AVOIDABLE TRANSACTIONS UNDER INSOLVENCY AND BANKRUPTCY CODE, 2016

One of the major issues, which Interim Resolution Professional or Resolution Professional or Liquidator has to face, is diversion of funds to third parties in proximity to initiation of Corporate Insolvency Resolution Process (CIRP). Such transactions are prejudicial to the creditors as they lead to depletion of assets of the Corporate Debtor.  Such transactions have to be avoided for maximisation of assets of the Corporate Debtor.

The Code is having provisions for avoidance of Preferential Transactions, Undervalued Transactions, Extortionate Transaction, and Fraudulent Transactions which have been entered into by the Corporate Debtor with third parties in proximity to commencement of CIRP.

The look back period for Preferential Transactions and Undervalued Transactions are two years preceding insolvency commencement date in case of related parties of the Corporate Debtor and one year in other cases. The look back period for Extortionate Credit Transactions are two years preceding insolvency commencement date for all parties.  There are also provisions for avoidance of fraudulent trading or wrongful trading for which no look back period has been prescribed under the Code. Functioning of the Code shows that admission of a case takes much longer period than fourteen days as prescribed under the Code. The Insolvency Law Committee in its 5^th Report has recommended that look back period should be calculated from date of filing of application for initiating CIRP rather than insolvency commencement date.

PREFERENTIAL TRANSACTIONS

Section 43 and 44 of the Code deals with Preferential Transactions. Section 43 of the Code deals of nature of Preferential Transactions and Section 44 deals with orders which can be passed by the Adjudicating Authority.

Where the Liquidator or the Resolution Professional is of the opinion that the Corporate Debtor has given a preference to related parties within two years and others within one year of insolvency commencement date, he has to apply to the Adjudicating Authority for avoidance of Preferential Transactions.

A Corporate Debtor is deemed to have given a preference if there is a transfer of property or an interest thereof of the Corporate Debtor for the benefit of the creditor or a surety or a guarantor   on account of an antecedent Financial Debt or Operational Debt or other liabilities owed by the Corporate Debtor. Such transfer of property has the effect of putting such creditor or a surety or a guarantor in a beneficial position than it would have been in event of a distribution of assets under section 53.

Following transactions are not covered under the category of Preferential Transactions.

• Transfer made in ordinary course of the business or financial affairs of the Corporate Debtor.
• Any transfer creating a security interest in property acquired by Corporate Debtor to the extent such security interest secures new value and was given at a time of or after the signing of a security agreement that contains a description of such property as security interest and was used by the Corporate Debtor to acquire such property. Such transfer was registered with an information utility on or before thirty days after the Corporate Debtor received possession of such property.  New value means money or its worth in goods, services, or new credit, or release by the transferee of property previously transferred to such transferee in a transaction that is neither void or voidable by the Liquidator or the Resolution Professional under the Code.

ORDERS IN CASE OF PREFERENTIAL TRANSACTIONS

Under Section 44, the Adjudicating Authority has wide powers to issue orders in cases of   Preferential Transactions entered by the Corporate Debtor with third parties. On the application of the Resolution Professional or the Liquidator, the Adjudicating Authority can pass the following orders:

• Require any property transferred in connection with giving of the preference to be vested in the Corporate Debtor
• Require any property to be vested in Corporate Debtor if it represents the application either of the proceeds of sale of property so transferred or of money so transferred
• Release or discharge (in whole or in part) of any security interest created by the Corporate Debtor
• Require any person to pay such sums in respect of benefits received by him by the Corporate Debtor, such sums to the Liquidator or the Resolution Professional, as the case may be, as the Adjudicating Authority may direct
• Direct any guarantor, whose Financial Debts or Operational Debts owed to any person were released or discharged (in whole or in part) by giving of the preference, to be under such new or revived Financial Debts or Operational Debts to that person as the Adjudicating Authority deems appropriate.
• Direct for providing security or charge on any property for the discharge of any Financial Debt or Operational Debt under the order, and such security or charge or any property for the discharge of any Financial Debt or Operational Debt under the order, and such security or charge to have the same priority as a security or charge released or discharged wholly or in part by giving of the preference
• Direct for providing the extent to which any person whose property is so vested in the Corporate Debtor, or on whom Financial Debts or Operational Debts are imposed by the order, are to be proved in Liquidation or the Corporate Insolvency Resolution  Process for Financial Debts or Operational Debts which arose from, or were released or discharged wholly or in part by the giving of preference.

