Related-Party Creditors in Insolvency

A related-party creditor is a creditor having a legally specified connection with the corporate debtor, such as through control, management or shareholding. In a corporate insolvency resolution process, a related-party financial creditor is generally denied participation and voting rights in the committee of creditors (CoC) to prevent conflicts of interest and manipulation of collective decisions.

Statutory rule

Under Section 21(2) of the Insolvency and Bankruptcy Code, a financial creditor that is a related party of the corporate debtor cannot represent, participate in, or vote in the CoC. The broad meaning of related party is provided in Section 5(24) and covers specified relationships involving control, management, shareholding and close association.

• The exclusion affects CoC rights; it does not, by itself, extinguish the creditor's underlying claim.

Rationale for exclusion

The CoC decides whether the corporate debtor should be resolved or liquidated and exercises commercial wisdom over matters such as resolution plans. A related-party creditor may have interests aligned with promoters or management rather than with independent creditors collectively.

• Exclusion prevents persons connected with the debtor from influencing the insolvency process through friendly, collusive or non-arm's-length debt.
• It protects the CoC's independence and integrity, ensuring that control rests primarily with creditors that have genuinely assessed and borne external credit risk.
• In Phoenix ARC Pvt. Ltd. v. Spade Financial Services Ltd., the Supreme Court explained that the rule prevents related parties from controlling the CoC and frustrating the Code's objectives.

Qualification and anti-circumvention

A regulated financial creditor is not excluded when it became a related party solely because pre-insolvency debt was converted or substituted into equity or equity-convertible instruments. This protects genuine restructuring by institutions regulated by a financial sector regulator.

• A creditor cannot evade the exclusion by ending its related-party connection merely to enter and influence the CoC; the substance and purpose of the arrangement remain relevant.