The Supreme Court, recently, in the case of Phoenix Arc Private Limited v. Spade Financial Services Limited 1, held that the intent of Sec. 21 of the Insolvency and Bankruptcy Code, 2016 ("IBC") will be defeated if related parties are just determined "in presaenti" i.e., on the present basis. The issue pertained to the interpretation of Section 21 of the IBC, which provides for constitution of the Committee of Creditors ("CoC").
Section 21(1) of the IBC requires the Insolvency Resolution Professional ("IRP") to constitute a CoC, after collating of the claims which are received against and determining the financial position of the corporate debtor. The CoC has to comprise of all financial creditors of the corporate debtor as per Section 21(2) of the IBC. The expression 'financial creditor' is defined in Section 5(7) to mean any person to whom a financial debt is owed and to include a person to whom such a debt has been legally assigned or transferred. However, the proviso to Section 21(2) states, inter alia, that a financial creditor shall not have the right of representation, participation or voting in a CoC meeting if it is a related party of the corporate debtor.
The question before the Apex Court was to decide whether the status of a related party is to be tested "in presaenti" or whether it relates back to the transaction through which financial debt was incurred. The controversy arose because Spade and AAA, the financial creditors of the corporate debtor were not related parties at the time of commencement of the corporate insolvency resolution process, even though they were so during the relevant period when the transactions constituting their financial debt took place. In order to answer the question posed before the bench, the Supreme Court analysed and discussed the literal and purposive interpretation of the proviso.
The Court recognised 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 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 Court observed that the true test for determining whether the exclusion which is created by 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.
If the proviso is read literally, it has the effect that it is only such financial creditors who are related parties on the CIRP commencement who are excluded. If a financial creditor was a related party prior in time but not on the CIRP date, then the proviso will not be applicable. If such a literal interpretation is allowed, it will defeat the very purpose, i.e., having an independent CoC for the benefit of the corporate debtor.
Moving away from the literal interpretation, the Court further observed that 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 a corporate debtor, the exclusion which is created by the first proviso to Section 21(2) must apply. However, the Court also observed 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.
The Court therefore clarified and concluded 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 corporate insolvency resolution process, 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 Court therefore adopted purposive interpretation of Section 21(2) in order to give credence to the import of the Section. This decision is a welcome change as it lessens the scope of exploitative parties claiming staking a claim in the CoC based on collusive transactions while escaping the first proviso due to fraudulent activities.
1 Civil Appeal No. 3063 of 2020
Originally Published by Obhan & Associates, February 2021
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