Related Party Creditors and the Committee of Creditors

If promoters could lend to their own company through friendly entities and then vote on its future as financial creditors, they could steer the insolvency process, block rescue by outsiders and keep control of the business. The Code prevents this by excluding related party financial creditors from the committee of creditors. This note explains who is a related party, the scope of the exclusion and its exception, the Supreme Court's decision in Phoenix ARC, and the other consequences of related party status.

1. Related Party of a Corporate Debtor, Section 5(24)

Section 5(24) lists thirteen categories of persons who are related parties of a corporate debtor. They can be grouped as follows.

Figure 1: The categories in section 5(24)

• Insiders. A director or partner of the corporate debtor or a relative of such a person, and its key managerial personnel or their relatives.
• Linked firms and companies. A limited liability partnership or partnership firm in which a director, partner or manager of the debtor or a relative is a partner, and a private or public company in which such a person is a director and holds, with relatives, more than two per cent of the share capital.
• Persons of influence. Bodies corporate whose board or management is accustomed to act on the advice or directions of a director, partner or manager of the debtor, and persons on whose advice such a director, partner or manager is accustomed to act, other than advice given in a professional capacity.
• Group companies. A holding, subsidiary or associate company of the corporate debtor, or a subsidiary of a holding company to which the debtor is a subsidiary.
• Control. Any person controlling more than twenty per cent of the voting rights in the debtor, any person in which the debtor controls more than twenty per cent of the voting rights, and any person who can control the composition of the debtor's board.
• Association. Any person associated with the debtor through participation in policy making, having more than two common directors, interchange of managerial personnel, or provision of essential technical information.
• Individuals, section 5(24A). A separate definition applies to related parties of an individual, such as relatives, partners and companies in which the individual is a director or holds more than two per cent of shares.

2. The Exclusion from the CoC

• First proviso to section 21(2). A financial creditor, or the authorised representative of a financial creditor, that is a related party of the corporate debtor has no right of representation, participation or voting in a meeting of the committee of creditors.
• Rationale. To prevent the promoters, through related entities, from influencing decisions on the resolution of the company whose failure they presided over, and to ensure that the committee acts in the interests of genuine creditors.
• Second proviso. Inserted in 2018, it provides that the exclusion does not apply to a financial creditor regulated by a financial sector regulator, such as a bank, if it is a related party solely on account of converting or substituting debt into equity shares or convertible instruments before the insolvency commencement date; a bank that took equity in a failing company under a restructuring scheme is therefore not silenced.

Figure 2: Does the creditor sit on the CoC?

3. Phoenix ARC v Spade Financial Services, 2021

• Facts. Spade Financial and AAA Landmark claimed to be financial creditors of AKME Projects; the resolution professional excluded them from the committee as related parties, pointing to their links with the promoters and the nature of their transactions.
• Collusive transactions. Decided on 1 February 2021, the Supreme Court held that their transactions with the corporate debtor were collusive, entered into to give the promoters a voice in the process, and so were not genuine financial debts at all.
• Time of assessment. Ordinarily, whether a financial creditor is a related party is judged when the committee is constituted; but where a creditor was a related party and ceased to be one merely to circumvent the proviso and participate in the committee, it must still be excluded, since the purpose of the provision is to exclude those who would act in the interests of the promoters.
• Significance. The Court looked at the substance of relationships rather than their form, preventing evasion by transfers of shares or resignations timed just before the process.

4. Other Consequences of Related Party Status

Figure 3: Effects of related party status across the Code

• Initiation and claims. A related party financial creditor may still file an application under section 7 and submit its claim, which is admitted if genuine; the exclusion concerns only the committee.
• Treatment in plans. Resolution plans often provide little or nothing for related party creditors, and tribunals have generally treated this as a commercial decision of the committee, since such creditors stand in a different position from independent lenders.
• Avoidance transactions. A preference given to a related party is caught if made within two years before the insolvency commencement date, against one year for others (section 43(4); Topic 48)
• Section 29A. Connected persons of ineligible promoters, including related parties in certain cases, are barred from submitting resolution plans (Topic 38)
• Committee of operational creditors. Where all financial creditors are related parties, the committee is formed of operational creditors and representatives of workmen and employees (Regulation 16; Topic 25)

5. Frequently Asked Questions

Can a holding company that lent to its subsidiary vote in the subsidiary's CoC?

No. A holding company is a related party under section 5(24)(i), and the first proviso to section 21(2) excludes it from representation, participation and voting.

A bank converted part of its loan into a 30 per cent equity stake before insolvency. Can it vote?

Yes. Although the shareholding makes it a related party, the second proviso to section 21(2) preserves the voting rights of a regulated financial creditor that is a related party solely because of converting debt into equity before the insolvency commencement date.

When is related party status tested?

Ordinarily at the time the committee is constituted. But, as held in Phoenix ARC (2021), a creditor that ceased to be a related party only to circumvent the exclusion will still be kept out.

6. Related Topics

• Topic 7: Financial Debt and Financial Creditors. Collusive debt.
• Topic 25: Committee of Creditors. Constitution and voting.
• Topic 38: Section 29A. Ineligible resolution applicants.