The Insolvency and Bankruptcy Code, 2016 (“Code”), has marked a significant shift in India’s corporate insolvency landscape, transitioning from a debtor-centric approach to a creditor-centric approach. With the committee of creditors (“CoC”) now driving the resolution process, it has become imperative for “related parties”, likely to sabotage the resolution process of a corporate debtor, to be excluded from the same. For this purpose, the Code stipulates that “related parties” should not (i) regain control of the company either by means of submitting a resolution plan (Section 29A); or (ii) be allowed to influence the resolution process by participating and voting in CoC meetings (first proviso to Section 21(2)).
However, debarment from CoC participation is a major concern among pure play financial investors/ private equity financiers that possess minority protective rights on account of their investments in such corporate debtors. While these external creditors may have no pre-existing relationship with the corporate debtor, they are stuck within the confines of the first proviso to Section 21(2).
Understanding “related parties”: Literal v Purposive Interpretation of “Control”
Under Section 5(24)(j) of the Code, any person who ‘controls’ more than 20% of the voting rights in a corporate debtor, on account of ownership or voting agreements, comes within the ambit of a “related party”. A ‘related party’ is disqualified from becoming a part of the CoC by virtue of the first proviso of Section 21(2). While a literal interpretation of the said provisions under the Code would simplicitor debar any creditor holding more than 20% voting rights in the corporate debtor from participating in the CoC, such an approach is counter-intuitive.
The Hon’ble Supreme Court has repeatedly emphasised the importance of purposive interpretation of statutory provisions, basis both the text and the context in which said provisions have been enacted, including in Arcelor Mittal[i]. Further, in Phoenix ARC[ii], the Hon’ble Supreme Court has held that the true test for determining whether the exclusion in the first proviso to Section 21(2) applies should be formulated in a manner that furthers the object and purpose of the Code and not lead to its provisions being defeated by disingenuous strategies.
Pertinently, even the definition of “control” under the Code has long been accepted to denote proactive and effective control and not merely reactive control by virtue of exercising certain affirmative voting rights.
The Hon’ble Supreme Court in Arcelor Mittal has held that “control” under Section 29-A(c)[iii] would mean only positive control and the mere power to block special resolutions of a company, i.e. reactive control, cannot amount to “control” under Section 29A. Further, the Hon’ble Supreme Court found the observations of the Securities Appellate Tribunal (“SAT”) in Subhkam Ventures[iv] to be apposite and applicable to the expression “control” in Section 29-A(c), which inter alia held that the real test of control is whether the person is in the driving seat and not when he is merely controlling the brakes.
As such, “control” under the Code has not been understood in a literal and absolute sense.
However, the National Company Law Tribunal’s (“NCLT(s)”) interpretation of the term “control” — while deciding whether a creditor possessing voting rights, would be allowed to participate in the CoC or not — has been anything but consistent.
For instance, NCLT, Kolkata, in Sarga Udaipur Hotels and Resorts Private Limited v Housing & Urban Development Corporation Ltd.[v], noted that despite exercising 24.4% control, the influence the financial creditor wielded on the affairs of the corporate debtor was only “theoretical” and did not fit the shoes of a related party as interpreted by the Hon’ble Supreme Court in Phoenix ARC. Accordingly, the financial creditor was allowed to participate in the CoC of the corporate debtor.
On the other hand, in Zenith Infra Investment Holdings Pte. Limited v Rajneesh Kumar Aggarwal[vi] (“Zenith”),NCLT, New Delhi, took a more conservative approach and refused to permit a 30% shareholder to participate in the CoC, even though the said creditor was not a promoter and was not involved in the day-to-day management of the corporate debtor. In doing so, the NCLT not only failed to apply the test of “control” laid down by the Hon’ble Supreme Court in Arcelor Mittal, but also failed to adopt a purposive interpretation as urged by the Hon’ble Supreme Court in Phoenix ARC.
Exception to the Exclusion Rule – Second proviso to Section 21(2)
Pertinently, by way of the Insolvency and Bankruptcy Code (Second Amendment) Act, 2018, an exception to the general rule that a related party ought to be excluded from participating in the CoC was added in the form of Explanation 1 to Section 29A(c) and the second proviso to Section 21(2) of the Code. The rationale for the addition was elaborated in the Report of the Insolvency Law Committee, 2018, which noted that it would be unfair to deny pure play financial creditors representation or voting rights in the CoC on account of equity held by them, pursuant to past debt restructuring schemes.
