01 Feb 2121

A formerly related party creditor cannot be a part of Committee of Creditors as per first proviso of Section 21(2) of Insolvency and Bankruptcy Code, 2016 - Supreme Court of India

Case : Phoenix Arc Pvt. Ltd v. Spade Financial Services Pvt. Ltd & Ors. Civil Appeal No. 2842 of 2020

Court : Supreme Court of India

Bench : Justice Dr Dhananjaya Y Chandrachud, Justice Indu Malhotra and Justice Indira Banerjee

Decided on : 01 Feb 2121

Relevant Statutes

Sections 5(8), 5(24), 9, 21(2), 60 and 61 of the Insolvency and Bankruptcy Code, 2016

Brief Facts and Procedural History

1. Corporate Insolvency Resolution Process was initiated against the AKME Projects Ltd (Corporate Debtor) on 18 April 2018 on an application filed by an operational creditor, Mr. Hari Krishan Sharma, under Section 9 of Insolvency and Bankruptcy Code, 2016; during which claims were invited by the Interim Resolution Professional (IRP).

2. Spade Financial Services Pvt. Ltd filed its revised claim in Form C as a financial creditor for a sum of Rs. 109,11,00,000 on 20 May 2018. Spade Financial Services Pvt. Ltd had submitted that it has granted Inter Corporate Deposits (ICDs) of ₹66,00,00,000/- (approx.) to the Corporate Debtor between June 2009 and January 2013. Out of this amount, Spade Financial Services Pvt. Ltd claimed a principal amount of ₹23,00,00,000/-. The balance amount of ₹43,06,00,000/- was credited in the account of AAA Landmark Pvt. Ltd, a wholly-owned subsidiary of Spade Financial Services Pvt. Ltd. The total claim of Spade Financial Services Pvt. Ltd has increased to ₹109,11,00,000/- in 7 years on account of interest at the rate of 24%.

3. AAA Landmark Pvt. Ltd filed a revised claim in Form C as a financial creditor for a sum of ₹109,72,00,000 on 23 May 2018. It had entered into a Development Agreement dated 1 March 2012 with the Corporate Debtor for a sale consideration of ₹32,80,00,000/- to purchase development rights in a project. On 25 October 2012, the Development Agreement was terminated and an Agreement to sell, along with a Side Letter, was executed between AAA Landmark Pvt. Ltd and the Corporate Debtor for purchase of flats. The sale consideration was enhanced to ₹86,01,00,000/-. AAA Landmark Pvt. Ltd paid a sum of ₹43,06,00,000/- as advance payment. This amount was adjusted out of the Inter Corporate Deposits payable to Spade Financial Services Pvt. Ltd. The claim of AAA Landmark Pvt. Ltd is with respect to the principal amount of ₹43,06,00,000/- which along with interest at the rate of 18% increased to ₹109,72,00,000 in 5 years.

4. On 25 May 2018, the Interim Resolution Professional rejected the claim of Spade Financial Services Pvt. Ltd, inter alia, on the ground that the claim was not like financial debt in terms of Section 5(8) of Insolvency and Bankruptcy Code, 2016 since consideration was absent for the time value of money, i.e., the period of repayment of the claimed Inter Corporate Deposits was not stipulated, and that the claim of AAA Landmark Pvt. Ltd as a financial creditor in Form C was filed after the expiry of the period for filing such a claim.

5. Aggrieved by the rejection of their claim as financial creditors, AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd filed applications before the National Company Law Tribunal to be included in the Committee of Creditors. The National Company Law Tribunal by its order dated 30 May 2018 allowed them to submit their claims as financial creditors with a direction to the Interim Resolution Professional to consider the claims. None of the creditors on the Committee of Creditors were represented in the proceedings.

6. The voting share of Phoenix Arc Pvt. Ltd was reduced to 4.28% on account of AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd is included in the Committee of Creditors. After the meeting with Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd on 1 June 2018, Phoenix Arc Pvt. Ltd and YES Bank filed applications under Section 60(5)(c) of the Insolvency and Bankruptcy Code, 2016 seeking reconstitution of Committee of Creditors in terms of the Insolvency and Bankruptcy (Amendment) Ordinance 2018, and The removal of Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd from the Committee of Creditors and prohibition on their voting respectively. By an order dated 19 July 2019 of the National Company Law Tribunal, (National Company Law Tribunal or Adjudicating Authority) held that AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd has to be excluded from the Committee of Creditors formed concerning the Corporate Insolvency Resolution Process initiated against Corporate Debtor.

7. AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd preferred an appeal under Section 61 of the Insolvency and Bankruptcy Code, 2016 to assail the aforesaid order which was dismissed by National Company Law Appellate Tribunal by a judgment dated 27 January 2020.

8. Through appeal under Section 62 of Insolvency and Bankruptcy Code, 2016 Phoenix Arc Pvt. Ltd challenged the finding of the National Company Law Appellate Tribunal about Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd being financial creditors as erroneous.

9. Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd filed an appeal under Section 62 to assail the decision of the National Company Law Appellate Tribunal affirming their exclusion from participating in the Committee of Creditors 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 Insolvency and Bankruptcy Code, 2016.

Issues of the Case

Whether Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd are financial creditors of the Corporate Debtor?

Whether Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd are related parties of the Corporate Debtor?

Whether Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd can be excluded from the Committee of Creditors?

The Observations of the Court

The Honourable Supreme Court Observed that:

1. The order of the National Company Law Tribunal dated 31 May 2018 did not operate as res judicata as it was passed without furnishing an opportunity of being heard to the financial creditors such as Phoenix Arc Pvt. Ltd and YES Bank. Hence, they were legitimately within their rights in seeking a direction for the exclusion of AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd from the Committee of Creditors, if they were aggrieved by the terms of that order.

2. National Company Law Tribunal in its decision on 19 July 2019 concluded that the transaction between the corporate debtor, and Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd was not a financial debt under Section 5(8) as they were collusive and Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd was not a financial creditor under Section 5(7). National Company Law Appellate Tribunal affirmed the same.

3. The National Company Law Tribunal held that Arun Anand and his companies, namely, Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd Landmark were related parties to the Corporate Debtor. However, soon after signing the Agreement to sell, he resigned from all the companies of The Anil Nanda Group and so they were no longer related to the Corporate Debtor at the time of filing of application of Corporate Insolvency Resolution Process.

4. However, it was noted that the first proviso to Section 21(2) has been substituted with effect from 6 June 2018, the effect of which is to exclude a financial creditor who is a related party of the corporate debtor from being represented in and from participating or voting in a meeting of the Committee of Creditors.

5. Section 21(2) stipulates that the Committee of Creditors comprises all financial creditors of the corporate debtor. The first proviso to Section 21(2) was amended in 2018. Having held that AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd are not financial creditors, National Company Law Tribunal concluded that they were not entitled to inclusion in the Committee of Creditors. It noted the deep entanglement of the affairs of the corporate debtor and the Arun Anand group of companies, the close business relationship of the past, and the fact that the accounts of the corporate debtor had not been finalized, audited, or filed with the Registrar of Companies since 2016.

6. Under Section 5(7) of the Insolvency and Bankruptcy Code, 2016, a person can be categorized as a financial creditor if a financial debt is owed to it. Section 5(8) of the Insolvency and Bankruptcy Code, 2016 stipulates that the essential ingredient of financial debt is disbursal against consideration for the time value of money. [Swiss Ribbons Pvt. Ltd. v. Union of India, (2019) 4 SCC 17]

7. The expression "disbursed" refers to money that has been paid against consideration for the "time value of money". The "disbursal" must be money and must be against consideration for the "time value of money", meaning thereby, the fact that such money is now no longer with the lender, but is with the borrower, who then utilizes the money. [Pioneer Urban Land and Infrastructure Ltd v. Union of India, (2019) 8 SCC 416]

8. The term "time value" has been interpreted to mean compensation or the price paid for the length of time for which the money has been disbursed. This may be in the form of interest paid on the money or factoring of a discount in the payment. [Report of the Insolvency Law Committee, 26 March 2018]

9. The money advanced as debt should be received by 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 time for which the money is lent.

