This article is written by Pragya Dixit pursuing Certificate Course in Competition Law, Practice and Enforcement from LawSikho.
Table of Contents
Introduction
The Supreme Court (SC) of India recently in the case of Phoenix Arc Private Limited v. Spade Financial Services Limited & Ors., (Phoenix case) while dismissing the appeal filed by two parties namely AAA Landmark Private Land (AAA) and Spade Financial Services Limited (Spade) asserted that transactions which are collusive and sham and collusive in nature do not amount to “Financial Debt” under the Insolvency and Bankruptcy Code, 2016 (hereinafter referred to as ‘IBC’ or ‘the code’). The SC held that such transactions are performed with dishonest intention and have an adverse impact on genuine creditors of the corporate debtor (CD), thus no party should be allowed to reap undue advantages out of them.
Committee of creditors and its undeniable importance under IBC
The Insolvency and Bankruptcy Code, 2016 (IBC), is the apex legislation in India the creation of which lies in the objective of rescuing corporate debtors in distress. In the process of rescuing such debtors, the code ensures that the rights and interests of the legitimate creditors stay protected.
Under IBC, whenever any corporate entity goes insolvent and commits a default, it is well within the power of the financial creditor, an operational creditor, or the corporate debtor itself to approach the NCLT for the initiation of a CIRP. In a situation where a company goes insolvent, it is implied that it is the creditors of the company and their interests which are under the biggest threat. A creditor of a company is a person who has lent its money with an expectation of the return of the principal amount accompanied with the interest. However, in a situation of default, it becomes very difficult to reinstate those dues of creditors.
Thus, it is undeniable that creditors have the highest vested interests in an insolvent entity and the Code did not fail to recognize it. Resultantly Section 18 and Section 21 of the Code, creates an obligation on the Interim Resolution Professional to constitute a committee of creditors(CoC). This committee of creditors has the supreme power with respect to making decisions while a CIRP is in the run.
Thus, it is not difficult to understand how much importance code lays on the CoC and their commercial wisdom when it comes to the resolution of an insolvent entity.
However, the commercial interests of the legitimate creditors are always vulnerable to threats. The code has presupposed such instances and it has recognized this possibility by providing for the avoidance of such transactions which can possibly be detrimental to the interests of the creditors, under Section 43 (Preferential transactions), Section 45 (Undervalued transactions), Section 49 (Transactions defrauding creditors) and Section 50 (Extortionate credit transactions). This recognition makes the Code’s intention of facilitating the interest of its legitimate creditors more explicit and anything to the contrary is a blatant disregard of the primary objective of the Code.
It is in the pursuance of the above objective, the Supreme Court in its ruling in the Phoenix case while extensively deliberating on the scope of related parties and Financial creditors, discarded the underlying transactions as a sham and collusive in nature. Let’s have a look at what the Phoenix case is all about.
Facts of the case
The factual circumstances involved a company AKME Projects limited, which was undergoing a CIRP. While that CIRP was in process, two financial Creditors of the company namely Phoenix Arc Private Limited and Yes Bank Limited, filed applications before NCLT seeking for the exclusion of AAA Landmark Private Limited and Spade Financial Services Private Limited from the CoC on the ground that they are related parties.
In pursuance to the above application NCLT in its order held that Spade and AAA both would not qualify as “financial creditors”, hence cannot be a part of CoC, and did not consider deliberating on the question regarding whether they are related parties or not. This order by NCLT was appealed in NCLAT, NCLAT ruled that though Spade and AAA both are qualified as financial creditors of the company, however, they are related parties to the corporate debtor (CD) and related parties are disqualified to have any right of representation or participation in a meeting of the CoC. Thus, on these grounds, NCLAT excluded them from the process of the CoC. The problem arose from the NCLAT’s decision of involving Spade and AAA in financial creditors and this ruling was further challenged in the SC.
Issues involved
The questions that lied before the Supreme Court in the Phoenix case, revolved around three issues, these 3 issues:
- Whether Spade and AAA are Financial Creditors of the Corporate Debtor?
- Whether Spade and AAA are related parties of the Corporate Debtor?
- Whether Spade and AAA have to be excluded from the CoC?
