The Supreme Court (“SC”) has in its judgement dated February 1, 2021 in the matter of Phoenix Arc Private Limited v. Spade Financial Services Limited and Others [Civil Appeal No. 2842 of 2020] (“Judgement”) held that those related party financial creditors that cease to be related parties in order to circumvent their exclusion from the committee of creditors, under the first proviso to Section 21(2) of the Insolvency and Bankruptcy Code, 2016 (“IBC”), should also be considered as being covered by the exclusion thereunder.

Facts
This Judgement governs two sets of appeals arising from the order of the National Company Law Appellate Tribunal (“NCLAT”) dated January 27, 2020. The NCLAT had dismissed the appeal preferred by AAA Landmark Private Limited (“AAA”) and Spade Financial Services Private Limited (“Spade”) against the National Company Law Tribunal, New Delhi Bench-III (“NCLT”) order dated July 19, 2019 (“NCLT Order”), which ruled that they needed to be excluded from the committee of creditors (“CoC”) formed for the corporate insolvency resolution process (“CIRP”) against AKME Projects Limited, the Corporate Debtor (“Corporate Debtor”). The first appeal was preferred by Phoenix Arc Private Limited (“First Applicant/ Appellant”), which, while agreeing with the NCLAT order of excluding Spade and AAA (collectively referred to as “Second Applicants/ Respondents”) from CoC, on account of being related parties of Corporate Debtor, disagreed with their being classified as financial creditors (“Financial Creditor”). Another appeal was independently filed by the Second Applicants to challenge the NCLAT order with regard to their exclusion from the CoC.

Mr. Anil Nanda, is a majority shareholder of Joint Investment Private Limited (“JIPL”), which in turn held a stake in Spade and 80% shareholding in the Corporate Debtor. The Corporate Debtor is a part of Anil Nanda Group of Companies (“Group Companies”). Mr. Arun Anand was the Group CEO of the Group Companies, which included the Corporate Debtor, from November 26, 2012 to February 14, 2013, and a director of the Second Applicants. Mr. Arun Anand was also a director of the Corporate Debtor up to March 31, 2002. Further, Mr. Arun Anand is the brother-in- law of Mr. Sonal Anand who was a director of the Corporate Debtor from 2007 to 2013, at the time when the relevant transactions between the Second Applicants and the Corporate Debtor took place. After February 2013, Mr. Arun Anand had no relation with the Corporate Debtor.

Spade had filed its claim as a Financial Creditor for a sum of INR 109 crores on May 20, 2018 on the basis of an alleged Memorandum of Understanding dated August 12, 2011 (“MOU”) executed with the Corporate Debtor, which stated that Inter Corporate Deposits (“ICDs”) were granted to the Corporate Debtor by Spade bearing an interest of 24%, though in actuality only 12% interest was charged. AAA, a wholly owned subsidiary of Spade, had entered into a Development Agreement on March 1, 2012 (“Development Agreement”), through which Corporate Debtor sold 38.3% of its development rights in its real estate project, AKME RAAGA, to AAA for INR 32.80 crores. Subsequently, an Agreement to Sell dated October 25, 2012 (“Agreement to Sell”), which superseded the Development Agreement was entered into, through which AAA bought a saleable area of 313,928 square feet in AKME RAAGA at a price of INR 43.06 crores. A side letter dated October 25, 2012 (“Side Letter”), which was to be read as a part of the Agreement to Sell, noted that the area bought by AAA was 38.3% of AKME RAAGA, and AAA would provide for the cost of its development accordingly.

