Related Party Can't Be Allowed Backdoor Entry Into CoC On Account Of Its Operational Debt: NCLT Kolkata

Brief Facts:

M/s Energy Properties Private Limited (Corporate Debtor) is the owner of a plot of land in Howrah, West Bengal. M/s Avani Towers Private Limited (Financial Creditor/Developer) signed a Development Agreement dated 16.06.2008. According to the terms of the agreement, the Developer was required to deposit Rs.12 crores as security. The security deposit included a further amount of up to Rs. 3 crores subject to an interest rate of 18% per year compounded quarterly. The Financial Creditor did not do any development work on the relevant premises. Parties engaged in a dispute as a result of non-performance of development work.

The Financial Creditor filed a petition under section 7 of IBC qua the debt of Rs. 10.91 crores, which consisted of the security deposit of Rs. 3.50 crores. On 20.03.2024, NCLT admitted the petition. The Applicant stated that Avani Towers is a related party of the Corporate Debtor under Section 5(24) of the IBC. The Applicant contended that the classification of claim of Avani Towers as operational debt was erroneous and dehors the provisions of IBC. Avani Towers had a 40% shareholding in the Corporate Debtor. Therefore, it was disqualified from being a member of the CoC. The RP treated the sum of Rs. 12 crores as operational debt only to avoid the trappings of Section 21 of IBC and to constitute the CoC with Avani Towers having an overwhelming majority in it.

Mr. Chintan Jhunjhunwala, suspended Director of Corporate Debtor preferred an application questioning the classification of Avani Towers as operational creditor of the Corporate Debtor. In an order dated 27.09.2024 it was held that a creditor who already stands classified as a 'related party Financial Creditor' under Section 5(24) of the Code cannot represent the CoC in any manner and that the first proviso of Section 21(2) shall squarely apply to an Operational Creditor.

The Members of the Bench had a difference of opinion on the issue of inclusion of Avani Towers in the CoC of the Corporate Debtor. Therefore, in terms of Section 419(5) of the Companies Act, 2013, a reference of the following issue was made for the opinion of the NCLT.

Issue:

Whether a financial creditor who has been categorized as a related party under Section 5(24) of the Code can be included in the CoC in terms of Regulation 16 of the IBBI (Insolvency Resolution Process for Corporate Persons), 2016 on account of its operational debt.

Submissions:

Mr. Joy Saha, Senior Counsel appearing for the Applicant contended that the advance of Rs. 3.5 crores with 18% interest falls within the ambit of financial debt under Section 5(8) of the IBC. He referred to Carestream Health India Pvt. Ltd. v. Seaview Mercantile LLP in Company Appeal (AT) (Insolvency) No. 579 of 2023, where it was held that “the scope of "operational debt" under the IBC does not encompass situations like security deposits unrelated to any immediate service rendered”.

He referred to the judgment of Supreme Court in Phoenix Arc Private Limited vs. Spade Financial Services Limited & Ors. to buttress that the exclusion referred to in first proviso to Section 21(2) of IBC, 2016 is related not to debts but relationship existing between the parties.

Mr. Jishnu Saha, Senior Counsel for Respondent No. 2, submitted that when the RP had decided to include Respondent No. 2 in CoC as operational creditor, the CoC rightly decided to not include Respondent No. 2 in CoC being a Financial Creditor.

He referred to the judgment rendered by the Supreme Court in Phoenix ARC Private Limited v. Spade Financial Services Limited & Ors. and espoused that the meaning of the first proviso to Section 21(2) of IBC is to exclude the related party of the Corporate Debtor from CoC to obviate conflict of interest in the event that the party is allowed to become part of CoC.

Observations:

The Tribunal noted that in the minutes of the first meeting of the CoC of the Corporate Debtor, it had been categorically noted that Avani Towers Pvt. Ltd. i.e. the sole financial creditor of the Corporate Debtor was a related party of the Corporate Debtor.

