Phoenix Arc Private Limited vs Spade Financial Services Limited & Ors.

Insolvency and Bankruptcy Code, 2016 – ss.43, 45(2), 49,

50 – “avoidable transactions” – Held: 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 Corporate Insolvency Resolution Process (CIRP) – 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.

Insolvency and Bankruptcy Code, 2016 – s.5(24) – ‘related party’ – Held: Definition of the expression ‘related party’ in s.5(24) is exhaustive – The definition describes a commutative relationship – The definition of ‘related party’ under IBC is significantly broad – The intention of the legislature in adopting such a broad definition was to capture all kinds of inter-relationships between the financial creditor and the corporate debtor.

Insolvency and Bankruptcy Code, 2016 – First proviso to s.21(2), s.5(24) – Exclusion under first proviso to s.21(2) – Application of – Held: While the default rule under the first proviso to s.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 s.21(2), should also be considered as being covered by the exclusion thereunder – In the present case, there is a finding that AAA and Spade were related parties within the meaning of s.5(24) at the time when the alleged financial debt on the basis of which they assert a claim to be a part of the CoC was created – 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 – 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, this was due to commercial contrivances through which these entities seek to now enter the CoC – The pervasive influence of the promoter/director of the Corporate Debtor over these entities is clear, and allowing them in the CoC would definitely affect the other independent financial creditors.

Insolvency and Bankruptcy Code, 2016 – First proviso to s.21(2) – Object and purpose for enactment – Amendment to First proviso to s.21(2) – Reason for – Discussed.

Words & Phrases – “disburse”, “time value of money” – Meaning of – Discussed – Insolvency and Bankruptcy Code, 2016 – s.5(8).

Disposing of the appeals, the Court

HELD: 1.1 The order of the NCLT dated 31 May 2018 did not operate as res judicata. The order was passed without hearing financial creditors such as Phoenix and YES Bank. Hence, they were legitimately within their rights in seeking a direction for the exclusion of AAA Landmark Private Limited (AAA) and Spade Financial Services Private Limited (Spade) from the CoC, if they were aggrieved by the terms of that order. The earlier order was passed without furnishing them with an opportunity of being heard. [Para 31][1103-F; 1104-A-B]

1.2 The argument that the issue of the eligibility of Spade and AAA as financial creditors was never raised before the NCLT is contrary to the material produced on record. The NCLT’s order dated 19 July 2019 was passed after arguments were led on the real nature of transactions between the parties. [Para 32][1104B; 1104-D-E]

1.3 Sub-section (2) of Section 21 stipulates that the CoC is to comprise of all financial creditors of the corporate debtor. The first proviso to Sub-section (2) has been amended by Act 26 of 2018 with effect from 6 June 2018. Having held that AAA and Spade are not financial creditors, NCLT came to the conclusion that they were not entitled to inclusion in the CoC. The Adjudicating Authority was of the view that it was not really necessary for it to consider what should be the date with reference to which a related party should be determined. But it is evident that the NCLT did come to the conclusion that Mr. Arun Anand and his various companies namely AAA and Spade were related parties to the corporate debtor though after 2013, Mr Arun Anand resigned from all the companies of the Anil Nanda Group. The Adjudicating Authority observed that they are no longer related to the corporate debtor at the time of the filing of the application for initiation of the CIRP. 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 finalised, audited or filed with the Registrar of Companies since 2016. Reading the order of the NCLT as it stands, it is not possible to accept the submission that the applications filed by YES Bank and Phoenix were 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. In light of the above discussion, the submission that NCLAT exceeded its jurisdiction by considering the second issue relating to the determination of the status of AAA and Spade as related parties not agreed with. Thus, there is no reason to remand the matter to NCLAT for reconsideration. An order of remand cannot be passed in a routine manner, and it should be passed only if a re-consideration is necessary. An unwarranted order of remand does not serve the cause of justice and merely extends the life of litigation. [Paras 38, 39][1108-A-C; 1108-C-G]

2. Under Section 5(7) of the IBC, a person can be categorised 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. [Para 43][1110-E-F]

Swiss Ribbons Pvt. Ltd. v. Union of India (2019) 4 SCC

17 : [2019] 3 SCR 535; Pioneer Urban Land and Infrastructure Ltd vs. Union of India (2019) 8 SCC 416 : [2019] 10 SCR 381 – relied on.