The CoC was constituted on May 22, 2018. The Interim Resolution Professional (“IRP”) rejected the claim of Spade, inter alia, on the ground that the claim was not in the nature of a financial debt in terms of Section 5(8) (Financial debt) of the IBC, since there was an absence of consideration for the time value of money, that is, the period of repayment of the claimed ICDs was not stipulated. The IRP also rejected the claim of AAA on the ground that its claim as a Financial Creditor was filed after the expiry of the period for filing such a claim.
Aggrieved, the Second Applicants initiated proceedings before the NCLT, which, by its order on May 31, 2018 (“2018 Order”) allowed the applications. However, none of the other Financial Creditors, such as the First Applicant, were parties to these proceedings. Subsequently, on an application moved by the First Applicant and Yes Bank, another Financial Creditor of the Corporate Debtor, for the exclusion of Second Applicants from the CoC on the ground that they were related parties to the Corporate Debtor, the NCLT by its order dated July 19, 2019 ruled that Second Applicants were not Financial Creditors to the Corporate Debtor. In an appeal to the NCLAT by the Second Applicants, it was held that the Second Applicants were related parties to the Corporate Debtor, on the ground that, inter alia, during the transaction period, Spade led by Mr. Arun Anand was making financial arrangements on the advice of Corporate Debtor led by Mr. Anil Nanda, promoter of Corporate Debtor and Mr. Sonal Anand, brother-in-law of Mr. Arun Anand. One such arrangement was the MOU. The NCLAT also noted that AAA was a partner of the Corporate Debtor in accordance with Section 5(24)(a) (Related party) of the IBC. It further reasoned that Corporate Debtor was acting on the directions of Mr. Arun Anand, who, along with his family, was the majority shareholder in Spade, of which AAA is a wholly-owned subsidiary. Hence, NCLAT came to the conclusion that though the Second Applicants were admittedly Financial Creditors of the Corporate Debtor, the NCLT had rightly excluded the Second Applicants from participation in the CoC, since Mr. Anil Nanda, in concert with Mr. Arun Anand and his family, was trying to gain a backdoor entry into the CoC through the web of companies that were related parties to the Corporate Debtor. Aggrieved with the NCLAT order, both the First and Second Applicants moved the SC.

Issues
1. Whether Second Applicants were Financial Creditors of the Corporate Debtor.
2. Whether Second Applicants were related parties of the Corporate Debtor.
3. Whether Second Applicants should be excluded from the CoC.

Arguments
Contentions raised by the First Applicant:
The issue raised by the First Applicant against the NCLAT order was that while the NCLAT correctly dismissed the appeal file by the Second Applicants, deeming them to be related parties and thereby excluding them from the CoC, the NCLAT wrongly pronounced that the Second Applicants were “admittedly” Financial Creditors. This stance was never taken or admitted by the First Applicant and hence it sought to challenge this part of the NCLAT order. It was argued that the Second Applicants were not creditors, let alone Financial Creditors of the Corporate Debtor, as per Section 5(7) (Financial creditor) of the IBC. Further, it was contended that the Development Agreement was collusive in nature. AAA had sought to purchase 38.3% of the development rights in AKME RAAGA as a co-developer or partner. However, the development license granted by the government could not be sub-divided. As a result, the Corporate Debtor and AAA converted the Development Agreement into an unregistered Agreement to Sell. AAA had subsequently executed an unlawful Side Letter with the intention to co-develop the land and sell it in the market. Thus, it was argued that the intent of the parties was to circumvent the laws, government policies and regulations to continue developing the project. It was also argued that the MOU on the basis of which Spade submitted its claim was collusive and unenforceable and such claim was time barred. The IRP rejected the claim of Spade, inter alia, on the ground that the claim was not in the nature of a financial debt in terms of Section 5(8) of the IBC since there was an absence of consideration for the time value of money, that is, the period of repayment of the claimed ICDs was not stipulated. The IRP also rejected the claim of AAA on the ground that its claim as a Financial Creditor in Form C was filed after the expiry of the period for filing such a claim.

It was further submitted that Mr. Arun Anand incorporated the Corporate Debtor in 2003, which was subsequently acquired by Mr. Anil Nanda in 2007. During the relevant transactions with the Second Applicants, Mr. Arun Anand held the position of Consultant or Strategic Advisor to the Corporate Debtor, and later became the Group CEO of the Group Companies of which the Corporate Debtor was also a part. During this period, Mr. Arun Anand’s brother in-law, Mr. Sonal Anand, was a director of the Corporate Debtor. Further, he was also the whole-time director of JIPL, a wholly-owned subsidiary of the Corporate Debtor, and held shareholding in Spade, and Mr. Anil Nanda was a promoter/director of the Corporate Debtor. The litigation between Spade and the Corporate Debtor was initiated after the IBC came into force to create a notion of dispute. It was also argued that the provisions of Section 21(2) (Committee of creditors) of the IBC must be interpreted in a purposive manner so as to not defeat the fulfilment of the objects of the legislation.

