A Seat at the Table Lost: Why the IBC's Take on Nominee Directors Needs a Rethink

Tanishq Bhonsle*

Introduction

The classification of financial creditors as related parties under the Insolvency and Bankruptcy Code (“IBC”), 2016, has been a contentious issue, particularly where the classification is based solely on the power given to a financial creditor to appoint a nominee director. The IBC, designed to ensure a structured and efficient resolution process for financially distressed corporate debtors, follows a creditor-in-control model. Herein, the Committee of Creditors (“CoC”)—is comprised only of financial creditors entrusted with decision-making authority during the Corporate Insolvency Resolution Process (“CIRP”). However, Sections 5(24) and proviso to section 21(2) of the IBC, which disqualify related parties from participating in the CoC, often conflict with the well-established practice of financial institutions appointing nominee directors to safeguard their interests as such appointments help the financial creditor to ensure financial discipline and proper allocation of funds.

The crux of the issue lies in the interpretation of control exercised by such creditors who have appointed a nominee director to the CD’s Board. Several judicial pronouncements discussed below have adopted a strict stance, holding that the mere right to appoint a nominee director amounts to positive control, thereby classifying the appointing financial creditor as a related party. This interpretation, while aimed at preventing conflicts of interest, may have unintended consequences—excluding legitimate financial creditors from the resolution process and undermining lender protection mechanisms and thus prejudicing the interests of fair play creditors. However, recent rulings, indicate a shift towards a purposive interpretation, emphasizing fact-based determinations rather than blanket disqualifications.

This article critically examines the conflict between nominee directorships and the related party provisions under the IBC. It analyses key judicial decisions wherein the courts have adopted a strict stance while interpreting the control exercised by such an FC, where merely the right to appoint a nominee director has been equated with the exercise of positive control. It argues for a balanced approach that preserves both the integrity of the insolvency framework and the rights of financial creditors. By advocating for a purposive interpretation of the relevant provisions, this article highlights the importance of taking into account multiple factors that would amount to positive control and would bring such a financial creditor within the definition of related party, ensuring that financial creditors are not unfairly debarred from participating in the insolvency resolution process.

Section 5(24) and the Dilemma of Nominee Directorships

The Insolvency and Bankruptcy Code , 2016 (“IBC”), was enacted to resolve financial distress among corporate debtors while maximizing the value of their assets. India, like the UK, Australia, and Singapore, follows a creditor-in-control model that vests decision-making authority with the CoC. As per Section 21(2) of the IBC, the CoC comprises only of financial creditors, empowering them to oversee the management of the corporate debtor during the CIRP. Contrary to the debtor-in-possession model used in the United States, where the existing management retains control. By excluding the previous management, the creditor-in-control model ensures an objective and commercially sound resolution process. 

To safeguard this framework, provisions such as Section 5(24) and Section 21(2) of the IBC disqualify related parties of the corporate debtor from participating in the CoC. The restriction prevents related party creditors from participating in the CoC, thereby ensuring that decisions are driven by the collective interest of all creditors rather than personal agendas. This provision serves to mitigate conflicts of interest within the CoC and protect the rights of unrelated financial creditors.

However, this provision conflicts with the established practice of financial institutions appointing nominee directors under the Companies Act, 2013. As per the explanation to Section 149(7) of the Companies Act, nominee directors serve to protect the financial creditor’s interests on the board of the corporate debtor. It has become a standard practice for financial creditors to appoint nominee directors whenever a significant financial transaction occurs between a creditor and a debtor. 

Nominee directors, given their role, owe fiduciary duties not only to the company but also to the financial creditor that appointed them, as affirmed in Tata Consultancy Services Ltd. & Ors. v. Cyrus Investments Pvt. Ltd. & Ors. This duality of obligation brings financial creditors appointing such nominee directors within the definition of a related party, resulting in their exclusion from the CoC. This creates a paradox in which financial creditors, by exercising standard lender protection mechanisms, are denied their rights as financial creditors in the insolvency resolution process.

Nominee Directors and Positive Control: The Court’s Perspective

Adjudicating authorities have consistently adopted a stringent approach in determining related party status for nominee directors appointed to a corporate debtor’s (“CD”) board by financial creditors. This is evident in multiple rulings where courts have interpreted merely the right to appoint a nominee director as an exercise of positive control and haven’t considered the behaviour of such a director on the board, thereby classifying the appointing financial creditor as a related party.

For instance, in IDBI Trusteeship Services Ltd. v. Abhinav Mukherji, The NCLAT reviewed the agreements between the corporate debtor (CD) and the debenture holders to determine whether ECL Finance Ltd. and IDBI Trusteeship Services Ltd. should be classified as related parties. The Articles of Association (AoA) granted these parties several rights, including the ability to appoint nominee directors in the event of a default, influence key managerial personnel etc. Additionally, the AoA specified certain decisions that could not be made by the corporate debtor without the consent of the debenture holder’s representative. While the creditors contended that these clauses were designed to promote financial discipline rather than exert control—pointing out that a nominee director had not been appointed and that the right to appoint one was merely stated in the AoA—the NCLAT determined that these rights, although not exercised, constituted positive control, either directly or indirectly. Thus, the court classified ECL Finance Ltd. and IDBI Trusteeship Services Ltd. as related parties.

