Supreme Court says sham Transactions with corporate debtor is not financial debt

Supreme Court says sham Transactions with corporate debtor is not financial debt

The Court remarked that the 'financial debt' means a debt along with the interest, which is disbursed against the consideration for the time value of money

The Supreme Court headed by three judges' bench, Justices DY Chandrachud, Indu Malhotra and Indira Banerjee on 1 February 2021 disposed of the appeals filed by the appellant, Phoenix Arc Pvt Ltd, and held that collusive or sham transactions with a corporate debtor will not amount to 'financial debt' within the meaning of the Insolvency and Bankruptcy Code 2016 (IBC).

The brief background of the case was that the appeals challenged the orders of the National Company Law Appellate Tribunal (NCLAT) and the National Company Law Tribunal (NCLT) which excluded two entities - AAA Landmark Pvt Ltd (AAA) and Spade Financial Services Pvt Ltd (Spade) from the Committee of Creditors (CoC) constituted for the insolvency resolution of a corporate debtor.

Initially, the NCLT in its order ruled that the said entities were not 'financial creditors' as their transactions with the corporate debtor were collusive in nature and excluded them from the CoC.

Following which an appeal was preferred in the NCLAT which, as a result, lead to reverse the findings of the NCLT and held that the entities were financial creditors but disqualified them from the CoC on the pretext that they were 'related parties' of the corporate debtor.

Three primary issues arose before the Top Court:

1. Whether Spade and AAA are financial creditors of the Corporate Debtor;

2. Whether Spade and AAA are related parties of the Corporate Debtor;

3. Whether Spade and AAA have to be excluded from the CoC.

The Apex Court then proceeded to analyze the meaning of 'financial debt' and 'collusive transactions'. The Court remarked that the 'financial debt' means a debt along with the interest, if any, which is disbursed against the consideration for the time value of money.

Court referred to the report Insolvency Law Committee where it had interpreted the term 'time value' means compensation or the price paid for the length of time for which the money has been disbursed. This may be in the form of interest paid on the money or factoring of a discount in the payment.

The Apex Court observed, "The IBC recognizes that for the success of an insolvency regime, the real nature of the transactions has to be unearthed in order to prevent any person from taking undue benefit of its provisions to the detriment of the rights of legitimate creditors."

The Court pointed out that the IBC had made provisions for identifying, annulling or disregarding 'avoidable transactions' which distressed companies may have undertaken to hamper recovery of creditors in the event of the initiation of the corporate insolvency resolution process (CIRP). Such avoidable transactions include: firstly, the preferential transactions under Section 43 of the IBC; secondly, the undervalued transactions under Section 45(2) of the IBC; thirdly, transactions defrauding creditors under Section 49 of the IBC and; fourthly, extortionate transactions under Section 50 of the IBC.

"A transaction which is sham or collusive would only create an illusion that money has been disbursed to a borrower with the object of receiving consideration in the form of time value of money, when in fact the parties have entered into the transaction with a different or an ulterior motive. In other words, the real agreement between the parties is something other than advancing a financial debt", Court added.

Since the commercial arrangements between Spade and AAA, and the Corporate Debtor were collusive in nature in the aforementioned case, the Court observed that they would not constitute a 'financial debt'. Hence Spade and AAA were not financial creditors of the Corporate Debtor.

The Court clarified that the "exclusion under the first proviso to Section 21(2) of IBC is related not to the debt itself but to the relationship existing between a related party financial creditor and the corporate debtor. As such, the financial creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC."

However, the Court asserted that in the case where the related party financial creditor divests itself of its shareholding or ceases to become a related party in a business capacity with the sole intention of participating the CoC and sabotage the CIRP, by diluting the vote share of other creditors or otherwise, it would be in keeping with the object and purpose of the first proviso to Section 21(2) of IBC, to consider the former related party creditor, as one debarred under the first proviso.

The Court concluded that the transactions between Spade and AAA on one hand, and the Corporate Debtor on the other, which gave rise to their alleged financial debts, were 'collusive in nature' and ordered that, "the decision of the NCLAT, in as much as it referred to Spade and AAA as financial creditors, is set aside. Due to the collusive nature of their transactions alleged to be a financial debt under Section 5(8), Spade and AAA cannot be labelled as financial creditors under Section 5(7)", while dismissing the appeals.