Financial Creditor Can Be Excluded From CoC If It Got Rid Of 'Related Party' Label Only With Intention To Circumvent Bar Under Section 21(2) IBC : SC

In a significant verdict, the Supreme Court has held that a financial creditor which is not a "related party" to the corporate debtor at present can also be excluded from the Committee of Creditors(CoC) if it is found that its removal of the "related party" label was a part of strategy to bypass the bar under Section 21(2), first proviso of the Insolvency and Bankruptcy Code(IBC).

The Court held that the default rule is that to be disqualified from being included in the CoC, a financial creditor must be a "related party" in praesenti(at present). However, there could be cases where related party financial creditor devise mechanisms such as divesting itself of shareholding to gain entry into the CoC. If such financial creditors are allowed entry into the CoC, it will sabotage the resolution process.

Therefore, the Court held that the financial creditors that cease to be related parties in order to circumvent the disqualification under the first proviso to Section 21(2) of the Insolvency and Bankruptcy Code, should also be considered as being covered by the disqualification thereunder.

In this case Phoenix Arc Private Limited v Spade Financial Services Ltd and others, the Court said :

"...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".

The bench headed by Justice DY Chandrachud in this case was considering the issue whether the disqualification under the proviso would attach to a financial creditor only in praesenti, or if the disqualification also extends to those financial creditors who were related to the corporate debtor at the time of acquiring the debt.

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, the bench also comprising Justices Indu Malhotra and Indira Banerjee observed.

Financial Creditor which got rid of its "Related Party" status only with the sole intention of entering CoC must be excluded

In this case, National Company Law Appellate Tribunal had dismissed that appeal against NCLT order which held that AAA Landmark Private Limited and Spade Financial Services Private Limited have to be excluded from the Committee of Creditors ("CoC") formed in relation to the Corporate Insolvency Resolution Process ("CIRP") initiated against AKME Projects Limited ("Corporate Debtor"). It was held that they are related parties of the Corporate Debtor and are hence to be excluded from the CoC.

As per first proviso of Section 21(2),  financial creditor or the authorised representative of the financial creditor referred to in subsection (6) or sub-section (6-A) or sub-section (5) of Section 24, 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.

Since the provisions is using the word "is", the appellants argued that only those creditors who are related parties in praesenti will attract the disqualification under Section 21(2).

Before the Apex Court, the contention raised was that the existence of a live link of being a related party in the present is a requirement of the statutory provision. In other words, it was contended that since in the first proviso to Section 21(2), the expression "is a related party" is used, this must clearly be a reference to the present and not to an uncertain past.

Examining these contentions, the bench noted 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 and therefore the financial creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC. However,  the bench added:

 "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."

Context, object and purpose of the provisions should be considered while giving the interpretation.

The Court observed that 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.   However, it is relevant to examine whether the object and purpose for which the proviso was enacted, are fulfilled by the literal interpretation of the first proviso.

"..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 bench said.

The bench observed that accepting the arguments of the appellants "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", the bench observed.

Collusive transactions

The Court noted that the appellants in the case, 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.

The Court also 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", the bench observed on the facts of the case.

Observing thus, the bench disposed of the appeal as follows:

(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.

CASE: Phoenix Arc Private Limited Gaurav Agrawal Vs Spade Financial Services Limited [ Civil Appeal No. 2842 of 2020]

CORAM: Justices DY Chandrachud, Indu Malhotra and Indira Banerjee

COUNSEL: (i) Sr. Adv  K.V. Viswanathan for AAA and Spade; (ii) Sr. Adv Neeraj Kishan Kaul for Phoenix; and (iii) Sr. Adv Sanjiv Sen for the Resolution Professional

CITATION: LL 2021 SC 55

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