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Decoding Preferential Transactions Under The Insolvency And Bankruptcy Code

Sanjeev Kumar & Anshul Sehgal
21 May 2020 3:00 AM GMT
Decoding Preferential Transactions Under The Insolvency And Bankruptcy Code
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Black's Law Dictionary defines "preferential transfer" as "a prebankruptcy transfer made by an insolvent debtor to or for the benefit of a creditor, thereby allowing the creditor to receive more than its appropriate share of the debtor's assets".

Insolvency and bankruptcy laws across the globe, including the recently introduced Insolvency & Bankruptcy Code, 2016 ("IBC") in India, deals with preferential transactions. Such transactions are also known as 'voidable preference', 'liquidation preference', 'voidable transfers' or 'preferential assignments'.

It has been seen that, being privy to insider information, debtors tend to apprehend inevitable bankruptcy and enter into preferential transactions just prior to slipping into the red, in order to park valuable assets beyond the hands of creditors who would otherwise have a share in the liquidation of such assets, with either connected or unconnected entities.

One of the crucial factors which has been observed and is a commonality in the laws across the world is the 'time frame' which has been earmarked for detecting such transactions. The technical term for this being the 'look back period'. Though, the time period varies across countries, but the intent of the law has been very clear that the look back period is always a few couple of years just before the date that debtors are pushed into the clutches of insolvency.

IBC in India also operates on the globally accepted principles for identification and treatment of preferential transactions, which is enshrined under Sections 43[2] and 44 of IBC. While Section 43 of IBC lays down the essentials of establishing a preferential transaction under IBC whereas Section 44[3] of IBC lays down the extant of the orders which can be passed by the concerned adjudicating authority under IBC while dealing with preferential transactions.

Upon a bare reading of the concerned provisions, the intent of the Legislature has been to give the power of reporting such transactions to the Liquidator or the Resolution Professional of the corporate debtor. Thus, Section 43 of IBC appears to be extremely restrictive as it does not explicitly provide any other aggrieved person to report a preferential transaction. In a given situation, it might be the case where the Liquidator / Resolution Professional may derelict in their duties to report such preferential transactions, then in such a scenario, there should be the option for a creditor / aggrieved party to also approach the concerned adjudicating authority to report such preferential transactions.

This issue had come up before the National Company Law Tribunal, Ahmedabad Bench[4] whereby it was held that a creditor first ought to place relevant material alleging preferential transactions before the Resolution Professional and if the duty bound Resolution Professional fails to invoke the jurisdiction of the concerned adjudicating authority under Section 43 of IBC then the creditor would be entitled to approach the adjudicating authority.

This appears to be the correct approach which is based on the principle of 'Ubi jus ibi remedium' i.e. there is a wrong, there is a remedy. Thus, if any wrong has been committed then the law provides a remedy for that and any person will not suffer a wrong without a remedy as no wrong should be allowed to go without any compensation if it can be redressed by a court of law. Nonetheless, it is high time that the Legislature made the required amendment to this Section of IBC.

Coming to understanding the nuances involved in Section 43 of IBC; there are two set of conditions which have to made out for declaring a specific transaction as "preferential". Firstly, there ought to be a transfer for property and interest by the corporate debtor. This transfer should be specifically of such a nature that resulted in benefit of a creditor or surety or guarantor which is for an antecedent debt (financial or operational) or any other liability. Secondly, once the transfer has been carried out, it should be shown that in the event the corporate debtor was to be rendered into liquidation then the transfer made, has placed such a party in a beneficial position than it would have been in the liquidation process.

While Section 43(2) of IBC lays down the ingredients of proving a preferential transaction, the same can only be considered by the concerned adjudicating authority if it falls within the 'look back period' as provided under Section 43(4) of IBC. This provides for another distinction i.e. whether the concerned party involved for the transaction is a related party or not. If it is found to be a related party to the debtor, then the look back period is two years prior to the date of commencement of insolvency and if the concerned party is not a related party then the look back period being one year from the date of commencement of insolvency.

The IBC vide Section 5(24)[5] of IBC provides for an exhaustive definition of who falls within the meaning of being a 'related party' for the purposes of the IBC.

Thus, it is only when a transaction meets the tests laid down in the positive clauses i.e. Section 43(2) read with Section 43(4) of IBC, an action can lie against such preferential transactions. But, this not where the entire process ends, IBC provides for an escape route mechanism vide the negative clause i.e. Section 43(3) of IBC. Under the said provision, any such transaction which is alleged to be preferential, if shown to have been made in "ordinary course of business" or "routine affairs" or if due to any such transfer a security interest has been created in favor of the debtor which gives a new value to the concerned property and which is duly registered within a period of thirty days from the receipt, then such no action shall lie against such transaction, even if the deeming fictions under Sections 43(2) and 43(4) of IBC are satisfied.

