Phoenix ARC Pvt. Ltd. Vs. Spade Financial Services Limited & Ors - Exclusion of Related Party financial creditors from CoC [first proviso to Section 21(2)]

SCI (01.02.2021) in Phoenix Arc Pvt. Ltd. Vs. Spade Financial Services Limited & Ors [Civil Appeal No. 2842 of 2020] held that; 

• # 44.  . . . . . .This Court has interpreted the term “disbursal” in Pioneer Urban Land and Infrastructure Ltd vs. Union of India in the following terms: -  # 71. . . .The expression "disbursed" refers to money which has been paid against consideration for the "time value of money". In short, the "disbursal" must be money and must be against consideration for the "time value of money", meaning thereby, the fact that such money is now no longer with the lender, but is with the borrower, who then utilises the money….”        (emphasis supplied)

• # 52. Since the commercial arrangements between Spade and AAA, and the Corporate Debtor were collusive in nature, they would not constitute a ‘financial debt’. Hence, Spade and AAA are not financial creditors of the Corporate Debtor.

• # 58. 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.

• # 94.   . . 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.

• # 95. Hence, 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. . . . 

 

Excerpts of the order;

# 2 Phoenix, in Civil Appeal No. 2842 of 2020, submits that though the NCLAT correctly dismissed the appeal filed by Spade and AAA, holding that they are related parties of the Corporate Debtor and are hence to be excluded from the CoC, there is an erroneous finding that they are financial creditors. In paragraph 11 of its judgment, the NCLAT has observed that:

• “…admittedly appellants are the financial creditors of the corporate debtor AKME Projects Limited...”

It has been submitted that there was never any admission on the part of Phoenix that AAA and Spade are financial creditors. The appeal by Phoenix seeks to challenge the above finding on the ground that;

• (i) It is contrary to the record; an

• (ii) The specific stand of Phoenix is that both AAA and Spade are not even creditors of the corporate debtor, much less financial creditors.

Phoenix is thus in appeal under Section 62 of IBC, confined to the finding that AAA and Spade are financial creditors.

 

# 3 Spade and AAA have independently filed an appeal under Section 62, Civil Appeal No. 3063 of 2020, in order to assail the decision of the NCLAT dated 27 January 2020 affirming their exclusion from participating in the CoC on the ground that they are related parties of the Corporate Debtor in terms of Section 5(24) and the first proviso to Section 21(2) of IBC.

 

# 4 Based on the above appeals, three issues have arisen for consideration before this Court:

• (i) Whether Spade and AAA are financial creditors of the Corporate Debtor;

• (ii) Whether Spade and AAA are related parties of the Corporate Debtor; and

• (iii) Whether Spade and AAA have to be excluded from the CoC.

 

CIRP for the Corporate Debtor

# 5 The brief facts of the case are that CIRP has been initiated against the Corporate Debtor on 18 April 2018 on an application filed by an operational creditor, Mr. Hari Krishan Sharma, under Section 9 of IBC.

 

# 6 During the CIRP, claims were invited by the Interim Resolution Professional (“IRP”). Spade filed its claim in Form C as a financial creditor for a sum of Rs. 52,96,00,000 on 10 May 2018. Thereafter, Spade filed a revised Form C for a sum of Rs. 109,11,00,000 on 20 May 2018. Spade had filed the form on the basis of an alleged Memorandum of Understanding dated 12 August 2011 executed with the Corporate Debtor, which stated that Inter Corporate Deposits (“ICDs”) of Rs. 26,55,00,000 have been granted to the Corporate Debtor by Spade bearing interest of 24% repayable in terms of the mutual agreement between the parties. However, Spade has submitted before this Court that it has granted ICDs of Rs. 66,00,00,000 (approx.) to the Corporate Debtor between June 2009 and January 2013. Out of this amount, Spade is claiming a principal amount of Rs. 23,00,00,000. The balance amount of Rs 43,06,00,000 was credited in the account of AAA, which is a wholly owned subsidiary of Spade. The total claim of Spade has increased to Rs. 109,11,00,000 in 7 years on account of interest at the rate of 24%.

