A JUDICIAL REPRIMAND FOR THE PRACTICE OF CROSS COLLATERALIZATION

- Megh Apte and Rohit Anand Das

SYNOPSIS

Recently, the Hon’ble Delhi High Court in its judgement in the case of Sunil Goel v. Indiabulls
Housing Finance Limited on 31st August 2020 delivered a judicial precedent on the issue of cross-
collateralisation. In the field of banking and finance, a ‘collateral’ basically means an additional
security for the performance of the principal obligation, and on the discharge of such performance of
the obligation, such collateral has to be surrendered. Generally, ‘cross-collateralisation’ is a method
used by lenders to use the collateral of one loan, such as a car, to secure another loan that the
borrower has with the lender. The Hon’ble Court while passing the judgement observed “cross-
collateralisation” necessarily requires the same collateral being available, as security against more
than one loan and “cross-collateralisation”, as a concept known to commercial contracts, necessarily
predicates the usage of the collateral, available as security against one loan, as collateral against a
second loan. Hence, inclusion of a clause related to cross-collateralisation in lending contracts such as
loan agreements is a common practice and by the application of the underlying principle of cross-
collateralisation, a lender has a legal right to seize or liquidate any or all assets pledged by a borrower
(e.g. for different loans with the same lender) even if only one loan goes into default.
However, as an effect of the cross collateralization practised by the lending entities entering into
Loan Agreements with the borrowers, has led the Hon’ble Delhi High Court to decide on the
contentious legal issue with regard to pledging and de-pledging an underlying collateral that was
brought forth in the case of Sunil Goel v. Indiabulls Housing Finance Limited1, where the Hon’ble
Court ruled on the contentious issue of cross collateralization of securities .
The purpose of this article is to undertake a threefold exercise which will throw light on the concept
and practice of cross collateralization in the lending industry and the analysis of the judgement of the
Hon'ble Delhi High Court. They are categorised as under:
1. A study into the practice of cross collateralization of security.
2. Understanding the reasons as to its application in the banking sector.
3. Analysing the Hon’ble Delhi HC’s judgment in Sunil Goel v. Indiabulls Housing Finance
Limited.

1. A study into the practice of cross collateralization of security specific to the case in hand
involving pledge of shares
At the outset, it is important to understand the meaning of ‘pledge’ as defined under Section 172 of
the Indian Contract Act, 1872. The said provision reads as under “The bailment of goods as security
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 for payment of a debt or performance of a promise is called 'pledge'. The entire controversy begins at
this point as to whether the goods shall act as a security for one particular debt or for further debts as
well. In the present commercial lending scheme, the word ‘goods’ has been replaced by shares
wherein shares are pledged, charged or furnished as security against the loan. This is a necessary step
which is taken by public sector and private sector banks in order to prevent such loan account from
being converted into a Non-Performing Asset (NPA).

Till this point, this is a fairly equitable method of lending which aims to ensure a win-win situation
for all the parties in the transaction. The legal problem is called into question when these pledged
shares are deemed to be ‘security’ for future loans which may be advanced by the lenders. It is
important to note that the clauses which create a cross liability in the pledged shares are drafted into
the loan agreements which covers each and every future loan. The concept of cross collateralization as
applicable to commercial contracts predicates the reciprocity of security and commonality of the
partiesI have used an example to elucidate the concept ‘If a company ‘A’ is engaged in the business of
making pharmaceuticals and obtains a working capital loan and pledges its shares with the lender, and
in the future a company ‘B’ which is a subsidiary of company ‘A’ obtains a loan for a working capital
from the same lender or a subsidiary company of the lender, the pledged shares in the first loan shall
act as a security for the second loan as well.’ However, this practice has led to certain probable
confusing scenario wherein, the quantum of lending has increased due to two but there is only one
common security against two separate loans and thereby the value of such underlying security
remains the same. Hence, there is a probability of collapse of the lending economy if both the separate
loan accounts are designated as NPA, wherein one becomes an NPA due to an actual default and the
other becomes an NPA on technical basis that the underlying security itself has gone in default.

2. Understanding the reasons as to its application in the banking sector.

First and foremost, every loan account bears a risk of default on the repayment. Thus, in order to
study credit worthiness private credit rating agencies have been made an important cog in the banking
machinery. These Credit Rating Agencies (CRA) are regulated by the SEBI (Credit Rating Agencies)
Regulations, 1999 wherein these agencies are required to carry out a vast amount of due diligence.
The role of these CRAs is to ensure that a borrower’s loan account is not a potential designated NPA.
The topic of discussion and scrutiny amongst the circles in the Indian banking sector revolves around
the issue of NPAs. The Standing Committee on Finance (2017-2018) in its Sixty-Eighth Report has
addressed this issue and observed that banks’ capacity to lend has been constrained due to mounting
NPAs. As a result, the RBI has issued various guidelines aimed at the resolution of stressed assets of
banks. This included introduction of certain schemes, such as: (i) Strategic Debt Restructuring -which
allowed banks to change the management of the defaulting company, and (ii) Joint Lenders’ Forum -

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 where lenders evolved a resolution plan and voted on its implementation. In line with the stated
enactment of the Insolvency and Bankruptcy Code, 2016 (IBC), the RBI, through a circular in
February 2018, substituted all the specific pre-existing guidelines with a simplified, generic, time-
bound framework for the resolution of stressed assets. 2.

