Directors' Dilemma: Balancing Multiple Board Seats and Posts Amid Related Party Risks

As the new regime under the Insolvency and Bankruptcy Code, 2016 ("Code") is progressively enacted to facilitate the restructuring of companies and individuals, the notion of "related party" has become an increasingly pivotal concern for directors assuming roles across multiple entities. Directors are growing apprehensive as their relation with the ‘Corporate debtor’, may preclude their companies from engaging or voting in the Committee of Creditors under Section 21(2) of the Code, or from submitting resolution plans pursuant to Section 29A. Furthermore, transactions conducted within two years prior to the commencement of insolvency proceedings may be subjected to rigorous scrutiny under Sections 43, 45, 47, 50, or 66 of the Code, potentially being deemed preferential, undervalued, fraudulent, or extortionate. This mounting uncertainty underscores the urgent need for clarity, enabling directors, shareholders, and key managerial personnel to confidently assume positions in multiple companies without the looming risk of triggering undesirable legal ramifications.

Related party under IBC

The term "related party" is defined under Sections 5(24) and 5(24A) of the Code, providing an exhaustive list of situations in which both a corporate entity and an individual may be considered ‘related party’ to a corporate debtor. Specifically, sub-sections (f), (h), and (m) of Section 5(24) address scenarios in which a director of one company simultaneously holds a position or acts in some capacity with a corporate debtor. In such cases, the director and, further, its company too is likely to be classified as a related party to the corporate debtor under the Code.

Definition under IBC describes a commutative relationship

In the case of Phoenix Arc Private Limited vs. Spade Financial Services Limited & Ors. AIR 2021 SC 776 (“Pheonix ARC”), the Hon’ble Supreme Court, despite relying on an unreliable source, observed that the definition of “related party" under the Code, describes a commutative relationship. This means that X may be considered a related party to Y if either X is related to Y, or Y is related to X.

The view that a related party relationship is commutative raises doubts and warrants further scrutiny, as it broadens the definition to cover all forms of inter-relationships between the financial creditor and the corporate debtor, potentially extending its scope beyond what was originally intended.

Common Directorship and Collusive Transactions Coinciding at the Same Time: Key Indicators of Related Party Status

In the case of Phoenix Arc., the Supreme Court examined transactions between Spade Financial Services Limited (“Spade”), AAA Landmark Private Limited (“AAA”), and the corporate debtor, which had occurred well before the initiation of the Corporate Insolvency Resolution Process (“CIRP”). These transactions, involving substantial amounts, were deemed to be sham transactions by the Court. Furthermore, since these transactions took place while the director of Spade and AAA held key positions within the corporate debtor, both Spade and AAA were classified as related parties to the corporate debtor. This conclusion was based on the understanding that the director, partner, or manager of the corporate debtor had acted on the advice, directions, or instructions of the corporate debtor.

The Supreme Court has held that due to the virtue of holding the position of consultant, CEO, strategic advisor, a person can influence the affairs of Corporate Debtor

In the case of Phoenix Arc., Mr. Arun Anand, director of Spade and AAA, was also a director of the Corporate Debtor up to 31 March 2002. Further, Mr. Arun Anand and his son, Mr. Aditya Anand, held shareholding in the Corporate Debtor until the year 2004/2005. Mr. Arun Anand was also closely related to one of the directors of the Corporate Debtor, Mr. Sonal Anand, who is his brother-in-law; and Mr. Arun Anand has worked in different capacities for Mr. Anil Nanda, promoter of Corporate Debtor, for about 25 years.

During the relevant period when the sham transaction happened between Corporate Debtor and Spade in the year 2010 to 2013, Mr. Arun Anand was a consultant, Strategic Advisor and then group CEO and thereafter held no position in Corporate Debtor till the initiation of CIRP in 2018.

The Supreme Court has while giving its findings, relied on the deep entanglement between the entities associated with Mr. Arun Anand and Mr. Anil Nanda, noting that Mr. Arun Anand held positions during the relevant period that could have allowed him to influence the affairs of the Corporate Debtor.

1. Deep Interlinking of Interests:

• The involvement of Mr. Arun Anand with the Corporate Debtor, both directly and through familial and professional connections (e.g., his brother-in-law Mr. Sonal Anand, and his long-term working relationship with Mr. Anil Nanda, the promoter), indicates a high degree of entanglement. This suggests that, during the relevant period, Mr. Anand might have had significant influence over the Corporate Debtor’s decisions.

• This entanglement plays a central role in how courts view the corporate relationships when assessing whether there was a potential for conflicts of interest or undue influence in corporate transactions, particularly in cases like the one in Phoenix Arc.

2. Influence and Control of Corporate Decisions:

• Mr. Arun Anand’s role in the Corporate Debtor (as a director until 2002, and later as a strategic advisor and group CEO from 2010 to 2013) provides him with an extensive history in the company’s governance. Even though he was no longer holding any official position post-2013 until the initiation of CIRP (2018), his previous positions may have left a lasting influence on the operations of the Corporate Debtor.

• The court’s reliance on these deep connections, particularly the ability of a person to influence decisions, highlights that the actions or directions of such individuals can create potential conflicts of interest when assessing related party transactions.

3. Caution on Broad Interpretation:

• While the Court’s interpretation of deep interrelationships in Phoenix Arc may be valid in this specific context, such an approach should not be universally applied to all cases. It should not have overreaching interpretations, especially when considering professionals (e.g., auditors) who may not have a direct influence on corporate governance but play a role in routine functions.

