COMMITTEE OF CREDITOR & THEORY OF VALUE MAXIMIZATION: THE CRY STORY OF RELATED PARTY RESOLVED

Shubham Budhiraja

BACKGROUND

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.

RELATED PARTY UNDER IBC

The expression ‘related party’ is defined in Section 5(24) in relation to a corporate debtor. Section 5(24A) provides a corresponding definition in relation to an individual.

The definition describes a commutative relationship, meaning that X can be a related party of Y, if either X is related to Y, or Y is related to X. The definition of ‘related party’ under the IBC is significantly broad. The intention of the legislature in adopting such a broad definition was to capture all kinds of interrelationships between the financial creditor and the corporate debtor

The term ‘related party’ has also been defined by Parliament in the Companies Act, 2013 for all corporations. The definition of the expression has also been expanded for listed entities by the Securities Exchange Board of India by amendment to the Equity Listing Agreement to include elements mentioned under applicable accounting standards. However, in the present case, we are assessing its definition only under the IBC, which is exhaustive. The purpose of defining the term separately under different statutes is not to avoid inconsistency but because the purpose of each of them is different. Hence, while understanding the meaning of ‘related party’ in the context of the IBC, it is important to keep in mind that it was defined to ensure that those entities which are related to the Corporate Debtor can be identified clearly, since their presence can often negatively affect the insolvency process. Strict determination of intent or mens rea may not always be possible by the NCLT and NCLAT in summary proceedings; it is possible to draw the inference from the facts at hand.

COC COMPOSITION & COLLECTIVE PROCESS - VALUE BASED THEORY

Section 21(1) of the IBC requires the IRP to form the CoC for the CIRP of the Corporate Debtor. The membership of the CoC is determined in accordance with Section 21(2)

Hence, the first proviso states that any financial creditor, barring the exceptions provided in the second proviso, shall not have any right of representation, participation and voting in the meeting of the CoC, if it is a related party of the Corporate Debtor.

Article published in the Yale Law Journal, titled ‘Bankruptcy, Non-Bankruptcy Entitlements, and the Creditors’ Bargain’, Thomas H. Jackson, argues that creditors prefer a collective process as opposed to a race to grab as many assets, which often leads ultimately to the demise of the corporate debtor. The reason why a collective process is considered superior is because individual creditors, left to their own whims, are motivated to act solely in their own interests, even when their interests may directly conflict with the creditors’ collective interests as a group. This self-interest creates a collective action problem, such that creditors eventually enter a grab race, operating under the belief that they would have recourse to fewer or no assets, if they delay their actions in the hope that creditors will be able to coordinate and agree to act collectively. Bankruptcy law seeks to resolve this by preventing individual creditor action. The creditor’s bargain theory therefore, operates to maximise group welfare through collectivization.

 In India, the IBC adopts a CIRP operationalized through the CoC once the CIRP commences. In addition to the creditor’s bargain theory, the design of the IBC is also influenced by the value-based theory postulated by Korobkin, in an influential piece of academic writing in the Columbia Law review, where under insolvency law considers the distributional impact of winding up on those who may not have formal legal rights to the assets of the business. The aim of bankruptcy law under this theory is to take into account the multidimensional but conflicting interests of various claimants, and provide for a solution where under each claimant derives optimal value

The CoC is comprised of financial creditors, under loan and debt contracts, who have the right to vote on decisions and operational creditors such as employees, rental obligations, utilities payments and trade credit, who can participate in the CoC, but do not have the right to vote.

The aim of the CoC is to enable coordination between various creditors so as to ensure that the interests of all stakeholders are balanced, and the value of the assets of the entity in financial distress is maximised.

The report of the Bankruptcy Law Reforms Committee (Volume I: Rationale and Design) of November 2015, has underscored the need to meet the liabilities of all creditors, who are not part of the CIRP, and that of treating the rights of all creditors fairly, through the collective insolvency resolution process, operationalized by the CoC

These objects underscore the composition of the CoC, guided by Section 21 of the IBC. The objects and purposes of the Code are best served when the CIRP is driven by external creditors, so as ensure that the CoC is not sabotaged by related parties of the corporate debtor. This is the intent behind the first proviso to Section 21(2) which disqualifies a financial creditor or the authorised representative of the financial creditor under sub-section (6) or sub-section (6A) or sub-section (5) of section 24, if it is a related party of the corporate debtor, from having any right of representation, participation or voting in a meeting of the committee of creditors

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. It is pertinent to note that disqualification of related parties from being members of the CoC, has also been recommended in the UNCITRAL Legislative Guide on Insolvency law

Consequently, the first proviso to Section 21(2) was amended, to extend the disqualification to the specified authorised representatives, in case that these representatives happened to be related parties of the corporate debtor. The introduction of the phrase “is” along with related party was not a guiding factor behind the Parliamentary amendment.

WHETHER RELATED PARTY “IS” IN PRESENT OR WOULD COVER “PAST” ALSO?- LITERAL OR PURPOSIVE?

Whether the disqualification under the proviso would attach to a financial creditor only in praesenti, or if the disqualification also extends to those financial creditors who were related to the corporate debtor at the time of acquiring the debt

Thus, facially, it would appear that the use of the simple present tense in the first proviso to Section 21(2) indicates that the disqualification applies in praesenti. Furthermore, this interpretation would also be supported by a reading of the first proviso to Section 21(2), in light of the definition of ‘related party’ under Section 5(24), which uses phrases such as ‘is accustomed to act’ or ‘is associated’ to define a related party in the present tense.  However, it is relevant to examine whether the object and purpose for which the proviso was enacted, are fulfilled by the literal interpretation of the first proviso.

In Abhay Singh Chautala vs C.B.I., where the court did not interpret the word “is” in praesenti because that would lead to an absurd result, defeating the purpose of the concerned provision

In Arcelor Mittal India Private Limited v. Satish Kumar Gupta, the court has approved of a purposive interpretation of Section 29-A of the IBC

The purpose of excluding a related party of a corporate debtor from the CoC is to obviate conflicts of interest which are likely to arise in the event that a related party is allowed to become a part of the CoC

Thus, it has been clarified that the exclusion under the first proviso to Section 21(2) 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, in 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), to consider the former related party creditor, as one debarred under the first proviso

CONCLUSION

Default rule under the first proviso to Section 21(2) is that only those financial creditors that are related parties in praesenti would be debarred from the CoC, those related party financial creditors that cease to be related parties in order to circumvent the exclusion under the first proviso to Section 21(2), should also be considered as being covered by the exclusion thereunder.

PERSONAL VIEWS

Thus court given a midway interpretation to the definition of related party as it is neither literal nor completely purposive rather it held that generally it covers only present related party but if any related party exist only to protect itself from coverage of Section 21 then it would also be covered within this ambit of related party because otherwise the collective COC approach of value theory and Insolvency objective will never be met