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Related parties cannot be included in the CoC by way of collusive transactions: SC

Related parties cannot be included in the CoC by way of collusive transactions: SC

A three Judge Bench of the Hon’ble Supreme Court comprising of Justices Dr. Dhananjaya Y. Chandrachud, Indu Malhotra and Indira Banerjee in the case of Phoenix Arc Private Limited v. Spade Financial Services Limited and Others, REED 2021 SC 02501, held that a collusive transaction cannot lead to the creation of a ‘financial debt’ under the Insolvency and Bankruptcy Code, 2016, and therefore, such a transacting party is not entitled to be a part of Committee of Creditors. The brief background of the case, the issue raised and analysis of the ruling are discussed below.


BACKGROUND


A corporate insolvency resolution process (CIRP) was initiated against AKME Projects Limited (corporate debtor). Phoenix Arc Private Limited and Yes Bank Limited (financial creditors) filed applications seeking the exclusion of AAA Landmark Private Limited (AAA) and Spade Financial Services Private Limited (Spade), from the Committee of Creditors (CoC) on the ground that they are related parties. The present appeals have been filed assailing the judgment dated 27 January 2020 passed by National Company Law Appellate Tribunal (NCLAT), wherein it held that although Spade and AAA are ‘admittedly’ financial creditors of the corporate debtor, they being related parties must be excluded from the CoC.  Aggrieved thereof, both the parties challenged this judgment, with financial creditors contending that Spade and AAA are not financial creditors of the corporate debtor and Spade and AAA arguing that they are not the related parties of Corporate Debtor.


ISSUES



The issues framed by the Supreme Court for its consideration were as follows:

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

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

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


ANALYSIS


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


As per Section 5(8) of IBC, a financial debt 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 above definition mandates that the debt extended by the creditor should actually be disbursed to the corporate debtor. The Supreme Court relied on the interpretation of ‘disbursal’ as done in Pioneer Urban Land and Infrastructure Ltd. v. Union of India, REED 2019 SC 08502, and 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.” Hence, the court concluded that ‘sham transactions’ cannot give rise to a ‘debt’. 


In the present case, the Court observed that the Memorandum of Understanding on the basis of which Spade staked its claim was unstamped and unregistered and did not stipulate a period of repayment. Hence, the consideration for time value of money was absent, which is an essential ingredient of a financial debt. Further, the Corporate Debtor had entered into multiple agreements with AAA regarding the same property without giving any explanation or rationale regarding variation in the consideration. This showed that the transactions were collusive in nature entered with the purpose of diverting properties of the Corporate Debtor to AAA. Thus, the transaction between Spade & AAA and the Corporate Debtor was collusive in nature and accordingly, Spade and AAA are not financial creditors.


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


The court noted that the definition of related party’ under section 5(24) of the IBC is rather broad, and includes certain subjective clauses in the definition, which refer to instances where one person ‘acts on the advice, directions or instructions in the ordinary course of businesses’ of other person or is ‘accustomed to act’ as such. On facts, the court 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, namely Mr. Anil Anand, a promoter of the corporate debtor and Mr. Sonal Anand, who is Mr. Arun Anand’s brother-in-law. Further, Mr Arun Anand did hold positions during which could have been used by him to guide the affairs of the Corporate Debtor. The collusive nature of the transactions between the parties also substantiated the same. Hence, the Court concluded that Mr. Arun Anand, Spade and AAA were related parties of the corporate debtor under the IBC.


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


The first proviso to Section 21(2) of the IBC disqualifies a Financial Creditor or its authorized representative, 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. Relying on this, it was argued that there must be a present relationship of 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 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, Principles of Statutory Interpretation (First Edition 2015, Lexis Nexis), 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. Accordingly, Spade and AAA were excluded from the CoC in accordance with the first proviso of section 21(2).


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