Once, the alleged preferential transaction meets the deeming fiction requirements of Section 43 of IBC and pass the muster test of the exclusion clause, then Section 44 of IBC lays down the nature of orders which can be passed by the concerned adjudicating authority which are vast and extensive in nature. The adjudicating authority literally have been have been equipped with the power to unscramble the scrambled egg!

Considering the mischief and interplay of the deeming fiction and exclusion clause, the Hon'ble Supreme Court of India recently in a decision[6] ("Jaypee case") laid down the tests which need to answer for proving an alleged transaction to be a 'preferential transaction' within the ambit of the IBC which are:

"(i) As to whether such transfer is for the benefit of a creditor or a surety or a guarantor?

(ii) As to whether such transfer is for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor?

(iii) As to whether such transfer 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 being made in accordance with Section 53?

(iv) If such transfer had been for the benefit of a related party (other than an employee), as to whether the same was made during the period of two years preceding the insolvency commencement date; and if such transfer had been for the benefit of an unrelated party, as to whether the same was made during the period of one year preceding the insolvency commencement date?

(v) As to whether such transfer is not an excluded transaction in terms of sub-section (3) of Section 43?"

While examining certain transactions undertaken by the giant home developer infrastructure company, a very poignant question of law was posed by the debtor company, before the Apex Court in the Jaypee case. That, whether the look back period under Section 43(4) of IBC by its very nature can come into operation, at least one year after the enactment of the Code and or else, it would be giving retrospective effect to these provisions which is not permissible under law?

This line of argument was struck down by the Apex Court by relying on the underlying schemata of the IBC. It was observed that the intent of the Legislature behind Section 43 of IBC has been to reverse the unwarranted better position that the beneficiary of a preference acquires. It was held that the power to strike down preferential transactions was to ensure that any property which in likelihood would have been lost due to such a transaction is brought back into the pool of assets of the corporate debtor which may prove to revive the debtor or in the situation of liquidation, ensure pro rata, equitable and just distribution of its assets amongst all creditors as per the waterfall mechanism.

While analyzing the proposition placed before itself, the Hon'ble Supreme Court also observed that if the applicability of Section 43 qua the look back period was to be as per the date of commencement of IBC, then the results would be nothing short of a catastrophe. It was stated that if this line of approach was to be accepted, the end result would be of postponing the effective date of operation of Section 43 of IBC by two years in the case of related party and to one year in the case of unrelated party, and thereby, effectively postponing the application of entire Section 43 for a period of two years!

Now, whether certain parts of Section 43 of IBC can be a self-goal? In order to analyze this, it is necessary to delve into what constitutes as "ordinary" course of business transactions? If a transaction is found to have been made in the ordinary course of business, then irrespective of any of the ingredients of Section 43 of IBC having been made out, such transactions would never be put under the scanner. But could it be said that this was the intent of the Legislature by using such words in the statute? If this line of approach is to hold good, then it would amount to sanctifying almost every transaction that a corporate debtor would undertake as the interpretation of ordinary course of business could be a tool which in turn frustrates every transaction which comes under the scanner.

However, this issue also stands settled with the decision of the Apex Court in the Jaypee case whereby applying the principle of purposive interpretation, it was held that, "only by way of such reading of "or" as "and", it could be ensured that the principal focus of the enquiry on dealings and affairs of the corporate debtor is not distracted and remains on its trajectory, so as to reach to the final answer of the core question as to whether corporate debtor has done anything which falls foul of its corporate responsibilities." Thus, just by claiming a transaction to have been made in the "ordinary" course would not release the scanner over such transactions and will have to go through the rigors of testing as provided under Section 43 of IBC.

The entire rigors for preferential transactions under IBC, seem to be too cumbersome?

To conclude, in what appears to be a ready reckoner, the Hon'ble Supreme Court, in the Jaypee case, has laid down a step wise approach that the Resolution Professional or the Liquidator is required to undertake for reporting a preferential transaction action under the IBC. Though, this may be beneficial for resolution professionals under the IBC, however, it is our considered opinion that even adjudicating authorities and the appellate authority under the IBC should treat the following process as the bible for adjudication of preferential transactions under Section 43 of IBC:

  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.

  1. 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 of commencement of insolvency.

In the above two stages the concerned adjudicating authority under the IBC should ensure whether the resolution professional was diligent in performing its duties i.e. to segregate the transactions undertaken by the corporate debtor during the look period, either two years or one year, and then segregating them as per the applicability of, whether related party or not as provided under Section 5(24) of IBC. This is where in our considered Opinion and as held by the National Company Law Tribunal, Ahmedabad; the Legislature ought to bring about a suitable amendment that explicitly allows other stakeholders to also report transactions which are preferential in nature.

