Collusive Commercial Transactions With Corporate Debtor Will Not Constitute 'Financial Debt' Under IBC : Supreme Court

The Supreme Court has 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 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", observed a bench headed by Justice DY Chandrachud in the case Phoenix Arc Private Limited v Spade Financial Services Ltd and others.

The Supreme Court was hearing appeals challenging the orders of the NCLAT and the NCLT which excluded two entities(AAA & Spade) from the Committee of Creditors constituted for the insolvency resolution of a corporate debtor. The NCLT held that the entities were not "financial creditors" as their transactions with the corporate debtor were collusive in nature and excluded them from the CoC. In appeal, the NCLAT reversed the finding that they were not financial creditors. The NCLAT held that the entities were financial creditors but disqualified them from the CoC on the ground that they were "related parties" of the corporate debtor.

What are collusive transactions?

While considering the issue, the bench discussed the meaning of 'financial debt' and 'collusive transactions'.

It noted that "financial debt" means a debt along with interest, if any, which is disbursed against the consideration for the time value of money.

In the decision in Pioneer Urban Land and Infrastructure Ltd vs. Union of India, the Court had interpreted the term "disbursed" as money which has been paid against consideration for the "time value of money".

"..the "disbursal" must be money and must be against consideration for the "time value of money", meaning thereby, the fact that such money is now no longer with the lender, but is with the borrower, who then utilises the money", the Court had observed in Pioneer.

The Insolvency Law Committee has interpreted "time value"  to mean 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.

In this backdrop, the SC in the present case observed :

"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".

The bench noted that the IBC has 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 CIRP. Such avoidable transactions include: (i) preferential transactions under Section 43 of the IBC; (ii)undervalued transactions under Section 45(2) of the IBC; (iii) transactions defrauding creditors under Section 49 of the IBC; and (iv) extortionate transactions under Section 50 of the IBC.

On facts, the Court noted that the entities and the Corporate Debtor had entered into multiple agreements regarding the same property without giving any explanation or rationale regarding variation in the consideration. This showed that the transactions were collusive in nature entered with the purpose of diverting properties of the Corporate Debtor to the entities.

"Since the commercial arrangements between Spade and AAA, and the Corporate Debtor were collusive in nature, they would not constitute a 'financial debt'. Hence, Spade and AAA are not financial creditors of the Corporate Debtor", the bench, also comprising Justices Indira Banerjee and Indu Malhotra, observed.

Financial Creditor Can Be Excluded From CoC If It Got Rid Of 'Related Party' Label Only With Intention To Circumvent Bar Under Section 21(2) IBC : SC