from the other to arrive at the net amount payable to the corporate debtor or to the other party.

Illustration: X owes Rs. 100 to the corporate debtor. The corporate debtor owes Rs. 70 to X. After set off, Rs. 30 is payable by X to the corporate debtor.

4. Whether the bank can enforce security interest over such FDR under section 52.

Alternatively, the Bank (FC) can enforce security interest over the FDR, under the provisions of section 52, which has precondition of permission of Liquidator under section 52(3), after verification of the security interest by the Liquidator.

However, the option of enforcement of security interest vs. set-off, during the liquidation process has following infirmities;

i). Prior to implementation of The Companies Act,2013, under The Companies Act,1956, the charge of “Banker’s Specific Lien” / “Pledge” was not required to be registered, whereas, under The Companies Act, 2013, all types of charges are required to be registered. I understand that, in most of cases, banks have not revised their internal guidelines for getting registered the charge of “Banker’s Specific Lien” / “Pledge”  of FDR’s.

• • • The Companies Act, 1956

             Section 125. Certain charges to be void against liquidator or creditors unless registered.

             (4) This section applies to the following charges:-

             (e) a charge, not being a pledge, on any movable property of the company;

Permission for enforcement of security interest in respect of FDR under lien/pledge will be denied by the liquidator if the charge of lien/pledge of FDR is not registered with ROC.

ii). Proceeds of enforcement of security interest are subject to sharing as per section 52(8) read with liquidation regulation 21A(2).

iii). Further the priority of distribution, in the liquidation process, of the balance of claim amount (unsecured) of BG unpaid after enforcement of security interest as above, will be lower under section 53(1)(e)(ii).

Thus claiming set-off of FDR in claim amount under regulation 29 of liquidation process regulations, as per supra above is a better option. The balance of claim amount of BG (unsecured financial debt) unpaid after set-off,  will have higher priority for distribution under liquidation process [section 53(1)(d)(ii)].

Provisions in respect of the definition of Charge (security interest) and its registration are as under;

I&B Code, 2016

Section 3(4) “charge” means an interest or lien created on the property or assets of any person or any of its undertakings or both, as the case may be, as security and includes a mortgage;

The Companies  Act, 2013

Section 2(16) “charge” means an interest or lien created on the property or assets of a company or any of its undertakings or both as security and includes a mortgage;

Section 77. Duty to register charges, etc. – (1) It shall be the duty of every company creating a charge within or outside India, on its property or assets or any of its undertakings, whether tangible or otherwise, and situated in or outside India, to register the particulars of the charge signed by the company and the charge-holder together with the instruments, if any, creating such charge in such form, on payment of such fees and in such manner as may be prescribed, with the Registrar within thirty days of its creation:

(3) Notwithstanding anything contained in any other law for the time being in force, no charge created by a company shall be taken into account by the liquidator or any other creditor unless it is duly registered under sub-section (1) and a certificate of registration of such charge is given by the Registrar under sub-section (2).

(4) Nothing in sub-section (3) shall prejudice any contract or obligation for the repayment of the money secured by a charge.

References;

1. Article “Set-Off Clause” By JULIA KAGAN, Investopedia (11.09.2019)
2. Insolvency & Bankruptcy Code, 2016.
3. The Companies Act, 2013.
4. The Companies Act, 1956
5. The Indian Contract Act, 1872
6. e-Book “Claims of Creditors” by Arvind Mangla, a publication of Amazon Kindle Store.

Disclaimer: The sole purpose of this blog is to create awareness on the subject and must not be used as a guide for taking or recommending any action or decision. A reader must do his own research and seek professional advice if he intends to take any action or decision in the matters covered in this blog.