[Another post on this topic is available here]
A three-judge bench of the Supreme Court of India on 1 February 2021 rendered important and interesting pronouncements on some aspects of the Insolvency and Bankruptcy Code, 2016 (IBC) in Phoenix Arc Private Limited v Spade Financial Services Limited. Speaking through Dr. Dhananjaya Y Chandrachud, J, the Court ruled that a collusive transaction cannot lead to the creation of a “financial debt” for the purposes of the IBC. The transacting party, who is therefore not a “financial creditor”, fails to obtain a seat at the table in meetings of the committee of creditors (CoC). The Court also shed light on the meaning of the term “related party” in relation to the corporate debtor, as such a party too is excluded from the CoC process. In arriving at its outcome, the Court relied heavily on a purposive interpretation of the IBC in light of its objectives and philosophy. While the ruling in a welcome step in the ongoing process of ironing out the creases in a legislation of recent vintage that has been put to rigorous testing in a short span of time, it also leaves some loose ends that remain to be tied.
A corporate insolvency resolution process (CIRP) was initiated against AKME Projects Limited, the corporate debtor. While the matter was before the National Company Law Tribunal (NCLT), two of the financial creditors, Phoenix Arc Private Limited and Yes Bank Limited, filed applications seeking the exclusion of two entities, AAA Landmark Private Limited and Spade Financial Services Private Limited, from the CoC process on the ground that they are related parties. The facts indicate that Spade had executed a memorandum of understanding with the corporate debtor under which it granted the latter some intercorporate deposits (ICDs). Spade had entered into a development agreement with the corporate debtor under which it some amounts were outstanding from the corporate debtor to Spade.
The NCLT concluded that Spade and AAA did not quality as “financial creditors” and hence did not venture to consider whether they are related parties. On appeal, the National Company Law Appellate Tribunal (NCLAT) noted that Spade and AAA are “admittedly” financial creditors of the corporate debtor, but went on to hold that they are related parties and must be excluded from the CoC process. The NCLAT found that Mr. Arun Anand was the majority shareholder (directly or indirectly) of Spade and AAA, and that he enjoyed a close relationship with two members of the management of the corporate debtor, being Mr. Anil Anand (a promoter of the corporate debtor) and Mr. Sonal Anand (who also happens to be Mr. Arun Anand’s brother-in-law). It is against the NCLAT’s ruling that both parties appealed to the Supreme Court, with (i) Phoenix as to the ruling that Spade and AAA are financial creditors of the corporate debtor; and (ii) Spade and AAA as to the ruling that they are related parties.
The Supreme Court considered three issues, whether: (i) Spade and AAA are financial creditors of the corporate debtor; (ii) Spade and AAA are related parties of the corporate debtor; and (iii) Spade and AAA must be excluded from the CoC’s decision-making process.
The Impact of Collusive Transactions
Section 5(7) of the IBC defines a “financial creditor” as a person to whom a final debt is owed. This brings to the fore the definition of “financial debt” in section 5(8), which is a “debt along with interest, if any, which is disbursed against the consideration for the time value of money”, and includes a number of specific transactions giving rise to such a debt. The Supreme Court in Swiss Ribbons Pvt. Ltd. v. Union of India and Pioneer Urban Land and Infrastructure Ltd v. Union of India placed substantial emphasis on the terminology of “disbursal” and “time value of money” used in the statutory provision. However, the crux of the question in the present case was whether, even if the above requirements are satisfied, the statutory provision can countenance collusive transactions that give rise to a financial debt and thereby permit the financial creditors therein a say on the CoC. The Court noted as follows:
“The above discussion shows that money advanced as debt should be in the receipt of the borrower. The borrower is obligated to return the money or its equivalent along with the consideration for a time value of money, which is the compensation or price payable for the period of time for which the money is lent. 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. In other words, the real agreement between the parties is something other than advancing a financial debt.”