Similarly, in Phoenix Tech Power Pvt. Ltd. v. K.V. Srinivas & Others, The NCLT determined that Telangana State Trade Promotion Corporation Ltd. (TSTPCL) qualifies as a related party under Section 5(24) of the IBC. This classification is due to the significant influence that TSTPCL's nominee directors exert over the corporate debtor's decisions, which encompasses both positive and restrictive control. The Tribunal dismissed the argument that nominee directors lack control, citing specific provisions in the Articles of Association (AoA) of corporate debtors that require a minimum of three directors to vote on certain matters, including at least one nominee director. Consequently, the Tribunal instructed the resolution professional to restructure the Committee of Creditors (CoC) by excluding TSTPCL in order to prevent any undue influence during the insolvency proceedings.

These cases illustrate a legal position where merely possessing the right to appoint a nominee director is construed as an act of positive control. However, this approach is flawed as it disrupts the lender protection framework, which allows creditors to safeguard their financial interests through board representation. The automatic classification of financial creditors as related parties because of nominee directorships can unjustly exclude them from the Committee of Creditors (CoC). This exclusion restricts their ability to influence the resolution process and places them at a much lower priority, akin to equity shareholders, in the waterfall mechanism compared to other creditors.

A more balanced approach is necessary to ensure that fair play financial creditors—those without any ulterior motive to favor the corporate debtor or manipulate the insolvency proceedings—are not unfairly debarred from participating in the CoC. If a financial creditor does not engage in any conduct that undermines the resolution process or serves the interests of the debtor at the expense of external creditors, it should not be disqualified merely for exercising a standard lender protection mechanism. Adjudicating authorities should instead focus on a fact-based determination of whether the nominee director is exerting undue influence rather than imposing a blanket presumption of control. This approach would uphold the integrity of the insolvency framework while maintaining investor confidence and fostering a more predictable financial ecosystem.

Towards a More Balanced and Fact-Based Adjudication Framework

Rather than adhering to a literal interpretation of Section 5(24) and the proviso to Section 21(2) of the IBC, adjudicating authorities should adopt a purposive approach, particularly where a financial creditor who appoints a nominee director is a related party. In Sarga Udaipur Hotels and Resorts Pvt. Ltd. v. HUDCO, The NCLT Kolkata clarified that although the financial creditor had appointed a nominee director on the debtor company's board, its influence over the company was mainly theoretical. The nominee director did not have any actual power over the debtor's policy decisions, and the directors, partners, and managers were not acting on the advice of this nominee director, as required by section 5(24)(h) of the code. As a result, the financial creditor was allowed to participate in the Committee of Creditors (CoC). This decision illustrates that the NCLT applied a purposive interpretation of the related party provision rather than adhering strictly to the text.

Furthermore, adjudicating authorities should align with the ruling in ODAT GmbH v. The CoC of Darjeeling Organic Tea Estates Pvt. Ltd., where the court also adopted a purposive interpretation. It held that merely holding a position within the CD, even as a director, does not inherently create a conflict of interest. The adjudicating authority while dealing with cases of section 5(24)(h) should ensure that it has been proved that on the advice of such nominee directors the corporate debtor was accustomed to act. Moreover, section 5(24)(m) can only be attracted when there is some evidence on record which states that such director was involved in the policy making process of the CD, for example- appointment of staff or employees. Only upon establishing such facts, backed by evidence, should a financial creditor be classified as a related party.

In light of the ODAT and HUDCO ruling, which should be used as a guiding principle in evaluating allegations of related party status linked to a nominee directorship, courts must assess the positive control that a nominee director has over the affairs of the company. This assessment should focus on the advice given by the nominee director to the company, their involvement in the policymaking process, and their participation in the day-to-day operations, rather than merely on the right to appoint a nominee director. This can be determined by examining the Articles of Association and other relevant documents of the company. Moreover, it is important to note that nominee directors are typically non-executive and do not possess significant decision-making authority over the company’s daily operations.

By adopting this approach, adjudicating authorities can ensure that pure financial creditors are not improperly classified as related parties due to standard lender protection mechanisms, such as the nomination of a director to the company’s board. This interpretation promotes financial discipline and enhances investor confidence. Ultimately, it encourages financial institutions to extend credit facilities to more companies without concerns about being labeled as related party creditors solely for appointing a nominee director to the company’s board.

Conclusion

The classification of financial creditors as related parties under the IBC solely due to the appointment of nominee directors presents a significant challenge to the creditor-in-control framework. While judicial interpretations have often leaned towards a strict application of Section 5(24), a more nuanced, purposive approach is necessary to prevent the undue exclusion of legitimate financial creditors from the resolution process. Adjudicating authorities should focus on fact-based assessments of actual control rather than a blanket presumption of influence. Striking this balance will uphold the integrity of the insolvency framework, ensure fair participation in the CoC, and maintain investor confidence, ultimately fostering a more efficient and predictable insolvency resolution process.

*The author is a Third-year student of law at Maharashtra National Law University, Nagpur.