What exactly constitutes a financial debt under IBC?
Financial debt is defined under Section 5(8) of the IBC, which states that “Financial Debt is a debt, which is disbursed against the consideration for the time value of money.”
The words “time value” have been interpreted to mean compensation or the price paid for the length of time for which the money has been disbursed. The essence of any financial debt is that the “amount should have been raised under a transaction having the commercial effect of a borrowing.
When taken into the perspective of the current problem, the SC found that the transactions which are collusive in nature only creates an illusion that money has been disbursed to a borrower with the object of receiving consideration, however, the reality is different. Thus, disbursal of such a debt cannot be termed as financial debt under IBC.
Related parties and conundrum associated
It is of utmost importance to refine and understand the concept of related parties in relation to a Corporate Debtor. The definition of related party is quite broad and the Code under Section 5(24) discusses a plethora of relationships that comes under the purview of related parties. For instance, Clauses (f), (g) and (h) of Section 5(24) of the Code includes those persons under the ambit of a related party on whose advice, directions or instructions, actions are being taken in the ordinary course of business.
The entire purpose behind making definition of related party expansive enough is to ensure that when a CoC is formed, the credible creditors of the company shall be involved, who have similar interests and are not otherwise biased, as if contrary happens there can be a negative impact on the insolvency process of the corporate debtor. This intent of the Code can be seen under 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.
The reasoning behind this section entails that involvement of related parties can adversely impact the process of resolution.
The case goes far beyond discussing the scope of related parties. While dealing with this issue, SC discarded the argument which states that the scope of section 21(2) only involves the present relationship of the financial creditor as a related party of the corporate debtor. The SC held that if such a narrow interpretation of the proviso is taken then the purpose of the proviso stands defeated. The court found that the factual matrix of the case suggests that the said parties were related to the corporate party during the relevant time period when such transactions took place. The facts were substantial to conclude that the transactions were a result of past collusion between the corporate debtor and its related parties. Thus, past relationships shall not be avoided while determining the scope of the related party with reference to a corporate debtor undergoing CIRP.
The decision of the Supreme Court
The SC while dealing with the above-mentioned questions, extensively deliberated on the scope of financial debt and related parties as provided under the code. The apex court found that the entangled relationships and collusive arrangements in the present case explicitly show the ulterior motives behind the transactions involved. The court found that the Board of Directors of the company was acting under the influence of a common set of individuals. Sham activities like interlacing amongst companies, charging of lower interest rates, non-registration of charges, inconsistencies in completion of formal documentation, absence of disbursal of the entire amount which was lent, etc., denoted that the purpose behind the transactions was something else but the disbursal of financial debt.
There were ulterior motives involved whereby the intention was to defraud and compromise the interests of legitimate creditors of the company. Hence, SC declared that the transactions involved are collusive. The court defined that “A collusive transaction is a transaction which is nothing but a sham. Such transactions would only create an illusion that money has been disbursed to a borrower with the object of receiving consideration in the form of the 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.”
Judgement analysis
The faulty ruling of NCLAT where it referred to Spade and AAA as Financial creditors of the corporate debtor was rightly overturned by the SC. Collusive or sham transactions as discussed previously are forbidden by the very intent of the Code. The reasons for the same are that such transactions are nothing but a deception. On the face of it, these transactions might appear as a debt disbursed for the “time value of money”. However, to its core, it has ulterior motives. If allowed, they are capable of acting as highly detrimental to the interests of the legitimate creditors of the CD and unfairly benefit CD and the other parties involved, which is a blatant disregard of the objective of the Code.
Thus, SC while considering various factors in the Phoenix case elaborated on the concept of collusive transactions and in its conclusion held that due to the collusive nature of transactions involved the debt disbursed cannot be deemed as a financial debt under Section 5(8) and thus Spade and AAA do not qualify as financial creditors under Section 5(7) of the Code.
Conclusion
The ruling is a progressive one and exhaustively defines the contours of related parties and financial creditors under the IBC. Thus, the case would definitely serve as a precedence in the world of insolvency. However, the findings of the case were entirely based on the factual matrix of the case and the successful application of these findings in the future can only be made by taking into consideration the facts and circumstances presented before the court and not otherwise.
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