Concept of Related Party: Interpretation by Letter or Spirit of the IBC?

[Richa Saraf is a Legal Advisor at Vinod Kothari & Co.]

In J.R. Agro Industries P. Limited v. Swadisht Oils P. Ltd. (decided on 24 July 2018), the National Company Law Tribunal (NCLT) Allahabad observed that“if claim of related party is given priority over operational creditors, it would not be just to operational creditor”. In the instant matter, the related party and the corporate debtor had common directorship and common promoters. Therefore, keeping in view the global practices, especially the UNCITRAL Legislative Guide on Insolvency Law, the NCLT opined that a claim of a related party, whether in the nature of loan or otherwise, should rank subordinate to the claim of operational creditors, and should be treated at par with equity shareholders under section 53(1)(h) of the Insolvency and Bankruptcy Code, 2016.

Who is a Related Party?

The first question for discussion is who will construed to be a “related party” with reference to the corporate debtor. While section 5(24) of the Code provides for the definition of related party of the corporate debtor, the expression “related party” describes a commutative relationship, i.e. X can be related party of Y, if either X is related to Y, or Y is related to X. It cannot be argued that X is not a related party to corporate debtor, if corporate debtor falls within the definition of “related party” with reference to X.

The definition stipulated in the Code is constructed so as to be limited from the perspective of the corporate debtor. The Insolvency and Bankruptcy Code (Amendment) Ordinance, 2018, has provided a definition with respect to an individual. However, there is still nothing in the Code as regards related party of a company or body corporate (other than corporate debtor). In such a scenario, in line with section 3(37) of the Code, the definition under section 2(76) of the Companies Act, 2013 is to be applied.

According to section 2(76)(iv) of the Companies Act, if a director of the company is a member or director of the other company, that other company becomes a related party. A similar clause is reflected in section 5(24)(d) of the Code, though it is constructed solely from the perspective of the corporate debtor.

It is relevant to mention that section 5(24)(m) of the Code is drafted most widely, and indicates that the stance of the draftsman is on the reality of inter-relationships between the two entities. If the two entities are operating under common control, the indicia as given in section 5(24)(m) will apply. Thus, interchange of personnel, participation in policy-making, or provision of technical information are indicators of association of the two entities. It is not necessary that the company in question must be a supplier of technical information, or must be participating in policy-making or would cause inter-change of personnel. If there is a common source of control over both the entities, it cannot be denied that the two entities become “associated” for that reason.

This discussion is also relevant for the purpose of determining who will constitute a part of committee of creditors (CoC), particularly with reference to first proviso to section 21(2) of the Code. The intent of section 21(2) of the Code in denying voting rights to related parties is to ensure that the corporate insolvency resolution process is driven by external creditors. Even though related parties may have claims, and may even file application for initiation of corporate insolvency resolution process, such parties cannot drive the insolvency resolution process, as that would be rife with conflicts of interest. Such a wholesome intent cannot be rendered infructuous by supplying a narrow or technical interpretation to the meaning of the term.

Priority of Related Party Claims in the Context of Swadisht Oils

In Swadisht Oils (discussed above),the resolution professional emphasized that the approval of resolution plan by the adjudicating authority is a mere formality because the CoC had already approved the plan with the requisite voting percentage (in fact with 100% voting rights). Further, the resolution plan satisfied all the requirements of section 30 of the Code and the regulations thereunder. It was clarified that the related party was not allowed to attend and participate in CoC meetings; hence, there was no occasion to influence the decision of CoC members. Yet the resolution plan pays almost nil dues of the operational creditors, and instead prioritises the claim of related party unsecured financial creditor according to the waterfall mechanism (section 53). “Section 53(1)(d) treats all unsecured financial creditors at par so far as priority for their payment is concerned and does not discriminate between unrelated creditors and related creditors”, and accordingly, it was emphasised that express legal provisions cannot be bypassed even on the ground of equity.

It was contended that as per regulation 38(1)(b) the liquidation value due to operational creditors should be paid in priority to any financial creditor and, in any event, before the expiry of thirty days after the approval of a resolution plan. As in most cases, here too, the liquidation value for operational creditors, after meeting the claims of financial creditors, was computed to be “nil”. Any payment to be made to such operational creditors, which was over and above such value, ought to be considered to be a “bonanza” to them.

