Divya Sethuraman*
Introduction
Corporate law across jurisdictions attempts to regulate transactions between a corporation and its related parties, driven by concerns of conflicts of interest that such dealings invoke. These regulations remain in force even when corporations do not remain solvent, and form a part of insolvency law relating to financially distressed companies. In India, the Insolvency and Bankruptcy Code 2016 (‘IBC’) pays particular attention to the insolvent company i.e., the corporate debtor (‘CD’) and its related parties, which forms the subject of this piece. Section 5(24) of the IBC enumerates various instances of relationships shared by the CD with other transacting entities which are deemed to occupy the position of a related party to the CD.
As per the proviso to Section 21(2) of the IBC, a related party to the CD is disqualified from being a member of the Committee of Creditors (‘CoC’) when the related party is a financial creditor (‘FC’) of the CD. Exclusion of such FCs from the CoC is especially contentious since it precludes them from advocating for their interests in the corporate insolvency resolution process (‘CIRP’) wherein the CoC deliberates the restructuring of the CD’s debt obligations. Given this significant implication for participation during the CIRP, in this piece, I focus on the legal standards employed to identify a related party to the CD. Specifically, I analyse cases where management personnel are shared between the FC and the CD, for instance, when the two entities have a common director on their Boards of Directors (‘Board'), and the FC is alleged to be a related party.
In doing so, I identify a shift in the decision-making trend; The first line of reasoning is where courts and tribunals determine related party status by prioritising (and even solely relying on) the nature of the position occupied by the common individual in the CD and FC. Once the position occupied is found to be one of considerable importance in both entities, the plausibility of the individual favouring their FC to other external creditors is considered to be of high plausibility and sufficient to fulfil the relevant sub-clauses of Section 5(24). The recent 2024 NCLAT decision in ODAT GmbH v The CoC of Darjeeling Organic Tea Estates Pvt Ltd (‘ODAT’) exemplifies the shift towards a second line of reasoning. Per ODAT, the nature of the position occupied by the common individual in the FC and the CD – even if that role is of a director – does not necessarily invoke a conflict of interest, nor the assumption of the individual representing the dual interests of the FC and CD (¶12- ¶14). Rather, there will only be a conclusive determination of unfair treatment of external creditors when records of such behaviour on the individual’s behalf are presented as evidence. After this, the FC will be deemed the CD’s related party (¶12- ¶14).
I argue in favour of adopting the first line of reasoning that prioritises the position occupied by the common individual in the FC and CD and identify flaws in relying on factual evidence/records of the common individual’s actions as per the ODAT ruling. I provide three reasons to substantiate this argument: First, the strong possibility of the common individual acting in a dual capacity and representing dual interests when simultaneously occupying roles within the FC and CD; Second, the reduced possibility of the common individual acting in only a singular capacity (particularly as a common director), since they owe duties towards both entities as per the Companies Act 2013 (‘2013 Act’) and the respective company’s Articles of Association; Third, the presence or absence of an evidentiary record of the common individual acting in a dual capacity in the past being irrelevant to the related party determination during the CIRP or liquidation which is concerned with whether the related FC may act in a manner that prejudices external creditors given a position on the CoC, in the future.
The piece’s roadmap is as follows: In Section II, I discuss the reasons for the separate classification of related party creditors from the larger pool of creditors; In Section III, I analyse the interpretation of Section 5(24) in Supreme Court and National Company Law Tribunal (‘NCLT’) cases that have adopted the identified first manner of reasoning. In Section IV, I examine the National Company Law Appellate Tribunal’s (‘NCLAT’) ODAT decision which marks a new line of reasoning, signifying a shift in the trend from the cases outlined in the previous Section. Further, I also argue in favour of the Supreme Court and NCLT’s reasoning; Lastly, in Section V, I conclude.