3. Collusive Transactions

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. The 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 the IBC; (ii) undervalued transactions under Section 45(2) of the IBC; (iii) transactions defrauding creditors under Section 49 of the IBC; and (iv) extortionate transactions under Section 50 of the IBC. The 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. [Paras 46, 48][1112-B-C; 1114-A-C]

Prem Chand Tandon v. Krishna Chand Kapoor (1973)

2 SCC 366 – relied on.

Snook v. London and West Riding Investments Ltd. [1967] 2 QB 786 – referred to.

4. Spade and AAA

NCLT in its order dated 19 July 2019 has undertaken a detailed analysis of the transactions to arrive at a finding that the transactions were collusive. The findings of the NCLT in its order dated 19 July 2019 are agreed with. As noted by NCLT, the Memorandum of Understanding dated 12 August 2011, on the basis of which Spade had filed its claim in Form C before the IRP, 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 (ICDs) given by Spade to the Corporate Debtor. However, despite the creation of a formal document, the rate of interest being charged on the ICDs was 12% as mentioned in the claim before the IRP, which is half of the interest rate of 24% stipulated in the Memorandum of Understanding. During the arguments, it was also brought to the notice of this Court that the Memorandum of Understanding is unregistered and unstamped. The IRP in his letter dated 25 May 2018 has noted that as per the ledger provided by Spade, 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. It has been submitted in the written submissions filed on behalf of Spade and AAA 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 due to a dispute. This submission in fact further fortifies the finding of the IRP that no interest has been paid on the alleged loan. The IRP has also noted in his letter that the Memorandum of Understanding does not stipulate the period of repayment. Hence, the consideration for time value of money is absent, which is an essential ingredient of a financial debt. The NCLT has also noted that a major portion of the ICDs was credited in the account of Mr Arun Anand holding that the entire amount was not “disbursed” to the Corporate Debtor. NCLAT has also made a similar finding in paragraph 11(i) of its judgement. Under Clause 2 of the Memorandum of Understanding, the amount of Rs. 26.55 Crores has been disbursed not only to the Corporate Debtor but also to “other companies on behalf of AKME”. In any event, the entirety of the ICDs were not disbursed to Spade. Additionally, no Board resolution was passed by Spade approving the grant of ICDs and the charge created on the loan was not registered with the Registrar of Companies. The Memorandum of Understanding was an eye-wash and collusive. NCLT in its order dated 19 July 2019 has noted that AAA and the Corporate Debtor had entered into multiple agreements 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. Since the Development Agreement could not be implemented because the license for the project could not be split into two parts, an Agreement to Sell and a Side Letter were executed on 25 October 2012. The Agreement to Sell was entered to purchase FSI/flats equivalent to 38.3% of the total FSI in relation to specific units identified and allotted in the agreement. Apparently, the sale consideration was re-negotiated and enhanced from Rs 32.80 crores under the Development Agreement to Rs 86.01 crores under the Agreement to Sell. Clause 3 of the Side Letter dated 25 October 2012 shows that the intent of the parties was to continue to co-develop the land. It appears 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. The transaction between AAA and the Corporate Debtor was collusive in nature. Since 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. [Paras 49-52][1115F-H; 1116-A-H; 1117-A-G]

5. Whether Spade and AAA are related parties

The definition of the expression ‘related party’ in Section 5(24) is exhaustive, since the expression is defined to “mean” what is set out in clauses (a) to (m). The expression ‘related party’ is defined in Section 5(24) in relation to a corporate debtor. Section 5(24A) provides a corresponding definition in relation to an individual. The definition describes a commutative relationship, meaning that X can be a related party of Y, if either X is related to Y, or Y is related to X. The definition of ‘related party’ under the IBC is significantly broad. The intention of the legislature in adopting such a broad definition was to capture all kinds of inter-relationships between the financial creditor and the corporate debtor. While understanding the meaning of ‘related party’ in the context of the IBC, it is important to keep in mind that it was defined to ensure that those entities which are related to the Corporate Debtor can be identified clearly, since their presence can often negatively affect the insolvency process. It is not difficult to accept the conclusion of the NCLAT that Mr Arun Anand would be a related party of the Corporate Debtor in accordance with Section 5(24)(h) and Sections 5(24)(m)(i). Presently, the court has to determine whether the Corporate Debtor’s board, directors, etc, are accustomed to act on Mr Arun Anand’s advice/direction/instruction and if he participates in the policy-making process 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 and Mr Anil Nanda, and Mr Arun Anand did hold positions during this period which could have been used by him to guide the affairs of the Corporate Debtor. This finding is further supported by conclusion that the transactions between the Corporate Debtor and the entities led by Mr Arun Anand were collusive in nature. The NCLAT’s conclusion that Spade entered into two transactions on the basis of the advice/instructions/directions of the board/directors of the Corporate Debtor under Section 5(24)(f) is accepted. As already held, the transactions between AAA and the Corporate Debtor were collusive in nature. This supports the findings of the NCLAT that the Agreement to Sell and Side Letter dated 25 October 2012 were a mere eye-wash, through which they sought to develop the AKME RAAGA project together while circumventing government guidelines. Hence, AAA would be a partner of the Corporate Debtor within the meaning of Section 5(24)(a). Mr Arun Anand, Spade and AAA were related parties of the Corporate Debtor during the relevant period when the transactions on the basis of which Spade and AAA claim their status as financial creditors took place. [Paras 57-59, 62-65][1120-B-C; 1121-E-G; 1122-G-H; 1123-AH]

