Registration of security interest: A peculiar Indian problem

by Pratik Datta.

When a lender extends credit to a company, it often secures repayment by way of a security (often referred to as a “charge”) created over certain assets or properties of that company. Company law usually requires such security to be registered with an agency. For instance, in the UK, company charges are registered with the Companies House. Registration of security could serve three different purposes:

1. the purpose of registration of security could be to publish the existence of such security to make it available for public inspection. This gives potential lenders to the company information about the extent of prior lending to the company which may rank ahead of their own contemplated advances. Such information may also be of interest to credit analysts, resolution professionals, shareholders and investors.

2. registration may be necessary for ‘perfection’ of the security. That is, registration may be treated by law as a necessary part of the process whereby a person obtains a security interest against the company. Without registration, the person in question would fail to obtain security interest and so would not be able to rely on it against the unsecured creditors of the company during the company’s insolvency.

3. registration could be used in law as a way of determining priority among secured creditors. For example, the law could require that priorities among secured creditors be determined by the date of registration of the security instead of the date of creation of security.

In India, we have a peculiar situation. When a bank or notified financial institution extends a secured credit facility to a company, three different registrations are necessary under three different laws for the same security.

1. Under section 77 of Companies Act 2013, a company creating charge on its assets or properties is required to register the particulars of such charge with the Registrar of Companies (‘RoC’). This involves providing the relevant information in Form No. CHG-1 (for charges other than debentures) or Form No. CHG-9 (for debentures), getting it signed by both the company and the charge holder, and then filing the Form along with the underlying credit agreement with the ROC.

2. Under section 23 of Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFAESI Act’), the particulars of every transaction (involving banks and notified financial institutions) creating security interest must be filed with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (‘CERSAI’). This involves filing Form I with CERSAI.

3. Under section 215(2) of the Insolvency and Bankruptcy Code 2016 (‘IBC’), a financial creditor (which typically includes banks and regulated financial institutions) is mandatorily required to submit financial information and information relating to assets, in relation to which any security interest has been created, to an Information Utility (“IU”). Unlike RoC or CERSAI, IUs are required to authenticate and verify information of default, and issue a record of default in Form D to its registered uses.

As a result of these legal provisions, every single secured credit transaction in India has to be mandatorily registered with the RoC, the CERSAI as well as an IU. More than increasing compliance burden, this institutional overlap increases the legal uncertainties around security creation and enforcement, with potentially adverse implications for the entire secured credit landscape. A recent case illustrates the point.

Case in point

In Bizloan Pvt. Ltd. v. Mr. Amit Chandrashekhar Poddar (“Bizloan judgment”), the NCLAT was seized of a unique situation where a corporate credit transaction was registered only with CERSAI but not with RoC. Bizloan Private Ltd. (“Bizloan”) provided financial credit facilities to Autocop (India) Pvt. Ltd. (“Autocop”) in the form of sales bill discounting and purchase bill discounting of Rs. 1 crore in aggregate. Subsequently, Autocop went into corporate insolvency resolution process (“CIRP”) under the Insolvency and Bankruptcy Code 2016 (“IBC”). Bizloan filed its claims in Form C during CIRP, which were admitted in full without indicating if they were secured or unsecured. It was only when Bizloan received the final resolution plan for Autocop that it realized that Bizloan had been classified as an unsecured financial creditor. Bizloan challenged this classification but by then Autocop had been put into liquidation. The NCLT dismissed Bizloan’s challenge. Consequently, Bizloan approached NCLAT in appeal.

Bizloan’s arguments

1. Bizloan argued that proving security interest in liquidation proceedings under IBC should be governed by Regulation 21 of the IBB (Liquidation Process) Regulations, 2016, which states:

The existence of a security interest may be proved by a secured creditor on the basis of -

1. the records available in an information utility, if any;
2. certificate of registration of charge issued by the Registrar of Companies; or
3. proof of registration of charge with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India.

Evidently, proof of registration of charge with CERSAI is sufficient for proving security interest in a liquidation by virtue of Regulation 21(c) of the Liquidation Regulations.

2. Bizloan further argued that section 238 of the IBC overrides provisions of other statutes. Therefore, if there is any inconsistency between IBC and any other statute, IBC and the regulations issued under it should prevail.