The separate classification of related party creditors
Creditors who are related parties to the CD under insolvency law are legally considered to belong to a separate group, distinct from the class of creditors. The reasons for this are discussed herein. Clark observes that the CD’s management, by virtue of the shared relationship itself, prefers executing corporate assets in favour of related parties and related party creditors, rather than external creditors during insolvency (pages 509-510). While per se, such transactions do not detrimentally impact the CD since they also discharge debt towards the related party, Zwieten notes that the same disadvantages non-related external creditors (page 2). External non-related creditors are subject to satisfying their credit from a smaller pool of assets (page 2). In India, this concern has been identified by courts as the possibility of a conflict of interest in the CoC (which decides on revising debt obligations during insolvency) (¶76; ¶90) and the disadvantaging of external creditors without allowing for the maximisation of the value of assets. In the absence of a legal framework regulating such action on the part of the CD, the same can adversely impact the availability of credit (especially unsecured credit) extended by external creditors to the CD (page 2).
Generally, this regulation takes the form of transaction avoidance law. Transaction avoidance legal rules do not ex-ante prohibit credit arrangements between a CD and its related party (page 3). Rather, they contemplate an ex-post reassessment of the related party’s position in relation to other external creditors at the time of insolvency proceedings, particularly during liquidation (pages 3-4). Often, courts are entrusted with the responsibility of carrying out this ex-post reassessment by intervening through the doctrine of equitable subordination (¶61). In applying this doctrine, courts ensure that the claims of external creditors are prioritised over the related party creditors during liquidation when the latter group attempts to obtain an advantage in receiving payments by employing legal mechanisms (¶60). In Kraakman and others’ words, this intervention of the court is an instance of the ‘standards’ strategy (page 33) being employed, whereby ex-post the transaction, legal rules such as the above doctrine allow the subordination of the debt of related party creditors to that of external non-related creditors (page 135).
The need to ensure that FCs related to the CD do not benefit at the expense of external FCs has similarly driven legislation in India, where the law distinguishes between operational creditors and FCs (¶1.25). Related party FCs are precluded from being members of the CoC under the proviso of Section 21(2) of the IBC to ensure that in the process of restructuring the CD’s debt obligations, they do not steer the CoC towards benefitting the CD at the expense of other external creditors (¶1.25). Section 5(24) defines the related party to the CIRP in very broad terms to capture a wide range of relationships, which furthers the concern for impartiality. A reading of the sub-clauses (a)-(m) of this Section discerns that an individual, firm, or body corporate can be a related party to the CD in a ‘commutative fashion,’ whereby the former is related to the latter or vice versa (¶58).
However, the IBC does not specify the position of related party FCs in case the company undergoes liquidation and its assets are disposed of. The waterfall mechanism in Section 53 only distinguishes between secured and unsecured creditors. It does not differentiate between even financial and operational creditors, let alone creditors who are also related parties to the CD. In this context, an ex-post review is conducted by Indian courts during liquidation. Case law reveals that once the determination that a particular FC is also a related party to the CD is made, the debt of the related party FC is subordinated to that of other creditors. For instance, in JR Agro Industries Pvt Ltd v Swadisht Oils Pvt Ltd, the NCLT deliberated on a resolution plan for a CD, approved by the CoC but challenged by a related party FC. The FC shared promoters, directors, and management personnel with the CD [page 45]. It challenged the resolution plan on the ground that it did not account at all for the debts owed by the CD to the FC, owing to the FC’s non-participation in the CoC given its related party status. In deciding the matter, the NCLT recognised the absence of any specification in the IBC, including Section 53’s waterfall mechanism, as to the priority to be accorded to related and non-related party FCs when the CD’s debts are discharged. Terming the relationship between the related party FC and the CD as ‘intra-group debt’ [page 42], the NCLT referred to the legislative guidance issued by the United Nations Commission on International Trade Law (‘UNCITRAL’) for insolvency law [page 45]. Per UNCITRAL, intra-group debt is treated on par with an equity contribution. By virtue of this, the amount owed to the related party FC ranks lower in priority than that to all other creditors, including non-related party creditors [pages 42-43]. Relying on this framework, the NCLT reasoned that a related party FC was to be treated on the same plane as the CD’s equity shareholders as provided in Section 53(1)(h) [page 46]. The satisfaction of their claims ranked lower in priority than non-related party FCs, other creditors (including operational creditors), and all other debts and dues [pages 46-47]. The resolution plan was directed to be modified to this effect, with the related party FC’s debt subordinated to that of all other creditors [pages 49-50]. Essentially, the debt of the FC was subordinated to that of other creditors by virtue of its related party status having been determined.