10. “Sham transactions” means acts are done or documents executed by the parties to the “sham” which are intended by them to give to third parties or the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create. All the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a “shammer” affect the rights of a party whom he deceived. [Snook v. London and West Riding Investments Ltd, (1967) 2 QB 786]

11. The Insolvency and Bankruptcy Code, 2016 recognizes that for the success of an insolvency regime, the real nature of the transactions has to be unearthed to prevent any person from taking undue benefit of its provisions to the detriment of the rights of legitimate creditors. The Insolvency and Bankruptcy Code, 2016 contains provisions for identifying, annulling, or disregarding “avoidable transactions” that distressed companies may have undertaken to hamper the recovery of creditors in the event of the initiation of the Corporate Insolvency Resolution Process. Such avoidable transactions include:

a. Preferential transactions under Section 43.

b. Undervalued transactions under Section 45(2).

c. Transactions defrauding creditors under Section 49.

d. Extortionate transactions under Section 50.

12. National Company Law Tribunal noted that the Memorandum of Understanding, based on which Spade Financial Services Pvt. Ltd had filed its claim in Form C before the Interim Resolution Professional, which was signed two years after the commencement of the purported transaction. The execution of the Memorandum of Understanding was sought to be explained on the basis that a formal document was created for specifying the rate of interest on the Inter Corporate Deposits given by Spade Financial Services Pvt. Ltd to the Corporate Debtor. However, despite the creation of a formal document, the rate of interest being charged on the Inter Corporate Deposits was 12% as mentioned in the claim before the Interim Resolution Professional, which is half of the interest rate of 24%, stipulated in the Memorandum of Understanding.

13. The Memorandum of Understanding was unregistered and unstamped. The Interim Resolution Professional in his letter dated noted that as per the ledger provided by Spade Financial Services Pvt. Ltd, no interest was claimed on the alleged debt and no adjustment was made regarding the payment of principal or interest by the Corporate Debtor to Spade Financial Services Pvt. Ltd. The written submissions filed on behalf of Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd revealed that the auditors of the Corporate Debtor had been putting a note in its balance sheets stating that the interest of 12% was not being paid to Spade Financial Services Pvt. Ltd due to a dispute. This submission fortified the finding of the Interim Resolution Professional that no interest has been paid on the alleged loan. The Memorandum of Understanding did not stipulate the period of repayment. Hence, the consideration for the time value of money was absent, which is an essential ingredient of financial debt.

14. The major portion of the Inter Corporate Deposits was credited in the account of Mr. Arun Anand holding that the entire amount was not “disbursed” to the Corporate Debtor. No Board resolution was passed by Spade Financial Services Pvt. Ltd approving the grant of Inter Corporate Deposits and the charge created on the loan was not registered with the Registrar of Companies. Thus, the Memorandum of Understanding was an eye-wash and collusive. It appeared that the parties converted the Development Agreement into an Agreement to sell executed along with a Side Letter to circumvent the legal prohibition on splitting a development license into two parts. It would not constitute a ‘financial debt’. Hence Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd were not financial creditors of the Corporate Debtor.

15. The definition of ‘related party’ under Section 5(24) of the Insolvency and Bankruptcy Code, 2016 is significantly broad. The intention of the legislature in adopting such a broad definition was to capture all kinds of interrelationships between the financial creditor and the corporate debtor.

16. Mr. Arun Anand had held multiple positions in companies that form part of Anil Nanda Group of Companies. Further, Mr. Anil Nanda has himself invested in companies owned by Mr. Arun Anand and had commercial transactions with them. Through Spade Financial Services Pvt. Ltd and AAA’s admission, Mr. Arun Anand was appointed as the Group CEO of the Anil Nanda Group of Companies (for however short a period) on circular approval by Mr. Anil Nanda himself. Finally, Mr. Arun Anand’s brother-in-law, Mr. Sonal Anand, was also consistently associated with companies in the Anil Nanda Group of Companies, including the Corporate Debtor and JIPL. This deep entanglement between these individuals was noted by the National Company Law Tribunal and the National Company Law Appellate Tribunal. Thus, Mr. Arun Anand would be a related party of the Corporate Debtor under Section 5(24)(h) and Sections 5(24)(m)(i).

17. A collective process is considered superior for creditors as individual creditors, left to their whims, are motivated to act solely in their interests, even when their interests may directly conflict with the creditors’ collective interests as a group. Bankruptcy law seeks to resolve this by preventing individual creditor action. The creditor’s bargain theory, therefore, operates to maximize group welfare through collectivization.

