[Sikha Bansal is a Partner and Megha Mittal an Associate at Vinod Kothari & Company.
Another set of posts on the topic is available here]
Generally, in order to classify a transaction as a related party transaction, one needs to first determine whether the parties involved are ‘related parties’. However, in a recent case Phoenix Arc Private Limited v. Spade Financial Services Limited & Ors, the Supreme Court has deduced ‘relationship’ between the parties on the basis of the underlying transactions.
The Supreme Court has read the definitions of ‘financial creditor’ and ‘related party’ (in relation to the corporate debtor) under sections 5(7) and section 5(24), respectively, of Insolvency and Bankruptcy Code, 2016 (‘Code’), in light of the ‘collusive arrangements’, ‘and ‘extensive history demonstrating interrelationship’ among the parties. Broadly put, it was held that the boards of directors of these companies were ‘acting’ under the pervasive influence of common set of individuals, having ‘deeply entangled’ interrelationships. Besides, the Court refused to entertain the entities as financial creditors, as the debt was merely an eye-wash, arising out of sham and collusive transactions.
Therefore, the Court’s ruling, in a way, uses ‘smoke’ to trace if there is a ‘fire’. The presence of collusion and entangled interrelationships have been seen as indicators suggesting that the parties were in fact ‘related’ and are thus ineligible to occupy seats in the committee of creditors. This post touches upon the significant aspects of the ruling, including how this ‘smoke-test’ used by the Supreme Court can act as a precedent in interpreting the provisions of the Code, specifically those relating to related parties.
Collusive Transactions
While the instance case is quite fact-specific, one may note that existence of collusive transactions was one of the indicators, which led to the inference that the parties were related (refer paragraph 62 of the ruling). Circumstances which led to the conclusion that the transactions were collusive are – existence of web of companies, charging lower rate of interest as against the formalised terms, inconsistencies in formal documentation to circumvent the applicable laws, non-registration of charges and, most importantly, the absence of ‘disbursal’ of the entire amount on which the purported claim of ‘financial debt’ was founded.
The Supreme Court noted the definition of ‘financial debt’ under section 5(8) and emphasised on the word ‘disbursed’ and ‘time value of money’. Often gone unnoticed, the term disbursed in the principal clause of section 5(8) in fact holds much relevance: it requires that the debt extended by the creditor should actually be disbursed to the borrower (here, corporate debtor). The Court relied on the interpretation of ‘disbursal’ as laid down in Pioneer Urban Land and Infrastructure Ltd. v. Union of India. Thus, it observed that “. . . . money advanced as debt should be in the receipt of the borrower. . . A transaction which is sham or collusive would only create an illusion that money has been disbursed to a borrower with the object of receiving consideration in the form of time value of money, when in fact the parties have entered into the transaction with a different or an ulterior motive.”
Thus, a sham only creates an optical illusion of legal rights and obligations between parties which either do not exist or exist differently from what parties actually intend to create. Hence, where the transaction itself is a device which only appears to exist and does not actually exist, there is no question of any ‘time value of money’ or ‘disbursal’ and, thus, there cannot exist a ‘debt’ at all. Thus, ‘sham transactions’ cannot give rise to a ‘debt’.
‘Accustomed to Act’ or ‘Acting on the Advice of’
The definition of “related party” under section 5(24) of the Code is rather broad, thereby making clear the intent of law to capture all kinds of interrelationships between the financial creditor and the corporate debtor. This is evident from inclusion of certain subjective clauses in the definition – e.g., clauses (f), (g) and (h) of section 5(24) which refer to instances where one person ‘acts on the advice, directions or instructions in the ordinary course of business’ of other person or is ‘accustomed to act’ as such. Such expressions are not new in the context of corporate laws. Similar provisions are contained in section 2(76) of the Companies Act, 2013 and were present in the Companies Act, 1956 too.
The purpose of such an expansive definition is “to ensure that those entities which are related to the Corporate Debtor can be identified clearly, since their presence can often negatively affect the insolvency process”. Besides, the SC observed that the definition describes a commutative relationship as well.[1]
So, how does one understand that the parties are acting in the said manner? In the instant case, the Supreme Court took note of the connection between two individuals, the positions held by one in the entities controlled by the other person which could have been used by such person to guide the affairs of the corporate debtor, and deep entanglement between such entities during the relevant period. The Court noted as follows:
“62. While a strict determination of intent or mens rea may not always be possible by the NCLT and NCLAT in summary proceedings, it is possible to draw the inference from the facts at hand. These facts are that there was a deep entanglement between the entities of .. . . did hold positions during this period which could have been used by him to guide the affairs of the Corporate Debtor”.
Whether Past Relationship Counts
Relying on the proviso to section 21(2) of the Code, it was argued that there must be a present relationship between the financial creditor and the corporate debtor to exclude the financial creditor from the committee of creditors; that is, the reference is to present and not to an uncertain past.
The Supreme Court noted that the parties were related during the relevant time when the transactions constituting their alleged financial debt took place. Referring to an authoritative commentary by Justice G.P. Singh which states that the terms may not be interpreted in their literal context, if the same leads to absurdity of law, the Court held: “The true test for determining whether the exclusion in the first proviso to Section 21(2) applies must be formulated in a manner which would advance the object and purpose of the statute and not lead to its provisions being defeated by disingenuous strategies.” Therefore, “while the default rule under the first proviso to Section 21(2) is that only those financial creditors that are related parties in praesenti would be debarred from the CoC, those related party financial creditors that cease to be related parties in order to circumvent the exclusion under the first proviso to Section 21(2), should also be considered as being covered by the exclusion thereunder.”
Conclusion
The ruling is one of its kind, in a way that it goes beyond the objective clauses of the definition of ‘related party’ and permeates the so-called commercial arrangements between the parties, to hold that there was an element of ‘relationship’ between the parties as they acted under pervasive influence. This test, what we prefer to call ‘smoke-test’, used by the Supreme Court in unearthing ‘related party’ arrangements between the parties, would act as a precedent, even for cases where strict determination of the intention of the parties is not possible. The authors, however, would conclude with a word of caution. The ruling relies heavily on facts and, as such, should be applied in a given context so as not to stand in the way of pure commercial arrangements.
– Sikha Bansal & Megha Mittal
[1] The Supreme Court cited with approval the views as expressed on this Blog in “Concept of Related Party: Interpretation by Letter or Spirit of the IBC?
