Between the Lines | Supreme Court: If a corporate debtor has only offered security by pledging shares, without undertaking an obligation to discharge the borrower’s liability, then the creditor in such a case will not become ‘financial creditor’ vis-à-vis the corporate debtor as defined under the IBC

The Hon’ble Supreme Court (“SC”) has in its judgment dated February 03, 2021 (“Judgement”), delivered by a three judge bench, in the matter of Phoenix Arc Private Limited v. Ketulbhai Ramubhai Patel [Civil Appeal No.5146 Of 2019], held that if a corporate debtor has only offered security by pledging shares, without undertaking an obligation to discharge the borrower’s liability, then the creditor in such a case will not become ‘financial creditor’ vis-à-vis the corporate debtor as defined under the Insolvency and Bankruptcy Code, 2016 (“IBC”).

Facts

Phoenix ARC Private Limited (“Appellant”) filed an appeal under Section 62 of the IBC against the judgment of the National Company Law Appellate Tribunal, New Delhi (“NCLAT”) dated April 09, 2019 wherein the NCLAT had dismissed the appeal filed by Appellant and held that pledge of shares in question did not amount to disbursement of any amount against the consideration for the time value of money and that it did not fall within the ambit of Section 5(8)(f) of the IBC. Previously, National Company Law Tribunal, Mumbai (“NCLT”) by order dated February 22, 2019 had rejected the miscellaneous application filed by the Appellant under Section 60(5)(c) of the IBC and held that the Appellant is not a financial creditor of Doshion Veolia Water Solutions Private Limited (“Corporate Debtor”).
The predecessor of the Appellant, L & T Infrastructure Finance Company Limited (“Lender”) advanced a financial facility of INR 40 crores repayable in 72 structured monthly instalments, to Doshion Limited (“Borrower”) (the parent company of the Corporate Debtor), by way of a facility agreement dated May 12, 2011 (“Facility Agreement”) executed between the Lender and the Borrower. The board of directors of Corporate Debtor passed a resolution on July 26, 2011 to give ‘Non-Disposal Undertaking’ in favour of the Lender whereby it was authorised to provide an undertaking to the effect that 100% of the Corporate Debtor’s shareholding in Gondwana Engineers Limited (“GEL”) shall not be disposed of so long as any amounts were due, payable and outstanding under the financial assistance provided by the Lender to the Borrower. The said deed of undertaking was executed by the Corporate Debtor in favour of the Lender (“Deed of Undertaking”) on January 10, 2012.

On January 10, 2012, an agreement was also executed between the Corporate Debtor and the Lender by which, 40,160 shares of GEL were pledged as a security (“Pledge Agreement”). Subsequently, by agreement dated December 30, 2013 (“Assignment Deed”), the Lender assigned all rights, title and interest in the financial facility including any security, interest therein in favour of the Appellant under Section 5 (Acquisition of rights or interest in financial assets) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.

Subsequently, the Borrower failed to repay the loan as per the terms of the Facility Agreement. Therefore, the Appellant issued a notice dated February 19, 2014 and recalled the financial facility. Further, the Appellant filed an application before the Debts Recovery Tribunal, Ahmedabad.

In the interim, Bank of Baroda (“Intervenor”) filed a company petition before the NCLT under Section 7 of the IBC to initiate the corporate insolvency resolution process (“CIRP”) in respect of the Corporate Debtor which was admitted by an order dated August 31, 2018.Consequently, the CIRP commenced, thereby the interim resolution professional for the Corporate Debtor was appointed, who was later confirmed as the resolution professional (“Respondent”). Subsequently, the Appellant filed a claim for an amount of INR 83,49,85,667/- with the Respondent. The Appellant stated that pledge of shares by the Corporate Debtor was in essence a guarantee for financial debt and, therefore, Appellant was a financial creditor of the Corporate Debtor. However, the Respondent by e-mails dated September 20, 2018 and November 23, 2018, expressed an opinion that as per the Pledge Agreement, the Corporate Debtor’s liability was restricted to pledge of the shares only. The Respondent by e-mail dated December 04, 2018 rejected the claim of the Appellant as financial creditor of the Corporate Debtor on the ground that there was no separate deed of guarantee executed in favour of the Lender by the Corporate Debtor.

Thereafter, the Appellant filed miscellaneous application before the NCLT, seeking a direction to the Respondent to admit the claim of the Appellant as a financial debt with all consequential benefits. However, the NCLT rejected the application. Subsequently, the NCLAT dismissed the appeal filed by the Appellant. Aggrieved by the judgment of the NCLAT, the Appellant filed an appeal before the SC.

The relevant provisions in the instant case include Sections 5(7) (definition of financial creditor), 5(8) (definition of financial debt), 3(10) (definition of creditor) and 3(11) (definition of debt) of the IBC.

Issue

Whether the Appellant is a financial creditor qua the Corporate Debtor basis the Pledge Agreement and the Deed of Undertaking executed with the Lender.

Arguments

Contentions raised by the Appellant:

There is a debt which is payable by the Corporate Debtor to the Appellant. The Appellant had stepped into the shoes of Lender by virtue of the Assignment Deed. The Appellant is a financial creditor within the meaning of Section 5(8)(b) read with Section 5(8)(i) of the IBC. The Lender (Appellant) had full rights to pursue against the surety even before the Borrower. The Borrower had borrowed a financial facility and therefore, Corporate Debtor undertook a liability, by creating a security interest in the form of pledge of shares of GEL in favour of the Lender.
A concern was raised that if the Appellant was not accepted as financial creditor as per the provisions of the IBC, it consequently would leave the Appellant effectively remediless inasmuch as the Appellant could not enforce the guarantee during the subsistence of moratorium period. Further, if the resolution plan was passed without any redress to the Appellant, the Appellant shall be gravely prejudiced since recovery of the claim amount from the Corporate Debtor will be impossible.

The Corporate Debtor in effect had provided a guarantee to Lender against the debts due from the Borrower, and in case of non-payment, a charge subsisted upon the 100% shareholding of GEL. The liability of the Corporate Debtor, who is the surety, was co-extensive to that of the Borrower under Section 128 of the Indian Contract Act, 1872 (“1872 Act”).

Appellant submitted that any security that would permit the right of action against a third party that is not the Borrower, would amount to guarantee. The mere fact that Corporate Debtor has not borrowed money from the Appellant, could not absolve the Corporate Debtor from its liability as guarantor. The term guarantee is not to be understood narrowly but broadly to include any security created by third party to secure repayment of financial debt including a pledge of shares. Therefore, the pledge of shares by Corporate Debtor to secure the loan advanced to the Borrower amounts to a guarantee. The Appellant further submitted that the judgment of the SC in the case of Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and others, [(2020) 8 SCC 401], which was also relied upon by the Respondent, had been rendered in a specific facts scenario, which do not apply to the present case.