Liquidator’s arguments

1. The Liquidator relied on section 77(3) of the Companies Act 2013, which states:

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 appointed under this Act or the Insolvency and Bankruptcy Code, 2016 (31 of 2016), as the case may be, 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 subsection (2).

The underlined portion of the above provision was inserted through the Eleventh Schedule of the IBC itself, which came into effect from November 15, 2016. The liquidator highlighted that the words “shall” makes him duty bound to follow the above provision. Further, if there is any conflict between section 77 of Companies Act 2013 and Regulation 21 of the Liquidation Regulations issued under the IBC, the former will override the latter since section 77 is a specific provision dealing with the particular situation (that is, registration of charges) and it explicitly uses the words ““notwithstanding anything contained in any other law”. Since Bizloan’s charge was not registered with the RoC under section 77 of the Companies Act 2013 and only registered with CERSAI, Bizloan cannot be treated as a secured financial creditor in liquidation governed by the IBC.

2. The liquidator further argued that Regulation 21 is an outcome of section 52(3)(b) of the IBC, which states:

Before any security interest is realised by the secured creditor under this section, the liquidator shall verify such security interest and permit the secured creditor to realise only such security interest, the existence of which may be proved either – (a) by the records of such security interest maintained by an information utility; or (b) by such other means as may be specified by the Board.

The liquidator argued that section 52(3) applies only before a secured creditor chooses to “realise” its security interest, which does not come into the picture in Bizloan’s case since Bizloan had effectively “relinquished it security interest to the liquidation estate” and was to receive the sale proceeds in terms of section 53 of IBC.

3. The Liquidator further highlighted that Regulation 21 uses the words “may prove”, which is discretionary and not mandatory. In contrast, section 77 uses the word “shall” which is mandatory and binding.

4. Additionally, the Liquidator argued that if there is a conflict between section 77 and Regulation 21, Regulation 21 of the Liquidation Regulations issued under section 240 of the IBC will have to give way to section 255 of the IBC, which amended section 77(3) of the Companies Act explicitly giving more weightage to section 77 of Companies Act 2013 in matters of registration of charges on a company’s assets or properties.

5. The Liquidator also drew attention to section 20(4) of the SARFAESI Act 2002, which reads:

The provisions of this Act pertaining to the Central Registry shall be in addition to and not in derogation of any of the provisions contained in the Registration Act, 1908 (16 of 1908), the Companies Act, 1956 (1 of 1956), the Merchant Shipping Act, 1958 (44 of 1958), the Patents Act, 1970 (39 of 1970), the Motor Vehicles Act, 1988 (49 of 1988), and the Designs Act, 2000 (16 of 2000) or any other law requiring registration of charges and shall not affect the priority of charges or validity thereof under those Acts or laws.

Accordingly, the Liquidator argued that SARFAESI Act 2002 is ‘only in addition and not in derogation of’ the provisions of Companies Act 2013 and any other law. Therefore, registration with CERSAI under SARFAESI Act 2002 cannot affect the priority of charges or validity thereof under those other Acts or laws.

NCLAT’s judgment

The NCLAT noted the well-established principle of statutory interpretation that a latter law prevails over an older law. Accordingly, it observed that the IBC came into effect on December 1, 2016 while the amendment to section 77(3) of Companies Act 2013 came into effect earlier on November 11, 2016. Further, Regulation 21 of the Liquidation Regulations came into effect on December 15, 2016, after the amendment to section 77(3) of Companies Act 2013. Therefore, NCLAT concluded that the IBC will override the amended section 77(3) of Companies Act 2013. Consequently, it was held that security interest of a creditor can be proved if the same is available only in CERSAI. It is not completely and exclusively dependent on charge registered with RoC under section 77 of Companies Act 2013. As a result, Bizloan should be treated as a secured financial creditor based on its CERSAI registration pursuant to Regulation 21 of the Liquidation Regulations.

Analysis of NCLAT’s reasoning

The NCLAT’s reasoning is problematic. The general principle of statutory interpretation that a new law overrides an old law is based on the assumption that if both laws have been enacted by the Parliament at different points in time, it is reasonable to assume that the latter law reflects the latest policy intent of the Parliament and therefore, should prevail over the earlier law.

