The Supreme Court in Phoenix Arc Private Limited v. Spade Financial Services Limited, recently decided an interesting and pertinent issue under the Insolvency & Bankruptcy Code, 2016 (IBC). The issue was related to the interpretation of Section 21 of the Code, which provides for constitution of the Committee of Creditors (CoC).

Section 21(2) provides that the CoC shall comprise all financial creditors. However, the proviso to Section 21(2) states, inter alia, that a financial creditor shall not have the right of representation, participation or voting in a CoC meeting if it is a related party of the corporate debtor.

The Supreme Court was called upon to decide whether the status of a related party is to be tested in “praesenti” or whether it relates back to the transaction through which the financial debt was incurred.

Brief factual background

The case presented a rather peculiar and convoluted factual matrix. The corporate debtor was controlled by Mr. X. Mr. X had a very close associate, Mr. A, who held numerous positions in Mr. X's group of companies, and had a long-standing relationship with Mr. X. Interestingly, it was Mr. A who had initially incorporated the corporate debtor with his own capital and continued to control it for a substantial period of time. Mr. A later transferred control of the corporate debtor as well as the directorship to Mr. X.

Around the same time, Spade and AAA, the companies floated by Mr. A, entered into various transactions, inter-corporate deposits and MOUs which had the effect of the corporate debtor borrowing money from Spade and AAA. During the relevant transactions with Spade and AAA, Mr. A held the position of Consultant or Strategic Advisor to the corporate debtor, and later became the Group CEO of the Mr. X Group of Companies.

Thus, despite such a convoluted arrangement, it can easily be appreciated that both Mr. A and Mr. X were intricately related in the business of the corporate debtor. Further, both Spade and AAA had deeply entrenched financial interests in the corporate debtor owing to Mr. A. All the formal relationships were severed prior to the commencement of the Corporate Insolvency Resolution Process (CIRP).

Supreme Court's decision

The Supreme Court returned a specific finding that AAA and Spade were related parties within the meaning of Section 5(24) of the IBC at the time when the alleged financial debt was created. In this context, the Supreme Court answered various issues based on the peculiar facts of the case.

However, it was faced with an obstacle in the form of literal interpretation of the proviso to Section 21(2). In order to get over this difficulty (rightly so), the Supreme Court relied on the purposive interpretation of the proviso. Hence, it held that in case 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 in the CoC and sabotaging the CIRP, the first proviso to Section 21(2) will be applicable.

Comments

1. Court recognises the intent behind the first proviso:

Section 21 provides for formation of a CoC which will steer the CIRP for the resolution of the corporate debtor so that the financial creditors who are genuinely interested in the revival of the corporate debtor have enough control and incentives to steer the whole process. The proviso to Section 21(2) excludes related parties from being part of the CoC. There are valid reasons for the same – a financial creditor who is a related party will act for the benefit of the promoter/person through whom such financial creditor is related to the corporate debtor.

2. Court acknowledges that literal interpretation will defeat the object:

It is to avoid these situations that related parties have been excluded. However, when the proviso is read literally, it has the effect that it is only such financial creditors who are related parties in praesenti (on the CIRP date) who are excluded. If a financial creditor was a related party prior in time but not on the date of the CIRP, then the proviso will not be applicable. The aforesaid reading is not in tune with the aforementioned object of the section. If such a literal interpretation is provided, then it will defeat the very object – having an independent CoC for the benefit of the corporate debtor and value maximisation.

3. Purposive interpretation to further the object:

The word “is” is to be purposively read to mean even those financial creditors who have submitted the claims based on debts which were incurred or transactions which were carried out when such financial creditors were related parties to the corporate debtor. Such financial creditors may not be related parties in praesenti because of use of fraudulent or collusive commercial devices, but the claim still suffers from the shadow of a related party transaction.

4. Punishing collusive/fraudulent transactions/devices:

Otherwise, any related party financial creditor with a view to sabotaging the CIRP and hijacking the CoC proceedings, may devise a fraudulent or collusive mechanism (like in the present case) of removing the label of related party prior to the corporate debtor running down the ground and then take benefit of the CIRP at the cost of other independent financial creditors.

The way forward

• Balanced view: The Supreme Court was presented with two extreme views – the literal view and the purposive view. However, it has rightly chosen the middle path by stating that 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. However, 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.

• Commercial transaction is ‘debt’ and not collusive/fraudulent debt: This decision mandates another level of check to ascertain whether an actual financial debt by an independent creditor stands against the corporate debtor. In doing so, the purported debt and its circumstances must be examined.

• Attending circumstances become important: To know the true nature of transactions entered into between financial creditors and the corporate debtor, it is imperative that the status, influence and inter-relationship amongst the parties must be examined, inter-alia, for the period the transactions were entered into. In this regard, the close relationship of key managerial persons is also quintessential.

• Purposive interpretation of IBC provisions: In consideration of the above case, purposeful interpretation of S. 21(2) and S.5 (24) of the Code must be done by lifting the corporate veil, to see the real actors and beneficiaries behind the transactions. Therefore, the rigour ought to be much more as the resultant impact of a related party on the CoC would consequentially impinge upon the procedural integrity and compromise the commercial wisdom of the CoC.

• Need for amendment to IBC or the regulations: Since this decision now provides an additional check, it is imperative for the resolution professional to verify the antecedents of the debt and the status of the parties to the transactions. Similar to the requirement of tendering an affidavit of compliance with Section 29A, perhaps the regulations can be amended to mandate that all financial creditors shall disclose the degree of relation with the corporate debtor and the commercial nature of the transaction on an affidavit.

Finally, this decision is a game changer inasmuch as it reduces the scope of unscrupulous parties staking a claim in the CoC based on collusive transactions while escaping the first proviso due to fraudulent devices. This is also a rare decision by a court where an economic legislation has been interpreted to introduce an additional rigour which was not present in the text of the provision. As such, it has the effect of furthering the object of the IBC and also benefitting the banking industry.

Deepak Joshi is a dually qualified professional. He is a graduate of Campus Law Centre, Faculty of Law, University of Delhi and a Fellow Chartered Accountant. He currently practices law in the courts of Delhi. He can be reached at mail@deepakjoshi.in.