 

# 7 AAA filed its claim before the IRP in Form F as a creditor other than a financial creditor or operational creditor for a sum of Rs. 93,90,00,000 on 10 May 2018. Thereafter, AAA filed a revised claim in Form C as a financial creditor for a sum of Rs. 109,72,00,000 on 23 May 2018. It had entered into a Development Agreement dated 1 March 2012 with the Corporate Debtor for a sale consideration of Rs. 32,80,00,000 to purchase development rights in a project. On 25 October 2012, the Development Agreement was terminated and an Agreement to Sell, along with a Side Letter, was executed between AAA and the Corporate Debtor for purchase of flats. The sale consideration for the Agreement to Sell was enhanced to Rs. 86,01,00,000 from Rs. 32,80,00,000 under the Development Agreement. AAA paid a sum of Rs. 43,06,00,000 as advance payment under the Agreement to Sell. This amount was adjusted out of the ICDs payable to Spade as noted above. The claim of AAA is with respect to the principal amount of Rs. 43,06,00,000, which along with interest at the rate of 18% increased to Rs. 109,72,00,000 in 5 years.

 

# 8 The CoC was constituted on 22 May 2018. On 25 May 2018, the IRP rejected the claim of Spade, inter alia, on the ground that the claim was not in the nature of a financial debt in terms of Section 5(8) of IBC since there was an absence of consideration for the time value of money, i.e., the period of repayment of the claimed ICDs was not stipulated. The IRP also rejected the claim of AAA on the ground that its claim as a financial creditor in Form C was filed after the expiry of the period for filing such a claim.

 

Proceedings before NCLT

# 9 Aggrieved by the rejection of their claim as financial creditors, AAA and Spade filed applications before the NCLT to be included in the CoC. The NCLT by its order dated 30 May 2018 allowed the applications. However, none of the other financial creditors, such as Phoenix and YES Bank, were parties to these proceedings. The NCLT observed that AAA’s original claim in Form F was filed on time and it has only amended its claim as one under Form C. The NCLT further observed that the amount given by Spade in the form of ICDs has been received as a deposit and is attracting interest as reflected in Form ‘26 AS’, deducting TDS on interest. Thus, NCLT allowed Spade and AAA to submit their claims as financial creditors with a direction to the IRP to consider the claims.

 

# 12 The application moved on behalf of YES Bank under Section 60(5), on 28 June 2018, sought the following reliefs:

• (i) A direction to the IRP to reconstitute the CoC in terms of the Insolvency and Bankruptcy (Amendment) Ordinance 2018 (“IBC Ordinance 2018”); and

• (ii) A direction prohibiting the IRP from allowing AAA and Spade to participate and vote in the meeting of the COC.

 

# 13 The applications filed under Section 60(5) by Phoenix also sought similar reliefs for:

• (i) The removal of Spade and AAA from the CoC; and

• (ii) Directing the constitution of the CoC in terms of the IBC Ordinance 2018.

 

# 14 NCLT in its judgment dated 19 July 2019 formulated two issues for determination. These two issues were:

• “i. What is the nature of the transaction between the parties and does it qualify to be treated as financial debt as defined under Section 5(8) of IBC, 2016.

• ii. What is the date on which there should be relation between the two parties for the alleged Financial Creditor to be included in the definition "related party'.”

 

# 15 In relation to the first issue, the NCLT held that:

• “...the transactions between CD and both SPADE and AAA Landmark are collusive in nature and do not qualify as financial debt for the purpose of IBC.”

Accordingly, NCLT held that Spade and AAA did not qualify to be considered as financial creditors.

 

# 16 In relation to the second issue, NCLT held that it “does not require a reply” in view of its above-mentioned finding. However, it took note of the first proviso to Section 21(2) of the IBC, which was introduced with effect from 6 June 2018. Under the first proviso, inter alia, a financial creditor who is a related party of the corporate debtor shall not have the right of representation, participation or voting in the CoC. The Adjudicating Authority held that “there is no doubt in our mind that Arun Anand and his company namely Spade and AAA Landmark were related parties to the CD”. However, the NCLT noted that after 2013, soon after the execution to the Agreement to Sell of 25 October 2012, Arun Anand resigned from all the companies of the Anil Nanda Group and was no longer related to the Corporate Debtor at the time of the filing of the application for initiation of the CIRP. Ultimately, the Adjudicating Authority held that there was a deep entanglement between the affairs of the corporate debtor and the group representing the Arun Anand companies which could not be unravelled in the summary jurisdiction before the Tribunal. The ultimate decision of the NCLT was to allow the applications filed by YES Bank and Phoenix for the exclusion of AAA and Spade from the CoC based on its findings on the first issue.