Any such order will not affect any interest in property which was acquired from a person other than a Corporate Debtor or any interest derived from such interest and was acquired in good faith and for values. Any order will not require a person who received a benefit from the Preferential Transaction in good faith and for value to pay a sum to the Liquidator or the Resolution Professional.

In cases where a person,  who has acquired an interest in property from another person other than a Corporate Debtor, or who has received a benefit from the preference or such another person to whom Corporate Debtor gave the preference, had sufficient information of the intimation or commencement of insolvency resolution process of the Corporate Debtor or is a related party, it will be presumed that the interest was acquired or the benefit was received  otherwise than in a good faith unless the contrary is shown. A person is deemed to have sufficient information or opportunity to avail such information if a public announcement regarding Corporate Insolvency Resolution Process has been made under Section 13.

The Supreme Court analysed preferential transactions in detail in Anuj Jain¹ case and discussed steps to be taken by a Resolution Professional in respect of Preferential Transactions.

28.1. Looking to the legal fictions created by Section 43 and looking to the duties and responsibilities per Section 25, in our view, for the purpose of application of Section 43 of the Code in any insolvency resolution process, what a Resolution Professional is ordinarily required to do could be illustrated as follows:

1. In the first place, the Resolution Professional shall have to take two major but distinct steps. One shall be of sifting through the entire cargo of transactions relating to the property or an interest thereof of the Corporate Debtor backwards from the date of commencement of insolvency and up to the preceding two years. The other distinct step shall be of identifying the persons involved in such transactions and of putting them in two categories; one being of the persons who fall within the definition of ‘related party’ in terms of Section 5(24) of the Code and another of the remaining persons.

2. In the next step, the Resolution Professional ought to identify as to in which of the said transactions of preceding two years, the beneficiary is a related party of the Corporate Debtor and in which the beneficiary is not a related party. It would lead to bifurcation of the identified transactions into two sub-sets: One concerning related party/parties and other concerning unrelated party/parties with each sub-set requiring different analysis. The sub-set concerning unrelated party/parties shall further be trimmed to include only the transactions of preceding one year from the date of commencement of insolvency.

3. Having thus obtained two sub-sets of transactions to scan, the steps thereafter would be to examine every transaction in each of these sub-sets to find: (i) as to whether the transaction is of transfer of property or an interest thereof of the Corporate Debtor; and (ii) as to whether the beneficiary involved in the transaction stands in the capacity of creditor or surety or guarantor qua the Corporate Debtor. These steps shall lead to shortlisting of such transactions which carry the potential of being preferential.

4. In the next step, the said shortlisted transactions would be scrutinised to find if the transfer in question is made for or on account of an antecedent Financial Debt or Operational Debt or other liability owed by the Corporate Debtor. The transactions which are so found would be answering to clause (a) of sub-section (2) of Section 43.

5. In yet further step, such of the scanned and scrutinised transactions that are found covered by clause (a) of sub-section (2) of Section 43 shall have to be examined on another touchstone as to whether the transfer in question has the effect of putting such creditor or surety or guarantor in a beneficial position than it would have been in the event of distribution of assets per Section 53 of the Code. If answer to this question is in the affirmative, the transaction under examination shall be deemed to be of preference within a relevant time, provided it does not fall within the exclusion provided by sub-section (3) of Section 43.

6. In the next and equally necessary step, the transaction which otherwise is to be of deemed preference, will have to pass through another filtration to find if it does not answer to either of the clauses (a) and (b) of sub-section (3) of Section 43. 

7. After the Resolution Professional has carried out the aforesaid volumetric as also gravimetric analysis of the transactions on the defined coordinates, he shall be required to apply to the Adjudicating Authority for necessary order/s in relation to the transaction/s that had passed through all the positive tests of sub-section (4) and sub-section (2) as also negative test of sub-section (3).

AVOIDANCE OF UNDERVALUED TRANSACTIONS

Section 45, 46 & 47 deals with avoidance of Undervalued Transactions. Section 45 deals with nature of Undervalued Transactions. Section 46 delas with application by creditor in cases of Undervalued Transactions and Section 48 deals with the nature of orders passed by the NCLT.

