Debt or equity? A question of form

While constitutional law and criminal law tend to occupy public discourse, it’s the quiet hum of corporate law that keeps the economic system running, and of which the public is aware only sporadically. This is a shame because corporate law is a fascinating field of study, with the centrepiece of the domain being the artificial legal personality of the corporation that enables it to borrow, invest, contract, and sue others. At the same time, the separate lives of corporations are susceptible to economic risk, because the people who lend money to the corporation will usually have recourse only to the assets of the corporation, and not to the assets of the individuals behind the corporation.

Protecting creditors is the great preoccupation of corporate law. While the Companies Act, 2013, contains various creditor-friendly rules, the most significant provisions lie in India’s bankruptcy code, which prioritises creditors over shareholders in asset distributions when a corporation becomes insolvent and liquidates. The corporation owes nothing to its shareholders if there is no money left in the kitty after the creditors have been satisfied. By acquiring equity in the company, shareholders can participate in the company’s prosperity, but they are also singed by its failures.

Usually, the distinction between debt and equity is easy to discern, but in some cases, like EPC Constructions v Matix Fertilizers, a Supreme Court case decided last year, the distinction comes up for renewed scrutiny. A fertiliser company hired a construction company to build a fertiliser plant. Over a period of time, the fertiliser company owed a large sum of money to the construction company that remained unpaid, eventually stalling the construction. It’s fascinating that when parties enter into contracts of this kind, they share each other’s fates. The construction company’s receivables depended on the successful completion of the factory. But the factory could not be constructed without an additional infusion of money. Because the dues were unpaid, the construction company was now not only a contractor but also a creditor of the fertiliser company.

The relationship continued to deteriorate with the declining financial viability of the fertiliser company. In desperation, the construction company agreed to convert the fertiliser company’s debt into equity, becoming a preferential shareholder of the fertiliser company.

Why did this happen? Because the fertiliser company convinced the construction company that once there was more equity in the fertiliser company, other lenders would agree to provide more money on the assurance that the company stood on strong capital. The creditor’s stature of preferential shareholder meant that the fertiliser company had to pay the sum it owed to the construction company after three years.

From the construction company’s perspective, this was just a change of form, from a straightforward debt to something that was debt but swaddled in a form of equity. But in law, form matters. The fertiliser company could not pay its debts and entered insolvency proceedings. The preference shares had not been redeemed. In corporate law, a preference shareholder can receive the money back in a redemption only in two circumstances: either the company has made enough profits to redeem the preference shares, or there is money available for the redemption from a separate raising of equity money. Why? Because corporate law is designed to protect creditors and is concerned with money in the company getting diluted due to payouts to preferential shareholders.

The construction company filed a claim in the insolvency proceedings seeking its money back, not as a shareholder but as a creditor. But here, it ran into a problem because corporate law’s concern is with creditors. Shareholders are not entitled to receive their money this way; in the order of distribution called the waterfall, they are the last in line. The courts refused to treat the construction company as a creditor, even though it assumed itself as one when its outstanding receivables were converted into equity.

But form is not merely a formality. When the matter reached the Supreme Court, the Court stated that the difference between debt and equity was fundamental. If the contract states that it’s a share, it cannot be termed as debt. This case is critical because it says something important about the nature of commercial relationships – their dependence on form. Once the parties chose a form, they were bound by it, making it pointless to assert other underlying contractual intent. As the Court put it, “the eggs having been scrambled”, the parties’ “attempt to unscramble it must necessarily fail.”

The writer is a law professor who thinks that the law is too important to be left to the lawyers.

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.