Supreme Court clarifies the definition of “related party” under the Insolvency and Bankruptcy Code: Phoenix Arc vs. Spade Financial (2021)

Introduction

Date of the Judgment: 1 February 2021
Citation: (2021) INSC 42
Judges: Dr Dhananjaya Y Chandrachud, J, Indu Malhotra, J, and Indira Banerjee, J

Can a financial creditor be excluded from the Committee of Creditors (CoC) if they were a related party of the corporate debtor when the debt was created, even if they aren’t at the time of the insolvency proceedings? The Supreme Court of India addressed this critical question in a recent judgment. This case revolves around the interpretation of the term “related party” under the Insolvency and Bankruptcy Code, 2016 (IBC), and its implications for the composition of the CoC during a Corporate Insolvency Resolution Process (CIRP). The court had to determine whether a creditor’s past relationship with the debtor could disqualify them from the CoC, even if that relationship no longer exists. The judgment was delivered by a three-judge bench comprising of Dr. Dhananjaya Y Chandrachud, J, Indu Malhotra, J, and Indira Banerjee, J.

Case Background

The Corporate Insolvency Resolution Process (CIRP) was initiated against AKME Projects Limited (“Corporate Debtor”) on April 18, 2018, following an application by an operational creditor. During the CIRP, the Interim Resolution Professional (IRP) invited claims. Spade Financial Services Private Limited (“Spade”) filed a claim as a financial creditor for ₹52,96,00,000 on May 10, 2018, later revising it to ₹109,11,00,000 on May 20, 2018. Spade based its claim on a Memorandum of Understanding (MOU) dated August 12, 2011, alleging Inter Corporate Deposits (ICDs) of ₹26,55,00,000 with a 24% interest rate. Spade later claimed to have granted ICDs of approximately ₹66,00,00,000 between June 2009 and January 2013, claiming a principal amount of ₹23,00,00,000. The balance ₹43,06,00,000 was credited to AAA Landmark Private Limited (“AAA”), a wholly-owned subsidiary of Spade. AAA also filed a claim as a financial creditor for ₹109,72,00,000, based on a Development Agreement dated March 1, 2012, later converted into an Agreement to Sell dated October 25, 2012, for flats, with an advance payment of ₹43,06,00,000.

The IRP rejected both claims on May 25, 2018. Spade’s claim was rejected for lacking consideration for the time value of money, and AAA’s claim was rejected for being filed late. Aggrieved, Spade and AAA filed applications before the National Company Law Tribunal (NCLT) to be included in the CoC. The NCLT initially allowed their applications on May 30, 2018, but this decision was challenged by other financial creditors, Phoenix Arc Private Limited (“Phoenix”) and YES Bank, who sought their exclusion from the CoC, asserting that Spade and AAA were related parties of the Corporate Debtor.

Timeline:

Course of Proceedings

The NCLT, in its order dated July 19, 2019, framed two key issues: (i) the nature of the transactions between the parties and whether they qualified as financial debt under Section 5(8) of the IBC, and (ii) the relevant date for determining if a party is a “related party.” The NCLT held that the transactions between the Corporate Debtor and both Spade and AAA were collusive and did not qualify as financial debt. Consequently, NCLT excluded them from the CoC. The NCLT noted that Arun Anand and his companies were related parties but that the relationship had ended by the time CIRP was initiated.

On appeal, the National Company Law Appellate Tribunal (NCLAT) acknowledged that Spade and AAA were financial creditors, but affirmed their exclusion from the CoC, holding that they were related parties of the Corporate Debtor under Section 5(24) of the IBC. The NCLAT based its decision on several factors, including AAA being a partner of the Corporate Debtor, Spade acting on the advice of the Corporate Debtor, and Arun Anand participating in the policy-making process of the Corporate Debtor. The NCLAT also noted that a holding company of the Corporate Debtor held shareholding in Spade.