 

Proceedings before NCLAT

# 19 Hence, NCLAT came to the conclusion that the Adjudicating Authority had rightly excluded both Spade and AAA from participation in the CoC since Mr. Anil Nanda, in concert with Mr. Arun Anand and his family, had created a web of companies which were related parties to the Corporate Debtor, and was now trying to gain a backdoor entry into the CoC through them.

 

Financial Creditor and Financial Debt

# 44 In this context, it would be relevant to discuss the meaning of the terms “disburse” and “time value of money” used in the principal clause of Section 5(8) of the IBC. This Court has interpreted the term “disbursal” in Pioneer Urban Land and Infrastructure Ltd vs. Union of India11 in the following terms:

• “70. The definition of "financial debt" in Section 5(8) then goes on to state that a "debt" must be "disbursed" against the consideration for time value of money. "Disbursement" is defined in Black's Law Dictionary (10th Edn.) to mean: “1. The act of paying out money, commonly from a fund or in settlement of a debt or account payable. 2. The money so paid; an amount of money given for a particular purpose.”

• 71. In the present context, it is clear that the expression "disburse" would refer to the payment of instalments by the allottee to the real estate developer for the particular purpose of funding the real estate project in which the allottee is to be allotted a flat/apartment. The expression "disbursed" refers to money which has been paid against consideration for the "time value of money". In short, the "disbursal" must be money and must be against consideration for the "time value of money", meaning thereby, the fact that such money is now no longer with the lender, but is with the borrower, who then utilises the money….”        (emphasis supplied)

 

# 46 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.

 

# 48 The IBC has made provisions for identifying, annulling or disregarding “avoidable transactions” which distressed companies may have undertaken to hamper recovery of creditors in the event of the initiation of CIRP. Such avoidable transactions include: (i) preferential transactions under Section 43 of the IBC; (ii) undervalued transactions under Section 45(2) of the IBC; (iii) transactions defrauding creditors under Section 49 of the IBC; and (iv) extortionate transactions under Section 50 of the IBC. The IBC recognizes that for the success of an insolvency regime, the real nature of the transactions has to be unearthed in order to prevent any person from taking undue benefit of its provisions to the detriment of the rights of legitimate creditors.

 

# 52 Since the commercial arrangements between Spade and AAA, and the Corporate Debtor were collusive in nature, they would not constitute a ‘financial debt’. Hence, Spade and AAA are not financial creditors of the Corporate Debtor.

 

# 58 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.

 

# 59 The term ‘related party’ has also been defined by Parliament in the Companies Act, 2013 for all corporations. The definition of the expression has also been expanded for listed entities by the Securities Exchange Board of India by amendment to the Equity Listing Agreement to include elements mentioned under applicable accounting standards. However, in the present case, we are assessing its definition only under the IBC, which is exhaustive. The purpose of defining the term separately under different statutes is not to avoid inconsistency but because the purpose of each of them is different. Hence, while understanding the meaning of ‘related party’ in the context of the IBC, it is important to keep in mind that it was defined 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.

 

# 72 The CoC is comprised of financial creditors, under loan and debt contracts, who have the right to vote on decisions and operational creditors such as employees, rental obligations, utilities payments and trade credit, who can participate in the CoC, but do not have the right to vote. The aim of the CoC is to enable coordination between various creditors so as to ensure that the interests of all stakeholders are balanced, and the value of the assets of the entity in financial distress is maximised.

 

# 75 These objects underscore the composition of the CoC, guided by Section 21 of the IBC. The objects and purposes of the Code are best served when the CIRP is driven by external creditors, so as ensure that the CoC is not sabotaged by related parties of the corporate debtor. This is the intent behind the first proviso to Section 21(2) which disqualifies a financial creditor or the authorised representative of the financial creditor under sub-section (6) or sub-section (6A) or sub-section (5) of section 24, if it is a related party of the corporate debtor, from having any right of representation, participation or voting in a meeting of the committee of creditors.

