1. INTRODUCTION

The recent judgment of the Supreme Court in ECL Finance Limited v. Abhinav Mukherjee is causing much consternation within the lending community, and rightly so. The court essentially classified ECL Finance (a lender and a debenture holder) as a related party of the corporate debtor (a real estate development company) under the Insolvency and Bankruptcy Code, 2016 (IBC) and disqualified it from voting on the creditors’ committee. The basis for this was certain rights that ECL Finance had under the facility agreement and the debenture trust deed, and certain provisions of the articles of association of the corporate debtor, which the court said gave ECL Finance “all-pervasive control” over the corporate debtor.  We examine the impact of the judgment below,

2.RIGHTS TAKEN INTO ACCOUNT BY THE COURT

2.1 The key factors listed by the court leading to “all-pervasive control” were as follows:

(i) Nominee director has final say in a deadlock: The debenture holders had the right to appoint a nominee director upon the occurrence of an event of default. The articles of association provided that in the event of a deadlock in a board or shareholders meeting, the decision of the nominee director would be final and binding;

(ii) Budget approval: The debenture holders had the power to approve quarterly budgets, including to ask for modifications (though modifications were required to be mutually agreed with the corporate debtor);

(iii) Personnel related rights: The facility agreement conferred a few specific rights in relation to personnel/other appointments, apart from the right of the lender to appoint a nominee director and an observer on the board of directors of the corporate debtor:

(a) No key personnel who were in place at the time of execution of the facility agreement could be removed without the lender’s consent;

(b) The corporate debtor was required to appoint and change key personnel in technical, financial and executive posts if it had failed to comply with the business plan; and

(c) The lender had a right to appoint consultants to inspect the working of the borrower or examine its accounts.

(iv) Project related rights: The lender had the right to appoint real estate agents/distributing agents on behalf of the corporate debtor for sale of specific units. There was also a power or attorney conferring wide rights in connection with construction of the relevant real estate projects. The judgment does not state whether such powers were exercisable upfront or upon an event of default. The articles also provided for control of the lender over the project revenues and payments.

2.2 The court held that the test for being classified a related party under the IBC is less rigorous than the “control” test under section 29A (which restricts “connected persons” from acting as resolution applicants in a corporate insolvency process), as the related party test only requires participation in the policy making process of the corporate debtor, and not “positive control” as envisaged under section 29A. In the court’s words, to satisfy the related party test, “The requirement would not be to the extent of being in the driving seat, but a role of navigation would suffice, in determining policy and channelising business interests.”

3. MISSING THE WOOD FOR THE TREES?

3.1 Out of all the rights listed above, the only one which may be seen as slightly unusual is the right to make the final decision in a deadlock, as it can be seen as an overarching controlling power. All the other rights are very commonly included in financing documents of every type to protect lenders.

3.2 Taking a step back from the detail, the court did not look at the purpose behind the related party voting disqualification. The reason for the provision is that persons affiliated with the corporate debtor voting on the creditors committee will create a conflict and will not allow financial creditors to take a decision to protect their interests (taking into account the mandatory rights of the operational creditors). The fall-out of the judgment is that the very financial creditors, who sought to protect the value of assets which would repay them, are out of the decision-making process in insolvency! There was no suggestion of a sham or that ECL Finance was in any manner working with promoters – they were penalised for acting as a prudent lender should.

4. WHAT NOW?

It is hoped that the principles set out in the judgment will be revisited as it would be an undesirable outcome to ask creditors to weaken their credit protection rights for the fear of being treated as related parties in insolvency. There are however a few things to be mindful of as far as financing documents are concerned, to address the impact of the judgment:

(i) Care should be taken to frame rights as negative rights rather than positive rights – while the court said that the related party test is less rigorous than the section 29A test which requires positive control, rights which are in the nature of consent rights should still help to show that there was no “all pervasive control”.

(ii)Articles of association should be treated with caution. The articles of association of a company is an agreement between the company and its shareholders. It does not confer rights on lenders. However a practice of extensively including financing provisions in articles of association has developed, partly from wishing to provide public notice of such provisions. This is not to say that financing provisions have no place in the articles, but it would be important to examine the relevant provisions carefully and include them only to the extent necessary or useful – for instance, provisions connected with shares or debentures, or appointment of nominee directors.

(iii) It would also be worth considering including an acknowledgement from the obligors that the lenders are not related parties by virtue of the financing documents or relevant provisions in the articles.

Authors – Sonali Mahapatra, Rituparno Bhattacharya, Nidhi Rani and Nakul Sonejee – Partners

Disclaimer: This alert only highlights key issues and is not intended to be comprehensive. The contents of this alert do not constitute any opinion or determination on, or certification in respect of, the application of Indian law by Talwar Thakore & Associates (“TT&A”). No part of this alert should be considered an advertisement or solicitation of TT&A’s professional services.