Legal Framework

The Supreme Court examined the following key provisions of the Insolvency and Bankruptcy Code, 2016 (IBC):

• Section 5(7): Defines “financial creditor” as any person to whom a financial debt is owed.
• Section 5(8): Defines “financial debt” as a debt disbursed against the consideration for the time value of money, including interest. It includes money borrowed, amounts raised through various financial instruments, and any transaction with the commercial effect of borrowing.
• Section 5(24): Defines “related party” in relation to a corporate debtor, including directors, partners, key managerial personnel, and entities that act on the advice or instructions of the corporate debtor’s management.
• Section 21(2): Specifies that the Committee of Creditors (CoC) shall comprise all financial creditors, with a proviso that a related party financial creditor shall not have any right of representation, participation, or voting in a CoC meeting.

The Court emphasized that a financial debt must involve a disbursal against consideration for the time value of money, meaning that the borrower must be obligated to return the money or its equivalent along with compensation for the time the money was lent. The Court also noted that the definition of “related party” under the IBC is exhaustive and broad, intended to capture all kinds of inter-relationships between the financial creditor and the corporate debtor.

Arguments

Submissions of Mr. K.V. Viswanathan (Counsel for AAA and Spade):

• The NCLT’s order dated May 31, 2018, which allowed AAA and Spade to submit their claims as financial creditors, operated as res judicata.
• The subsequent applications by YES Bank and Phoenix only sought a re-constitution of the CoC, not a re-evaluation of AAA and Spade’s status as financial creditors.
• The NCLAT erred in rejecting the appeal despite acknowledging that AAA and Spade were financial creditors.
• The term “is a related party” in the first proviso to Section 21(2) should be interpreted in the present tense, meaning the relationship should exist at the time of the CIRP, not at the time the debt was created.
• There were no common key managerial personnel or directors between the Corporate Debtor and Spade and AAA during the relevant period of the transactions.
• Mr. Arun Anand was a mere salaried employee without any ability to influence the decision-making process of the Corporate Debtor.
• JIPL, and through it the Corporate Debtor, holds only 1.45% shareholding in Spade, which is below the 2% threshold in Section 5(24)(d).

Submissions of Mr. Neeraj Kishan Kaul (Counsel for Phoenix):

• AAA and Spade are not creditors of the Corporate Debtor, much less financial creditors, under Section 5(7) of the IBC.
• The Development Agreement between AAA and the Corporate Debtor was collusive, and the subsequent Agreement to Sell and Side Letter were an attempt to circumvent laws and regulations.
• Spade concealed the real nature of the transactions and filed an unlawful claim as a financial creditor.
• The Memorandum of Understanding (MOU) was unenforceable and an eye-wash.
• The essential element of a financial debt in terms of Section 5(8) of the IBC is absent, which is the consideration for the time value of money.

Submissions of Mr. Sanjiv Sen (Counsel for the Resolution Professional):

• Supported the submissions of Mr. Kaul.
• Two of the original shareholders of the Corporate Debtor, along with Mr. Arun Anand, now have shareholding and positions in Spade.
• There have been fraudulent transactions between Spade and JIPL.

Issues Framed by the Supreme Court

The Supreme Court framed the following issues for consideration:

1. Whether Spade and AAA are financial creditors of the Corporate Debtor.
2. Whether Spade and AAA are related parties of the Corporate Debtor.
3. Whether Spade and AAA have to be excluded from the CoC.

Treatment of the Issue by the Court

The following table demonstrates as to how the Court decided the issues

Authorities

The Supreme Court relied on the following authorities:

Judgment

How each authority was viewed by the Court?

• The Supreme Court relied on Swiss Ribbons Pvt. Ltd. v. Union of India [(2019) 4 SCC 17]* to emphasize that a financial debt must be disbursed against the consideration for the time value of money.
• The Court used Pioneer Urban Land and Infrastructure Ltd vs. Union of India [(2019) 8 SCC 416]* to define “disburse” as payment of money for a specific purpose.
• Snook vs. London and West Riding Investments Ltd. [1967] 2 QB 786* was cited to explain the concept of “sham transactions,” highlighting that such transactions are intended to give a false appearance of legal rights and obligations.
• Prem Chand Tandon vs. Krishna Chand Kapoor [(1973) 2 SCC 366]* was used to explain how courts examine the real nature of transactions to identify collusive arrangements.
• The Court distinguished the definition of “control” in Arcelor Mittal India (P) Ltd. vs Satish Kumar Gupta [(2019) 2 SCC 1]* from the concept of “related party” under Section 5(24) of the IBC.
• Abhay Singh Chautala vs C.B.I. [(2011) 7 SCC 141]* and R S Nayak v. A R Antulay [AIR 1984 SC 684]* were used to justify a purposive interpretation of “is” in the first proviso of Section 21(2), stating that a literal interpretation should be avoided if it leads to an absurd result.
• The Court referred to Principles of Statutory Interpretation by G.P. Singh to emphasize the importance of a purposive interpretation of statutes.
• The UNCITRAL Legislative Guide on Insolvency Law, 2005* was cited to show that the disqualification of related parties from creditor committees is a common practice in insolvency law.

