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  • Mansi Verma

Exploring the Conjunctive Test to Navigate the Treatment of Assignees of Related Party Financial Creditors Post Phoenix ARC v. Spade

[Mansi is a student at Gujarat National Law University.]


Related party financial creditors are disqualified from participating within the committee of creditors (COC) by virtue of the proviso to Section 21(2) of Insolvency and Bankruptcy Code 2016 (IBC). Such a disqualification has traditionally been attached to the assignees of such related party financial creditors as well. Judicial pronouncements prior to Phoenix ARC v. Spade Financial Services Limited (Phoenix v. Spade) have cited various arguments to draw this conclusion. The judicial pronouncement in Phoenix v Spade creates scope for potentially altering this stance.


The post argues that the stance taken in Phoenix v. Spade creates scope for participation of assignees of related party financial creditors within the COC which is a colossal aberration from the established judicial precedent and goes against the intent of the legislation in addition to being unworkable if the situation presents itself. By scrutinizing the potential problems created with such an arrangement while also taking reference from the US bankruptcy landscape, the post discusses the employment of the conjunctive test for preservation of the claims of genuine stakeholders within the COC.


Treatment of Assignees Prior to Phoenix ARC Judgment


Section 5(24) of IBC provides for a very expansive definition of the term 'related party financial creditor'. Section 21 (2) restricts the rights of the related party financial creditor by stipulating that they 'shall not have any right of representation, participation or voting in the COC'. The purpose of carving out such an exclusion is to prevent any conflict of interest which may arise by virtue of the relationship that the corporate debtor shares with the financial creditor.


The case of Edelweiss Asset Reconstruction v. Synergy Dooray pronounced that the assignee of a related party financial creditor would be allowed to participate within the COC irrespective of the status of related party status of the financial creditor. This position was radically changed in the case of Pankaj Yadav v. State Bank of India wherein the court concluded that if the assignor is a related party, the assignee shall also be treated in the same status as the related party vis-à-vis the impugned debt. This rationale was subsequently upheld in Radha Industries Private Limited v. M/S Jayshree S Iyer IRP for Badreshwar Vidyut Private Limited.


Critical Analysis: Challenges to Follow Post the Phoenix ARC and ILCR


Through an analysis of the Insolvency Law Committee Report (ILCR) observations, it can be concluded that the assignment of debt, if made to the third-party assignee and if done in good faith, such an assignee must not be disqualified from the COC. The onus is on the resolution professional to verify such a claim. If it is demonstrated that a related party financial creditor had transferred its debt to another party intending fraud, to disrupt the corporate insolvency resolution process under the IBC, the recipient of the debt should be regarded as a related party financial creditor according to the initial condition outlined in Section 21(2).

 

The Supreme Court referred to the ILCR and adopted a rather liberal view in Phoenix v. Spade whereby it pronounced that “a financial creditor who in praesenti is not a related party financial creditor would not be debarred from being a member of the COC”.

 

The Supreme Court as well as the ILCR opined that if the purpose of the assignment of debt by a related party financial creditor is to vitiate the proceedings of the COC or to dilute the voting share of other creditors in the COC, then that should be considered the threshold for establishing “bad faith” on part of the assignee of such related party financial creditors.


The proof of “bad faith” is an indeterminate threshold to which the Indian insolvency and bankruptcy regime provides no definite answers. There is no paradigm of mala fide intention or a yardstick to establish timelines against which the test of bad faith must be assessed.


The Case of Non-Statutory Insiders Within the US Bankruptcy Landscape: Lessons that Follow


The US bankruptcy regime follows the debtor in control model. However, it is the financial creditors who vote on approval of the resolution plan. Section 101(31) of the US Bankruptcy Code defines statutory insiders. Those who are not included within this definition but assume the properties of an insider are termed as non-statutory insiders as was explained in the case of US Bank National Association v. The Village at Lakeridge LLC. These are entities that share a close relationship with the corporate debtor due to which the transaction undertaken between them cannot be considered arms-length basis. The assignees of related party financial creditors can be considered non statutory insiders since they are not specifically included within the statute but are deemed insiders in several judicial pronouncements. The case of US Bank National Association v. The Village at Lakeridge LLC was one such case where the assignee of the related party creditor shared a close and personal association with one of the members on the board of corporate debtor. In the final appeal to the ninth circuit court, the judge opined that acquisition of a statutory claim from a related party does not automatically result in an insider status of the assignee.


The court propounded a conjunctive test to determine the intention on part of the assignee which is based on two considerations -- first, the closeness of the relationship between the alleged insider and the debtor for it to be enumerated as an insider, and second, whether there is anything to suggest that transaction was not done on an arms-length basis which has to be determined based on the factual matrix of every case.

 

The Conjunctive Test Within the Indian Landscape


In order to apply the conjunctive test within the Indian context, the elements of the conjunctive test need to be determined. The first part of the conjunctive test merely states that the closeness of the relationship between the debtor and the insider need to be determined. Such a “closeness” is a subjective consideration, however closeness between a debtor and a creditor could potentially suggest the following:


First, the extent of exercise of control of the alleged insider on the decision making of the debtor. Second, whether such a control translates to exercise of undue influence on the debtor which means whether the contractual arrangement between the debtor and the creditor would empower the creditor to coerce the debtor into transactions not in the debtor’s best interest. Third, the extent of the creditor’s access to the debtor’s financial information. 

 

A contract which empowered the creditor to coerce the debtor to undertake transactions not in their best interest can be illustrated through the case of Re Winstar Communications Inc case wherein a strategic partnership where the creditor “agrees to help finance and construct the debtor’s global broadband telecommunications network” was entered into. Here, the creditor extended a USD 2,000,000,000 line of credit secured by a lien on virtually all of the debtor’s assets. It also included a supply agreement, under which creditor took primary responsibility for the construction of the debtor's network under the condition that the debtor would purchase 65% of the equipment and services from the creditor during the first year of the contract and 70% thereafter. It was determined by the court that such an arrangement followed by subsequent contracts led to the creditor controlling the decisions of the debtor and forcing the debtor into transactions not needed in the first place which led to the court declaring the creditor a non-statutory insider.

 

Generally, such arrangements are "multifaceted relationships" that evolve over years and include relationships such as creditor and debtor, principal and agent, joint venturers, attorney and client, landlord and tenant, and close friends. Within the Indian context, such relationships could be used as the vantage point of determining whether the assignment of the debt by the related party financial creditor was done in “bad faith” followed by an examination of the contractual arrangement between the related party financial creditor and the debtor to determine the “closeness of their relationship”. On the basis of this, the intent behind the assignment of debt by the related party could be determined by the resolution professional to admit genuine claims.

 

Regarding the application of the second prong of the conjunctive test to the Indian context, having an arms-length basis transaction does not exempt a related party from exclusion from the COC. If the assignee is the related party of the related party financial creditor, such an assignee is excluded from within the COC without testing the assignment against the threshold of bad faith.


Conclusion


By virtue of the Supreme Court decision in Phoenix v. Spade, a carve out has been created for participation of assignee of a related party financial creditor to participate in the COC provided that the debt is assigned in good faith. It is upon the resolution professional to determine the related party status of such an assignee. The test of bad faith and intention as devised through Phoenix v. Spade is impracticable and indeterminable and the conjunctive test, if applied to specific assignments by determining the closeness of the relationship between the assignee and the related party financial creditor, could provide a vantage point to overcome this challenge. Lessons can be taken from the US bankruptcy regime to arrive at just and logical conclusions.

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