Contentions raised by the Respondent:

The Appellant is not a creditor of the Corporate Debtor in any nature whatsoever. The Appellant has no right of recovery of any debt from the Corporate Debtor. The Appellant only had a limited right of enforcing and realising the value of the shares held by the Corporate Debtor of GEL which are provided as a security for the financial assistance extended to the Borrower as per the Pledge Agreement.

The Pledge Agreement cannot be equated with guarantee as both are absolutely different in terms of their ramification and implication as per the provisions under the 1872 Act. Section 5(8)(I) of the IBC takes within its ambit any liability arising out of a guarantee for any of the items referred to in sub-clauses (a) to (h) of Section 5(8) of the IBC only, and not any other instrument that is in the nature of a guarantee. The Corporate Debtor has not executed any deed of guarantee with the Appellant to perform the promise, or discharge the liability of a third party in case of his default. In the event of default by the Borrower, the Appellant has the limited right to realise the money by selling the shares pledged. The Corporate Debtor had not promised to repay the debt that was recoverable from the Borrower. The Appellant cannot claim their Pledge Agreement to be a guarantee as there is no deed of guarantee executed.

The Respondent and the Intervenor contended that the object of the IBC is entirely different. IBC is not a mechanism for recovery of any amount. As an admitted fact, the Appellant has already moved the Debt Recovery Tribunal, Ahmedabad, for recovery and realisation of its dues.

Observations of the Supreme Court

Transaction:
The Corporate Debtor was not a party to the Facility Agreement executed between the Borrower and the Lender. It was the Borrower who had promised to repay the loan of INR 40 crores as per the terms of the Facility Agreement. ‘Schedule-IV’ of the Facility Agreement provided for ‘Security Creation’ which, inter alia, included, a pledge of 100% equity shares together with all accretions thereon of GEL. Subsequently, 40,160 shares of GEL were pledged, by executing the Pledge Agreement and the Deed of Undertaking, between the Lender and the Corporate Debtor. The SC observed that it transpires that since some shares of GEL were also held by the Corporate Debtor (the subsidiary of the Borrower), the same were also pledged with the Lender as additional security.

Analysing provisions of the IBC and the 1872 Act:

The SC perused the provisions of the IBC and noted that, Section 5(7) of the IBC defines ‘financial creditor’ as any person to whom a financial debt is owed and includes a person to whom such debt has been legally assigned or transferred to. The word ‘guarantee’ and ‘indemnity’ under Section 5(8)(i) of the IBC have not been defined in the IBC. As per Section 3(37) of the IBC, words and expressions used that are not defined in the IBC, but defined in the 1872 Act, shall have the meaning respectively assigned to them.

Therefore, the SC noted that, Section 126 of the 1872 Act defines ‘Contract of guarantee’ as a contract to perform the promise, or discharge the liability, of a third person in case of his default. The SC observed that, the Corporate Debtor had not entered into a contract to perform the promise, or discharge the liability of Borrower in case of default. The SC noted that the Pledge Agreement was limited to pledge of shares as security. The promise as made by the Borrower in the Facility Agreement to discharge the liability of debt of INR 40 crores was not undertaken by the Corporate Debtor. Therefore, the Pledge Agreement and Deed of Undertaking executed between the Lender and Corporate Debtor could not be termed as contract of guarantee within the meaning of Section 126 of the 1872 Act.

The SC noted that the fundamental requirement for a creditor to be recognized as a financial creditor under Section 5 of the IBC, is that there must be a financial debt which is owed to that person irrespective of him being the principal creditor to whom the financial debt is owed or an assignee in terms of extended meaning. The SC further observed that, the definition, by its very frame, cannot be read so expansive/ infinitely wide, that the essential requirements of disbursement against the consideration for the time value of money could be forsaken in the manner that any transaction could standalone to become a financial debt. Further, the SC noted that Sections 5(7) and 5(8) prescribe the transactions vis-à-vis a corporate debtor. Therefore, for the Lender to be designated as a financial creditor of the Corporate Debtor, it had to be proved that the Corporate Debtor owed a financial debt to the Lender.

The SC noted that, the Respondent had relied on two-judge bench judgment of Jaypee Infratech Limited v. Axis Bank Limited (supra) wherein one of the issues raised was similar to the issue raised in this Judgement, therefore, the paragraphs 46 to 50.2, containing an elaborate analysis on the meaning of ‘financial debt’, ‘financial creditor’ under Section 5 of the IBC and ‘debt’ and ‘secured creditor’ under Section 3 of the IBC were extensively noted by the SC in this Judgement.

Ambit of a financial creditor and a creditor under the IBC:

The SC noted that the generic term ‘creditor’ is defined to mean any person to whom the debt is owed. Further, it is clarified that it includes a ‘financial creditor’, a ‘secured creditor’, an ‘unsecured creditor’, an ‘operational creditor’, and a ‘decree-holder’. A “secured creditor” as per Section 3(30) of the IBC means a creditor in whose favor a security interest is created; and “security interest”, as per Section 3(31) of the IBC, means a right, title or interest or claim of property created in favor of or provided for a secured creditor by a transaction which secures payment for the purpose of an obligation.

The SC further noted that, under Section 3(11) of the IBC ‘Debt’ means a liability or obligation in respect of a claim which is due from any person and that it includes a ‘financial debt’ and an ‘operational debt’.Further, Section 5(8) of the IBC defines ‘financial debt’ as debt along with interest, if any, which is disbursed against the consideration for the time value of money and the second part of the definition provides instances/ methods to raise financial debt.

The SC observed that the conjoint reading of the statutory provisions with the enunciation of the SC in Swiss Ribbons Private Limited and Another. v. Union of India and Others. [(2019) 4 SCC 17], clarified the scheme of the IBC, and the intention of the legislature, of the expression ‘financial creditor’ to mean a person who has direct engagement in the functioning of a corporate debtor; who is involved right from the beginning while assessing the viability of a corporate debtor; engaging in restructuring of the loan as well as in re-organization of a corporate debtor’s business.

The SC contrasted the position and role of a financial creditor with that of a person having only security interest over the assets of the corporate debtor. The latter shall have only the interest of realizing the value of its security, there being no other stakes involved and least any stake in the corporate debtor’s growth or equitable liquidation, while the former would, not only safeguard its own interests, but would also be interested in rejuvenation, revival and growth of the corporate debtor, thereby safeguarding the interests of other stakeholders. The SC noted, if a person having only security interest over the assets of the corporate debtor is also included as a financial creditor and thereby allowed to have consequential benefits, rights/opinions in the CIRP and/or liquidation process as contemplated under the IBC, the growth and revival of the corporate debtor may be the casualty. Such result would defeat the very objective of the IBC, particularly of the provisions aimed at CIRP.