What weighed in the mind of the Court?

The Supreme Court’s decision was significantly influenced by the following factors:

• Collusive Nature of Transactions: The Court found that the transactions between the Corporate Debtor and Spade and AAA were collusive and designed to circumvent regulations and benefit related parties. The Court noted the multiple agreements, the lack of clear financial records, and the timing of the transactions.
• Deep Entanglement: The close relationship between Mr. Arun Anand and Mr. Anil Nanda, and the various positions they and their family members held in the Corporate Debtor and related companies, weighed heavily on the Court’s mind. This demonstrated a clear conflict of interest.
• Purposive Interpretation of IBC: The Court emphasized the need to interpret the IBC in a manner that fulfills its objectives, particularly ensuring that related parties do not control the CoC and undermine the insolvency process.
• Prevention of Abuse: The Court sought to prevent the misuse of the IBC by related parties who might try to circumvent the rules by creating artificial commercial arrangements.
• Time Value of Money: The Court stressed that a key element of financial debt is the consideration for the time value of money, which was absent in the transactions between the Corporate Debtor and Spade and AAA.

Logical Reasoning:

The Court rejected the argument that the term “is” in the first proviso of Section 21(2) should be interpreted strictly in the present tense. The Court held that such a literal interpretation would defeat the purpose of the provision, which is to prevent related parties from controlling the CoC. The Court emphasized that the exclusion applies not only to those who are related parties at the time of the CIRP but also to those who were related parties when the debt was created, especially when the relationship was used to create collusive transactions.

“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.”

“The purpose of excluding a related party of a corporate debtor from the CoC is to obviate conflicts of interest which are likely to arise in the event that a related party is allowed to become a part of the CoC.”

“Therefore, it could be stated that where a financial creditor seeks a position on the CoC on the basis of a debt which was created when it was a related party of the corporate debtor, the exclusion which is created by the first proviso to Section 21(2) must apply.”

Key Takeaways

• Definition of Related Party: The Supreme Court clarified that the term “related party” under the IBC is to be interpreted broadly to capture all kinds of inter-relationships between the financial creditor and the corporate debtor.
• Exclusion from CoC: A financial creditor can be excluded from the CoC if they were a related party of the corporate debtor when the debt was created, even if they are not related at the time of the CIRP.
• Purposive Interpretation: The IBC must be interpreted in a manner that fulfills its objectives, particularly preventing related parties from controlling the CoC and undermining the insolvency process.
• Collusive Transactions: Transactions that are collusive and lack the essential elements of a financial debt will not be recognized
• Time Value of Money: A key element of a financial debt is the consideration for the time value of money.
• Scrutiny of Transactions: Insolvency professionals and tribunals must scrutinize transactions to identify collusive arrangements and prevent the misuse of the IBC.
• No Res Judicata: An order passed without hearing all relevant parties is not binding and does not operate as res judicata.

Conclusion

The Supreme Court’s judgment in Phoenix Arc Private Limited vs. Spade Financial Services Limited & Ors. provides a crucial clarification on the definition of “related party” under the IBC. The Court held that the exclusion of related parties from the CoC applies not only to those who are related at the time of the CIRP but also to those who were related when the debt was created. This judgment emphasizes the importance of a purposive interpretation of the IBC to prevent abuse of the insolvency process by related parties and to ensure a fair and transparent resolution. The Court’s focus on the collusive nature of the transactions and the deep entanglement between the parties highlights the need for careful scrutiny of financial arrangements during insolvency proceedings. This ruling will have significant implications for the composition of the CoC and the overall effectiveness of the CIRP process in India.