The Tribunal observed that Section 5(24)(j) of the Code indicates that any person who controls more than 20% of voting rights in the Corporate Debtor on account of ownership or a voting agreement would fall in the definition of related party of the Corporate Debtor. It was further observed that the provision does not provide that the expression 'control' would mean control over the 'voting rights' in the Corporate Debtor on account of 'ownership' or 'voting agreement'.

The Tribunal referred to the judgment of the Supreme Court in Phoenix Arc Private Limited vs. Spade Financial Services Private Limited & Ors. [Civil Appeal No. 2842 of 2020], where it was observed that the term 'related party' has been defined in IBC to ensure that those entities which are related to the Corporate Debtor are identified clearly since their presence can often negatively affect the insolvency process. The Court further held that the object of the Code is best served when the CIRP is driven by external creditors so as to ensure that the CoC is not sabotaged by related parties of the Corporate Debtor. Therefore, this Adjudicating Authority has to ensure that the CIRP is driven by external creditors and prevent related parties from controlling the CIRP of the Corporate Debtor.

Another pertinent observation made in Phoenix Arc was that the exclusion from CoC under Section 21(2) of the Code relates to the relationship existing between the parties and not the debt itself.

The Tribunal held that “once the relationship between a person/ entity and the corporate debtor has been found to be falling within the definition of 'related party' under Section 5(24) of the Code, such person/ entity cannot be included in the CoC under Section 21 of the Code on account of its debt being an operational debt.”

The Tribunal went on to observe that as per Section 21(2) of the Code, the CoC shall comprise all Financial Creditors. The Operational Creditors become part of the CoC under Regulation 16 of IBBI (Insolvency Resolution Process for Corporate Persons), 2016 only when the Corporate Debtor has no financial debt or where all financial creditors are found to be related party of the Corporate Debtor.

The Tribunal remarked, “allowing the same entity to become part of the CoC by donning the hat of an operational creditor would result in absurdity in the current statutory framework”. It observed that there cannot be any justification as to how a disqualification which keeps the financial creditor out of the CoC does not apply to an operational creditor as the basic objective of classifying an entity as a related party is to exclude it from the CoC.

The Tribunal referred to the matter of Arcom Medical Devices Private Limited vs. B & A Health Care Private Limited, where the NCLT held that the Respondent therein was a related party of the Corporate Debtor and was liable to be excluded from the CoC, even though the relationship between the Respondent and the Corporate Debtor was that of operational debt.

The Tribunal held that the rationale for excluding related parties from the CoC is to ensure fairness, prevent conflicts of interest, and maintain the integrity of the decision-making process in the CIRP.

The Tribunal opined that once a financial creditor has been classified as a related party of the Corporate Debtor in terms of Section 5(24)(j) of the IBC and excluded from CoC in terms of the first proviso to Section 21(2), it cannot be given representation in the CoC as an operational creditor as inclusion in the latter category would defeat the legislative intent of enacting the said law.

The Tribunal placed the matter before a Division Bench.

Case Title: M/s Avani Towers Private Limited vs. M/s Energy Properties Private Limited

Case Number: IA(IBC) No. 1299/ (KB)/ 2024 in Company Petition No. (IB)-1711/(KB)/2019

For the Applicant : Mr. Joy Saha, Sr. Adv. Mr. Kumarjit Banerjee, Adv. Mr. Sanchari Chakraborty, Adv. Mr. Aasil Naushad, Adv. Mr. Snehasish Chakraborty, Adv.

For the Respondent No. 2 : Mr. Jishnu Saha, Sr. Adv. Mr. Shaunak Mitra, Adv. Mr. Orijit Chatterjee, Adv. Ms. Swati Dalmia, Adv. Mr. Shubham Raj, Adv. Ms. Neha Sinha, Adv. Mr. Jitendra Lohia, RP of Avani Towers Pvt. Ltd.

For the RP : Ms. Manju Bhuteria, Adv. Mr. Ram Ratan Modi, Adv. Ms. Arundhati Barman Roy, Adv. Mr. Mahesh Chand Gupta, RP in person

Date of Order: 21.11.2024