The SC, therefore, concluded that a person such as the Lender, having only security interest over the assets of the Corporate Debtor, even if falling within the description of ‘secured creditor’ by virtue of collateral security extended by the Corporate Debtor, would nevertheless stand outside the sect of ‘financial creditors’ as per the provisions of the IBC. Hence, it would remain a debt alone and cannot partake the character of a ‘financial debt’ within the meaning of Section 5(8) of the IBC.

Thus, the security interest by way of the Pledge Agreement created in favor of the Lender, made the Lender a secured creditor only. The SC observed that on reading all the defining clauses harmoniously, it is clear that the legislature has maintained a distinction amongst the expressions ‘financial creditor’ and ‘secured creditor’. The SC concluded that every secured creditor and financial creditor would be a creditor; but every secured creditor may not be a financial creditor.

The SC observed that, the analysis as stated above and the consequent ratio of Jaypee Infratech Limited v. Axis Bank Limited (supra) were completely applicable to the present case, since herein the Corporate Debtor had only extended a security by pledging shares of GEL. The SC observed that therefore, the Pledge Agreement and the Deed of Undertaking, executed subsequent to the Facility Agreement, were security in favour of the Lender, who at best will be secured creditor and not the financial creditor qua the Corporate Debtor within the meaning of Sections 5(7) and 5(8) of the IBC.

Decision of the Supreme Court

The SC upheld the decision of the Respondent as approved by the NCLAT that, the Appellant was not a financial creditor of the Corporate Debtor and it also held that the miscellaneous application was rightly rejected by the NCLT.

However, the SC clarified that the observations made in this Judgement were only for deciding the claim of the Appellant as the financial creditor within the meaning of Sections 5(7) and 5(8) of the IBC and, therefore, shall have no bearing on any other proceedings undertaken by the Appellant to establish any of its right(s) in accordance with law. Thereby, the SC dismissed the appeal.

Vaish Associates Advocates View:

The SC distinguished the role of a financial creditor and secured creditor. The SC by this Judgement clarified that if the Corporate Debtor does not owe a financial debt to the Lender, then the Lender cannot be recognized as a financial creditor. The SC observed that, methods for raising debt may include modes prescribed in sub-clauses (a) to (f) of Section 5(8) of the IBC. Further, the judiciary has on multiple occasions clarified without an iota of doubt that for a debt to become ‘financial debt’, the fundamental principle is that the debt must exist and that it ought to be a disbursal against the consideration for time value of money, even if the mode of raising debt is not necessarily as stated in the section, it must at least have the features which could be traced to such essential elements in the principal clause of Section 5(8) of the IBC.

The SC observed the unique position that the financial creditor holds, due to its own direct involvement in a functional existence of the corporate debtor. The SC observed that the financial creditors are entrusted with the task of ensuring the sustenance and growth of the corporate debtor, akin to that of a guardian. In other words, in the context of CIRP, this class of stakeholder, namely, financial creditor, is entrusted by the legislature with such a role that it would look forward to ensure that the corporate debtor is rejuvenated and gets back on its wheels with reasonable capacity of repaying its debts and to discharge its various obligations. Therefore, the role of financial creditors and the consequential benefits they receive, including the voting rights in the committee of creditors, aim for the resolution of the corporate debtor.

…
For more information please write to Mr. Bomi Daruwala at [email protected]

Between the Lines | Supreme Court: Related parties cannot be included in the committee of creditors by way of collusive transactions

The Supreme Court (“SC”) has in its judgement dated February 1, 2021 in the matter of Phoenix Arc Private Limited v. Spade Financial Services Limited and Others [Civil Appeal No. 2842 of 2020] (“Judgement”) held that those related party financial creditors that cease to be related parties in order to circumvent their exclusion from the committee of creditors, under the first proviso to Section 21(2) of the Insolvency and Bankruptcy Code, 2016 (“IBC”), should also be considered as being covered by the exclusion thereunder.

Facts
This Judgement governs two sets of appeals arising from the order of the National Company Law Appellate Tribunal (“NCLAT”) dated January 27, 2020. The NCLAT had dismissed the appeal preferred by AAA Landmark Private Limited (“AAA”) and Spade Financial Services Private Limited (“Spade”) against the National Company Law Tribunal, New Delhi Bench-III (“NCLT”) order dated July 19, 2019 (“NCLT Order”), which ruled that they needed to be excluded from the committee of creditors (“CoC”) formed for the corporate insolvency resolution process (“CIRP”) against AKME Projects Limited, the Corporate Debtor (“Corporate Debtor”). The first appeal was preferred by Phoenix Arc Private Limited (“First Applicant/ Appellant”), which, while agreeing with the NCLAT order of excluding Spade and AAA (collectively referred to as “Second Applicants/ Respondents”) from CoC, on account of being related parties of Corporate Debtor, disagreed with their being classified as financial creditors (“Financial Creditor”). Another appeal was independently filed by the Second Applicants to challenge the NCLAT order with regard to their exclusion from the CoC.

Mr. Anil Nanda, is a majority shareholder of Joint Investment Private Limited (“JIPL”), which in turn held a stake in Spade and 80% shareholding in the Corporate Debtor. The Corporate Debtor is a part of Anil Nanda Group of Companies (“Group Companies”). Mr. Arun Anand was the Group CEO of the Group Companies, which included the Corporate Debtor, from November 26, 2012 to February 14, 2013, and a director of the Second Applicants. Mr. Arun Anand was also a director of the Corporate Debtor up to March 31, 2002. Further, Mr. Arun Anand is the brother-in- law of Mr. Sonal Anand who was a director of the Corporate Debtor from 2007 to 2013, at the time when the relevant transactions between the Second Applicants and the Corporate Debtor took place. After February 2013, Mr. Arun Anand had no relation with the Corporate Debtor.