 

# 77 It is pertinent to note that disqualification of related parties from being members of the CoC, has also been recommended in the UNCITRAL Legislative Guide on Insolvency law:

• “The insolvency law should specify the creditors that are eligible to be appointed to a committee. Creditors who may not be appointed to a creditor committee would include related persons and others who for any reason might not be impartial. The insolvency law should specify whether or not a creditor’s claim must be admitted before the creditor is entitled to be appointed to a committee.”

In interpreting the legislation, which represents a Parliamentary effort to bring about structural changes in the resolution of corporate insolvencies, the effort of the court must be to aid the fulfilment of the objects of the IBC.

 

# 84 Thus, facially, it would appear that the use of the simple present tense in the first proviso to Section 21(2) indicates that the disqualification applies in praesenti. Furthermore, this interpretation would also be supported by a reading of the first proviso to Section 21(2), in light of the definition of ‘related party’ under Section 5(24), which uses phrases such as ‘is accustomed to act’ or ‘is associated’ to define a related party in the present tense.

 

# 90 Hence, we would need to consider the meaning of the first proviso in the light of the context, object and purpose for which it was enacted. 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. The logic underlying the exclusion has been summarised as follows;

• “The Committee was of the view that the disability under the first proviso to Section 21(2) is aimed at removing any conflict of interest within the CoC, to prevent erstwhile promoters and other related parties of the corporate debtor from gaining control of the corporate debtor during the CIRP by virtue of any loan that may have been provided by them.”

Accepting the submission of Mr Viswanathan would allow the statutory provision to be defeated by a related party of a corporate debtor creating commercial contrivances which have the effect of denuding its status as a related party, by the time that the CIRP is initiated. 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.

 

# 91 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. For, it is on the strength of the financial debt as defined in Section 5(8) that an entity claiming as a financial creditor under Section 5(7) seeks a position on the CoC under Section 21(2). If the definition of the expression ‘related party’ under section 5(24) applies at the time when the debt was created, the exclusion in the first proviso to Section 21(2) would stand attracted.

 

# 92 However, if such an interpretation is given to the first proviso of Section 21(2), all financial creditors would stand excluded if they were a ‘related party’ of the corporate debtor at the time when the financial debt was created. This may arguably lead to absurd conclusions for entities which have legitimately taken over the debt of related parties, or where the related party entity had stopped being a ‘related party’ long ago.

 

# 94 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.

 

# 95 Hence, 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. Mr Kaul has argued, correctly in our opinion, that if this interpretation is not given to the first proviso of Section 21(2), then a related party financial creditor can devise a mechanism to remove its label of a ‘related party’ before the Corporate Debtor undergoes CIRP, so as to be able to enter the CoC and influence its decision making at the cost of other financial creditors.

 

# 96 In the present case, there is a finding that AAA and Spade were related parties within the meaning of Section 5(24) at the time when the alleged financial debt on the basis of which they assert a claim to be a part of the CoC was created. This was due to the long-standing relationship between Mr Arun Anand and Mr Anil Nanda, and their respective corporations. Admittedly, such a relationship still existed even in 2017, since Mr Anil Nanda’s JIPL held shareholding in Mr Arun Anand’s Spade. Further, we have also concluded that the transactions between Spade and AAA on one hand, and the Corporate Debtor on the other hand, which gave rise to their alleged financial debts were collusive in nature. Therefore, it is evident that there existed a deeply entangled relationship between Spade, AAA and Corporate Debtor, when the alleged financial debt arose. While their status as related parties may no longer stand, we are inclined to agree with Mr Kaul that this was due to commercial contrivances through which these entities seek to now enter the CoC. The pervasive influence of Mr Anil Nanda (the promoter/director of the Corporate Debtor) over these entities is clear, and allowing them in the CoC would definitely affect the other independent financial creditors.

 

Conclusion

# 97 In conclusion, we hold that:

• (i) The decision of the NCLAT, in as much as it referred to Spade and AAA as financial creditors, is set aside. Due to the collusive nature of their transactions alleged to be a financial debt under Section 5(8), Spade and AAA cannot be labelled as financial creditors under Section 5(7);

• (ii) The decision of the NCLAT, in as much as it referred to Spade and AAA as related parties of the Corporate Debtor under Section 5(24), is affirmed; and

• (iii) The decision of the NCLAT, in as much as it excluded Spade and AAA from the CoC in accordance with the first proviso of Section 21(2), is affirmed but for the reasons mentioned above.

 

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