  1. 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.

The next stage clears out the division of categories to whom such alleged transactions have been made, by the debtor, which could potentially be tagged as "preferential" in nature and under the ambit of IBC.

  1. 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.

After the division of categories to whom the transactions have been made to, the next step entails finding out the purpose for which these transactions were undertake which would satisfy the checkpoints under Section 43(2) of IBC.

  1. In yet further step, such of the scanned and scrutinized 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.

  1. 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.

These are one of the most important stages while dealing with a preferential transaction, as to whether the transactions which have met the criteria under Section 43(2)(a) of IBC, if found to have put the concerned person with whom the transaction was undertaken, in a beneficial position than it would have been in the event of liquidation of the debtor, then such a transaction will be stamped as preferential, only if it passes the exclusionary clause under Section 43(3) of IBC in the next step.

  1. 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).

Thus, after having gone through the entire cumbersome and step wise procedure, if the transaction is not covered under the exclusionary clause of Section 43 of IBC, then the resolution professional / liquidator [and hopefully, other creditors / stakeholders, soon!] is bound to report such transaction to the concerned Adjudicating Authority, which shall judicially scrutinize the impugned transactions and accordingly adjudicate whether such transaction ought to be dealt with as per the mandate provided under Section 44 of IBC.

***



[1] The authors of this article, Sanjeev Kumar is a Partner and Anshul Sehgal is a Managing Associate in the Litigation and Dispute Resolution Group at L&L Partners Law Offices, New Delhi, India who specialize in Insolvency and bankruptcy matters. The views expressed are personal.

[2] Section 43. Preferential transactions and relevant time.

(1) Where the liquidator or the resolution professional, as the case may be, is of the opinion that the corporate debtor has at a relevant time given a preference in such transactions and in such manner as laid down in sub-section (2) to any persons as referred to in sub-section (4), he shall apply to the Adjudicating Authority for avoidance of preferential transactions and for, one or more of the orders referred to in section 44.

(2) A corporate debtor shall be deemed to have given a preference, if—

(a) there is a transfer of property or an interest thereof of the corporate debtor for the benefit of a creditor or a surety or a guarantor for or on account of an antecedent financial debt or operational debt or other liabilities owed by the corporate debtor; and

(b) the transfer under clause (a) has the effect of putting such creditor or a surety or a guarantor in a beneficial position than it would have been in the event of a distribution of assets being made in accordance with section 53.

(3) For the purposes of sub-section (2), a preference shall not include the following transfers—

(a) transfer made in the ordinary course of the business or financial affairs of the corporate debtor or the transferee;

(b) any transfer creating a security interest in property acquired by the corporate debtor to the extent that—

(i) such security interest secures new value and was given at the time of or after the signing of a security agreement that contains a description of such property as security interest and was used by corporate debtor to acquire such property; and

(ii) such transfer was registered with an information utility on or before thirty days after the corporate debtor receives possession of such property:

Provided that any transfer made in pursuance of the order of a court shall not, preclude such transfer to be deemed as giving of preference by the corporate debtor.

Explanation.—For the purpose of sub-section (3) of this section, "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 nor voidable by the liquidator or the resolution professional under this Code, including proceeds of such property, but does not include a financial debt or operational debt substituted for existing financial debt or operational debt.

(4) A preference shall be deemed to be given at a relevant time, if—

(a) it is given to a related party (other than by reason only of being an employee), during the period of two years preceding the insolvency commencement date; or

(b) a preference is given to a person other than a related party during the period of one year preceding the insolvency commencement date.

[3] Section 44. Orders in case of preferential transactions.

The Adjudicating Authority, may, on an application made by the resolution professional or liquidator under sub-section (1) of section 43, by an order:

(a) require any property transferred in connection with the giving of the preference to be vested in the corporate debtor;

(b) require any property to be so vested if it represents the application either of the proceeds of sale of property so transferred or of money so transferred;

(c) release or discharge (in whole or in part) of any security interest created by the corporate debtor;

(d) require any person to pay such sums in respect of benefits received by him Adjudicating Authority may direct;

(e) direct any guarantor, whose financial debts or operational debts owed to any person were released or discharged (in whole or in part) by the 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;

(f) 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 to have the same priority as a security or charge released or discharged wholly or in part by the giving of the preference; and

(g) 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 the 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 the preference:

Provided that an order under this section shall not—

(a) affect any interest in property which was acquired from a person other than the corporate debtor or any interest derived from such interest and was acquired in good faith and for value;

(b) 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.