Spade had filed its claim as a Financial Creditor for a sum of INR 109 crores on May 20, 2018 on the basis of an alleged Memorandum of Understanding dated August 12, 2011 (“MOU”) executed with the Corporate Debtor, which stated that Inter Corporate Deposits (“ICDs”) were granted to the Corporate Debtor by Spade bearing an interest of 24%, though in actuality only 12% interest was charged. AAA, a wholly owned subsidiary of Spade, had entered into a Development Agreement on March 1, 2012 (“Development Agreement”), through which Corporate Debtor sold 38.3% of its development rights in its real estate project, AKME RAAGA, to AAA for INR 32.80 crores. Subsequently, an Agreement to Sell dated October 25, 2012 (“Agreement to Sell”), which superseded the Development Agreement was entered into, through which AAA bought a saleable area of 313,928 square feet in AKME RAAGA at a price of INR 43.06 crores. A side letter dated October 25, 2012 (“Side Letter”), which was to be read as a part of the Agreement to Sell, noted that the area bought by AAA was 38.3% of AKME RAAGA, and AAA would provide for the cost of its development accordingly.

The CoC was constituted on May 22, 2018. The Interim Resolution Professional (“IRP”) rejected the claim of Spade, inter alia, on the ground that the claim was not in the nature of a financial debt in terms of Section 5(8) (Financial debt) of the IBC, since there was an absence of consideration for the time value of money, that is, the period of repayment of the claimed ICDs was not stipulated. The IRP also rejected the claim of AAA on the ground that its claim as a Financial Creditor was filed after the expiry of the period for filing such a claim.
Aggrieved, the Second Applicants initiated proceedings before the NCLT, which, by its order on May 31, 2018 (“2018 Order”) allowed the applications. However, none of the other Financial Creditors, such as the First Applicant, were parties to these proceedings. Subsequently, on an application moved by the First Applicant and Yes Bank, another Financial Creditor of the Corporate Debtor, for the exclusion of Second Applicants from the CoC on the ground that they were related parties to the Corporate Debtor, the NCLT by its order dated July 19, 2019 ruled that Second Applicants were not Financial Creditors to the Corporate Debtor. In an appeal to the NCLAT by the Second Applicants, it was held that the Second Applicants were related parties to the Corporate Debtor, on the ground that, inter alia, during the transaction period, Spade led by Mr. Arun Anand was making financial arrangements on the advice of Corporate Debtor led by Mr. Anil Nanda, promoter of Corporate Debtor and Mr. Sonal Anand, brother-in-law of Mr. Arun Anand. One such arrangement was the MOU. The NCLAT also noted that AAA was a partner of the Corporate Debtor in accordance with Section 5(24)(a) (Related party) of the IBC. It further reasoned that Corporate Debtor was acting on the directions of Mr. Arun Anand, who, along with his family, was the majority shareholder in Spade, of which AAA is a wholly-owned subsidiary. Hence, NCLAT came to the conclusion that though the Second Applicants were admittedly Financial Creditors of the Corporate Debtor, the NCLT had rightly excluded the Second Applicants from participation in the CoC, since Mr. Anil Nanda, in concert with Mr. Arun Anand and his family, was trying to gain a backdoor entry into the CoC through the web of companies that were related parties to the Corporate Debtor. Aggrieved with the NCLAT order, both the First and Second Applicants moved the SC.

Issues
1. Whether Second Applicants were Financial Creditors of the Corporate Debtor.
2. Whether Second Applicants were related parties of the Corporate Debtor.
3. Whether Second Applicants should be excluded from the CoC.

Arguments
Contentions raised by the First Applicant:
The issue raised by the First Applicant against the NCLAT order was that while the NCLAT correctly dismissed the appeal file by the Second Applicants, deeming them to be related parties and thereby excluding them from the CoC, the NCLAT wrongly pronounced that the Second Applicants were “admittedly” Financial Creditors. This stance was never taken or admitted by the First Applicant and hence it sought to challenge this part of the NCLAT order. It was argued that the Second Applicants were not creditors, let alone Financial Creditors of the Corporate Debtor, as per Section 5(7) (Financial creditor) of the IBC. Further, it was contended that the Development Agreement was collusive in nature. AAA had sought to purchase 38.3% of the development rights in AKME RAAGA as a co-developer or partner. However, the development license granted by the government could not be sub-divided. As a result, the Corporate Debtor and AAA converted the Development Agreement into an unregistered Agreement to Sell. AAA had subsequently executed an unlawful Side Letter with the intention to co-develop the land and sell it in the market. Thus, it was argued that the intent of the parties was to circumvent the laws, government policies and regulations to continue developing the project. It was also argued that the MOU on the basis of which Spade submitted its claim was collusive and unenforceable and such claim was time barred. The IRP rejected the claim of Spade, inter alia, on the ground that the claim was not in the nature of a financial debt in terms of Section 5(8) of the IBC since there was an absence of consideration for the time value of money, that is, the period of repayment of the claimed ICDs was not stipulated. The IRP also rejected the claim of AAA on the ground that its claim as a Financial Creditor in Form C was filed after the expiry of the period for filing such a claim.

It was further submitted that Mr. Arun Anand incorporated the Corporate Debtor in 2003, which was subsequently acquired by Mr. Anil Nanda in 2007. During the relevant transactions with the Second Applicants, Mr. Arun Anand held the position of Consultant or Strategic Advisor to the Corporate Debtor, and later became the Group CEO of the Group Companies of which the Corporate Debtor was also a part. During this period, Mr. Arun Anand’s brother in-law, Mr. Sonal Anand, was a director of the Corporate Debtor. Further, he was also the whole-time director of JIPL, a wholly-owned subsidiary of the Corporate Debtor, and held shareholding in Spade, and Mr. Anil Nanda was a promoter/director of the Corporate Debtor. The litigation between Spade and the Corporate Debtor was initiated after the IBC came into force to create a notion of dispute. It was also argued that the provisions of Section 21(2) (Committee of creditors) of the IBC must be interpreted in a purposive manner so as to not defeat the fulfilment of the objects of the legislation.

Contentions raised by the Second Applicants:

It was submitted that the issue of whether or not they were Financial Creditors was dealt with by the 2018 Order and this operated as res judicata. The question of eligibility of the Second Applicants as Financial Creditors was never raised before the NCLT by First Applicant. The NCLT was strictly meant to deal with whether or not they were related parties of the Corporate Debtor. Subsequently, in the appeal before the NCLAT, the only issue that came into consideration was whether or not they were Financial Creditors. Though the NCLAT adjudged them to be Financial Creditors, it dismissed the appeal on the ground that they were related parties, which according to the Second Applicants, was an error of jurisdiction, since the question of them being related parties was not under consideration.

It was argued that there were no common key managerial personnel or directors between the Corporate Debtor and the Second Applicants during the relevant period of the transactions between 2010 to 2013. The NCLAT had incorrectly held that Mr. Arun Anand was in a position to influence the decision making of the Corporate Debtor, without satisfying the test of “control” established in Arcelor Mittal India Private Limited v. Satish Kumar Gupta [(2019) 2 SCC 1]. Mr. Arun Anand had no decision-making powers, nor could he influence any policy making decision. JIPL and through it, the Corporate Debtor held 1.45% in Spade, below the requisite 2% threshold in Section 5(24)(d) of the IBC. It was also argued that the Corporate Debtor and AAA were not partners according to Section 5(24)(a) of the IBC.