Given this account of the legislatively broad construction of the related party to the CD in Section 5(24) and the court’s intervention in subordinating related party FCs during liquidation, it is the relationships envisaged in sub-clauses (h) and (m) of Section 5(24) that have been the subject of significant litigation. Sub-clause (h) deems ‘any person on whose advice, directions or instructions, a director, partner or manager of the corporate debtor is accustomed to act’ a related party. This sub-clause comes into play, especially in the case of one or more individuals occupying simultaneous roles in the CD and the FC— a recurring factual scenario. Here, it is scrutinised whether the CD or its key personnel act as per this individual and therefore the FC (the person), who must then be disqualified from the CoC as a related party. Sub-clause (m) identifies a person associated with the CD to be a related party when the person: (i) participates in the CD’s policy making; or (ii) shares essential technical information, or when such a person is a company, (iii) shares managerial personnel or (iv) more than two common directors. Evidently, (iv) of sub-clause (m) is an objective determination, and (ii) is also largely objective in the case of the same recurring factual scenario, of one or more individuals occupying simultaneous roles in the CD and the FC. It is (i) and (iii) of sub-clause (m) that become the subject of discussion in the aforementioned scenario, and whether this common individual disqualifies the FC from CoC privileges as a related party is debated.
Significantly, when the common individual’s role is that of a director on the Boards of the FC and CD, Section 5(24)(m) is discussed in some detail by courts only when there are either one or two such individuals. This is the case since the FC and CD having more than two common directors immediately attracts the related party status for the FC (per Section 5(24)(m)(iv)), directly disqualifying it from the CoC. No rationale has been provided for ascribing immediate related party status to the FC when the FC and CD share more than two directors in the IBC, and not when they share either one or two directors. Taking note of the ‘more than two common directors’ related party trigger is relevant given that even when one director of a company is a director of another company, the other company is a related party of the first as per Section 2(76)(iv) of the 2013 Act.
The cases discussed in this piece concern Section 5(24)(h) and Section 5(24)(m)(i) or (iii), with there being only one or two common individuals in senior roles in the FC and CD or acting as directors on both Boards. In the following Section, I will focus on the first line of reasoning employed by courts and tribunals to determine related party status.
Interpreting Section 5(24) of the IBC
Perhaps the most authoritative discussion laying down the framework to determine whether the FC is a related party to the CD in the presence of common individual(s) in senior roles in both organisations is Phoenix Arc Pvt Ltd v Spade Financial Services Ltd and Others (‘Phoenix’) (¶1-2; ¶60-61). In Phoenix, one individual occupied important managerial positions in the CD and the two FCs (¶62). The Supreme Court held that the FCs were related parties of the CD under Sections 5(24)(h) and 5(24)(m)(i), given that directors of the CD were bound to act upon the instructions of the common individual who participated in the CD’s decision making (¶62). Importantly, the Court’s finding of the FCs being related parties was centred around the very occupation of a pivotal position in all concerned entities by a common individual. In fact, the Court reasoned that given the individual’s high stature in the CD’s hierarchy and the ‘deep entanglement’ between the groups (¶62), he could have used the same to guide its actions in a manner beneficial to his other interests at the time of the FC extending the loan (¶62). Only after adopting this position did the Court hold that the same was borne out by the finding of collusion between the CD and impugned FCs (¶62). Cumulatively, the same was sufficient to satisfy the related party characteristics as per Sections 5(24)(h) and 5(24)(m)(i). The status was extended not only to parties related at the time of extending credit but those that ceased to be related parties purely to circumvent the CoC disqualification as per Section 21(2) (¶98; ¶103).
Importantly, the NCLT’s decision in Phoenix Tech Power (P) Ltd v KV Srinivas (‘KV Srinivas’) went even further than Phoenix in its reliance on the centrality of the nature of the positions occupied by two common individuals in the FC and CD (¶53), without examining any record of their behaviour (¶57). The situation before the NCLT was that of two non-executive nominee directors of the FC also being on the CD’s Board (¶9; ¶39; ¶53). The NCLT reasoned that the role of a director, irrespective of the director being non-executive and a nominee, was to act in the best interests of the company as per the various provisions of the 2013 Act (¶57-58). A common director would have to discharge this duty towards both the FC and the CD, invoking the real possibility of a conflict of interest in the CoC disadvantaging other external creditors (¶57-58). In fact, the NCLT probed the contents of the CD’s Articles of Association to buttress its argument about the central role any director on its Board would play in decision and policy making (¶58-60). In this case, the FC was declared a related party to the CD as per sub-clauses (h) and (m), and even (a), (j), and (l) of Section 5(24)(h) ((¶58). The same was premised on the possibility of misuse of the position held by the common director (¶60-61), even without considering any evidential record of the past behaviour of the individual, disqualifying it from the CoC.