The fact that collusive transactions are anathema to the philosophy of the IBC in writ large in other provisions such as sections 43, 45, 49 and 50 that deal with avoidance of certain transactions that tend to deprive benefits due to bona fide creditors of the company. On the facts of the case, the Court found that the transactions between the groups of companies controlled by Mr. Arun Anand and Mr. Anil Nanda were an eye wash and collusive in nature. Hence, they do not constitute a “financial debt” for the purpose of the IBC, thereby disentitling Spade and AAA from participating or voting in decisions of the CoC.
Scope of Related Parties
The definition of “related parties” becomes crucial as persons so related to the corporate debtor are not permitted to participate in the CoC since their interests are naturally at divergence with the interests of unrelated creditors. Section 5(24) of the IBC defines “related parties” through a list of relationships that come within its purview. For example, sub-section (f) pertains to any corporate whose management or board of directors acts on the advice or instructions of a director or manager of the corporate debtor. The related party situation arises owing to the influence that the corporate debtor exercises on the other person. The converse is true as well. For instance, sub-section (h) refers to persons “on whose advice, directions or instructions, a director, partner or manager of the corporate debtor is accustomed to act” and sub-section (m)(i) to such person’s “participation in policy making processes of the corporate debtor”.
The two-way relationship is elucidated by the Court in the following manner:
The definition describes a commutative relationship, meaning that X can be a related party of Y, if either X is related to Y, or Y is related to X. The definition of ‘related party’ under the IBC is significantly broad. The intention of the legislature in adopting such a broad definition was to capture all kinds of inter-relationships between the financial creditor and the corporate debtor.
The Court then went on analyse the relationship between Mr. Arun Anand and Mr. Anil Nanda based on the influence that each exercised on the other’s group of companies. For instance, it found that Mr. Arun Anand used his positions to “guide the affairs” of the corporate debtor. As to the converse, the Court found that Spade entered into the transactions on the basis of advice from the corporate debtor and, in particular, “due to the pervasive influence of Mr. Anil Nanda”. The collusive nature of the transactions between the parties (as discussed earlier) affected the Court’s decision on the question of related parties as well. The Court then concluded that Mr. Arun Anand, Spade and AAA were related parties of the corporate debtor for purposes of the IBC.
Timing of Relatedness
One peculiarity in the facts was that Mr. Arun Anand was no longer associated with the corporate debtor at the time the insolvency proceedings were initiated. Hence, the timing question arose whether the relatedness could merely have existed on the past, or whether they must continue in praesenti. This brings into focus the first proviso to section 21(2) of the IBC which provides that “a financial creditor …, if it is a related party of the corporate debtor, shall not have any right of representation, participation or voting in a meeting of the committee of creditors” [emphasis added]. This language gives rise to a conundrum. If a literal meaning is to be ascribed and the wording to be read in the present tense, it could lead to redundancy as related parties could always sever their relationships when insolvency is looming and thereby defeat the disqualification imposed by section 21(2). On the other hand, if the opposite meaning is to be ascribed leading the provision to operate backwards in time, how far back can one go to determine the relationship between the parties?
In unravelling the conundrum, the Court relied on the “context, object and purpose” of the IBC and found:
Thus, it has been clarified that the exclusion under the first proviso to Section 21(2) is related not to the debt itself but to the relationship existing between a related party financial creditor and the corporate debtor. As such, the financial creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC. However, in case where the related party financial creditor divests itself of its shareholding or ceases to become a related party in a business capacity with the sole intention of participating the CoC and sabotage the CIRP, by diluting the vote share of other creditors or otherwise, it would be in keeping with the object and purpose of the first proviso to Section 21(2), to consider the former related party creditor, as one debarred under the first proviso.
On the facts, the Court found that although the relationship between the parties were currently not such as to attract the prohibition under the first proviso to section 21(2), it was “due to commercial contrivances through which” Spade and AAA sought to enter the CoC. Hence, they ought to be excluded from the CoC.
 In articulating the above position, the Court relied on a post by Richa Saraf on this Blog.