6. Amendment to First Proviso of Section 21(2) 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. [Para 81][1132-B-C]

7. Related Parties - Interpretation In Praesenti 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. 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 the corporate debtor, the exclusion which is created by the first proviso to Section 21(2) must apply. For, it is on the strength of the financial debt as defined in Section 5(8) that an entity claiming as a financial creditor under Section 5(7) seeks a position on the CoC under Section 21(2). If the definition of the expression ‘related party’ under section 5(24) applies at the time when the debt was created, the exclusion in the first proviso to Section 21(2) would stand attracted. However, 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 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. Thus, it has been clarified 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 CIRP, 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. Hence, 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. In the present case, there is a finding that AAA and Spade were related parties within the meaning of Section 5(24) at the time when the alleged financial debt on the basis of which they assert a claim to be a part of the CoC was created. This was due to the longstanding 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. Further, 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, this was due to commercial contrivances through which these entities seek to now enter the CoC. The pervasive influence of Mr Anil Nanda (the promoter/director of the Corporate Debtor) over these entities is clear, and allowing them in the CoC would definitely affect the other independent financial creditors. [Paras 90-92, 9496][1138-G-H; 1139-D-F; 1140-G-H; 1141-A-G]

8. The decision of the NCLAT, in as much as it referred to Spade and AAA as financial creditors, is set aside. Due to the collusive nature of their transactions alleged to be a financial debt under Section 5(8), Spade and AAA cannot be labelled as financial creditors under Section 5(7). The decision of the NCLAT, in as much as it referred to Spade and AAA as related parties of the Corporate Debtor under Section 5(24), is affirmed. The decision of the NCLAT, in as much as it excluded Spade and AAA from the CoC in accordance with the first proviso of Section 21(2), is affirmed but for the reasons mentioned above. [Para 97][1141-GH; 1142-A-C] Arcelor Mittal India (P) Ltd. v. Satish Kumar Gupta (2019) 2 SCC 1 : [2018] 12 SCR 362 – relied on.

Abhay Singh Chautala v. C.B.I. (2011) 7 SCC 141 : [2011] 10 SCR 949; R.S. Nayak v. A.R. Antulay (1988)

2 SCC 602 : [1988] 1 Suppl. SCR 1 – referred to. Richa Saraf, ‘Concept of Related Party: Interpretation by Letter or Spirit of the IBC?’, (IndiaCorpLaw, 11 August 2018); Thomas H. Jackson, ‘Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain’, 91 Yale Law Journal 857, (1982) at 859-71; Medha Shekar and Anuradha Guru, Theoretical Framework of Insolvency Law; Douglas G. Baird, ‘A World Without Bankruptcy’, 50 Law & Contemporary Problems, Spring 1987; D.R. Korobkin, Rehabilitating values: A jurisprudence of bankruptcy, 91 Columbia Law Review (1991), Bankruptcy Law Reforms Committee, Volume I: Rationale and Design, of November 2015; Report of the Insolvency Law Committee, March 2018; Vidhi Centre for Legal Policy, Understanding the Insolvency and Bankruptcy Code, 2016: Analysing Developments in Jurisprudence; UNCITRAL, Legislative Guide on Insolvency Law, 2005; G.P. Singh, Principles of Statutory Interpretation (1st edn., Lexis Nexis 2015); Insolvency Law Committee Report, 2020.