Therefore, in these cases, related party status is determined predominantly with reference to the nature of the position occupied by the common individual or two of them in the hierarchies of the CD and FC. Once the nature of the position occupied is found to be one of considerable importance in both entities, the plausibility of the individual favouring their FC to other external creditors is accorded significant importance. Sometimes, the same alone is considered sufficient to satisfy 5(24), although often, related party status is declared when this plausibility is further supplemented by the individual’s behaviour. Animated by similar concerns of favourable treatment disadvantaging external creditors, the courts and tribunals declare the FC to be the CD’s related party. This excludes them from participating in the CoC, where crucial decisions as to the treatment of creditors can be made. In the next Section, I will examine the 2024 NCLAT ruling in ODAT, which signals a shift from the reasoning outlined above, and the implications of the same.
The NCLAT’s ODAT ruling and its implications
In ODAT, the NCLAT’s decision marks a shift away from the observed trend in the cases outlined above. In this case, although the same individual was a managing director of the foreign FC and a director of the CD (¶1), reversing the NCLT ruling, the NCLAT held that no related party relationship as per Sections 5(24)(h) and 5(24)(m) was established (¶17). The crux of the NCLAT’s decision was the need to satisfy a higher evidentiary threshold with regard to the actual record of the individual acting in the manner outlined in the sub-clauses of Section 5(24), and not the possibility of it in law or on paper (¶12; ¶13). Only then could a conflict of interest be ascertained, and a related party relationship be ascribed to the FC (¶12; ¶13). For instance, the FC was not declared a related party under Section 5(24)(h) since no material on record was placed from which an inference of the common director had advised/directed/instructed the CD following which the CD’s key personnel had acted upon it (¶12). Similarly, it was refuted that the FC was a related party under Section 5(24)(m)(i) (which identifies a person associated with the CD who participates in the CD’s policymaking as a related party), although the individual was an agricultural specialist appointed on the CD’s Board for his expertise (¶13). It was reasoned that in the absence of material, the individual (despite being the CD’s director) did not, in fact, participate in its policy-making, and that his actions were carried out in the capacity of the FC’s director (¶14). Since the FC did not impact the working of the CD, it was held that the two were not related parties (¶14).
Therefore, the ODAT ruling suggests a shift towards an entirely fact-based determination of related party status and thus, lays down a new standard. With this decision, the nature of the position occupied by the individual in the FC and the CD, even if that role is of a director, does not necessarily invoke a conflict of interest wherein that individual discharges their duties in the CD favouring their FC. Rather, there will be a conclusive determination of unfair treatment of external creditors only when records of such behaviour on the individual’s behalf are presented as evidence, after which the FC will be deemed the CD’s related party. This reasoning significantly differs from the earlier Supreme Court and NCLT decisions. I argue in favour of the Supreme Court and NCLT, for the following reasons.
First, since the common individual simultaneously occupies roles within the FC and CD’s hierarchies, even at the time of the lending of the debt to the CD, the assumption is that the individual is discharging their duties in a dual capacity in both entities. Arguing that the common individual acted in only a singular capacity (as reasoned in ODAT), say only as a key personnel member of the CD at the time of the extension of the loan by the FC, is not sufficient to extend a position to that FC in the CoC. In general, in light of the individual’s occupation of dual roles simultaneously, it is difficult to assert that there was no plausibility of favourable treatment given to the FC while the individual acted on behalf of the CD. In fact, it is this assumption of a common individual acting in a dual capacity when occupying two roles simultaneously, that animates Section 2(76)(iv) of the 2013 Act. This Section states that even when one director of a company is a director of another company, the other company is a related party of the first.
