In order to classify transactions between the related parties, it is important to determine whether the parties involved are “related parties”. The Supreme Court three-judges bench in a recent case of Phoenix Arc Private Limited v. Spade Financial Services Limited & Ors deduced important and interesting aspects of IBC, 2016. The Court infers a ‘relationship’ between parties on the basis of the underlying transaction.
The court shed light on ‘related parties’ and ‘financial creditor’ in relation to CD under S. 5(24) and 5(7) under IBC, 2016. Broadly, it was held that the BoD was having an entangled relationship and was acting under the influence of a common set of individuals. The Court in its ruling deduced that “collusive or sham transaction” cannot give rise to “financial debt” and it was merely an eye-wash.
The transacting party having collusion and entangled interrelationships showed that the parties were in fact ‘related’ and therefore failed to obtain a seat in the committee of creditors (CoC). This was obtained in the court’s ruling by the ‘Smoke Test’. This blog touches on the significant aspects of the ruling, including how can ‘smoke test’ be useful for the interpretation of the provision of the code, and more specifically to those involving related parties and how this can act as a precedent for interpreting the provision of the code.
Collusive Transaction’s ramifications
In the instant case, the presence of the collusive transaction was the indicator, which led to the inference the parties were infact related. Events which led to deduce that transaction was collusive are- low rate of interest charged as against the formalized terms, formal documentation inconsistency to evade the applicable laws, the existence of a web of companies, non-registration of charges, and default of ‘disbursal’ of amount on which the ‘financial debt’ claim was founded.
S. 5(7) of the IBC defines a “financial creditor” as a person to whom a final debt is owed and “financial debt” is defined in S. 5(8) of the code and emphasizes the word ‘disbursed’ and ‘time value of money. The term ‘disbursed’ in the principal clause holds much relevance and tends to require the extended debt by the creditor to be disbursed to the CD. The Supreme Court placed substantial emphasis on the terms of “disbursal” and “time value of money” used in the statutory provision in Pioneer Urban Land and Infrastructure Ltd v. Union of India and Swiss Ribbons Pvt. Ltd. v. Union of India. The Court noted as follows:
“Specifically, the real agreement would deduce a transaction, which is in existence apart from advancing a financial debt.”
Thus, in the facts, the court found that sham transactions were just the eyewash and collusive in nature. Hence it only creates the illusion of legal rights and obligations among the parties that either do not exist or exist differentially from what they intend to create. Hence, the transaction that appears to exist but does not, there is no question of ‘disbursal’ or ‘time value of money’ and the ‘debt’ does not exist at all. Thus, ‘collusive transactions’ cannot lead to ‘debt’.
‘Related parties conduct on the direction of’
The definition of ‘related parties’ in S. 5(24) of the code becomes crucial as it broadly captures all kinds of interrelationships between creditor and CD. For example, clause (f), (g), and (h) of S. 5(24) refers to ‘any corporate management or board of directors act on the advice or direction or instruction of a director or manager of the corporate debtor in the ordinary course of the transaction is accustomed to act’. These instances are not new in the context of corporate and clauses (m) and (i) to such person’s “participation in policy-making processes of the corporate debtor”.
The purpose for defining a commutative relationship with the intention to capture all kinds of inter-relationships between the FC and the CD. Also, for the identification of those entities, which are related to CD and negatively affecting the insolvency process?
There is a need to identify whether the party is acting in the said manner. The Supreme Court went on to analyze the relationship between the individuals. It was found that Arun Nanda used his position for guiding the affairs of the CD. The court found that the transaction has arisen under the advice of the CD (to be specified under the influence of Anil Nanda). There were deep, entangled relationships and collusive transactions between such entities during that period. The court ruled as follows:- “it is not possible to infer the mens rea or intent in summary proceedings, but a possible determination could be made from the deep entangle position between Mr. Arun Anand and Mr. Anil Nanda, where Mr. Anand holds a position to control the Corporate Debtor’s affairs”.
Slate of Past-relationship
Noted from the first the proviso to S. 21(2) of the IBC code, that with the effect of it is to exclude the FC from the committee of creditors (CoC), as it was argued that there must be an existing relationship between the CD and FC. It must be a clear reference to the present relation and not to an uncertain past.
The Supreme Court held that the parties are called ‘related parties’ till the time they are accompanied for the transactions, which accounted for the alleged financial debt. Justice G.P Singh, in one of his authoritative commentary, stated that the words of the statue may not be elucidated in their word-for-word context, if the interpretation takes into the absurdity of the law. The terms are required to be read with formulation, which could promote the object and intent of the statute. The idea behind the explicated terms means to preserve the statue from being defeated by duplicitous strategies. Therefore, S. 21(2) is interpreted in a manner that excludes FC from being part of the ‘Committee of creditors.’ Consequently, such FC should also be considered as ‘related parties.’
Decision
• Due to the presence of collusive nature of the transaction alleged to be a financial debt under S. 5(8), AAA and Spade called be FCs under S. 5(7).
• Spade and AAA are considered as related parties of the CD under S. 5(24) of the IBC code.
• In accordance with the first proviso of S. 21(2) of the code, the Spade and AAA are ineligible to be part of CoC.
Conclusion
The ruling is one of a unique kind that in a way it goes beyond the objects clause of the meaning of the ‘related party’ and imbue the commercial arrangements between the parties, to grasp the presence of an element of ‘relationship’ between parties as they had acted under the pervasive influence of the individual. The test, called the ‘smoke test’ used by the Supreme Court in pulling out ‘related party’ arrangements between the parties and will act as precedent, even for instances where parties’ determination of intention is not possible. The ruling totally relies upon the facts and should be tried in the given context so as not to interrupt the way of commercial arrangements.
[Priya Dutt is a 4th year student at NALSAR and Rishi Dutt is a 3rd year student Bharati Vidyapeeth, New Law College. The authors can be reached at priyadutt7828@gmail.com and rishidutt007@gmail.com]
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