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Insolvency Code : Collusive Transaction and Related Party explained by Supreme Court

In Phoenix Arc Private Limited vs Spade Financial Services Limited & Ors., the appeal filed by the Petitioner was to bar the Respondent from participating in the COC as they were related parties as far as the Corporate Debtor was concerned while the contention of the Respondent was that they were related at some time in the past but presently were not and therefore the bar as per Section 21(1) of Insolvency and Bankruptcy Act would not apply to them. The Petitioner had countered that the Respondents had tried to circumvent the bar by entering into collusive transactions with the Corporate Creditor in order to take the identity of a financial creditor.

Collusive Transactions

The Supreme Court observed 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.

Related Parties

Section 21(1) of the IBC requires the IRP to form the CoC for the CIRP of the Corporate Debtor. The first proviso in the said section states that any financial creditor, barring the exceptions provided in the second proviso, shall not have any right of representation, participation and voting in the meeting of the CoC, if it is a related party of the Corporate Debtor.

The Supreme Court held that 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.

Since the IBC attempts to balance the interests of all stakeholders, such that some stakeholders are not able to benefit at the expense of others, related party financial creditors are disqualified from being represented, participating or voting in the CoC, so as to prevent them from controlling the CoC to unfairly benefit the corporate debtor.

The controversy in this matter was from the interpretation of the first provisio of Section 21 (I) whether the disqualification under the proviso would attach to a financial creditor only in praesenti (at the present time), or if the disqualification also extends to those financial creditors who were related to the corporate debtor at the time of acquiring the debt.

In Arcelor Mittal India Private Limited vs. Satish Kumar Gupta, in answer to the issue whether ineligibility of the resolution applicant under Section 29- A(c) of the Code attached to an applicant at the date of commencement of the CIRP or at the time when the resolution plan is submitted by the resolution applicant. Based on the said judgment, on the face of it, 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.

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. The Supreme Court then referred to various commentaries and judgments which establishes that the purpose and object of the legislation would have to be carefully considered before coming to any conclusion.

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 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.

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, 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. 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.

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.

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.


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