Second, particularly in the case of the common individual occupying directorial positions in the Boards of the FC and CD, the possibility of the individual acting in only a singular capacity is reduced further. The same is the case since the duties a director is required to discharge, whether an executive director or not, are extensively prescribed under the 2013 Act, particularly in Section 166. Broadly, under this Section, the director owes a fiduciary duty towards the company and is to act in the company’s best interests. Given these central requirements for discharging the directorial role, it is expected that the common individual, being the FC and CD’s director, owes a duty to both entities. Further, additional duties and responsibilities are to be undertaken by the director as per the FC and CD’s Articles of Association. Evidently, there is an increased possibility of favourable treatment given to the FC by its director, while also being on the CD’s board during insolvency. This creates additional concerns when one considers the fact that a CD’s director owes duties towards all of the CD’s creditors during insolvency (Sections 45, 66, and 69 of the IBC), not simply those FCs where they also serve on the Board. The NCLAT in ODAT failed to consider the common director’s duties towards the two entities as per the 2013 Act and their respective Articles of Association, which created a conflict of interest that would necessarily invite the related party status and exclusion from the CoC.
Third, even if it is accepted that the individual did not previously act in a dual capacity in favouring the FC in the absence of an evidentiary record of the same (especially when the loan was extended by the FC), this consideration is irrelevant. This is the case since the related party determination is concerned with whether given a position on the CoC, the related FC will act in a manner that prejudices external creditors during the CIRP or liquidation. As outlined previously, the legislative rationale underpinning avoidance law such as the exclusion of a related party FC from the CoC is the possibility of unfair treatment of external creditors during insolvency or even liquidation (¶1.25), given the tendency of the CD’s management to favour related parties. Including the CD’s related party in the CoC would amount to representing the CD’s interests in the CoC, inviting the tendency of partial treatment in an IBC resolution process that is intended to be creditor driven. This may also discourage lending (particularly unsecured lending) (¶1.25), the latter being one of the main objectives of the IBC. ODAT’s related party determination test in cases of common personnel between the FC and CD fails to account for these legislative imperatives.
Thus, for these reasons, I argue that the reasoning in ODAT which requires an evidentiary record of behaviour that invokes conflict of interest, even if the common key person employed at the FC and CD is a director, is flawed. Once the nature of the position occupied is found to be one of considerable importance in both entities, especially a directorial role, the plausibility of the individual favouring their FC to other external creditors is evident. Prioritising the nature of the role, rather than insisting on an evidentiary record of the common individual’s action of declaring the FC as a related party to the CD is more aligned with the legislative intention and logic animating avoidance law that excludes related parties from the CoC. Given that two kinds of standards have been respectively employed by the NCLT and NCLAT, there is a serious lack of predictability in outcomes concerning this issue. The divergence in decision-making outlined above is undesirable, since it only serves to increase transaction costs for litigants who are incentivised to adjudicate the matter at multiple fora to seek a favourable outcome (¶141).
Conclusion
In this piece, I identified a shift in the trend in the decisions of courts and tribunals relating to the debt satisfaction claims of FCs alleged to be related parties to the CD, where management personnel are shared between the two. Particularly, I focussed on those decisions where the CD and FC had either one or two common directors on their Boards. One line of reasoning is where cases prioritise and even solely rely on the nature of the position occupied by the common individual in the CD and FC, as was the case in Phoenix and KV Srinivas. There has been a shift away from this reasoning as seen in the 2024 ODAT decision, where the nature of the position occupied by the common individual in the FC and the CD, even if that role is if a director, does not necessarily invoke a conflict of interest. Only when records of such behaviour on the individual’s behalf are presented as evidence will there be a conclusive determination of unfair treatment of external creditors, after which the FC will be deemed the CD’s related party.
Having identified the above, I further argued for the adoption of the first line of reasoning and highlighted the flaws in ODAT by providing three reasons for the same. Adopting the first approach to determine the FC’s related party status is particularly important since the purpose behind Section 5(24) regulating transactions between the corporation and its related party is to eliminate concerns of conflicts of interest that such dealings invoke. If the ODAT reasoning is followed, this purpose is not given effect. This is the case since it is not considered a conflict of interest even when the nature of the position occupied by the common individual in the FC and the CD is that of a director, unless there is material evidentiary record of the same.
*Divya Sethuraman is a B.A., LL.B. (Hons.) student at the National Law School of India University (NLSIU), Bengaluru.
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