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Related Party Financial Debt under IBC

Related Party Financial Debt under IBC
Exclusion from the CoC and impact of assignment

Background

The regime under the Insolvency and Bankruptcy Code, 2016 (“IBC”), is largely creditor centric.
In fact, extraordinary as it may sound, corporate insolvency resolution process (“CIRP”) under
IBC is nothing short of a puppet show, with the Committee of Creditors (“CoC”) as the puppet
master. The CoC, comprising of financial creditors of the corporate debtor, is paramount in terms
of making the most significant decisions of the process and plays a vital role in resolving the debt.

Exclusion of Related Parties from the CoC

Given the crucial role of the CoC, the IBC1 prohibits inclusion of related party financial creditors
into the CoC. And rightly so, as the object and purpose of IBC would be best served when CIRP is
driven by external creditors, so as to ensure that the CoC is not sabotaged by related parties of the
debtor.

Since the IBC attempts to balance the interests of all stakeholders, such that some stakeholders are
not able to benefit at the expense of others, related party financial creditors are disqualified from
being represented, participating or voting in the CoC, so as to prevent them from controlling the
CoC to unfairly benefit the corporate debtor

Even the UNCITRAL Legislative Guide on Insolvency Law4, recommends exclusion of related
parties from the CoC.

Impact of Assignment of Debt

Assignment of financial debt is not uncommon in India. Besides assignment of debt amongst the
institutional financial creditors, often, we have come across assignment of debt by an agreement to
entities other than financial institutions including but not limited to mergers and de mergers
resulting in assignment of rights and liabilities.

While the IBC is clear that a related party of the Debtor cannot be a member of the CoC, an
interesting question that arose for consideration was whether the assignee of such related party debt
would also suffer from the same handicap or the embargo on a related party from participating in
the resolution process would extend to the unrelated assignee of the debt?

One of the early judgments on this issue came during the nascent years of IBC, where the National
Company Law Appellate Tribunal (“NCLAT”)5 was faced with a situation where a promoter
assigned his debt to an erstwhile director of the corporate debtor, who was then admitted as a

  1. Section 21 and 24 of IBC
  2. Report of the Insolvency Law Committee, March 2018
  3. Vidhi Centre for Legal Policy, Understanding the Insolvency & Bankruptcy Code, 2016
  4. UNCITRAL Legislative Guide on Insolvency, 2005
  5. Pankaj Yadav v State Bank of India Ltd., Company Appeal (AT) (Insolvency) No. 28/2018

member of the CoC. This was challenged by a Bank which was also a member of the CoC. In a
short and crisp Judgment, the NCLAT held that the assignment could not change the nature of the
debt. Examining the facts, the NCLAT held that rights of the assignee could not be better than the
rights of the assignor and therefore, the assignee would also take over any disadvantages attached
to the debt. Concluding its Order, the NCLAT also observed that what the promoter could not have
achieved directly, could not be done through an assignee.

In early 2021, the Supreme Court of India6 was also faced with the same conundrum where a
financial creditor sought to enter the CoC basis a convoluted arrangement with a related party of
the debtor. After examining the provisions of IBC in light of the legislative intent, the Supreme
Court held that the exclusion of related parties from CoC is related not to the debt but to the
relationship existing between a related party financial creditor and the debtor. As such, a financial
creditor who in praesenti is not a related party, would not be debarred from being a member of the
CoC. The Court, however, clarified that if a related party financial creditor ceases to be a related
party with the sole intention of participating in the CoC and sabotage the CIRP, by diluting the vote
share of other creditors or otherwise, the disqualification should apply to such party as well.

Conclusion

The two judgments discussed above are premised on the same purport that the CoC must be
protected from related party influence and that a related party financial creditor who devises a
mechanism to remove its “related party” label should not be permitted to participate in the CoC.
However, there is a fundamental difference between the judgment of the NCLAT and the Supreme
Court – being that while the NCLAT held that the disqualification attached itself to the debt
resulting in a continued disqualification for any creditor that owns that debt, the Supreme Court
took a more liberal view of the matter. Relying on the Insolvency Law Committee Report of 2020,
the Supreme Court held that the disqualification is not related to the debt itself but is based on the
relationship existing between the corporate debtor and related party creditor. Thus, effectively
while a related party creditor does not have the right to become a member of the CoC, the assignee
of such a related party creditor may have this right. This is as such contrary to the settled principle
that the assignor cannot assign a right which she never had.

The question whether the assignee of a related party debt or any other person claiming to be a
financial creditor through a related party should be admitted as a member of the CoC has to be
examined on a case-to-case basis after applying the test laid down by the Supreme Court.

 

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