The Supreme Court recently in Phoenix Arc Private Limited v. Spade Financial Services Ltd. and others dealt with two sets of appeals being Civil Appeal No. 2842 of 2020 and Civil Appeal No. 3063 of 2020, arising from the judgment of the NCLAT dated 27th January 2020 whereby it dismissed the appeal under Section 61 of the IBC preferred by AAA Landmark Private Limited ("AAA") and Spade Financial Services Private Limited ("Spade") and held that they are related parties of the Corporate Debtor ("AKME Projects Limited"). The appeal before the NCLAT was to assail the order of NCLT dated 19th July 2019 whereby the NCLT held that the transactions between the Corporate Debtor and both Spade and AAA are collusive in nature and do not qualify as financial debt for the purpose of the IBC.
In Civil Appeal No. 2842 of 2020, it was submitted by Phoenix ARC 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 Committee of Creditors ("CoC"), there is an erroneous finding that they are financial creditors. In paragraph 11 of its judgment, the NCLAT had observed that, "...admittedly appellants are the financial creditors of the corporate debtor AKME Projects Limited...". It was submitted by Phoenix ARC that there was never any admission on the part of Phoenix that AAA and Spade are financial creditors. Phoenix challenged the above finding on the ground that:
(i) It is contrary to the record; and
(ii) The specific stand of Phoenix is that both AAA and Spade are not even creditors of the corporate debtor, much less financial creditors.
Spade and AAA independently filed an appeal under Section 62, Civil Appeal No. 3063 of 2020, in order to assail the decision of the NCLAT 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 the Code.
Based on the above, the following issues were framed before the Supreme 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?
The Supreme Court inter alia held 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.
- 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 IBC; (ii) undervalued transactions under Section 45(2) of IBC; (iii) transactions defrauding creditors under Section 49 of IBC; and (iv) extortionate transactions under Section 50 of IBC. 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.
- 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. While a strict determination of intent or mens rea may not always be possible by the NCLT and NCLAT in summary proceedings, it is possible to draw the inference from the facts at hand. These facts are that there was a deep entanglement between the entities of Mr Arun Anand (majority shareholder in Spade, of which AAA is a wholly-owned subsidiary) and Mr Anil Nanda (the promoter/director of the Corporate Debtor). Further, Mr Arun Anand did hold positions during this period which could have been used by him to guide the affairs of the Corporate Debtor. The Court took note of the close relationship between the key managerial personnel of the Corporate Debtor, Mr. Anil Nanda and the director of Spade and AAA, Mr. Arun Anand:
(i) Mr. Anil Nanda is the major shareholder of JIPL, which holds 80% of the shareholding in the Corporate Debtor;
(ii) The Corporate Debtor is a part of the Nanda Group of Companies;
(iii) Mr. Arun Anand was also a director of the Corporate Debtor up to 31stMarch 2002;
(iv) Mr. Arun Anand and his son, Mr. Aditya Anand, sold their shareholding in the Corporate Debtor in the year 2004/2005;
(v) Mr. Arun Anand was also closely related to one of the directors of the Corporate Debtor, Mr. Sonal Anand, who is his brother-in-law. Sonal Anand was the director of the Corporate Debtor from November 2007 to 2013; and
(vi) Mr. Arun Anand has worked in different capacities for Mr. Anil Nanda for about 25 years.
- The objects and purposes of the Code are 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. 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.
- An issue of interpretation in relation to the first proviso of Section 21(2) is 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. Originally, the first proviso to Section 21(2) read as follows: "Provided that a related party to whom a corporate debtor owes a financial debt shall not have any right of representation, participation or voting in a meeting of the committee of creditors.". The language was subsequently amended by the Amendment Act, 2018 and at present the first proviso reads as follows: "Provided that a financial creditor or the authorised representative of the financial creditor referred to in subsection (6) or sub-section (6A) 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.". The reason for the amendment appears to be the need to extend the disqualification in the first proviso of Section 21(2) to authorised representatives of financial creditors mentioned in Sections 21(6), 21(6A) and Section 24(5) as well. This was recommended by the Insolvency Law Committee, in its Report of March 2018. Consequently, the first proviso to Section 21(2) was amended, to extend the disqualification to the specified authorised representatives, in case that these representatives happened to be related parties of the corporate debtor. The introduction of the phrase "is" along with related party was not a guiding factor behind the Parliamentary amendment.
- 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. It was thus held that 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.
- 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, it was due to commercial contrivances through which these entities seek to now enter the CoC. Thus, held that the pervasive influence of Mr Anil Nanda (the promoter/director of the Corporate Debtor) over these entities was clear, and allowing them in the CoC would definitely affect the other independent financial creditors.
The above decision is a step forward towards achieving the objectives of the Code and sets the principles to ensure that the Committee of Creditors is not sabotaged by the Corporate Debtor or its personnel who through related parties of the corporate debtor try to gain a backdoor entry into the Committee of Creditors by way of entering into collusive and sham transactions.
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