The question whether compulsorily convertible debentures are debt or equity, before they are converted, assumes importance in the context of the borrower going into insolvency. At that stage, the resolution professional (RP) is confronted with the question as to whether he should treat the CCD holder as a financial debtor or as a shareholder.

The Supreme Court laid to rest any confusion on this issue, in its judgment in December 2023, in a dispute between the financial institution, IFCI and IVRCL Chengapalli Tollways Limited (ICTL). The apex court stressed on ‘repayment of principal’ test to ascertain whether CCDs are debt or equity. If the principal amount is to be repaid to the CCD holder, then the instrument is debt; otherwise, it is equity.

Oddly enough, in this case, IFCI’s CCDs had matured, but not yet converted into equity. IFCI argued that it was left remediless—the conversion of the CCDs into equity became impossible due to the insolvency of ICTL. IFCI was neither treated as shareholder nor as a financial creditor.

Yet, IFCI claimed its investment into the CCDs was debt; it wanted to be counted among the financial creditors.

IFCI lost its case at NCLT and the NCLAT. Both the Appellate Tribunal and the Supreme Court relied on the ‘repayment of principal’ test, laid down by the Supreme Court, in Narendra Kumar Maheshwari V Union of India. All three courts have held that if CCDs are to be necessarily converted into equity, they would be considered to be equity.

In Sahara India Real Estate Corporation Limited vs Securities and Exchange Board of India, the apex court discussed whether optionally fully convertible debentures at issue in that case fell within the definition of ‘securities’ under the Indian securities laws. While analyzing this issue, the SEBI had considered the issue of whether OCDs would be regarded as ‘debt’ or ‘equity’. Relying on the test in Narendra Kumar Maheshwari case, it held that unlike CCDs, an OCD holder has an option to choose whether it wants its principal amount repaid or converted into equity. Since the option contemplates repayment of the principal amount upon maturity, the SEBI concluded that OCDs would be treated as debt and not equity.

Writing in Mondaq, Neha Naik, Madhavi Doshi and Isha Patil, lawyers with Phoenix Legal, note: “The judgment in the present matter serves as an important reminder not only on the parameters of a second appeal under the IBC, but also on interpretation of commercial contracts and the boundaries within which, a court ought to interpret a commercial contract, which is assumed to always have been entered into by parties after negotiations and legal advice. The parties know their respective bargain and therefore it would be detrimental to commerce in general, if courts implied terms into commercial contracts. The Judgment importantly also observed that the nature of an instrument being debt or equity, would depend on facts and circumstances of each case, and hybrid instruments, such as CCDs, are to be read in context of a particular matter.”

In another article, Viral Mehta, Lakshmi Pradeep, Rajat Maloo and Advaita Kapoor, lawyers with S&R Associates, note that it is important to mention that although the Supreme Court judgment was delivered in the CIRP context. The treatment of CCDs from a tax or accounting perspective will need to be separately considered.