If the Liquidator or Resolution Professional on an examination of the transactions of the Corporate Debtor determines that certain transactions were made within two years in respect of related parties or one year for others preceding the insolvency commencement date, which were undervalued, he shall make an application before the Hon’ble Adjudicating Authority to declare such transactions as void and reverse the effect of such transaction in accordance with this chapter.

A transaction is considered undervalued where the Corporate Debtor makes a gift to a person or enters into a transaction with a person which involves the transfer of one or more assets by the Corporate Debtor for a consideration the value of which is significantly less than the value of the consideration provided by the Corporate Debtor and such transaction has not taken place in the ordinary course of business of Corporate Debtor.

APPLICATION BY CREDITOR IN CASES OF UNDERVALUED TRANSACTION 

If the Liquidator or the Resolution Professional has not filed application for avoidance of Undervalued Transactions, a creditor, a member, or a partner of the Corporate Debtor, may file an application before the Adjudicating Authority to declare such transaction void and reverse their effect.

If the Adjudicating Authority, after examination of the application is satisfied that Undervalued Transactions have occurred  and Liquidator or the Resolution Professional after having sufficient information or opportunity to avail information of such transaction did not report such transaction to the Adjudicating Authority,  has to pass an order restoring the position as it existed before such transaction  and reversing the effects thereof in the manner as laid down in Section 45 and Section 48 and require IBBI to initiate disciplinary proceedings  against the Liquidator or the Resolution Professional as the case may be.

ORDER IN CASES OF UNDERVALUED TRANSACTION  

Under Section 48 of the Code the NCLT has wide powers to pass orders in cases of Undervalued Transactions. The NCLT can pass orders of following nature.

• Require any property transferred as part of the transaction to be vested in the Corporate Debtor
• Release or discharge (in whole or in part) any security interest granted by the Corporate Debtor
• Require any person to pay such sums, in respect of benefits received by such person, to the Liquidator or the Resolution Professional as the Adjudicating Authority may direct
• Require the payment of such consideration for the transaction as may be determined by independent expert

TRANSACTION DEFRAUDING CREDITORS  

Section 49 of the Code deals with transaction defrauding creditors.

This is special case of avoidance of Undervalued Transactions wherein Corporate Debtor has deliberately and intentionally entered into Undervalued Transaction with third party for keeping assets of the Corporate Debtor beyond the reach of the any person who is entitled to make a claim against the Corporate Debtor and to adversely affect the interest of such person in relation to such claim.

In such cases, the Adjudicating Authority may issue order restoring the position as it existed before such transaction as if the transaction had not been entered into and protect interests of persons who are victims of such transactions

Any such order will not affect any interest in property which was acquired from a person other than the Corporate Debtor and was acquired in good faith for value and without notice of the relevant circumstances or affect any interest, or affect any interest deriving from such an interest.

Any such order will not require a person who received benefit from the transaction in good faith for value and without notice of the relevant circumstances to pay any sum unless he was a party to the transaction.

EXTORTIONATE CREDIT TRANSACTION

Section 50 of the Code deals with Extortionate Credit Transaction. In cases, where the Corporate Debtor has been a party to Extortionate Credit Transaction involving the receipt of Financial or Operational Debt during the period within two years preceding the insolvency commencement date, the Liquidator or the Resolution Professional may make an application for avoidance of such transaction to the Adjudicating Authority if the terms of such transaction required exorbitant payments to be made to the Corporate Debtor. Look back period in case of extortionate credit transaction is two years for related parties as well as others.

Extortionate Transaction has been defined under CIRP Regulation 5. A transaction has to be considered extortionate where the terms require the Corporate Debtor to make exorbitant payments in respect of the credit provided and are unconscionable under the principles of law relating to contracts. The definition of extortionate transaction as defined in the CIRP Regulation 5 seems to a vague definition as exorbitant payment as well as unconscionable contract seems to be subjective expressions. Unconscionable contract has not even been defined under the Indian Contract Act, 1872.

Any debt extended by any person providing financial services which is in compliance with any law for the time being in force in relation to such debt shall in no event be considered as an Extortionate Credit Transaction.