18. In India, the Insolvency and Bankruptcy Code, 2016 adopts a Corporate Insolvency Resolution Process operationalized through the Committee of Creditors after Corporate Insolvency Resolution Process commences. The design of the Insolvency and Bankruptcy Code, 2016 is also influenced by the value-based theory postulated by Korobkin. The aim of bankruptcy law under this theory is to take into account the multidimensional but conflicting interests of various claimants and provide for a solution whereunder each claimant derives optimal value.

19. The Committee of Creditors is comprised of financial creditors, under the loan and debt contracts, who have the right to vote on decisions and operational creditors such as employees, rental obligations, utility payments, and trade credit, who can participate in the Committee of Creditors but do not have the right to vote. The Committee of Creditors aims to enable coordination between various creditors to ensure that the interests of all stakeholders are balanced, and the value of the assets of the entity in financial distress is maximized.

20. The objects and purposes of the Code are best served when the Corporate Insolvency Resolution Process is driven by external creditors, to ensure that the Committee of Creditors is not sabotaged by parties related to the corporate debtor. This is the intent behind the first proviso to Section 21(2) which disqualifies a financial creditor or the authorized representative of the financial creditor under Section 24(5), 24(6), 24(6A) 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.

21. The amendment of 2018 was needed to extend such disqualification in the first proviso of Section 21(2) to authorized representatives of financial creditors mentioned in Sections 21(6), 21(6A), and Section 24(5) as well.

22. In Arcelor Mittal India Pvt. Ltd v. Satish Kumar Gupta, (2019) 2 SCC 1 the Court also approved purposive interpretation in light of the context, object, and purpose for which the provision was enacted; in a manner which would advance the object and purpose of the statute and not lead to its provisions being defeated by disingenuous strategies. 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 (in the present time).

23. However, the exclusion under the first proviso to Section 21(2) is related not to the debt itself but 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 Committee of Creditors. However, in a 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 in the Committee of Creditors and sabotage the Corporate Insolvency Resolution Process, by diluting the vote share of other creditors or otherwise, in keeping with the object and purpose of the first proviso to Section 21(2), it would consider the formerly related party creditor, as one debarred under the first proviso.

24. Hence, those related party financial creditors that cease to be related parties to circumvent the exclusion under the first proviso to Section 21(2), should also be considered as being covered by the exclusion thereunder; otherwise, a related party financial creditor can devise a mechanism to remove its label of a ‘related party’ before the Corporate Debtor undergoes Corporate Insolvency Resolution Process, to enter the Committee of Creditors and influence its decision making at the cost of other financial creditors.

25. In the present case, AAA Landmark Pvt. Ltd and Spade Financial Services Pvt. Ltd were related parties within the meaning of Section 5(24) at the time when the alleged financial debt based on which they assert a claim to be a part of the Committee of Creditors was created. This was due to the long-standing relationship between Mr. Arun Anand and Mr. Anil Nanda, and their respective corporations. Admittedly, such a relationship still existed even in 2017, since Mr. Anil Nanda’s JIPL held shareholding in Mr. Arun Anand’s Spade Financial Services Pvt. Ltd. Further, the transactions between Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd on one hand, and the Corporate Debtor on the other hand, which gave rise to their alleged financial debts were collusive. Therefore, there existed a deeply entangled relationship between Spade Financial Services Pvt. Ltd, AAA, and Corporate Debtor, when the alleged financial debt arose.

26. Although their status as related parties did no longer stand, it was due to commercial contrivances through which these entities sought to enter the Committee of Creditors. The pervasive sway of Mr. Anil Nanda (the promoter/director of the Corporate Debtor) over these entities was apparent, and allowing them in the Committee of Creditors would undeniably affect the other independent financial creditors.

The Decision Held by the Court

The Supreme Court disposed of the appeals with the following order:

1. The decision of the National Company Law Appellate Tribunal, referring to Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd as financial creditors was set aside. Due to the collusive nature of their transactions alleged to be a financial debt under Section 5(8), Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd were not financial creditors under Section 5(7).

2. The decision of the National Company Law Appellate Tribunal, referring to Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd as related parties of the Corporate Debtor under Section 5(24), was affirmed.

3. The decision of the National Company Law Appellate Tribunal, excluding Spade Financial Services Pvt. Ltd and AAA Landmark Pvt. Ltd from the Committee of Creditors following the first proviso of Section 21(2), was affirmed.

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