When IBC was enacted by the Parliament, section 255 of IBC amended section 77(3) of Companies Act 2013 to clarify that a liquidator appointed under IBC must take into account a charge created by a company only if such charge was registered under section 77 of Companies Act 2013. The Parliamentary intent was clearly to ensure that only charges registered under section 77 of Companies Act 2013 are taken into account in a liquidation under IBC.

The Ministry of Corporate Affairs (“MCA”) notified different provisions of IBC at different points in time because of administrative convenience. Parliamentary intent cannot reasonably be determined based on whether a provision of IBC was notified before another provision of the IBC by the MCA, that too within a span of a month. Therefore, the fundamental basis of NCLAT’s reasoning stands of unsure footing.

Policy issues

The NCLAT noted that RoC and CERSAI registrations serve different purposes. Registration of charges with RoC under section 77 of Companies Act 2013 is relevant for determining priority of claimants of a company during liquidation under IBC or winding up under Companies Act 2013. In contrast, CERSAI registration under section 20 of SARFAESI Act 2002 is relevant for realization of security interests by banks and notified financial institutions through the SARFAESI Act 2002. It is also noted that CERSAI registration helps in fraud prevention by allowing lenders to check if the asset being offered as security is already hypothecated or mortgaged.

On closer examination, these stated purposes do not appear to be mutually exclusive. When a bank or a notified financial institution extends secured credit to a company, the borrower company is mandated by law to register the charges with the RoC under section 77 of Companies Act 2013. This RoC data is available for public inspection. Potential lenders to the company can use the RoC data to check if the company has already given any of its assets or properties as security to any prior lender(s). Clearly, fraud prevention in corporate lending by banks and notified financial institutions cannot be a reason for setting up CERSAI.

CERSAI becomes relevant only for fraud prevention in the case of loans extended by banks or notified financial institutions to non-corporate borrowers such as individuals, sole proprietorships, societies, partnerships etc. The RoC does not have information on prior borrowings by such non-corporate borrowers or the existing security on the assets or properties of such borrowers. In such cases, CERSAI plays a legitimate role in fraud prevention.

The problem in the current institutional design lies is the overlap between RoC, CERSAI and IUs with respect to corporate secured lending. Banks and notified financial institutions have a strong incentive to register security interests in corporate lending transactions with CERSAI because it enables them to enforce such security interests through the special out-of-court enforcement mechanism under SARFAESI Act 2002. These lenders also have an incentive to get the same information filed with an IU so that they can rely on the IU’s record of default in insolvency proceedings under IBC. And the corporate borrower is anyways legally mandated to register the security with RoC under Companies Act 2013. Overall, these laws have created layers of institutions over one another for the same purpose, muddying the functional clarity between RoC, CERSAI and IUs.

Conclusion

The blurring of functionalities between the RoC, CERSAI and IUs not only creates avoidable transaction cost in corporate secured credit transactions, it also leads to legal risks around security creation as the Bizloan judgment illustrates.

Registration of a particular security interest against assets or properties of a particular corporate debtor should be done only once. Let’s assume that the registration agency is RoC. The corporate debtor should register a particular security interest only once with the ROC. In case of default, that RoC registration alone should be enough for banks and notified institutions to use enforcement rights under SARFAESI against such corporate debtors. Similarly, the same ROC registration alone should be adequate proof of security interest against a corporate debtor for the purposes of IBC. The law should not require the same security interest against the same corporate debtor to be registered with CERSAI or any IU.

CERSAI would, of course, remain relevant for registration of security interests against non-corporate borrowers. The case for IUs is more nuanced. The BLRC had envisaged an open competitive industry in the market for information required for insolvency and bankruptcy. This should be achieved by enabling multiple private competing businesses to perform the role of RoC, which would require a fundamental rethinking of the RoC as a state monopoly under Companies Act 2013. Adding an additional layer of IUs over the existing RoC to perform exactly the same function is not exactly the reform that the BLRC had envisaged.

The legal mechanics of achieving these outcomes is not particularly complex. Suitable amendments would be required to Companies Act 2013, SARFAESI Act 2002 and Insolvency and Bankruptcy Code 2016 and some subordinate legislations issued under these statutes. But first of all, the MCA (for RoC and IUs) and Ministry of Finance (for CERSAI) need to recognize the problems with the current laws on registration of security interests and agree on the policy pathway ahead.




The author is a lawyer.