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.

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 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.

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.

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.

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.

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.

5. 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.

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.

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.

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).

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.

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