• A director of a financial creditor who serves as an auditor for the Corporate Debtor, for instance, should not automatically be assumed to be a related party under the Code without further scrutiny of the context. The importance of distinguishing between routine professional relationships and situations where one party’s actions or influence over the Corporate Debtor is truly extraordinary is warranted.

4. Clarification of “Ordinary Course of Business” and Related Party:

• Referencing the Supreme Court's decision in Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited vs. Axis Bank Limited and Ors. (2020) 8 SCC 401, the concept of "ordinary course of business" is critical. For a body corporate to be classified as a related party under Section 5(24)(f) of the IBC, its actions must align with the ordinary flow of business activities. This means that the body corporate should be accustomed to acting based on the directions or advice of the Corporate Debtor’s managers or directors without any extraordinary or unique circumstances surrounding such interactions.

• The application of this standard reinforces the idea that a related party relationship should be seen as something that is part of routine business operations, rather than stemming from unusual or exceptional situations. This standard ensures that not every relationship or transaction involving a Corporate Debtor and an associated entity qualifies as a related party transaction, thereby avoiding an overly expansive interpretation of "related parties."

Supreme Court's Reliance on Circumstantial Evidence to Determine Whether Director, Partner, or Manager of Corporate Debtor Acted on Spade's Advice, Directions or Instructions

In considering whether the Corporate Debtor’s board, directors, and others were accustomed to acting on the advice, direction, or instruction of Mr. Arun Anand, and whether he participated in the policy-making process of the Corporate Debtor, the Supreme Court emphasized that establishing intent or mens rea may not always be feasible for the NCLT and NCLAT in summary proceedings. Instead, inferences can be drawn from the available facts. The Court relied on the deep entanglement between the entities associated with Mr. Arun Anand and Mr. Anil Nanda, noting that Mr. Arun Anand held positions during the relevant period that could have allowed him to influence the affairs of the Corporate Debtor. Further supporting this conclusion, the Supreme Court highlighted that the transactions between the Corporate Debtor and the entities led by Mr. Arun Anand were collusive in nature. Based on these findings, the Supreme Court concluded that Spade entered into two transactions based on the advice, instructions, or directions of the board or directors of the Corporate Debtor, thereby classifying them as related parties under Section 5(24)(f) of the Code.

The Supreme Court seems to have employed reverse reasoning in interpreting Section 5(24)(f) of the Code. It first noted the common directorship and sham transactions, then concluded that these must have been based on the advice, instructions, or directions of the Corporate Debtor’s board or directors. In doing so, the Court bypassed the crucial step of directly proving that the director, partner, or manager acted on Spade’s advice, and therefore these are related parties.

Interpreting “Advice, Directions or Instructions” in Relation to Corporate Debtor: Insights from Judicial Precedents

In ODAT GmbH vs. CA Santanu Brahma, IRP of Darjeeling Organic Tea Estates Private Limited CA(AT)(I) No. 1683 of 2023 (“ODAT GmbH”), the NCLAT ruled that to apply Section 5(24)(h) of the Code, it must be proven that a Director, Partner, or Manager of the Corporate Debtor acts on the advice of the financial creditor. Merely sharing a common director between the financial creditor and the Corporate Debtor is not enough to establish this. The NCLAT emphasized that it must be demonstrated and material placed on record to show that the director, promoter, or manager is accustomed to acting on the advice, direction, or instruction of the financial creditor.

Further, in ODAT GmbH, the NCLAT considered Rembert Biemond’s dual roles as a nominee director for the Corporate Debtor and managing director of ODAT GmbH, a financial creditor. The NCLAT concluded that Biemond’s actions as a director of the Corporate Debtor were independent of ODAT GmbH, and therefore, treating ODAT GmbH and Biemond as one was incorrect. The NCLAT further ruled out the applicability of Section 5(24)(m)(i) and Section 5(24)(m)(iv), finding no evidence that ODAT GmbH influenced the Corporate Debtor’s policy-making or exchanged technical information with it. The NCLAT order is currently pending in Civil Appeal No. 004681/2024 before the Supreme Court.

Interpretation of 'Is a Related Party' in Section 24(5) and Section 21(2) as Referring to the Present

The Supreme Court in Pheonix ARC examined the term "is" in relation to a related party of the corporate debtor, clarifying that the statute applies in praesenti, at the time of admission of the application seeking the initiation of the CIRP, rather than to parties that are no longer related to the corporate debtor.

The argument before the Supreme Court was that a financial creditor seeking a position on the Committee of Creditors (“CoC”) based on a debt created while it was a related party should be excluded under the first proviso to Section 21(2). However, applying this rule too broadly could unfairly exclude creditors who took over debt from related parties or whose related party status has long ceased. The Supreme Court held that the exclusion applies to the current relationship, not the debt itself. A financial creditor who is not a related party should not be debarred. However, if a former related party creditor divests its shareholding to manipulate the CoC or sabotage the CIRP, it would be in line with the law to exclude them.

Conclusion

The broad definition of "related party" under the Code aims to safeguard the integrity of the insolvency process but also presents challenges in interpreting the scope of its provisions, especially when dealing with complex corporate structures and overlapping roles. The judicial emphasis on circumstantial evidence and the need to establish direct influence or control is crucial to prevent abuse of the system. As the law develops, it is imperative for directors, financial creditors, and other stakeholders to be mindful of their roles and responsibilities, ensuring that their actions do not inadvertently undermine the resolution process.