The second proviso to Section 21(2) carved out an exception to the rule of exclusion of related parties from the CoC for persons: (i) regulated by a financial sector regulator; and (ii) who become related party, solely on account of conversion or substitution of debt into equity shares or completion of such transaction as may be prescribed, prior to the insolvency commencement date.
Subsequently, the Report of the Insolvency Law Committee, 2020 (“2020 ILC Report”), interpreted the phrase “regulated by a financial sector regulator” broadly to also include such foreign financial creditors who are not directly regulated by financial sector regulators, but whose managers or advisors are regulated by a regulator. The 2020 ILC Report noted that in view of the broad interpretation, no legislative change to the second proviso to Section 21(2) is required.
Therefore, the intent of the legislature is amply clear – a wide and purposive interpretation is required to be adopted to ensure that the interests of the financial creditors, who had no intention of acquiring control or running the corporate debtor’s business, remain protected.
Judicial Interpretation of the second proviso
The NCLT, Hyderabad, in State Bank of India v Gati Infrastructures Bhamsey Power Private Limited (“Gati Infrastructure”)[vii], allowed a financial creditor with 25% equity shareholding in the corporate debtor to participate in the CoC, in light of the fact that the creditor had exercised its put option, but was compelled to continue holding equity shares in the corporate debtor. In reaching such a conclusion, the NCLT held that the phrase “or completion of such transactions as may be prescribed” in the second proviso to Section 21(2), should also include such transactions which create compelling circumstances for financial creditors to continue as equity shareholders. The NCLT was of the view that lending financial institutions, which are involved in equity funding of projects (i) not with the intention to control or manage the company, but for the sole purpose of providing financial help to the promoters in the initial stages; and (ii) which had no intention to continue as equity shareholders, should not be classified as “related parties”.
In contrast, NCLT, Delhi, in Zenith has refrained from adopting a wide and purposive interpretation of the aforesaid phrase and has merely held that there were no compelling circumstances forcing the financial creditor to reluctantly hold its shareholding (as in Gati Infrastructure). However, NCLT, Delhi, failed to consider that the ratio in Gati Infrastructure was not entirely based on whether the exit option had been exercised by the creditor or not, rather on (i) the intention of the creditor behind funding the company; and (ii) whether the creditor wished to continue as an equity shareholder in the company or not.
In view of the conflicting decisions, it is imperative that the ambiguity around the interpretation of “completion of such transactions as may be prescribed” and the applicability of the second proviso to Section 21(2) is cleared, to safeguard the interests of financial creditors.
Conclusion
The Code aims to balance the interests of all stakeholders, including the rights of external creditors, who have not contributed to the downfall of the corporate debtor. A strict interpretation of the provisions to exclude bonafide financial investors from taking part in the CoC would have a detrimental and chilling effect on investments in India, consequently raising the cost of capital and degrading ease of doing business in the country.
For further information, please contact:
Raunak Dhillon, Partner, Cyril Amarchand Mangaldas
aunak.dhillon@cyrilshroff.com
[i] Arcelor Mittal India Private Limited v. Satish Kumar Gupta, [(2019) 2 SCC 1] (“Arcelor Mittal”).
[ii] Phoenix ARC Private Limited v. Spade Financial Services Limited, (2021) 3 SCC 475 (“Phoenix ARC”).
[iii] Explanation 1 of Section 29A(c) and the second proviso to Section 21(2) are pari materia and the second proviso to Section 21(2) was inserted vide the same amendment i.e. Act No. 26 of 2018 with effect from 06.06.2018.
[iv] Subhkam Ventures (I) Private Limited v. The Securities and Exchange Board of India, Appeal No. 8 of 2009.
[v] I.A. (IB) 514/KB/2022 in CP(IB) 202/KB/2021.
[vi] I.A. No. 2225 of 2024 in C.P. (IB) No. 545/(ND)/2023.
[vii] I.A. 1477 of 2023 in CP (IB) No. 203/HDB/2022
