Financial debt between related parties under the IBC – CoC exclusion and impact of disposal

Background

The regime provided by the Insolvency and Bankruptcy Code, 2016 (“IBC”), is largely creditor-centric. In fact, as extraordinary as it may seem, the process of resolving corporate insolvency (“CIRP”) under IBC is nothing less than a puppet show, with the Committee of Creditors (“CoC”) as a puppeteer. The CoC, made up of the financial creditors of the debtor company, is paramount in making the most important decisions in the process and plays a vital role in settling the debt.

Exclusion of related parties from the CoC

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

Since the IBC attempts to balance the interests of all stakeholders such that some stakeholders are not able to benefit from it to the detriment of others, financial creditors of related parties are disqualified from being represented, participate or vote in the CoC, to prevent them from controlling the CoC to unfairly benefit the debtor company.

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

Impact of the assignment of debt

Assignment of financial debts is not uncommon in India. In addition to the assignment of debt between institutional financial creditors, we have often encountered the assignment of debt by agreement to entities other than financial institutions, including, but not limited to, mergers and mergers resulting in an assignment of rights and responsibilities.

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

One of the first judgments on this issue was made during the early years of the IBC, where the National Company Law Appellate Tribunal (“NCLAT”) faced a situation where a promoter assigned his claim to a former director of the debtor company, who was then admitted as a member of the CoC. This was challenged by a bank which was also a member of the CoC. In a short and precise judgment, the NCLAT held that the assignment could not change the nature of the debt. Looking at the facts, the NCLAT held that the rights of the assignee could not be better than the rights of the assignor and therefore the assignee would also bear any disadvantage associated with the debt. Concluding its order, the NCLAT also observed that what the sponsor could not have done directly could not be done through an assignee.

In early 2021, the Supreme Court of India also faced the same conundrum where a financial creditor sought to enter into the CoC base a convoluted arrangement with a related party of the debtor. After reviewing the provisions of the IBC in light of legislative intent, the Supreme Court held that the related party exclusion from the CoC is not related to the debt but to the relationship between a related financial creditor and the debtor. Thus, a financial creditor who in praesenti is not a related party, would not be precluded from being a member of the CoC. The Court, however, clarified that if a related financial creditor ceases to be related for the sole purpose of participating in the CoC and sabotaging the CIRP, by diluting the voting share of other creditors or otherwise, the disqualification should apply to that creditor. party too.

Conclusion

Both judgments discussed above are based on the same objective that the CoC must be protected from the influence of related parties and that a related financial creditor who designs a mechanism to remove its “related party” label should not be allowed to participate in the CoC. However, there is a fundamental difference between the judgment of the NCLAT and that of the Supreme Court – since if the NCLAT found that the disqualification attached to the debt resulting in a continuing disqualification for any creditor owning that debt, the Court Supreme took a more liberal view of the matter. Relying on the 2020 Insolvency Law Committee report, the Supreme Court held that forfeiture is not related to the debt itself but is based on the relationship between the debtor company and the creditor related. Thus, although a linked creditor does not have the right to become a member of the CoC, the assignee of such a linked creditor may have this right. This is thus contrary to the established principle according to which the transferor cannot transfer a right which he never had.

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 should be considered on a case-by-case basis after applying the test established by the Supreme Court.