Contentions raised by the Second Applicants:

It was submitted that the issue of whether or not they were Financial Creditors was dealt with by the 2018 Order and this operated as res judicata. The question of eligibility of the Second Applicants as Financial Creditors was never raised before the NCLT by First Applicant. The NCLT was strictly meant to deal with whether or not they were related parties of the Corporate Debtor. Subsequently, in the appeal before the NCLAT, the only issue that came into consideration was whether or not they were Financial Creditors. Though the NCLAT adjudged them to be Financial Creditors, it dismissed the appeal on the ground that they were related parties, which according to the Second Applicants, was an error of jurisdiction, since the question of them being related parties was not under consideration.

It was argued that there were no common key managerial personnel or directors between the Corporate Debtor and the Second Applicants during the relevant period of the transactions between 2010 to 2013. The NCLAT had incorrectly held that Mr. Arun Anand was in a position to influence the decision making of the Corporate Debtor, without satisfying the test of “control” established in Arcelor Mittal India Private Limited v. Satish Kumar Gupta [(2019) 2 SCC 1]. Mr. Arun Anand had no decision-making powers, nor could he influence any policy making decision. JIPL and through it, the Corporate Debtor held 1.45% in Spade, below the requisite 2% threshold in Section 5(24)(d) of the IBC. It was also argued that the Corporate Debtor and AAA were not partners according to Section 5(24)(a) of the IBC.

First proviso to Section 21(2) of the IBC denies the right of representation, participation or voting in a meeting of the CoC to a Financial Creditor or an authorized representative of the Financial Creditor, if it is a related party of the corporate debtor. Laying stress on the expression “‘is’ a related party of the corporate debtor”, the submission was that the statute applies in praesenti on the date of the admission of an application seeking the initiation of the CIRP. It was urged that the existence of a live link of being a related party in the present is a requirement of the statutory provision.

Observations of the Supreme Court

Eligibility as Financial Creditors:

Addressing the question of res judicata, the SC did not deem the 2018 Order as res judicata. The order was passed without hearing the other Financial Creditors, such as the First Applicant and YES Bank, hence they were well within their rights to seek direction for the exclusion of Second Applicants from the CoC, if they were aggrieved by the terms of the 2018 Order. Considering the question of jurisdiction of the NCLAT, the SC disagreed with the contention that the NCLAT had acted outside of its jurisdiction. On analyzing the NCLT Order, the SC could not accept the submission that the application filed by Second Applicants was rejected only on the basis that they were not Financial Creditors and that there was no determination in regard to their status as related parties, as the NCLT Order had dealt with those issues as well.

The SC observed that under Section 5(7) of the IBC, a person could be categorized as a Financial Creditor if a financial debt is owed to it. Section 5(8) of the IBC stipulates that the essential ingredient of a financial debt is disbursal against consideration for the time value of money. As per the report of the Insolvency Law Committee in 2018, “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. This may be in the form of interest paid on the money or factoring of a discount in the payment.”. 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. The SC noted that the IBC 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. A transaction is collusive when the real agreement between the parties is something other than advancing a financial debt. The SC observed that the MOU on the basis of which Spade staked its claim was unstamped and unregistered and did not stipulate a period of repayment. Hence, the consideration for time value of money was absent, which is an essential ingredient of a financial debt.

Analyzing the observations in the NCLT Order, the SC noted that the Corporate Debtor had entered into multiple agreements with AAA regarding the same property without giving any explanation or rationale regarding variation in the consideration. This showed that the transactions were collusive in nature entered with the purpose of diverting properties of the Corporate Debtor to AAA. The SC opined 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 in two parts. Thus, the transaction between AAA and the Corporate Debtor was collusive in nature.

