The Compulsorily Convertible Debentures or CCDs offer the benefits of both debt in terms of interest payment and equity in terms of ownership after conversion at a specified time or event. This dual nature of the CCDs – being a debt instrument initially and later converting into equity has significant implications under the Insolvency and Bankruptcy Code, 2016 (IBC). The Corporate Favourite CCDs have emerged as a versatile instrument blending the features of both debt and equity. However, here’s what gets intriguing – How exactly should these hybrids be classified? Should they be treated as equity, reflecting an ownership stake, or as debt, signalling an obligation to repay?
Not just a technical role out as a debt or equity, the CCD is a game-changer. Why? Because only the external creditors can initiate the insolvency proceedings under the Bankruptsy Laws. In the case of a company liquidation, the stakes are even higher – creditors get paid first, leaving the shareholders at the end of the queue. So where do CCDs fit in this high-stakes scenario?
Ever since the introduction of the IBC, the NCLTs and NCLAT have passed various judgements and very recently the Supreme Court has also given some clarity on the same. This heated debate is far from settled. So, where does the truth lie?
Is a Compulsorily Convertible Debenture (CCD) classified as debt or equity? The answer isn’t just a technicality; it can determine who has the power to initiate Corporate Insolvency Resolution Proceedings (CIRP) and who gets paid first if liquidation occurs. Dive into our blog to understand why this distinction is crucial and how it impacts creditors and shareholders under the IBC.
The Indian Companies Act, 2013 has provisions for the issuance of Debentures as Compulsorily Convertible or Non-Convertible or Optionally Convertible. Section 2(30) of the Act defines debentures as debt. The definition is read as “a ‘debenture’ to include debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. That is, a debenture is a debt instrument for the company. Thus, the debentures whether CCD or OCD or NCD are treated as debt under this Act.
In the context of the Controller of Capital Issues’ decision, a CCD does not postulate any repayment of the principal, therefore cannot be considered as debt in its classic sense. [Supreme Court in the Narendra Kumar Maheshwari Vs Union of India (1990)] However, the SC used a very interesting concept of legal interpretation known as “Substance over Form” and stated that the CCD is not a debt in its classic sense but it does not mean it is not a debt at all. The argument is form vs substance. Until conversion, it is still debt in its form however it is not a debt in substance because there is no repayment at all. Hence, the CCD is considered as debt until conversion but after the same, it is equity in substance.
The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 has mentioned the CCD in the definition of equity and it is read as ‘equity instruments’ means “equity shares, convertible debentures, preference shares, and share warrants issued by an Indian company“. It further defines Convertible Debentures to include only CCD and read as ‘Convertible Debentures’ within this framework “pertains to debentures that are fully, compulsorily and mandatorily convertible”. Hence, the FEMA treats the CCDs as equity.
The main question in the treatment of CCDs under the Income Tax Act 1961 is whether interest payments for CCDs are deductible expenses. Section 36 of the Act allows deduction against the “borrowed capital” only and the question that arises is as to whether the CCDs are considered under the ambit of borrowed capital. The Rajasthan High Court in the case of CIT vs. Secure Meters Limited has held that when issued, the debenture is treated as a loan and therefore convertible or non-convertible status does not make the CCDs ineligible to be considered as borrowed capital.
The centre of the debate starts from the IBC itself. Section 3(11) of the code defines the term “Debt” which is read as “‘debt’ means a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt. The Committee of Creditors under the IBC consists only of Financial Creditors. The definition of “Debt” includes obligations in respect of a claim that is due from any person. The “Financial Creditor” includes someone to whom a financial debt is due. The definition of “Financial Debt” includes any amount raised under any note purchase facility or the issue of bonds, notes, debentures, loan stock, or any similar instrument. A prima facie reading of these definitions seems to consider CCD as Financial Debt which establishes the confusion of treating it as Financial Debt.
The determination of CCDs as debt or equity becomes crucial because of the 2 reasons:
Treating the so-called Compulsory Convertible Debentures as Financial Debt under the IBC would enable many stakeholders to initiate CIRP or Participate in the Liquidation of the companies. However, can it be treated as a Financial Debt? Let’s examine significant judicial rulings related to this matter:
GM Webtech Pvt. Ltd. vs. Boulevard Projects Pvt. Ltd (NCLT, New Delhi)
In this case, the CCDs were not matured as of the conversion date as mentioned in the Investment agreement. The interest on such CCDs was being paid and the appropriate TDS was also deducted on the same. However, when the CCD holder, as applicant under IBC, reached out to the Resolution Professional, the RP, on 9th April 2019 rejected the claim of the applicant stating the applicant’s affirmative rights in the corporate debtor as per the investment agreement.
The NCLT principal bench held that if debentures are not matured and not converted at the time of winding up or at the time of the admission of the application under the IBC, they would still be considered debentures. The CCDs would remain as debt if the payment for redemption is not complete. Lastly, the NCLT asked the RP to treat it as Financial Debt u/s 5(8) (c) of the IBC, 2016.
The Agritrade held 38,05,576 CCDs of SKS Power Generation (Chattisgarh) Limited, the RP rejected the claim of the applicant on the ground that the CCDs were being treated as “other equity” in the books of the Corporate Debtor implying it was not debt.
