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RELATED PARTY vis-a-vis A CORPORATE DEBTOR UNDER INSOLVENCY AND BANKRUPTCY CODE

The implementation of Insolvency and Bankruptcy code, 2016 (Code) has been irrefutably one of the most debatable subjects under Company Law. Once the company enters the resolution process, the spine of controversy is how a creditor is related to the company and which creditor will get how much share of dues which the company owes to them. Limiting the argument up to “related party”, as shares of the creditor is based on case to case, first we must understand, “Who will be construed as a Related Party” with reference to the corporate debtor. According to section 5(24) of the Code which talks about definition of related party of the corporate debtor, the definition of ‘related party’ can be inferred as a conditional relationship, in other words a commutative relation between the related party and corporate debtor. For example, ‘A’can be related party of ‘B’then‘B’ is related party of ‘A’, in that case either ‘A’ is related to ‘B’ or ‘B’ is related to ‘A’, it cannot be argued in a court of law that ‘B’ does not fall under the domain of related party to corporate debtor, if corporate debtor falls under the domain of related party with reference to ‘A’.
The definition of a related party enshrined in the Code is defined in such a way which is restricted from the view point of a corporate debtor. In 2018, there was an Insolvency and Bankruptcy (Amendment) Ordinance which provided a definition but only restricted to an individual. However, there is no transparency in the code with regard to related party of a corporate debtor, other than corporate debtor itself. Therefore, in line with section 3(37) of the Code, the definition of related party envisaged in Section 2(76) of the Companies Act, 2013 has to be taken into consideration. According to section 2(76)(iv) of the Companies Act, if a director or manager of the company is associated as a member or director of some ‘other company’, that ‘other company’ becomes a related party. Under the Code a similar clause in section 5(24)(d) has been included which is framed explicitly from the perspective of the corporate debtor. It is pertinent to mention about section 5(24)(m) of the Code, which is wide in nature and it is clearly witnessed that the intent of drafter gives a paramount importance to the inter-relationship between two companies. In other words, if two companies are running under common control or seal, the interpretation given in section 5(24)(m) will apply. Thus, we can draw a conclusion that participation in making policies and personnel management or providing technical information are activities carried out by two entities. It is not a condition precedent that the company which is in question for resolution or other company is a supplier of technical information or must be participating in policy making or involved in personnel management. If there is an indication of common source of control or common seal over both the companies, it cannot be turned down that both the entities are associated with each other.
After the determination of related parties, it is also relevant to discuss about the Committee of Creditors, particularly in relation to section 21(2) of the Code. If we interpret and analyze the intention of section 21(2) of the Code, it can be clearly seen it is denying the voting rights of related parties to ensure that resolution process is carried out by the external creditors. Considering the fact, related parties may have claim and they may even file an application for initiating resolution process, related parties cannot take advantage of initiating of resolution process, as it would have serious implications such as conflict of interest.
Placing reliance on the case of J. R. Agro Industries Private Limited V. Swadisht Oils Private Limited (July 24th, 2018), where the resolution professional contended that approval of resolution process by the adjudicating authority is merely a formality as the committee of creditors had already given approval for resolution process with the required voting percentage rather 100% voting rights were vested with them. In addition to that resolution process satisfied all the conditions laid down under section 30 of the Code with compliance to regulations thereunder. Further it was contended that neither related parties were allowed to coordinate with the committee of creditors nor they got involved in meeting with committee of creditors, therefore there was no chance to influence the members of committee of creditors. Finally, they argued resolution plan pays almost nil dues of the operational creditors and instead claim of the related party who are unsecured financial creditors, should be prioritized according to waterfall mechanism. Section 53(1)(d) of the Code states all unsecured financial creditors should be treated at par so far as, their priority of payment is concerned and does not differentiate between related creditors and unrelated creditors. This expression of legal provision cannot be ignored even on the ground of equity.
In the present case, a related party was getting almost 62% of its dues back, on the contrary operational creditors were receiving almost nothing. In situations like this, it was beyond imagination that after the approval of the resolution plan, the operational creditors will be associated to the corporate debtor for supplies, to keep it as a going concern. Therefore, it is very important to study insolvency laws of various jurisdictions, where the secured creditors are given priority as compared to unsecured creditors, but there is no clear distinction between financial and operational creditors. The UNICITRAL Legislative Guide on Insolvency Law provides a subordinate rank to the related parties of the corporate debtor which is nothing but rank equivalent to unsecured creditors. National Company Law Tribunal (NCLT) observed that in this particular case which is of peculiar nature, where a related party has been given priority over the operational creditors, even though the same members/related party are responsible for the insolvency of the company and restructuring of corporate debtor. NCLT also stated, this act is being discriminatory in nature.
Under the UNICITRAL Legislative Guide, claim of the related parties have been ranked at par with other unsecured financial creditors, on the other hand in the Code unsecured financial creditors even if they are related parties, they rank one step above the claims of unsecured operational creditors.  If we see the scenario of US and UK as well,operational creditors are given the first preference over the related parties. It was observed by the court of law that promoters’ loan to the company is as good as equity participation, that is, without any agreement between them to pay interest and there is no time limit for repayment. The court also opined that waterfall mechanism cannot be applied by the books. If the spirit of law is ignored, then in each and every case of loss making companies, the liquidation value of debts owing to the operational creditors will be nullified, which means operational creditors will never get their money is insolvency cases. The NCLT also stressed upon the Doctrine of equitable subordination, where the subordination is done by the court, wherein a valid and an enforceable claim of the operational creditors will be paid later in the scheme of distribution rather than paying the money in the normal course of action. The doctrine was originally introduced to prevent related parties from using legal mechanisms as weapons to procure claims on priority basis.  This doctrine is generally applicable if any misconduct happens for consideration and resulting in unfair advantage to a creditor. In this case, the judges also observed that courts are vested with powers to shuffle the priorities of creditors to prevent any kind of fraud or illegality etc. Applying the doctrine of equitable subordination, the court ordered that the claim of related party should be treated at par with equity shareholders and which falls under the domain of section 53(1) of the Code, which is below the rank of unsecured financial creditors and other debts too.
Finally, the NCLT Allahabad observed that, if the related parties to the corporate debtor are given priority over operational creditors, it would not be justifiable in the manner which operational creditor are managed. In the present case, the related party and the corporate debtor were working and functioning under common seal. Therefore, keeping in view the UNICITRAL Legislative Guide on Insolvency Law, the NCLT held that a claim of related party, should rank below the claim of operational creditors and they should be equivalent to the rank equity shareholders under section 53(1)(h) of the Code. Further, the court directed the Registrar to forward a copy of the order to Ministry of Corporate Affairs, Insolvency and Bankruptcy Board of India and the Central Government for examining the issues which are pointed out, so that related parties of the corporate debtor would not misuse or wrongly interpret the provisions of section 53 of the Code to defraud the creditors.

 

Picture Credit: CNBC-TV18

ABOUT THE AUTHOR:

 

 

S C Vaidyanathan is currently a fifth-year Law student at VIT School of Law, VIT University, Chennai. He has recently interned at Khaitan & Co., Bengaluru and was associated with their Litigation team. He has a keen interest in pursuing a career in Commercial litigation and Alternative Dispute Resolution. 

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