Related Parties:
The SC found it extremely crucial to understand the relationship between Mr. Arun Anand and Mr. Anil Nanda. Mr. Arun Anand has held multiple positions in companies which form part of the Group Companies. Further, Mr. Anil Nanda has himself invested in companies owned by Mr. Arun Anand, and had commercial transactions with them. Through the Second Applicants’ own admission, Mr. Arun Anand was appointed as the Group CEO of the Group Companies on approval of Mr. Anil Nanda himself. Mr. Arun Anand’s brother in-law, Mr. Sonal Anand, had also been consistently associated with companies in the Group Companies, including the Corporate Debtor and JIPL. Mr. Arun Anand was in control of the Second Applicants during the relevant period. Further, he held positions in the Corporate Debtor or the Group Companies, which included the Corporate Debtor. Mr. Anil Nanda and Mr. Sonal Anand also held positions in the Corporate Debtor and JIPL during this period. Thus, Mr. Arun Anand would be a related party of the Corporate Debtor in accordance with Sections 5(24)(h) and 5(24)(m)(i) of the IBC. While determining whether Mr. Arun Anand participated in the policy-making process of the Corporate Debtor, the SC observed that there was a deep entanglement between the entities of Mr. Arun Anand and Mr. Anil Nanda, and Mr. Arun Anand held such positions at the time of the relevant transactions which could have been used by him to guide the affairs of the Corporate Debtor. The SC thus concluded that Spade undertook the transactions due to the pervasive influence of Mr. Anil Nanda. It was also decided that the transactions between AAA and Corporate Debtor were collusive in nature and thus AAA was a partner of the Corporate Debtor within the meaning of Section 5(24)(a) of the IBC.

Exclusion from the CoC:

The SC observed that the objects and purposes of the IBC 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 was the intent behind the first proviso to Section 21(2) of the IBC which disqualifies a Financial Creditor or the authorized representative of the Financial Creditor under Sections 24(5), 24(6) or 24(6A) of the IBC, 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. While considering the issue of interpretation in relation to the first proviso to Section 21(2) of the IBC as to whether the disqualification under the said proviso would attach to a Financial Creditor only in praesenti, the SC examined the object and purpose behind the enactment of the said proviso. The SC relied on Abhay Singh Chautala v. C.B.I. [(2011) 7 SCC 141], where the court did not interpret the word “is” in praesenti because that would lead to an absurd result, defeating the purpose of the concerned proviso, that is, Section 19(1) of the Prevention of Corruption Act, 1947. 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 SC noted that exclusion under the first proviso to Section 21(2) of the IBC was related not to the debt itself but to the relationship existing between a related party Financial Creditor and the corporate debtor. Therefore, the Financial Creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC. However, 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) of the IBC, should also be considered as being covered by the exclusion. If this was not done, the related party to the Financial Creditor can devise a mechanism to remove its label of a ‘related party’ before the corporate debtor undergoes CIRP, so as to be able to enter the CoC and influence its decision making at the cost of other Financial Creditors. The SC observed the presence of a deeply entangled relationship between Spade, AAA and the Corporate Debtor, when the alleged financial debt arose. It concluded that though their status as related parties no longer existed, it was due to commercial contrivances through which they sought to enter the CoC, that they could not be allowed to be a part of the CoC.

Decision of the Supreme Court

Partially upholding the NCLAT order, the SC held that since the commercial arrangements between Second Applicants and the Corporate Debtor were collusive in nature, they would not constitute a ‘financial debt’. Hence, it was held that the Second Applicants were not Financial Creditors of the Corporate Debtor. Mr. Arun Anand and the Second Applicants were related parties of the Corporate Debtor during the relevant period when the transactions on the basis of which the Second Applicants claimed their status as Financial Creditors took place. Thus, it was held that the pervasive influence of Mr. Anil Nanda over these entities was clear, and allowing them in the CoC would definitely affect the other independent Financial Creditors. Contrary to what the NCLAT had observed, the Second Applicants could not be called Financial Creditors.

Vaish Associates Advocates View:

The key takeaway from this Judgement is that the SC has ensured that the sanctity of the CoC is not compromised by the action of a corporate debtor who through its related parties tries to gain backdoor entry into the CoC by way of collusive transactions. Merely because a Financial Creditor conveniently removes the label of related party from itself, just before the corporate debtor enters into CIRP, with the sole intention of participating in the CoC and sabotaging the CIRP, it cannot be granted the advantage of being included in the CoC.

The SC has also recognized that, for the success of the IBC, it is imperative that the true nature of the transactions be unearthed so as to prevent any person from taking undue advantage of its provisions to the detriment of the rights of the rightful creditors and has hence excluded collusive transactions from the ambit of financial debt. Thus, by this path breaking Judgement, the SC has precluded the opportunity for unscrupulous parties from staking a claim in the CoC and exploiting the provisions of the IBC based on collusive transactions to their advantage.

…
For more information please write to Mr. Bomi Daruwala at [email protected]

DOWNLOAD PDF FILE