Security Deposit for Unmaterialized Lease Not Necessarily 'Financial Debt' Under IBC: NCLAT - 2025-03-06

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NCLAT: Security Deposit for Abandoned Lease Agreement Does Not Automatically Qualify as Financial Debt

New Delhi – February 13, 2025 – The National Company Law Appellate Tribunal (NCLAT) Principal Bench, New Delhi, has ruled that a security deposit paid under a Memorandum of Understanding (MoU) for a lease agreement that ultimately did not materialize cannot automatically be classified as a 'financial debt' under the Insolvency and Bankruptcy Code (IBC), 2016. This judgment came in the case of Global Indian School Education Services Pvt. Ltd. v. Mr. Abhay Narayan Manudhane, Resolution Professional , where the appellant challenged an order by the National Company Law Tribunal (NCLT), Mumbai Bench.

Case Background: MoU vs. Financial Debt

Global Indian School Education Services Pvt. Ltd. (Appellant) had entered into an MoU with Housing Development and Infrastructure Ltd. (Corporate Debtor) in 2015 for constructing a school building on land owned by the Corporate Debtor. As per the MoU, Global Indian School paid a sum of ₹2,37,61,440, characterized as a 'security deposit,' equivalent to six months' rent. However, the Corporate Debtor failed to meet certain 'Conditions Precedent' outlined in the MoU, and the proposed lease agreement never came into effect.

Following the initiation of Corporate Insolvency Resolution Process (CIRP) against the Corporate Debtor, Global Indian School filed a claim, seeking classification as a 'financial creditor' for the deposited amount along with interest. The Resolution Professional (Respondent) initially categorized the claim as 'operational debt' and later as 'other debt', a decision upheld by the NCLT. Aggrieved, Global Indian School appealed to the NCLAT.

Arguments Presented

Appellant’s Contention:

Represented by Senior Advocate Mr. Krishnendu. Datta, Global Indian School argued that the security deposit should be considered a 'financial debt' under Section 5(8) of the IBC. They asserted:

• The deposit had the “commercial effect of borrowing” as it was intended to finance the construction.
• Clause 3.3 of the MoU stipulated a 9% interest on refund upon termination due to unmet conditions precedent, indicating a ‘time value of money’ element.
• Despite being termed a 'security deposit', in substance, it functioned as a mobilization advance.
• They relied on the Supreme Court’s judgment in Global Credit Capital Limited to argue that the true nature of the transaction should be considered over its form.

Respondent’s Counter-Arguments:

Ms. Meghna Rao, representing the Resolution Professional, countered that the deposit was purely a security for future rent and did not meet the criteria of ‘financial debt.’

• The MoU designated the amount as a 'security deposit,' refundable without interest upon completion of the lease term.
• Interest at 9% was only applicable upon termination due to the Corporate Debtor's default in meeting conditions precedent, characterizing it as penal interest or liquidated damages, not 'time value of money'.
• They cited the Supreme Court in Pioneer Urban Land to emphasize the necessity of ‘time value of money’ and ‘commercial effect of borrowing' for a debt to be financial.
• They also referenced NCLAT’s own precedent in Budhpur Buildcon Pvt. Ltd. , which held that penal interest does not qualify as financial debt.

NCLAT's Rationale and Decision

The NCLAT bench, comprising Members (Judicial) Justice Rakesh Kumar Jain and Members (Technical) Mr. Naresh Salecha and Mr. Indevar Pandey , meticulously examined the MoU clauses and arguments. The Tribunal emphasized the core requirement of Section 5(8) of the IBC – that a 'financial debt' must be disbursed against the 'consideration for the time value of money.'

Referring to the Supreme Court’s guidelines in Pioneer Urban Land and New Okhla Industrial Development Authority v. Anand Sonbhadra , the NCLAT reiterated the three key conditions for a financial debt: disbursal, commercial effect of borrowing, and time value of money.

The Tribunal noted:

> “We find the nature of the transaction very clear i.e. it is operational lease and thus, the money deposited by the Appellant with the Corporate Debtor can be described only as security deposit and not as financial debt. We also find that the interest @ 9% p.a. stipulated in Clause 3.3 of the MoU is in nature of penal interest or in nature of liquidated damages…the time value of money is definitely required in same form or other.”

The NCLAT distinguished the Global Credit Capital Limited case, noting that in that instance, interest was payable from day one, unlike the contingent interest in the present case. It concurred with the Respondent that the interest clause in the MoU was penal in nature and not indicative of a borrowing transaction with ‘time value of money’ from the outset.

> “A meaningful reading of Clauses 3.3 and 8.4 of the MoU reveals that the stipulation for interest was included solely to impose a penalty, should the Corporate Debtor fail to fulfil its obligations under the MoU to the satisfaction of the Appellant. The interest clause could only be involved upon a breach or termination of the agreement, indicating that the security deposit does not possess the characteristics of a financial transaction…”

Ultimately, the NCLAT concluded that the security deposit, in this context, lacked the essential elements to be classified as a ‘financial debt.’ Consequently, the appeal was dismissed, upholding the NCLT’s order.

Implications of the Judgment

This judgment clarifies that security deposits in lease agreements, especially when the underlying lease fails to materialize due to unmet conditions precedent, are not automatically categorized as ‘financial debts’ under the IBC. The crucial factor remains the presence of 'time value of money' and a demonstrable 'commercial effect of borrowing' at the inception of the transaction, not merely contingent clauses triggered by breach or termination. This ruling underscores the importance of carefully structuring agreements and clearly defining the nature of payments, especially in the context of potential insolvency proceedings.

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