First proviso to Section 21(2) of the IBC denies the right of representation, participation or voting in a meeting of the CoC to a Financial Creditor or an authorized representative of the Financial Creditor, if it is a related party of the corporate debtor. Laying stress on the expression “‘is’ a related party of the corporate debtor”, the submission was that the statute applies in praesenti on the date of the admission of an application seeking the initiation of the CIRP. It was urged that the existence of a live link of being a related party in the present is a requirement of the statutory provision.

Observations of the Supreme Court

Eligibility as Financial Creditors:

Addressing the question of res judicata, the SC did not deem the 2018 Order as res judicata. The order was passed without hearing the other Financial Creditors, such as the First Applicant and YES Bank, hence they were well within their rights to seek direction for the exclusion of Second Applicants from the CoC, if they were aggrieved by the terms of the 2018 Order. Considering the question of jurisdiction of the NCLAT, the SC disagreed with the contention that the NCLAT had acted outside of its jurisdiction. On analyzing the NCLT Order, the SC could not accept the submission that the application filed by Second Applicants was rejected only on the basis that they were not Financial Creditors and that there was no determination in regard to their status as related parties, as the NCLT Order had dealt with those issues as well.

The SC observed that under Section 5(7) of the IBC, a person could be categorized as a Financial Creditor if a financial debt is owed to it. Section 5(8) of the IBC stipulates that the essential ingredient of a financial debt is disbursal against consideration for the time value of money. As per the report of the Insolvency Law Committee in 2018, “The words “time value” have been interpreted 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.”. Money advanced as debt should be in the receipt of the borrower. The borrower is obligated to return the money or its equivalent along with the consideration for a time value of money, which is the compensation or price payable for the period of time for which the money is lent. The SC noted that the IBC recognizes that for the success of an insolvency regime, the real nature of the transactions has to be unearthed to prevent any person from taking undue benefit of its provisions to the detriment of the rights of legitimate creditors. A transaction is collusive when the real agreement between the parties is something other than advancing a financial debt. The SC observed that the MOU on the basis of which Spade staked its claim was unstamped and unregistered and did not stipulate a period of repayment. Hence, the consideration for time value of money was absent, which is an essential ingredient of a financial debt.

Analyzing the observations in the NCLT Order, the SC noted that the Corporate Debtor had entered into multiple agreements with AAA 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 AAA. The SC opined that the parties converted the Development Agreement into an Agreement to Sell executed along with a Side Letter to circumvent the legal prohibition on splitting a development license in two parts. Thus, the transaction between AAA and the Corporate Debtor was collusive in nature.

Related Parties:
The SC found it extremely crucial to understand the relationship between Mr. Arun Anand and Mr. Anil Nanda. Mr. Arun Anand has held multiple positions in companies which form part of the Group Companies. Further, Mr. Anil Nanda has himself invested in companies owned by Mr. Arun Anand, and had commercial transactions with them. Through the Second Applicants’ own admission, Mr. Arun Anand was appointed as the Group CEO of the Group Companies on approval of Mr. Anil Nanda himself. Mr. Arun Anand’s brother in-law, Mr. Sonal Anand, had also been consistently associated with companies in the Group Companies, including the Corporate Debtor and JIPL. Mr. Arun Anand was in control of the Second Applicants during the relevant period. Further, he held positions in the Corporate Debtor or the Group Companies, which included the Corporate Debtor. Mr. Anil Nanda and Mr. Sonal Anand also held positions in the Corporate Debtor and JIPL during this period. Thus, Mr. Arun Anand would be a related party of the Corporate Debtor in accordance with Sections 5(24)(h) and 5(24)(m)(i) of the IBC. While determining whether Mr. Arun Anand participated in the policy-making process of the Corporate Debtor, the SC observed that there was a deep entanglement between the entities of Mr. Arun Anand and Mr. Anil Nanda, and Mr. Arun Anand held such positions at the time of the relevant transactions which could have been used by him to guide the affairs of the Corporate Debtor. The SC thus concluded that Spade undertook the transactions due to the pervasive influence of Mr. Anil Nanda. It was also decided that the transactions between AAA and Corporate Debtor were collusive in nature and thus AAA was a partner of the Corporate Debtor within the meaning of Section 5(24)(a) of the IBC.

Exclusion from the CoC:

The SC observed that the objects and purposes of the IBC are best served when the CIRP is driven by external creditors, so as to ensure that the CoC is not sabotaged by related parties of the corporate debtor. This was the intent behind the first proviso to Section 21(2) of the IBC which disqualifies a Financial Creditor or the authorized representative of the Financial Creditor under Sections 24(5), 24(6) or 24(6A) of the IBC, if it is a related party of the corporate debtor, from having any right of representation, participation or voting in a meeting of the committee of creditors. While considering the issue of interpretation in relation to the first proviso to Section 21(2) of the IBC as to whether the disqualification under the said proviso would attach to a Financial Creditor only in praesenti, the SC examined the object and purpose behind the enactment of the said proviso. The SC relied on Abhay Singh Chautala v. C.B.I. [(2011) 7 SCC 141], where the court did not interpret the word “is” in praesenti because that would lead to an absurd result, defeating the purpose of the concerned proviso, that is, Section 19(1) of the Prevention of Corruption Act, 1947. The purpose of excluding a related party of a corporate debtor from the CoC is to obviate conflicts of interest which are likely to arise in the event that a related party is allowed to become a part of the CoC. The SC noted that exclusion under the first proviso to Section 21(2) of the IBC was related not to the debt itself but to the relationship existing between a related party Financial Creditor and the corporate debtor. Therefore, the Financial Creditor who in praesenti is not a related party, would not be debarred from being a member of the CoC. However, those related party Financial Creditors that cease to be related parties in order to circumvent the exclusion under the first proviso to Section 21(2) of the IBC, should also be considered as being covered by the exclusion. If this was not done, the related party to the Financial Creditor can devise a mechanism to remove its label of a ‘related party’ before the corporate debtor undergoes CIRP, so as to be able to enter the CoC and influence its decision making at the cost of other Financial Creditors. The SC observed the presence of a deeply entangled relationship between Spade, AAA and the Corporate Debtor, when the alleged financial debt arose. It concluded that though their status as related parties no longer existed, it was due to commercial contrivances through which they sought to enter the CoC, that they could not be allowed to be a part of the CoC.