Explanation I.— For the purpose of this section, it is clarified that where a person, who has acquired an interest in property from another person other than the corporate debtor, or who has received a benefit from the preference or such another person to whom the corporate debtor gave the preference,—

(i) had sufficient information of the initiation or commencement of insolvency resolution process of the corporate debtor;

(ii) is a related party, it shall be presumed that the interest was acquired or the benefit was received otherwise than in good faith unless the contrary is shown.

Explanation II. —A person shall be deemed to have sufficient information or opportunity to avail such information if a public announcement regarding the corporate insolvency resolution process has been made under section 13.

[4] Vitol S.A. vs. Asian Natural Resources (India) Ltd. and Ors. Order dated 06.11.2017.

[5] Section 5(24) "related party", in relation to a corporate debtor, means--

(a) a director or partner of the corporate debtor or a relative of a director or partner of the corporate debtor;

(b) a key managerial personnel of the corporate debtor or a relative of a key managerial personnel of the corporate debtor;

(c) a limited liability partnership or a partnership firm in which a director, partner, or manager of the corporate debtor or his relative is a partner;

(d) a private company in which a director, partner or manager of the corporate debtor is a director and holds along with his relatives, more than two per cent. of its share capital;

(e) a public company in which a director, partner or manager of the corporate debtor is a director and holds along with relatives, more than two per cent. of its paid-up share capital;

(f) any body corporate whose board of directors, managing director or manager, in the ordinary course of business, acts on the advice, directions or instructions of a director, partner or manager of the corporate debtor;

(g) any limited liability partnership or a partnership firm whose partners or employees in the ordinary course of business, acts on the advice, directions or instructions of a director, partner or manager of the corporate debtor;

(h) any person on whose advice, directions or instructions, a director, partner or manager of the corporate debtor is accustomed to act;

(i) a body corporate which is a holding, subsidiary or an associate company of the corporate debtor, or a subsidiary of a holding company to which the corporate debtor is a subsidiary;

(j) any person who controls more than twenty per cent. of voting rights in the corporate debtor on account of ownership or a voting agreement;

(k) any person in whom the corporate debtor controls more than twenty per cent. of voting rights on account of ownership or a voting agreement;

(l) any person who can control the composition of the board of directors or corresponding governing body of the corporate debtor;

(m) any person who is associated with the corporate debtor on account of--

(i) participation in policy making processes of the corporate debtor; or

(ii) having more than two directors in common between the corporate debtor and such person; or

(iii) interchange of managerial personnel between the corporate debtor and such person; or

(iv) provision of essential technical information to, or from, the corporate debtor;

(24A) "related party", in relation to an individual, means--

(a) a person who is a relative of the individual or a relative of the spouse of the individual;

(b) a partner of a limited liability partnership, or a limited liability partnership or a partnership firm, in which the individual is a partner;

(c) a person who is a trustee of a trust in which the beneficiary of the trust includes the individual, or the terms of the trust confers a power on the trustee which may be exercised for the benefit of the individual;

(d) a private company in which the individual is a director and holds along with his relatives, more than two per cent. of its share capital;

(e) a public company in which the individual is a director and holds along with relatives, more than two per cent. of its paid-up share capital;

(f) a body corporate whose board of directors, managing director or manager, in the ordinary course of business, acts on the advice, directions or instructions of the individual;

(g) any limited liability partnership or a partnership firm whose partners or employees in the ordinary course of business, act on the advice, directions or instructions of the individual;

(h) a person on whose advice, directions or instructions, the individual is accustomed to act;

(i) a company, where the individual or the individual along with its related party, own more than fifty per cent. of the share capital of the company or controls the appointment of the board of directors of the company.

Explanation.-- For the purposes of this clause,--

(a) "relative", with reference to any person, means anyone who is related to another, in the following manner, namely:-

(i) members of a Hindu Undivided Family,

(ii) husband,

(iii) wife,

(iv) father,

(v) mother,

(vi) son,

(vii) daughter,

(viii) son's daughter and son,

(ix) daughters daughter and son,

(x) grandson's daughter and son,

(xi) granddaughters daughter and son,

(xii) brother,

(xiii) sister,

(xiv) brother's son and daughter,

(xv) sister's son and daughter,

(xvi) father's father and mother,

(xvii) mother's father and mother,

(xviii) father's brother and sister,

(xix) mother's brother and sister, and

(b) wherever the relation is that of a son, daughter, sister or brother, their spouses shall also be included;.

[6] Anuj Jain Interim Resolution Professional for Jaypee Infratech limited v. Axis Bank Limited etc. Judgment dated 26.02.2020. 2020 SCC OnLine SC 237.

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