Trust Theory, Security and Margin Money: The effect of Moratorium under the Insolvency and Bankruptcy Code on such Transactions

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 given[1].

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 beneficiary[2]. 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 injury[3].

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 period[4]. 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.

Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein

References:
[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