ORDERS OF ADJUDICATING AUTHORITY IN RESPECT OF EXTORTIONATE CREDIT TRANSACTION

Where the Adjudicating Authority after examining the Application is satisfied that the terms of a credit transaction required exorbitant payments to be made by the Corporate Debtor, the Adjudicating Authority by order:

• restore the position as it existed prior to such transaction
• set aside the whole or part of the debt created on account of the Extortionate Credit Transaction
• modify the terms of the transaction
• require any person who is, or was, a party to the transaction to repay any amount received by any such person
• require any security interest that was created as part of the extortionate credit transaction   to be relinquished in favour of the Liquidator or the Resolution Professional

FRAUDULENT TRADING OR WRONGFUL TRADING

Section   66 and 67 of the Code deals with fraudulent or wrongful trading.

Section 66 (1) provides that  if  during the CIRP or  Liquidation Process, it is found that any business of the Corporate Debtor has been carried on with the intent to defraud creditors of the Corporate Debtor or for any fraudulent purpose, the Adjudicating Authority may on the application of the Resolution Professional or the Liquidator pass an order that any persons­ who were knowingly parties to the carrying on of the business in such manner shall be liable to make such contributions to the assets of the Corporate Debtor as it may deem fit.

Section 66 (2) provides that  on an application made by a Resolution Professional during the CIRP, the Adjudicating Authority may by an order direct that the a director or a partner of the Corporate Debtor, as the case may be, will be liable to make such contribution to the assets of the Corporate Debtor as it may deem fit, if  before the insolvency commencement date, such director or partner knew or ought to have known that there was no reasonable prospect of avoiding the commencement of a Corporate Insolvency Resolution Process in respect of such Corporate Debtor and such director or partner did not exercise due diligence in minimising the potential loss to the creditors of the Corporate Debtor.

A director or a partner of the Corporate Debtor will be deemed to have excercised due diligence if such diligence was expected of a person carrying out the same functions as carried out by such director or partner as the case may be in relation to the Corporate Debtor.

Under Section 67 of the Code, the NCLT has been given additional powers in cases of fraudulent or wrongful trading to pass orders.

While passing order under Section 66, the Adjudicating Authority may give further direction as it may deem appropriate for giving effect to the order. The Adjudicating Authority may provide for the liability of any person under the order to be a charge on any debt or obligation due from the Corporate Debtor to him or on any mortgage or charge or any interest in a mortgage or charge on assets of the Corporate Debtor held by or vested in him, or any person on his behalf, or any person claiming as assignee from or through the person liable or any person acting on his behalf and from time to time, make such further directions as may be necessary for enforcing any charge imposed under this section.

For the purposes of Section 66, “assignee” includes a person to whom or in whose favour, by the directions of the person held liable under clause (a) of the debt, obligation, mortgage or charge was created, issued or transferred or the interest created, but does not include an assignee for valuable consideration given in good faith and without notice of any of the grounds on which the declaration has been made.

While passing order under Section 66, the Adjudicating Authority by an order may direct that the whole or any part of any debt owned by the Corporate Debtor to the creditor and any interest thereon will rank in order of priority of payment under Section 53 after all other debts owed by the Corporate Debtor.

CONTINUATION OF PROCEEDINGS FOR AVOIDABLE TRANSACTIONS AFTER CIRP

There is confusion regarding continuation of proceedings for avoidance of transactions under Section 43, 45, 50 and 66. Delhi High Court in Venus Recruiters Pvt. Ltd² has held that avoidance applications relating of preferential and other transactions cannot survive beyond the conclusion of the CIRP.  Relevant Para is as under:

73. The prescribing of the above timelines has a purpose. The said purpose is that the RP includes these details in the Resolution Plan submitted under Section 30 to the NCLT. These details ought to be available before the NCLT at the time of approval of the Resolution Plan under Section 31. The argument that avoidance applications relating to preferential and other transactions can therefore survive beyond the conclusion of the CIRP is contrary to the Scheme of the Code.

The Insolvency Law Committee in its 5^th Report has recommended that a clarificatory amendment may be made to Section 26 so that the completion of CIRP proceedings do not affect the continuation of proceedings for avoidable transactions.

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1.Anuj Jain Interim Resolution Professional for Jaypee Infratech Vs. Axis Bank Ltd. Etc. Etc.; Civil Appeal No. 8512-8527 of 2019

2.Venus Recruiters Pvt. Ltd. vs. Union of India & Ors.;W.P.(C) 8705/2019