In the instant case, a related party was obtaining approximately 62% of its dues back, while the operational creditors were receiving almost nothing. In such circumstances, it was beyond imagination that, after approval of the plan, the operational creditors will be willing to continue their supplies to the corporate debtor, to keep it as a going concern. Thus, it is important to reflect upon insolvency laws of other jurisdictions, wherein priority is given to secured creditors over unsecured creditors, but there is no distinction between financial and operational creditors. A detailed discussion on this topic is available on this Blog.

The UNCITRAL Legislative Guide provides for subordinate ranking of related parties claims as regards ordinary unsecured claims. Relying on the same, NCLT pointed out that this particular case is a glaring example where admittedly a related party is getting priority over operational creditors, even though the same promoters are considered to be responsible for insolvency and restructuring of the corporate debtor. The same was regarded to be discriminatory.

Under the UNCITRAL Legislative Guide, related persons’ claims rank inferior to the claims of similar other unsecured creditors, while in the Code unsecured financial creditors (even if related parties) rank higher than the claims of unsecured operational creditors. Under prevailing practices in the UK and the US as well, operational creditors’ claims rank above the claims of the related party. It was observed that promoters’ loan to the company is similar to equity participation (mostly without time value of money, i.e., without any agreement to pay interest and without any time limit for repayment). Even otherwise, the waterfall mechanism under section 53 should not be merely applied by the books. If we ignore the spirit of law, then, in every case of defaulted/loss-making companies, the liquidation value of operational creditors will always be nil, and they will never get their dues in insolvency cases.

The related parties of the corporate debtor, whether in a familial or business capacity, are such category of creditors that require special consideration. Under some insolvency laws, these claims are always subordinated, and under other laws they are subordinated only on the basis of inequitable conduct. Other approaches for treatment of these claims do not relate to ranking, but only to restrictions on voting rights. Under the Code, an intragroup transaction may be subject to avoidance proceedings if proven to be fraudulent, preferential or undervalued. In the UNICITRAL Legislative Guide, such transactions are classified differently from similar transactions conducted between unrelated parties, with the consequence that the debt obligation will rank lower in priority than the same obligation between unrelated parties.

In this regard, it is relevant to cite paragraph 55 of the UNCITRAL Legislative Guide, which specifies that when a natural person or organisation owes debts to more than one creditor, the priority scheme established under applicable law may provide for subordination of certain types of claim: for example, the determination of the priority of related party claims. Even while a priority scheme is in place, a creditor with a higher priority may be paid after one with lower priority because of a court order. The NCLT Bench contemplated that owners and equity holders may have claim arising from loans extended to the debtor, and regarding claims arising from such equity interests (including claims with respect to their debt, accruing interest). Since many insolvency laws have adopted a general rule that the owners and equity holders of the business are not entitled to a distribution of the proceeds of assets until all other claims that are senior in priority have been fully repaid, a similar order was passed in the instant case.

The NCLT further deliberated upon the concept of equitable subordination (subordination by court), wherein a valid and enforceable claim is paid later in the distribution scheme than it would otherwise be paid in the normal course. The doctrine originally arose to prevent related persons from using legal mechanisms to obtain advantages in priority. It is generally applied if any conduct under consideration results in unfair advantage to a creditor or some harm to other creditors. The Bench examined that it may change or re-arrange the priority of claims to prevent a creditor who has committed fraud, illegality, or has acted inappropriately to gain advantage over other creditors, from benefiting in any manner.  Considering subordination to be pertinent to fair distribution,the NCLT ordered that the related party claim should be treated in the category of “equity shareholders”, thus categorising it under section 53(1)(h) of the Code below the rank of unsecured financial creditors and as well as other debts and dues.

Also, in the light of the facts and circumstances of the case, and to give justice to the operational creditors, the Bench ordered for modification of the resolution plan. It further directed the Registrar to send a copy of this order to the Insolvency and Bankruptcy Board of India, the Ministry of Corporate Affairs and Central Government through the Regional Director, for consideration on the issues which have been pointed out, so that related parties of the corporate debtor cannot misuse the provisions of section 53 to defraud the creditors.

Richa Saraf

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