Collusive business dealings with debtor company will not constitute “financial debt” according to IBC: Supreme Court

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The Supreme Court ruled that collusive or simulated transactions with a debtor company will not amount to “financial debt” within the meaning of the Insolvency and Bankruptcy Code 2016 (IBC). “The IBC recognizes that for an insolvency regime to be successful, the actual nature of the transactions must be brought to light in order to prevent anyone from taking undue advantage of its arrangements for …

The Supreme Court ruled that collusive or simulated transactions with a debtor company will not constitute “financial debt” within the meaning of the Insolvency and Bankruptcy Code 2016 (IBC).

“The IBC recognizes that for the success of an insolvency regime, the real nature of the operations must be brought to light in order to prevent any person from taking undue advantage of its provisions to the detriment of the rights of legitimate creditors”, observed a bench led by Judge DY Chandrachud in the case Phoenix Arc Private Limited v Spade Financial Services Ltd et al.

The Supreme Court was hearing appeals challenging NCLAT and NCLT orders that excluded two entities (AAA & Spade) from the creditors committee formed to resolve a corporate debtor insolvency. The NCLT ruled that the entities were not “financial creditors” because their transactions with the debtor company were collusive in nature and excluded them from the CoC. On appeal, NCLAT reversed the finding that they were not financial creditors. NCLAT ruled that the entities were financial creditors but disqualified them from the CoC on the grounds that they were “related parties” to the debtor company.

What are collusive transactions?

When considering the matter, the judiciary discussed the meaning of “financial debt” and “collusive transactions”.

He noted that “financial debt” means debt with interest, if any, that is disbursed against the counterpart of the the time value of money.

In the decision in Pioneer Urban Land and Infrastructure Ltd v Indian Union, the Court interpreted the term “disbursed” to mean money that has been paid for consideration for the “time value of money”.

“..the” disbursement “must be money and must be against the” time value of money “consideration, which therefore means the fact that this money is no longer with the lender, but is with the borrower, who then uses the money “, the Court observed in Pioneer.

The Insolvency Law Committee has interpreted “time value” to mean compensation or the price paid for the length of time the money has been paid. This can take the form of interest paid on the money or the factoring of a discount in the payment.

In this context, the SC in this case observed:

“A fictitious or collusive transaction would only create the illusion that money has been paid to a borrower for the purpose of receiving consideration in the form of a time value of money, when in fact the parties have entered into the transaction with one another or an ulterior motive. In other words, the true agreement between the parties is something other than the advance of a financial debt “.

The judiciary noted that the IBC has taken steps to identify, reverse or ignore “avoidable transactions” that troubled companies may have undertaken to impede recovery from creditors in the event of the opening of the CIRP. These avoidable transactions include: (i) preferential transactions under Article 43 of the IBC; (ii) dumped transactions under Article 45 (2) of the IBC; (iii) transactions defrauding creditors under Article 49 of the IBC; and (iv) exorbitant transactions under Article 50 of the IBC.

In terms of facts, the court noted that the entities and the debtor company had entered into several agreements concerning the same property without giving any explanation or justification concerning the variation of the consideration. This showed that the transactions were collusive in nature entered into with the aim of diverting the assets of the debtor company to the entities.

“Since the trade agreements between Spade and AAA and the debtor company were collusive in nature, they would not constitute ‘financial debt’. Therefore, Spade and AAA are not financial creditors of the debtor company ”, the bench, also comprising Judges Indira Banerjee and Indu Malhotra, observed.

The Court noted that the appellants in the case, AAA and Spade, were related parties within the meaning of section 5 (24) at the time the alleged financial debt on the basis of which they claim a claim to be part of the CoC was created.

The Court also concluded that the transactions between Spade and AAA on the one hand, and the Debtor Company on the other hand, which gave rise to their alleged financial debts, were of “collusive nature”.

“Therefore, it is evident that there was a deeply entangled relationship between Spade, AAA and Corporate Debtor, when the alleged financial debt arose. Although their related party status is no longer valid, we are inclined to be of agreement with M. due to the commercial artifices by which these entities now seek to enter the CoC. The pervasive influence of Mr. Anil Nanda (the promoter / director of the debtor company) over these entities is clear, and empowering them in the CoC would certainly affect other independent financial creditors “, the magistracy observed the facts of the case.

The judgment also ruled that a financial creditor who is not currently a “related party” to the debtor company can also be excluded from the Creditors Committee (CoC) if it is found that its removal of the “related party” label Was part of the strategy to bypass the bar under Article 21 (2), first provision of the Insolvency and Bankruptcy Code (IBC). A separate report explaining this aspect can be read here.

The financial creditor may be excluded from the CoC if it has discarded the label “related party” only with the intention of circumventing the prohibition under section 21 (2) IBC: SC

CAS: Phoenix Arc Private Limited v Spade Financial Services Limited [ Civil Appeal No. 2842 of 2020]

CORAM: Judges DY Chandrachud, Indu Malhotra and Indira Banerjee

LAWYER: (i) Sr. Adv KV Viswanathan for AAA and Spade; (ii) Sr Adv Neeraj Kishan Kaul for Phoenix; and (iii) Sr. Adv Sanjiv Sen for the Resolution Professional

REFERENCE: LL 2021 SC 55


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