Escalating NPAs require a bank to make higher provisions for losses in their books. The banks set
aside more funds to pay for anticipated future losses; and this, along with several structural issues,
leads to low profitability. Profitability of a bank is measured by its Return on Assets (RoA), which is
the ratio of the bank’s net profits to its net assets. Banks have witnessed a decline in their profitability
in the last has made them vulnerable to adverse future economic shocks and thereby putting
consumer’s deposits at risk.3 However, the public sector banks do not face the risk of being liquidated
since they are the lifeline of the economy and a bailout package shall be offered in case the situation
goes further south. However, private banks and private non-banking financial companies do not enjoy
the same luxuries available to their public sector counterparts and hence they have to tread the path
with utmost diligence in order to minimize their risk when it comes to advancing loans and hence the
practice of cross collateralization of security is being adopted. However, to reiterate, this practice does
not account as to what steps shall be taken in order to minimise the risk in the event of a double
default of the loans having only ‘one security’ against it.

3. Analysing the Hon’ble Delhi HC’s judgment in Sunil Goel v. Indiabulls Housing Finance
Limited

Before delving into the judgment’s analysis, it is important to study the factual matrix of the case. The
facts were as follows:
1) Mr. Sunil Goel (hereinafter referred to as the ‘Petitioner’) had shares in a company named
Omaxe Ltd which were pledged with India Bulls Housing Finance Limited (hereinafter referred to
as the ‘Respondent’).
2) These pledged shares formed a part of the security against the loans availed by Omaxe Forest Spa
and Hills Developers Limited (hereinafter referred to as “Omaxe Forest Spa”) from the
Respondent. Omaxe Forest Spa had availed three loans vide three separate loan agreements for
the amounts of INR65 Crore, INR 65 Crore and INR 20 Crore respectively. All, these Loan
Agreements were executed on September 29, 2015.
3) M/s Guild Builders Private Limited is a company in which the Petitioner and his two brothers
were the Directors till 2013.

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Examining the rise of Non-Performing Assets in India , Ahita Paul - September 13, 2018, PRS Legislative
Research.

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Supra note 1

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4) Omaxe Ltd, Guild Builders, the petitioner and his brothers were the Guarantors to the Loan
availed by Omaxe Forest Spa and Omaxe Ltd , Guild Builders, and the petitioner as the Pledgors,
against the loan availed by Omaxe Forest Spa.
5) After this Loan Agreement was entered into and executed, the Respondent advanced five separate
loans to Garv Buildtech Pvt Ltd and Omaxe Ltd in the period between June 2017 and March
2020. It is important to keep in mind that out of the five loans, two loans were advanced by
Indiabulls Commercial Credit Limited which is a subsidiary company of the Respondent.
6) In the meantime, the Petitioner, who held the position of Joint Managing Director in Omaxe Ltd
was ousted from his post. At this point, it would be important to state that the Petitioner held 19%
shares of Omaxe Ltd.
7) The Petitioner rightfully stated that on March 31 2020, the Loan amounts of INR . 65 Crore, INR
65 Crore and INR 20 Crore which were availed in September 2015 had been completely repaid.
As a result, according to the Loan Agreement, the Petitioner’s shares which were pledged with the
Respondent as security should have been de-pledged and released to the Petitioner. However, the
Respondent contended that the Petitioner’s pledged shares were security in the subsequent five
loans which were availed by Omaxe Ltd and Garv Buildtech Pvt Ltd. Therefore, it was contended
by the Respondent that until those loans were fully repaid, the Respondent had the right to hold
those pledged shares.
8) These set of facts have created this interesting proposition which was adjudicated by the Hon’ble
Delhi HC.

Analysis of the judgment

The Hon’ble Delhi HC has appropriately stated that the only loan agreements which were entered into
between the petitioner and the respondent were the three Loan Agreements executed on September
29, 2015. The Petitioner was not a party to the five loans which were executed between 2017 and
2020 in any capacity and hence the shares of Omaxe Ltd which were pledged with the Respondent
could not be deemed to be a security for these subsequent five loans.

