The Insolvency and Bankruptcy Code’s current treatment of insider lending creates a structural problem that undermines the fairness of recovery. Related-party creditors of insolvent companies receive the same recovery priority as genuine third-party creditors, despite the economic reality that many insider loans function as risk capital disguised as debt.
This matters because the IBC’s waterfall determines who gets paid first from the remaining assets. When promoters or related entities lend to their own companies, they often do so without the arm’s length due diligence that independent creditors would perform. Yet when the company fails, these insider creditors line up for recovery alongside banks and suppliers who had no control over the debtor’s operations.
The economic substance test is missing. A promoter’s loan to his own company, extended without security or proper documentation, more closely resembles an equity investment than genuine debt. But the Code doesn’t currently require insider creditors to prove their claims represent true debt rather than risk capital.
Several jurisdictions address this through subordination rules. Under US bankruptcy law, claims by insiders can be subordinated if they’re found to be inequitable. The UK’s insolvency framework similarly scrutinizes connected party transactions. India’s IBC lacks this analytical layer.
The regulatory pattern here reflects a broader tension in corporate law between form and substance. The Code currently accepts debt claims at face value if they meet basic documentation requirements. It doesn’t probe whether the transaction economics suggest the ‘lender’ was actually participating in the company’s business risk rather than providing genuine credit.
What’s not being disclosed in many IBC cases is the full context of how these insider loans originated. Were they extended when the company was already in distress? Did the insider have access to management information that external creditors lacked? These factors should influence recovery priority, but currently don’t.
The resolution professional’s role becomes complicated when significant insider claims exist. They must balance maximizing recovery for all creditors against the risk that insider claims may not represent genuine debt obligations. Without clear subordination rules, the process becomes uncertain.
My Boardroom Takeaway: Independent directors overseeing companies with related-party lending arrangements may wish to ensure proper documentation distinguishes genuine debt from risk capital. When approving related-party loans, boards should consider whether the terms and circumstances would pass an arm’s length test in potential insolvency proceedings. The economic substance of such arrangements matters more than their legal form when recovery priority is ultimately determined.