Related party exclusion cannot be avoided through divestment 

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Related party exclusion cannot be avoided through divestment 

Financial creditors that cease to be related parties in order to circumvent the exclusion under the Insolvency and Bankruptcy Code, 2016, should also be considered as being covered by the exclusion, according to a recent decision by the Supreme Court in Phoenix Arc Private Limited v Spade Financial Services Limited.

The first proviso to section 21(2) of the code provides that a financial creditor that is not a related party would not be debarred from being a member of the committee of creditors.

Justices DY Chandrachud, Indira Banerjee and Indu Malhotra were hearing appeals against an order of the National Company Law Appellate Tribunal (NCLAT) that dismissed the appeal under section 61 of the code, made by AAA Landmark and Spade Financial Services challenging an order of the National Company Law Tribunal (NCLT). However, though the NCLAT correctly dismissed the appeal filed by AAA Landmark and Spade, holding that they are related parties of the corporate debtor and are hence to be excluded from the committee of creditors, there was an erroneous finding that they are financial creditors.

Phoenix Arc, one of the other members of the creditors committee, challenged the aforementioned finding before the Supreme Court. The Supreme Court held 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. In the case where the related party financial creditor divests itself of its shareholding or ceases to be a related party in a business capacity with the sole intention of participating in the creditors committee and sabotaging the corporate insolvency resolution process, by diluting the votes 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.

If this interpretation is not given to the first proviso, then a related party financial creditor can devise a mechanism to remove its status as a “related party” before the corporate debtor undergoes the corporate insolvency resolution process, so as to be able to enter and influence the decision making of the creditors committee at the expense of other financial creditors, the court said.

The Supreme Court further held that such transactions that are collusive in nature and entered into with the purpose of ceasing to be a related party of the corporate debtor in order to become part of the committee of creditors are barred.


The dispute digest is compiled by Numen Law Offices, a multi-disciplinary law firm based in New Delhi & Mumbai. The authors can be contacted at support@numenlaw.com. Readers should not act on the basis of this information without seeking professional legal advice.