The Applicant challenged the same before the NCLT relying on the precedent set in the GM Webtech Case. However, the NCLT Mumbai passed a decision after digging out the Investment agreement and found out that the same had a clause mentioning that the CCDs were required to be mandatorily converted on the earlier of:
Accordingly, the court held that the Insolvency Proceedings were an analogous event causing the mandatory conversion of the CCDs and on such conversion, the CCDs ceased to become debt towards the principal amount. However, striking the balance between debt & equity treatment, the NCLT further stated that while the principal is subject to mandatory conversion, the interest accrued until a conversion is an “obligation” and therefore forms part of financial debt and should be admitted as such. Lastly, the NCLT admitted only accrued interest as financial debt and rejected the principal amount.
This is a landmark case by the Supreme Court which brings out clarity on the nature of CCD.
Facts of the Case:
A concession agreement was signed between the NHAI and ICTL (a Subsidiary of IVRCL) for a highway project. The financing was planned through a consortium of lenders including the State Bank of India (SBI) and the equity infusion and some part of the equity was via CCDs. IFCI subscribed to the CCDs amounting to INR 125 Cr and executed the Debenture Subscription Agreement (DSA) on 14th October 2011. The DSA allowed the IFCI to require the issuer to buy back the CCDs between the 3rd year and 6th year. However, this “put option” was not exercised.
The project later faced financial difficulties. IFCI invoked the corporate guarantee provided by the IVRCL and along with the SBI, initiated the CIRP against the ICTL under the IBC, 2016. On applying to claim as a Financial Creditors the Resolution Professional rejected the application citing the following reasons:
The IFCI appeared before NCLT and contended that the conversion of the CCD became impossible due to its insolvency which made the IFCI remediless because they would neither be treated as creditors nor shareholders and therefore CCD should be considered as debt because they were not converted into equity.
The NCLT relied on the judgment of Narendra Kumar Maheshwari v. Union of India which stated that “CCDs do not postulate any repayment of the principal amount. Any instrument which is compulsorily convertible into shares is regarded as an “equity” and not a loan or debt.” The NCLT further relied on the RBI Master Direction on foreign investment to say that the CCDs unlike optionally convertible debentures (OCDs) were equity and not debt.
The RP argued that the CCDs were defined as equity under the DSA and the financing plan had a clause mentioning the 7:3 debt-to-equity ratio and any amendment in this ratio required the prior approval of lenders which was never sought. The RP further stated that the ICTL does not have a liability or obligation towards IFCI because IFCI is actually an equity participant and therefore it does not have a debt to be repaid. Given the same, RP relied on Section 3 (11) of the code that debt is the liability or obligation for a claim that is due from any person. And since there is no point of dues after the maturity date, the IFCI is not a creditor at all.
The Hon’ble Supreme Court dismissed the IFCI’s appeal emphasizing that the security was provided by the IVRCL and not the ICTL and therefore the ICTL was not obligated to repay the CCDs. The SC observed that the DSA did not include the provision to reclassify the CCDs as financial debt upon the occurrence of any event as in the case of the Agritrade Power Holding Mauritius Limited vs. Ashish Arjunkumar Rathi. Thus, there was no obligation on ICTL to repay IFCI under the CCDs. Moreover, the SC noted that upon the conversion date, ICTL had no liability to repay as given under the definition of debt, hence IFCI could not claim any recovery from ICTL as a creditor.
The SC further stressed that commercial agreements like DSA are typically vetted by the experts and it is not the role of the court to imply anything to clear the terms of agreement, this view of the SC was supported by the reference to Nabha Private Limited v. Punjab State Power Corporation Limited case which held that the contracts should be interpreted as they are written.
The SC upheld the ruling of the NCLAT classifying the matured CCDs as equity and mentioned that classifying the CCD as debt would breach the DSA and concession agreement terms. The apex court also noted that if the IFCI wanted the CCDs to be considered as debt rather than equity, it should have sought the prior approval of the lenders. Since the approval was not obtained, the CCDs must be regarded as equity instruments in line with the original agreements.
The IFCI case was a landmark in plotting the clarity on the subject, based on the above discussion and analysis, we would like to have a scenario-based viewpoint:
CCDs as Debt
Understanding the discussed case laws under the IBC, it can be said that if the CIRP is initiated before the conversion event of the CCDs, there is a strong likelihood that these instruments may be considered debt under the IBC. Until the conversion, the CCDs remain the obligation of the company to repay the principal or pay interest, fitting the definition of financial debt under the IBC. The obligation remains until the event of conversion into equity thus allowing the CCD subscribers to be treated as financial creditors who can participate in the CIRP and have a say in the COC.
CCDs as Equity:
Opposite to the above, if the conversion event or date has lapsed or expired at the time the CIRP is initiated and the CCDs have not been converted into equity shares, these CCDs are less likely to be construed as financial debt. In such cases, the CCDs have effectively ceased to carry any repayment obligation which aligns them more closely with equity. Therefore, post-conversion or post-expiration, CCD holders may be regarded as equity shareholders with their claims subordinated to those of financial creditors in the insolvency process.