Decision of the Supreme Court

Partially upholding the NCLAT order, the SC held that since the commercial arrangements between Second Applicants and the Corporate Debtor were collusive in nature, they would not constitute a ‘financial debt’. Hence, it was held that the Second Applicants were not Financial Creditors of the Corporate Debtor. Mr. Arun Anand and the Second Applicants were related parties of the Corporate Debtor during the relevant period when the transactions on the basis of which the Second Applicants claimed their status as Financial Creditors took place. Thus, it was held that the pervasive influence of Mr. Anil Nanda over these entities was clear, and allowing them in the CoC would definitely affect the other independent Financial Creditors. Contrary to what the NCLAT had observed, the Second Applicants could not be called Financial Creditors.

Vaish Associates Advocates View:

The key takeaway from this Judgement is that the SC has ensured that the sanctity of the CoC is not compromised by the action of a corporate debtor who through its related parties tries to gain backdoor entry into the CoC by way of collusive transactions. Merely because a Financial Creditor conveniently removes the label of related party from itself, just before the corporate debtor enters into CIRP, with the sole intention of participating in the CoC and sabotaging the CIRP, it cannot be granted the advantage of being included in the CoC.

The SC has also recognized that, for the success of the IBC, it is imperative that the true nature of the transactions be unearthed so as to prevent any person from taking undue advantage of its provisions to the detriment of the rights of the rightful creditors and has hence excluded collusive transactions from the ambit of financial debt. Thus, by this path breaking Judgement, the SC has precluded the opportunity for unscrupulous parties from staking a claim in the CoC and exploiting the provisions of the IBC based on collusive transactions to their advantage.

…
For more information please write to Mr. Bomi Daruwala at [email protected]

Between the Lines | Telangana High Court: Natural justice principles to be followed before declaring borrower’s account as fraudulent

The Telangana High Court (“THC”) by its judgement dated December 10, 2020 in the matter of Mr. Rajesh Agarwal v. Reserve Bank of India and Others (Writ Petition No: 19102 of 2019) allowed the writ petition filed by a director of a company under Article 226 (Power of High Courts to issue certain writs) of the Constitution of India, 1949 (“Indian Constitution”) on the grounds, inter alia, that principles of natural justice had not been followed in respect of ‘Master Directions on Fraud’ (“Master Circular”) dated July 1, 2016, issued by the Reserve Bank of India (“RBI”).

Facts

The petitioner, Rajesh Agarwal, was the chairman and managing director (“Petitioner”) of M/s. B.S. Limited (“Company”). During 2006-2014, the Company availed loan facility amounting to INR 1406 crores from several banks, many of which banks were respondents in this writ petition (hereafter, “Respondent banks”). In 2013, the Madhya Pradesh Power Transmission Company Limited (“MPPTCL”) awarded the contract for certain infrastructure work to the Company (“Works”). As per MPPTCL, there was delay in execution of Works and shortage of working capital, as a result of which the said contract with the Company was terminated. MPPTCL, thereafter, also encashed bank guarantees of INR 140 crores. Upon contract cancellation and encashment of bank guarantees, the Company suffered a huge financial blow and could not repay its loan amounts. As per the circular guidelines of the RBI, respondent no.1, all lender banks formed a ‘Joint Lenders Forum’ (“JLF”) with the State Bank of India, respondent no.2, (“SBI”) acting as the lead bank.

As per the ‘Scheme for Sustainable Structuring of Stressed Assets’ announced by the RBI (“S4A Scheme”) by way of circular dated June 13, 2016, the JLF, on July 11, 2016 decided to adopt the S4A Scheme and conduct a ‘Forensic Audit and Techno-Economic Viability (“TEV”). On June 29, 2016, the Company’s account was declared by the JLF as non-performing asset. Basis the forensic audit report dated August 29, 2016 (“First Audit Report”), the JLF on August 31, 2016, observed that “there were no irregularities, with regard to fraudulent transactions pointed out in the Forensic Audit Report‘”. However, in furtherance to the TEV report dated September 14, 2016, the JLF observed that the Company was ineligible for S4A scheme as there were no minimum prescribed free cash flows by the Company. Therefore, the JLF requested the Company to submit an alternative plan for regularization of its account. The Company thereafter, proposed a ‘One-Time Settlement’ scheme (“OTS”). In February 2018, the OTS was rejected by the JLF. Thereafter, IDBI Bank, respondent no. 9 herein, being one of the member-banks of the JLF, declared the company’s account as “Red Flagged Account”. Basis a second forensic audit report dated April 06, 2018, (“Second Audit Report”), on April 21, 2018, IDBI Bank called for an explanation from the Company. Even though the Company responded that no irregular transactions had taken place in the audit period, IDBI Bank sought further clarifications from the Company to which the latter duly responded. Meanwhile, SBI filed a petition under Section 7 (initiation of corporate insolvency resolution process by financial creditor) of the Insolvency and Bankruptcy Code, 2016 before the National Company Law Tribunal, Hyderabad Bench (“NCLT”). The NCLT by an order passed on November 01, 2018, admitted the aforesaid application, and appointed a Dr. K.V. Srinivas as ‘interim resolution professional’ (“IRP”). However, when a resolution plan could not assist in revival of the Company, the NCLT by order dated November 04, 2019, directed the winding up of the Company and appointed a liquidator (“Liquidator”) in respect thereof. On February 15, 2019, the JLF invoked Clause 2.2 (classification of frauds) (1)(g) of the Master Circular, and declared the Company account as ‘fraud’ (“JLF Order”). The ‘Fraud Identification Committee’ (“FIC”) of SBI, on July 31, 2019, also resolved to identify the Company’s account as ‘fraud’ (“FIC Order”). It is noteworthy that both aforesaid decisions were taken prior to appointment of Liquidator by the NCLT.

Issues

• Whether the principles of natural justice, especially audi alteram partem (giving opportunity of hearing to the other side) should be read into the Master Circular.
• Whether the JLF was justified in concluding in its meeting, on February 15, 2019, that the Company is holder of fraudulent account.
• Whether the FIC was justified in concluding that the Company is a holder of fraudulent account.

Contentions of the Petitioner

As per Clause 8.12 (penal measures for fraudulent borrowers) sub clause (1) of the Master Circular, the penal provisions would also affect the Petitioner. Directors would be debarred from availing bank finance from ‘Scheduled Commercial Banks’, ‘Development Financial Institutions’, ‘Government owned NBFCs’, ‘Investment Institutions’, etc., for a period of five years from the date of full payment of the defrauded amount. Even after the lapse of five years, discretion is given to the financial institutions to decide whether to lend money to the concerned director(s) of a company. Therefore, the Petitioner would perhaps be denied the right to borrow finances for the rest of his life. This would impact the Petitioner’s fundamental right to carry on a trade or business and as a corollary, affect his right to life.