The Court has provided a lucid rationale on the ‘Cross Liability’ clause of the Loan Agreement and
held that two loans which were governed by independent loan agreements, the inclusion of a cross
collateralization clause in one of them, could not proprio vigore (on its own force) justify proceeding
against the collateral provided in the said loan agreement, for satisfaction of the loan in the other
agreements. This brings us to this practice which has found popularity especially amongst the private
sector financial institutions. The trick while analyzing this judgment would be to read the clause on
‘Cross Liability’ with the clause which defined ‘Group Borrower’s Dues’. It is interesting to note that
these Group Borrower’s Dues would include:

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 “all amounts payable to the Lender and/or the other group/associate entity/entities of the
Lender under/pursuant to any other Loan Agreement(s)/document(s) executed/to be
executed from time to time between
(a) the Lender and/or other group/associate entity/entities of the Lender and
(b) the Obligor(s) and/or other group/associate entity/entities of the Obligor(s) provided if any
Security under the Loan Documents is and/or shall also be a security under such other Loan
Agreement(s)/document(s).”
This clause essentially does away with the common law concept of privity of contract which states
that only Parties to a contract are entitled to sue against each other for non-performance of the
contract. As a result, the Respondent took the stance that even the five loans which were availed by
Garv Buildtech Pvt Ltd and Omaxe Ltd fell under the category of Group Borrower’s Dues and
therefore the Petitioner bore the liability for the same. The Court applied an interesting methodology
wherein it took the view that even if it were to be assumed that the loans advanced under the five loan
agreements were ‘Group Borrower’s Dues’, the value of the shares wouldn’t have been applicable to
the five loan agreements since there was no intention to pledge the shares to secure the subsequent
loans. Therefore, the Court held that such a juxtaposing of the two clauses would make zero
commercial sense since an obligor is being made liable for loan agreements, he is not a party to.
Furthermore, the Respondent had made an admission that the Loan Agreements which were executed
on 29th September 2015 were repaid in full and gave an assurance to the Petitioner that they would
release the security associated with those loans. This admission of the Respondent swung the case in
the favour of the Petitioner since the shares of Omaxe Ltd were security only for the Loan Agreement
executed on 29th September 2015. At this point, it would be important to point out Clause 1.1 of the
Pledge Agreement which dealt with Secured Obligations, Clause 1.1 reads as under
“Secured Obligations” shall mean the Loan(s) together with all interests, default
interests, costs, charges, expenses and other monies payable by the Obligor(s) to the
Lender under the Loan Agreement(s) and other Loan Document(s).”

The term “Loan” was defined in the same clause which read as under ““Loan(s)” means the loan(s)
of the total principal amount(s) as mentioned in Schedule IB hereunder disbursed or to be disbursed
under the Loan Agreement(s) and the other related Loan Documents.” The phrase ‘and the other
related Loan Documents’ clearly states that the liability of the Petitioner shall be extended only to
those Loans which form a part of the three loans which were executed on 29 th September 2015.
Furthermore, Clause 17 of the Pledge Agreement dealt with release of collateral which stated that the
collateral would be released upon Final Settlement of the Loan. The occurrence of Final Settlement
was already admitted by the Respondent and therefore taking all these clauses into account, the Delhi
High Court ordered the Respondent to release the pledged shares which were being illegally held as
security towards the five loan agreements entered into between September 2017 and March 2020.

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Thus, in light of the observation made by the Hon’ble High Court of Delhi, are two additional aspects
which requires particular monitoring and diligence.

Firstly, when the banks issue fresh loans, they should conduct additional due diligence regarding the
status of the charge on the security provided by the borrower. Otherwise, it might lead to a
commercial deadlock if a security for a fresh loan also acts as security for some previous loan with
some other bank as well; and causing a confusing scenario due to the conflicting charges on the
security. If the banks were to liquidate the security, in all logical sense, there will a conflict which is
likely to arise as to which bank shall have the higher/ first right to charge.

Secondly, the recent judgment of the National Company Law Appellate Tribunal (NCLAT) in Dr.
Vishnu Agarwal v. Piramal Enterprises 4 wherein the NCLAT had permitted a Financial Creditor to
file corporate insolvency proceedings against the Borrower as well as the Guarantor. This judgment
further clarifies the position that at the time of admitting the application, only one application shall be
admitted since both the applications are arising out of the same debt. This judgment in hindsight is
seen as a deterrent to the practice of cross collateralization. The Hon’ble Appellate Tribunal also held
that a joint application against the Borrower and the Guarantor cannot be filed unless the two are in a
joint venture relationship.

CONCLUSION

This judgment will have a far-reaching effect in the banking sector since it has critically analysed the
Cross Liability Clause which is extensively used in the generally banking sector and more
specifically lending industry. The banks are required to scrutinise more while conducting the due
diligence for any loan. Also, this judgment ensures that the borrower is not placed under duress even
after repaying the loan amounts for which they had pledged the security. wherein in reality there is
minimal security against these loans due to cross collateralization. This practice is a disaster waiting
to happen since it creates a bubble wherein a picture is painted that the amount of lending has
increased but there is only one security on two loans. Therefore, there is a probability of implosion of
the stability of such market if both the loan accounts are designated as NPA. Therefore, the regulatory
watchdogs such as the Reserve Bank of India and the Securities Exchange Board of India need to
bring in punitive measures which can be initiated against financial institutions for indulging in the
creation of cross collateralization of securities.

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[2019] 149 CLA 30 (NCLAT)