Protective Covenants In Finance Documents Do Not Make Financial Creditors Related Parties: NCLT Delhi

The New Delhi National Company Law Tribunal (NCLT) has held that protective covenants in financing documents, including escrow arrangements, reserved matter approvals, monitoring rights and inspection mechanisms, do not by themselves make financial creditors “related parties” under the Insolvency and Bankruptcy Code, 2016 (IBC), unless such rights demonstrate actual control over the management or affairs of the corporate debtor.

A Bench comprising Judicial Member Mahendra Khandelwal and Technical Member Atul Chaturvedi dismissed an application filed by the suspended directors of Shree Vardhman Buildprop Private Limited seeking removal of Kautilya Finance BV and Kautilya Real Estate Fund from the Committee of Creditors (CoC) on the ground that they had become related parties due to rights granted under the Debenture Trust Deeds. It observed:

“...The contractual rights relied upon by the Applicants are, in our considered view, protective covenants intended to safeguard the financial exposure of secured lenders and ensure completion of the financed project. Such commercial safeguards, without evidence of actual management control over the affairs of the Corporate Debtor, cannot attract the statutory disqualification contained in Section 21(2) of the Code.”

The applicants argued that the lenders exercised extensive control over the project through exclusive control over escrow accounts, approval rights over reserved matters, supervision of project cash flows, inspection rights and participation in commercial decisions. They contended that these rights effectively allowed the lenders to function as co-promoters and amounted to “control” under Section 5(24) of the IBC, which defines related parties, thereby attracting the bar under Section 21(2) that prevents related party financial creditors from participating in the CoC.

Rejecting the contention, the Tribunal held that the rights relied upon by the applicants were standard lender protection measures commonly included in structured project finance transactions. It observed that such arrangements were intended to ensure proper utilisation of funds, prevent diversion of project revenues and protect the lenders' financial exposure.

The Bench noted that the day-to-day management of the project, operation of the Project Operating Account and execution of the project remained with Shree Vardhman Buildprop Private Limited. It held that lender approvals for specified transactions were only commercially negotiated safeguards and did not amount to control over the corporate debtor's affairs.

Further, the Tribunal held that the applicants failed to establish that the lenders had powers to appoint or remove directors, control the composition of the board, determine business policies or replace the management of the corporate debtor. It also observed that the WhatsApp communications and other documents relied upon by the applicants only showed project monitoring and customer collection activities and did not establish that the lenders had assumed management or corporate governance functions.

It also observed that treating every lender with affirmative covenants, escrow controls and reporting obligations as exercising management control would result in most secured project finance lenders being excluded from CoCs, which would be inconsistent with the object and scheme of the IBC. It concluded that Kautilya Finance BV and Kautilya Real Estate Fund did not qualify as related parties under Section 5(24) of the IBC and upheld their participation in the Committee of Creditors.

Accordingly, the NCLT dismissed the application.