Even if a Liquidator has been appointed by the NCLT, in sum, the Petitioner’s fundamental rights were being affected. Therefore, the Petitioner had sufficient locus standi right to challenge the JLF Order and FIC Order. Moreover, the Company account was declared as ‘fraud’ by both the JLF and FIC without giving either the Company, or the Petitioner an opportunity of hearing. The opportunity had been denied to the Petitioner and the Company ostensibly on the ground that the Master Circular does not include the right of hearing in its scope and ambit. Therefore, the Petitioner had a right to challenge the constitutional validity of the Master Circular. Furthermore, the Petitioner had raised seminal constitutional issue with regard to the interpretation and legal validity of the Master Circular. Hence, the writ petition should be allowed.

The Master Circular had statutory force and despite being elaborate, did not provide for an opportunity of hearing to the borrower before declaration of an account as fraudulent. As soon as a borrower is declared as a fraudster, criminal and civil consequences would follow. This would not merely impact the goodwill in the market, but also affect the fundamental and civil rights of a borrower. Further, as per the Master Circular, even third parties are provided with an opportunity of hearing, that is those parties remotely related to the alleged fraud are also provided an opportunity. If the principles of natural justice were not read into the Master Circular, it would bestow the JLF and the FIC with unbridled power.

Dealing with the factual matrix, it was contended that the Second Audit Report and transaction audit report (prepared by IRP) were never furnished to the Petitioner or the Company. As far as IDBI Bank was concerned, it had merely paraphrased the Second Audit Report in its letters to the Company. The Petitioner had therefore been denied a substantive opportunity of hearing both by IDBI Bank and JLF. As far as minutes of the meeting held on February 15, 2019 were concerned, there were three different items on which JLF had sought clarification from the forensic auditor. The JLF was of the opinion that “if no clarification is sought from the Forensic Auditor”, the account will be classified as “fraud”. However, before actually declaring ‘fraud’ the JLF should have awaited clarification from the forensic auditor. It was unjustified in declaring the Company’s account as ‘fraud’, until all evidence was available. The FIC had also referred to a report submitted by the IRP, which had never been seen by either the Company or the JLF. The Master Circular was also confusing and vague. Clause 8.12 of the Master Circular states that the procedure for declaring a borrower as a wilful defaulter should be followed. Moreover, according to the Hon’ble Supreme Court of India (“SC”) in the case of SBI v. Jah Developers(2019) 6 SCC 787, before a borrower can be declared as a ‘wilful defaulter’, the borrower has to be given an opportunity of hearing by the JLF. Yet, the Master Circular dealing with fraud account denies such an opportunity of hearing to a borrower who may be declared as holder of fraud account. Moreover, in the JLF Order, the JLF has not just declared the Company as holder of a fraud account, but more so has declared the Company as a ‘wilful defaulter’. Therefore, even before declaring the Company as a wilful defaulter, an opportunity of hearing had to be given. It could also not rely on any findings of the NCLT, as the JLF decision was taken before NCLT findings.

Contentions of SBI (objections in respect of Petitioner’s locus standi)

The SBI had approached the NCLT for declaring the Company as insolvent. Since the IRP could not resurrect the Company despite best efforts, the NCLT appointed a Liquidator. As a consequence, the Petitioner no longer had a role to play in the Company’s affairs. The Petitioner, therefore, lacked the locus standi to challenge the JLF Order and FIC Order, and to challenge the legal validity of the Master Circular. Further, once the Company’s account is declared as ‘fraud’, the civil and criminal consequences will be faced by the Company, and not by the Petitioner. Therefore, the Petitioner was not justified in claiming that his fundamental and civil rights were being adversely affected by the JLF Order and FIC Order.

Contentions of RBI and SBI

In consonance with the goal for expediency of the Master Circular, the JLF had to take decisions at the earliest and report the same to RBI, and to expeditiously initiate the criminal investigation. If decisions weren’t taken expeditiously, or not reported to RBI or to the investigating agency, fraudsters would continue their illegal activity and endanger the banking sector. It is in the interest of the public that the decisions be taken without wastage of time. Therefore, the Master Circular did not provide for an opportunity of hearing to a borrower.

The very title of the Master Circular, “Classification and Reporting…” indicated that there are two purposes of the Master Circular, namely (i) to classify an account as ‘fraud’, and (ii) to report the decision both to the RBI and to the law enforcement agencies. Since the decision and investigation needed to be fast paced, the requirement of principles of natural justice should not be read into the Master Circular. Further, the meeting of the JLF is not an adjudicatory process; it is merely an administrative function. Therefore, the principles of natural justice cannot be read as part and parcel of the procedure to be adopted by the JLF. Moreover, the purpose of reaching the conclusion is only to set the criminal law into motion by reporting the fraud to the investigating agencies. Therefore, there was no legal requirement of giving an opportunity of hearing to the alleged accused. The application of principles of natural justice is also not universal. Indeed, there are circumstances where the said principles can be ignored. Even so, the IDBI brought the Second Audit Report to the notice of the Company byits letter and the Company had also replied to the same. It could not be said that the Company was denied an opportunity of hearing. According to an order passed by the Income Tax Department on November 29, 2017, the department had already noticed that some sham transactions were carried out by the Company. Moreover, in its order dated February 27, 2018, the NCLT had noticed the fact that the Company had huge trade receivables. Yet, it could not release/recover any of the outstanding trade receivables. Therefore, apparently, the Company had played fraud. Lastly, the FIC has considered the entire material which was placed before it, and had legally concluded that the Company was holder of a ‘fraud’ account.

Observations of the Telangana High Court

On perusal of Clause 8.12 sub-clauses 1 and 2 of the Master Circular, the THC observed that the Petitioner was well justified in claiming that the JLF Order and FIC Order would adversely affect his civil and fundamental rights, and therefore, he had the right to access justice under Article 226 of the Indian Constitution. Even if the Liquidator had been appointed by the NCLT, it did not pre-empt the Petitioner from challenging the JLF Order, FIC Order and the Master Circular. It was notable that the Liquidator was appointed after the decisions were taken by the JLF and FIC. Therefore, mere appointment of the Liquidator would not dilute the impact of the aforesaid clauses.The THC, whilst referring to a foray of past decisions of the SC, concluded that while interpreting the Master Circular, the principles of natural law would have to be borne in mind. The principles of natural law are applicable to both administrative and quasi-judicial decisions. But while seeing the existence of urgency, the court is required to balance between ‘hurry’ and ‘hearing’. The hearing can be short but substantive, prompt but effective. Merely because the title of the Master Circular is “fraud classification and reporting….”, it does not necessarily mean that the function of the JLF and FIC are limited merely to discovery of fraud, and its reporting by the commercial banks. A perusal of Clause 1.3 (purpose) of the Master Circular would reveal that the purpose was not just to discover a fraud being committed on a bank, but also to alert the other banks to take necessary safeguards/preventive measures against such parties who may be declared as ‘fraudster’. Moreover, the purpose is to initiate the investigation through investigating agencies. The THC rejected the contention that the urgency demanded that principles of natural justice should not be read into the Master Circular. A holistic review of the Master Circular would go to show that a complete elaborate safety system had been prescribed, including system of checks/investigations at different stages of loan’s life cycle, triggering of early warning signal, etc. Moreover, evidence to be read against a party needs to be furnished to the party. The party has to be given an opportunity to explain, or to challenge the evidence. Thus, the argument of urgency cannot be accepted for jettisoning the applicability of principles of natural justice.

Further, there was a notable gap of 4 ½ months between the decision of the JLF and the FIC. Therefore, it could not be said that the decision to declare the Company account as fraud has been taken on an ‘urgent’ basis. Furthermore, if the requirement of principle of nature justice is not read into the Master Circular, it would suffer from vagueness. For, on the one hand, provisions of the Master Circular, that is, Clause 8.9 (Lending under Consortium or Multiple Banking Arrangements) (sub-clauses 4 and 5) prima facie seem to deny the opportunity of hearing to the borrower, yet, Clause 8.12.1 of the Master Circular clearly states that the procedure for declaring a borrower as a willful defaulter has to be followed. Therefore, to erase the self-contained contradiction, and to save the Master Circular from the virus of vagueness, the principles of natural justice perforce would have to be read into Clause 8.9 (sub-clauses 4 and 5) of the Master Circular.

Pursuant to the application of the provisions of Master Circular, among other things, both fraudulent borrower and promoter/director(s), and other whole-time director(s) would be debarred from raising funds from banking system for a period of five years. Thus, once branded as ‘a fraudster’, or ‘a fraudulent borrower’, or ‘holder of a fraud account’, the stigma will continue for a considerable time. Such a stigma would, thus, adversely affect the fundamental rights of a promoter/director to carry on a trade or a business, which is guaranteed under Article 19(1)(g) (to practise any profession, or to carry on any occupation, trade or business) of the Indian Constitution. Therefore, such a classification would have grave civil consequences for promoter/director of a borrowing company. Further, since right to livelihood is part and parcel of fundamental right to life under Article 21 (Protection of life and personal liberty) of the Indian Constitution, the fundamental right can be deprived only by a reasonable procedure established by law. Thus, the Master Circular, as interpreted by the RBI, would be in violation of Article 21. Therefore, to save Clause 8.9 (sub-clauses 4 and 5) of the Master Circular from being declared as unconstitutional, it is essential to read the principles of natural justice into the said clauses. Classification of an account as ‘fraud’ has devastating impact on the life of a person as civil and criminal consequences would subsequently follow. Presently, unbridled power has been given to the JLF for declaring a person/company as ‘a fraudulent borrower’. Such an absolute power could not have been intended by the RBI while promulgating the Master Circular.

Decision of the Telangana High Court

The principles of audi alteram partem will have to be incorporated into Clause 8.9 (sub-clauses 4 and 5) of the Master Circular even if the said clauses are silent. Such an interpretation cannot be said to be farfetched. The party should be given a chance to challenge the evidence. Copies of report such as those submitted by IRP were never furnished to the Petitioner or the Company. Even though the IDBI bank report supposedly paraphrased the contents of Second Audit Report, complete copy of the forensic auditor report was never submitted along with the said letter. Many observations/items against the Company were closed not only on the basis of the Second Audit Report, but also on the basis of clarification / information submitted by the Company to the forensic auditor. Yet, the same opportunity to explain to the JLF was not given to the Company, or to the Petitioner. Hence, the JLF Order is legally invalid. Instead of awaiting clarifications from the forensic auditor, in respect of several other items, the JLF simply declared the account to be treated as fraud. But till it had heard from the forensic auditor, one way or the other, it could not have jumped the gun.

As far as the FIC was concerned, it had relied on the report submitted by the IRP. Here again, neither the Company nor the Petitioner had any information or knowledge about a report which was going to be read against them. However, this crucial step which is a part of audi alteram partem is conspicuously missing in the present case. It was noted that in respect of several items, the JLF had also decided that “in case no clarification is received from the Forensic Auditor, only then it will treat the account as fraud”. Once it has decided to wait till further clarification is submitted, the JLF is not justified in concluding that “the account be treated as fraud”. In fact, the JLF was legally required to wait for further clarification, or non-clarification from the forensic auditor.

Thereafter, the court ordered that: (i) the principle of audi alteram partem, part of the principles of natural justice, is to be read in Clause 8.9 (sub-clauses 4 and 5) of the Master Circular; (ii) FIC Order and JLF Order be set aside; (iii) JLF is directed to give an opportunity of hearing by furnishing copies of both reports (IRP’s Report and Second Auditor Report); (iv) JLF is directed to give an opportunity of personal hearing both to the Petitioner and to the Liquidator before taking any decision on the issue whether the account should be classified as ‘fraud’ or not; (v) After the JLF has taken its decision, the FIC is directed to pass its resolution whether the decision of the JLF should be confirmed or not; and (vi) said exercise shall be carried out by the JLF within a period of three months from the date of receipt of the certified copy of this judgment. Furthermore, the subsequent exercise by FIC shall be carried out within two months from the date of the decision of the JLF.

Vaish Associates Advocates View:

At the outset, application of Clause 8.9 (sub-clauses 4 and 5) of the Master Circular would deny justice to borrowers. Even if a decision has to be taken expediently, the principles of natural justice could be adopted to ensure that the borrower is given a chance to not only access all materials that have been used against him, but also given a chance to explain his case.

In this instance, the Company did not have precise knowledge about the information that was going to be read against them. In addition to the same, they were also denied a proper chance of explanation. As far as the point of urgency was concerned, it was rightly noted by the court that not even urgency could be substantial argument to jettison the principles of natural justice. Such unilateral decisions would set off grave penal consequences for the borrower, from which, a situation reversal would be very difficult. Any such mechanism and the consequences flowing from it would therefore clearly be a reproach to natural justice. It was apt for the THC to balance foresight and administration of justice in interpreting the object of the Master Circular.